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April 20, 2005

Hard Landings...

Three Views on Hard Landings

Mark Thoma channels Paul Krugman:

Economist's View: Krugman: No Good Monetary Policy Options in a Hard Landing: In his most recent column, Paul Krugman asks the... question:

In the 1970's soaring prices of oil and other commodities led to stagflation - a combination of high inflation and high unemployment, which left no good policy options. If the Fed cut interest rates to create jobs, it risked causing an inflationary spiral; if it raised interest rates to bring inflation down, it would further increase unemployment. Can it happen again?... We shouldn't overstate the case: we're not back to the economic misery of the 1970's. But the fact that we're already experiencing mild stagflation means that there will be no good options if something else goes wrong...

Thus, in a hard landing, Krugman says "there will be no good options." But the Fed will need to do something. What should the Fed do in a hard landing? Raise rates? Lower rates? I believe a recession will put the brakes on inflation, and if underlying real factors are the cause of inflation, aggregate demand policy isn't an effective tool for overcoming such shocks. Thus, I would lower rates in response to a slowdown if that were possible. But that is predicated upon the output slowdown counterbalancing inflationary pressure from other sources, and the possibility of lowering interest rates enough to stimulate the economy.

All of these questions would be much easier if both monetary and fiscal policy hadn't already been used to such an extent. With deficits as high as they are, using fiscal policy to stimulate the economy is politically and economically infeasible, and with interest rates this low it's hard to get much stimulation from driving them even lower. They can't go much lower in any case, though interest rates could be raised if the Fed decides to tighten in reponse to a stagflationary episode. Thus, the result of recent monetary and fiscal policy may be increased vulnerability to negative output shocks and a stagflationary episode.

William Polley flies airplanes:

William J. Polley: April 2005 Archives: I don't think I've defined what I think of as a hard/soft landing yet, so here goes. I am a licensed (but currently inactive) pilot.... When a new pilot makes a hard landing, it's usually because he or she thought the runway was about a foot higher than it really was.... Do it a few more feet up an you might bend the landing gear.... The another kind of hard landing is coming in too fast and slamming into the ground.... As long as you correct for it before you hit the runway, you might save the upholstery, but probably not your pride.... Last but not least is the hard landing that just happens. Everything is perfect and then the wind changes. It's like someone suddenly dropped you towards the ground....

What's my point? I remember when the term soft landing started to be used to describe what the Fed did in 1994-95. I liked the term because it seemed to describe in familiar aviation style terms what was happening. The changes in interest rates in 1994-95 were like the corrections that a pilot makes when coming in to land.... When things change at the last minute, things can indeed get dicey for both pilots and central bankers. You don't want to use all of your ability to control the situation until you really are safe on the ground. That is Mark's point, and it is a correct one--for pilots and central bankers.... A soft landing is stable inflation and unemployment at sustainable levels in the maturing phase of an expansion. You'll know it when you feel it (or don't feel it, as the case may be)...

And Brad Setser:

Brad Setser's Web Log: Martin Wolf, Korea's Central Bank, and Collateralized Debt Obligations: As Martin Wolf notes, Asia's current account surplus (savings surplus) shows up in the phenomenal growth in Asian central bank reserves.... Martin Wolf's excellent essay takes a lot of themes that we have discussed here, and pulls them together into a coherent picture. In my view (no doubt biased, since he cites Roubini), Wolf gets all nuances right.... It is vitally important to move over time to more balanced and healthy economic relationship. Yet extricating the US and East Asia from their current unhealthy and unbalanced embrace will require a rather delicate touch -- something the Bush Administration is not noted for.... The best evidence that the current situation is unsustainable? The current flow of private capital. To sustain current account deficits of its current magnitude, all of the world's surplus savings (the global current account surplus) needs to flow to the US. Yet private investors are putting a lot of their money in emerging Asia, not to the US.... Wolf correctly notes 'the private sector has been trying to push emerging market economies into current account deficit.' Asian central banks, however, are getting in the way. They are taking the funds flowing into Asia, along with Asia's own excess savings, and investing them in the US, making it possible for the US to get away with next-to-no household savings and a structural budget deficit....

Look at the Wall Street Journal's examination of the dilemmas facing Korea's central bank on Tuesday (p. C1). There are two reasons why Korea is less comfortable adding to its already substantial reserves than China. First... if the central bank is borrowing in won to invest in depreciating dollars, it has to explain itself. Second, Korea has to pay more to 'sterilize' its reserve inflows... on a cash flow basis, the Bank of Korea paid more in interest on its sterilization bonds than it earned on its reserves.... Losing money on every dollar of reserves makes you think twice about adding to your reserves....

We are in uncharted territory ... if a crisis hits, we think the market will absorb shocks smoothly -- but the truth is no one knows. I don't necessarily take comfort in the fact that 'real money' types are buying the safe parts of the CDOs, while hedge funds and other leveraged types are buying the risky parts. I worry that already leveraged hedge funds are buying instruments that themselves sometimes have a lot of embedded leverage. It may be that the hedge funds really do know how to hedge their risks, and thus are not as exposed as it would seem. But big risks are sometimes taken by investors looking for high returns to justify high fees in an environment where there is less and less easy money to be made....

Posted by DeLong at April 20, 2005 09:18 PM