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April 13, 2005

Our Twin Financial Puzzles: The Long Run May Come Like a Thief in the Night

The fact that nobody inside the administration is paying attention to the current drift of the economic ship of state closer to the shoals is one big reason that we need a really strong Treasury Department and a really strong Federal Reserve:

Brad Setser http://www.roubiniglobal.com/setser/archives/2005/04/economy_strong.html: Economy strong (for now), fiscal deficit not falling (by much): I have always thought the argument that attributed the widening trade deficit to the absence of growth abroad was a bit deceptive... growth abroad has been quite strong.... Europe and Japan have lagged, but much of the rest of the world -- including China -- has been growing like gangbusters. The problem... is... the composition of the growth -- strongly driven by exports. This global growth has been strong enough... to generate extremely good times for any exporter of natural resources....

The same argument holds for the US fiscal deficit. The US economy continues to grow at a nice clip. A strong economy usually leads tax revenues to grow.... Revenues, according to the CBO, are up 10.3% y/y.... Spending, though, is also rising: it is up 6.7% y/y. The CBO estimates the six month fiscal deficit for FY 05 to be $291 billion, $10 billion below the FY 2004 deficit. Remember, we spend more than we collect in taxes, to tax revenues have to increase much more than spending (in percentage terms) to reduce the deficit....

The Bush Administration now likes to talk about its intention to reduce the budget deficit, particularly at international meetings. But I still don't see any evidence that they are willing to do more than talk about reducing the budget deficit. Expect more rhetorical commitments from the Bush Administration around this weekend's G-7 meetings, but no greater willingness to act.

The optimists--inside the administration and out--about the current financial situation have only one economic argument: long-term interest rates are relatively low, and are not pricing the dollar-collapse and the U.S.-interest-rates-spike scenarios as having any substantial probability at all.

The pessimists on Wall Street are puzzled at why this economic argument is supposed to have force. From their perspective, demand for long-duration dollar-denominated securities is high because the Asian central banks are buying as if there were no tomorrow in order to keep the value of their currencies down, the U.S. Treasury is borrowing short (it is not issuing that many long-duration securities), and U.S. companies are cautious and are not undertaking the kinds of investments that would lead them to issue lots of long-duration bonds.

We economists respond by saying that for every market mispricing there is an open profit opportunity: if long-term interest rates are indeed too low--if long-term bonds are indeed priced too high--there is money to be made by shorting long-term U.S. bonds, parking the money in some other investment vehicle that is not underpriced, waiting for bond prices to return to fundamentals, and then covering your short position. People will try to profit from trades like this, and in so doing they will push prices close to fundamentals today.

But the Wall Street types have a counterargument: For any one financial institution to make the international bet--to bet on the decline of the dollar against the yuan over the next five years in a very serious, leveraged way is to put its survival at risk should the trades somehow go wrong. And trades do go wrong: remember the collapse of LTCM. The riskiness of the bets is magnified by the existence of very large actors in the financial markets that are not in the business of maximizing their profits: if the Bank of China and the Federal Reserve decided that they wanted to teach speculators a lesson and push the value of the dollar relative to the yuan up for 20 percent for a month and see how many financial institutions with speculative positions that would bankrupt, they could do so. Similarly, for any one financial institution to make the domestic bet--to bet on a serious rise in long-term interest rates over the next five years in a very serious, leveraged way is also to put its survival at risk. For where do you park your money? Real estate rental yields and stock market payout yields are very low, and real estate and stock prices may well fall as much as or more than bond prices if interest rates spike. The only organizations that can make the domestic bet that interest rates will rise are businesses that can borrow long-term now, lock in a low real interest rate, and invest in expanding their capacity. But America's businesses see enough real risk in the future that they do not want to build up their capacity by any more than they are currently doing.

We economists believe that market forces drive prices to fundamentals. But we are not careful enough to distinguish situations in which equilibrium-restoring forces are strong from those in which equilibrium-restoring forces are weak. At the moment those forces are weak. And this adds an additional danger: at any moment those forces may become strong.

The long run in which the dollar falls and U.S. long-term interest rates rise may come like a thief in the night as a very sudden shock. If it comes as a sudden shock rather than as a long, slow, gradual realization, it will come on that day when the gestalt of the players on Wall Street and elsewhere changes, and when they collectively regard holding dollars as the more risky rather than the less risky strategy in the short run, when they collectivley regard being long long-term U.S. Treasuries as the more risky rather than the less risky strategy in the short run. On that day the long run future will be, as football coach George Allen used to say, now.

When will that day come? Tomorrow? Next month? Next year? On January 21, 2009? A decade from now? We macroeconomists who believe in financial market equilibrium have, today, a certain similarity to Millenniarists: our models of when The Day will dawn are not much better than the models of those who base theirs on a rule that transforms HILLLARY RODHAM CLINTONN into the number 666.

Should that day come, keeping a financial crisis from becoming a major disaster may well require swift and rapid action by a Federal Reserve and a Treasury Department that have powerful and unconditional White House and Congressional support. Mexico in 1995 had a recession that only reduced Mexican GDP by six percent. That "only" is the result of Bill Clinton's backing his economic policy team when they said that supporting Mexico was the thing to do--even though others in the room were making sure that he was well aware that money loaned to Mexico in the crisis might well not come back. That "only" was a near-run thing: Senator Dole let Senator D'Amato slip his leash, and D'Amato came remarkably close to doing major damage both to Mexico in 1995-1996 and to East Asia in 1997-1998.

Remember that Alan Greenspan is supposed to retire next January. What is the scenario by which competent technocrats--in the Treasury or the Federal Reserve--manage to climb to a position in which this White House and this congressional leadership of Bush, Frist, Hastert, and Delay will give them the baton to handle as they think best whatever financial crisis may appear in the next several years?

Posted by DeLong at April 13, 2005 11:51 AM