Hard versus Soft Landing

Nouriel Roubini and David Altig debate the likelihood of a hard versus soft landing for the US’s financial imbalances in today’s WSJ econoblog. For those who aren’t familiar with the arguments, let me try to boil them down a bit. I think that Roubini’s hard landing scenario can be summarized as this:

  • The US current account (CA) deficit is being primarily funded by Asian central bank (CB) lending to the US, and is primarily driven by the US government’s budget deficit.
  • The enormous and growing CA deficit can not keep growing forever, and is probably unsustainable even at current levels. So at some point those Asian CBs will decide to stop lending additional funds to the US. They do not have to dump their current dollar assets to cause a crisis; simply stopping the accumulation of new dollar assets will suffice to cause difficulties.
  • When that happens, the US CA deficit must necessarily fall by a (roughly) similar amount over a short period of time. The only way that that can happen, particularly given continued US government deficits, is for a sharp fall in the dollar, a sharp rise in interest rates, a sharp fall in asset values, a sharp fall in consumption, and a large rise in US saving.

On the other hand, David Altig is relatively sanguine. He agrees that the CA deficit is unsustainably large, and that US fiscal policy is problematic. However, he makes the following points when arguing for a soft landing:

  • Foreign sources of funding won’t suddenly dry up. Asian CBs are not the only source of funds for the US; if they slow their lending to the US, then private foreign investors will step in as US interest rates rise and the dollar falls, making the net change in foreign lending quite gradual. Furthermore, foreign lenders will have a hard time finding investments (of similar riskiness) that pay as well as those in the US.
  • If foreign funding just slows gradually, there’s no cause for alarm. There will just be a gradual depreciation of the dollar, gradual rise in interest rates (and perhaps prices), and this will naturally reduce the US’s CA deficit by encouraging less consumption in the US. There’s no reason to think this adjustment needs to happen rapidly. Furthermore, it’s entirely possible that the US’s budget deficit will improve over the medium-term, making the adjustment happen even more smoothly.

It seems to me that there are a couple of important unresolved questions that hold the key to understanding which scenario is more likely. The first is this: how important is Asian CB lending to the US? If it were to fall or disappear, would that require a major change in the CA balance, or would other capital flows be enough to require only a small change in the CA balance? In an excellent post the other day Brad Setser argued that Asian CB lending is indeed the dominant source of funding for the US’s CA deficit. He took issue with the argument recently made by Ragu Rajan (of the IMF) that Asian CB lending is not of crucial importance to determining how the US’s CA deficit is financed.

The second unresolved (and probably unresolvable) question is this: assuming that Asian CB lending to the US is indeed a crucial determinant of the US’s CA deficit (see #1 above), will it be in the best interest of Asian CBs to stop lending additional funds to the US any time soon? The costs to those CBs of additional lending to the US are large: enormous potential capital losses when the dollar depreciates, growing inflationary pressures in their home countries (perhaps particularly in asset markets), and heightened protectionist pressures in the US.

But the costs that Asian CBs will incur if they stop lending to the US could be even greater: the sharp fall in exports to the US that would surely happen, a likely sudden rise in domestic interest rates, the crash in asset prices that would probably follow… all of which would make a recession — possibly a rather severe one — quite likely. Right now these costs are apparently greater than that aforementioned costs of continued lending to the US.

Is it likely that this calculus will ever change? I’ve generally been in the hard landing camp on this issue, but on this last question I’m not so sure. It seems entirely possible to me that the enormous downside risk of recession, asset price depreciation, and domestic economic dislocation could well outweigh any other consideration for a long time to come. If so, then Asian CBs will have every reason to only very gradually taper off their additional lending to the US — gradually enough to ensure that the hard landing scenario never happens.