A Tale of Two Landings: Part I
The best of times, or the worst of times: what will the US’s eventual current account (CA) adjustment entail?
As some of you have perhaps deduced by now, I have bravely staked out a position of indecision about whether I find the hard landing scenario or the soft landing scenario more compelling. As I alluded to in my last post on this subject, in the past I have generally argued that the US’s CA adjustment will be sharp and painful (see here for an example). But recently, as I’ve slightly rephrased the relevant question to myself (“Will Asian CBs ever find the cost of maintaining BWII to be larger than the very significant costs they will incur if they end BWII?”), I’ve come to wonder if the soft landing scenario isn’t more likely than I had previously thought.
So partly as a way to see how convincing each scenario really is, let me test them out by constructing a possible story for each one. First comes the story of the soft landing; in the next post (below) the hard landing will rear its ugly head. You can decide which part of my tale you find more compelling.
The Soft Landing
Relatively strong growth in the US propels this year’s CA deficit to around $750bn, or over 6% of GDP. Yet private capital flows into the US slow because of fears of further dollar depreciation. Asian CBs must therefore buy even larger quantities of dollar assets in 2005 than they did in 2003 or 2004. However, they continue to choose to do so because they calculate that the cost of not doing so is even greater.
Gradually, as US interest rates continue to rise in 2005 and 2006 and the long-awaited dollar depreciation still fails to materialize, private capital flows to the US pick up, allowing Asian CBs to slowly reduce their dollar accumulation. There may be some gradual depreciation of the dollar, but so long as the big Asian CBs keep affirming their fundamental support for the dollar then such depreciation would be limited and orderly.
Simultaneously, higher interest rates in the US cause the US economy to gradually slow. The US’s housing market will cool, imports will become more expensive, and households will do less consumption and more saving (including repayment of debts). The US government’s budget deficit will also gradually improve as a percent of GDP, even under pretty pessimistic assumptions about future tax and spending changes.
Within a few years, say by 2008, the end to the housing market boom and higher interest rates will have slowly pushed the US’s household savings rate from around 1% today to perhaps 2.5-3%. Over the same period, the budget deficit will have improved from about 4% of GDP today to perhaps 2.5% of GDP by 2008. These are not dramatic changes when spread over three or four years, but they may be enough. Absent a major boom in business spending, the US’s national borrowing needs will have eased to a relatively modest 3% of GDP from over 6% today. A CA deficit of that size should be easy to finance purely from private sources, particularly with higher US interest rates, and so by then the Asian CBs will be able to slowly unwind their dollar positions and shrink the pile of their dollar reserves to a more reasonable level, if they so desire.
What about the things that could go wrong with this story? For example, suppose that one of the smaller Asian CBs defects from the de facto BWII cartel. This would almost certainly send a tremor through international financial markets, and lots of international investors who have dollar assets would try to sell them. In addition, the defecting CB may be selling dollars. The dollar will surely depreciate, possibly dramatically, against the defecting country’s currency. There would also be some upward pressure on US interest rates.
However, the larger Asian CBs (i.e. Japan and China) will still have an incentive to keep the system stable, and will still have the means to do so. They can still buy enough additional dollars to keep their own exchange rates steady. Note that they have a literally unlimited ability to do so, since there’s no limit to the amount of domestic currency they can issue to buy dollars. Yes, such an event would raise the cost to them of maintaining the BWII system – in particular, the money supplies of China and Japan would have to grow faster than they would have otherwise – but it’s not self-evident that this would be enough to change their decision.
What if some other event causes private investors to dump (or start shorting) dollars en masse? Again, the Asian CBs face no limit in how many dollars they can buy, and this will put a floor under the dollar that will curtail speculation against the dollar. After all, the CBs have the ability to be long in the dollar in greater quantities and for longer than individual investors can short the dollar. Yes, if massive numbers of private investors all moved simultaneously against the dollar, the amount of dollars that the Asian CBs would have to accumulate in a short period of time could be breathtaking. But they could still do it – and as soon as that becomes apparent, lots of private investors will start betting that the short-sellers will be wrong, making CB action less necessary.
When all is said and done, what does this soft landing scenario imply? 1) A couple of years of somewhat high interest rates in the US. 2) A few years of modest economic growth in the US, but no outright recession. 3) A gradual depreciation of the dollar, much as the dollar has experienced on average over the past 35 years. 4) A slow but steady improvement in the US’s CA deficit as a % of GDP, as US import growth slows. 5) Net foreign debt that rises to 40-45% of GDP by 2008 or 2009 (from close to 30% today), but then more or less levels off. 6) Continued economic growth in the Asian economies. This is welcome in Japan, less so in China… but even in China this is still preferable to the alternative, which is a contraction and possible severe economic dislocation.
Now let me add my disclaimers. I’m still not quite convinced by this soft landing scenario. It seems quite possible… but there are a few necessary conditions and assumptions embedded in the story above that I’m somewhat skeptical of. You can judge those for yourself. Tell me what’s wrong with my soft landing story. And then read part II of this tale, which follows immediately below.