And now for the other, darker side of my tale: the hard landing for the US’s CA imbalance. I envision the hard landing to be triggered by some sort of shock to the system. One of the problems with the soft landing story is that there are many, many different possible shocks to choose from – some economic and some political – all of which could jeopardize the BWII system. Without specifying the initial shock, here’s what I imagine all of those hard landing scenarios would have in common.
The Hard Landing
For whatever reason, international investors start to think that the dollar will finally fall against the major Asian currencies, presumably because the BWII cartel is seen to be breaking up or losing its resolve. Private investors start to dump dollars en masse. Contrarians who are willing to bet that the Asian CBs will continue to maintain the BWII system are few and far between, so that the only major buyer of dollars left in the market are those Asian CBs. The quantity of dollars that they must buy is enormous: tens of billions of dollars per day is not out of the question.
The Asian CBs blink. They balk at the prospect of such massive intervention. They realize that if they don’t intervene there will be severe consequences… but for whatever reason they don’t have the stomach to buy dollars on such a massive scale. So they stop buying dollars altogether.
As a result, the dollar drops against those Asian currencies. It drops far and fast – perhaps a 30% depreciation, perhaps more, in a matter of days. Interest rates on US bonds rise just as fast, perhaps by a full percentage point, perhaps more. Around the world, stock markets fall just as fast as interest rates rise.
Thanks to suddenly expensive imports, there’s a spike in US inflation. Business and consumer confidence plummet, business investment spending dries up, house prices begin to fall, consumers curtail their spending, and the US economy screeches to a halt. A recession ensues. Recessions also grip many of the Asian economies, due to their own higher interest rates and sharply lower US imports of Asian goods.
Note that higher interest rates in the US and the end of the danger of a major dollar depreciation will probably entice private investors back into US assets before too long, so that the US will still be able to obtain a sizeable amount of foreign lending. In that sense, markets will do what they typically do, and as a result the US CA deficit will not need to disappear overnight. But it will shrink, and rather rapidly, as consumption falls in the US.
So what do I envision as the end results of this hard landing scenario? 1) Interest rates in the US will move sharply higher over a period of days or weeks. Stock markets decline substantially as a result. 2) The dollar will depreciate by a substantial amount against the major Asian currencies. 3) Inflation in the US will jump upward very quickly, though perhaps only temporarily. 4) Household wealth in the US will fall significantly, due to the falling stock market and the bursting of the house price bubble. 5) The US economy will experience a rather sharp contraction, which I imagine to be deeper than either of the past two recessions… perhaps similar to the 1974-75 recession triggered by the first oil shock. 6) As households quickly retrench and reduce consumption, US imports fall, causing a fairly rapid fall in the US CA deficit over the course of a year or two. 7) Most of the Asian economies will also experience recession, with particular economic dislocation in their export industries.
Needless to say, this is not a happy story. But that has never really been in doubt. The important questions are this: is it a plausible story, and is it a likely story? Are the implicit assummptions and conditions that make this story possible more realistic than those in the tale of my first landing? In trying to answer that question I come back, again and again, to the crux of the matter: what will the two big Asian CBs do if confonted with suddenly increased pressure on the dollar?
I still find the answer to that question to be elusive.