Over the past week or so I’ve been thinking about the merits of the two competing scenarios that I spun out for you last week: the soft landing versus the hard landing for the US’s CA imbalance. After playing around with some simple spreadsheet models of the US’s national accounts, here are some of my conclusions:
1. Even a gradual fall in the US’s CA deficit to a “modest” 4% of GDP by 2009 (as I described in my soft landing scenario) will require a rise in personal savings rates from about 1.5% today to about 4% in 2009.
2. Such a gradual fall in the CA deficit also implies that (a) the US’s marginal propensity to import falls noticeably, and/or that (b) the US export growth rate rises to about 7-9% per year for three or four years in a row.
3. Changes (1) and (2) will not happen by themselves. In fact, it’s hard for me to see why they would ever happen except in response to significant changes in US interest rates (and other asset prices) and the dollar exchange rate. I am not convinced that a slow and moderate rise in interest rates would be enough to cause such a dramatic change in savings behavior in the US, or that a gradual dollar depreciation would be enough to cause such a sustained boom in exports.
4. The soft landing scenario assumes that Asian CBs maintain the BWII system to keep the dollar from weakening rapidly. But it would be extremely difficult for them to allow the dollar to weaken gradually. The history of gradual fixed-exchange rate realignments is not good. That’s because a small change in a fixed exchange rate typically leads to increased speculative flows, not decreased speculative flows, which means that the fixed exchange rate becomes even more expensive to maintain than it was before. So a gradual depreciation of the dollar is a feat that I doubt the Asian CBs (or anyone else) could achieve.
5. Hence, the soft landing scenario, in which the BWII system continues, the US dollar does not fall, and interest rates rise only moderately, will not bring about a gradual improvement in the US’s CA deficit. The Asian CBs can keep BWII going for a while longer, if they want… but the US’s CA deficit will not fall on its own if they do so. And so they will have to be willing to keep BWII going in the face of US CA deficits of 5, 6 or 7% of GDP for the foreseeable future. Rather than a soft landing for the US CA deficit, that scenario really contains no landing at all.
So after spending a week thinking hard about the plausibility of the soft landing scenario, I just don’t find it believable. No, I think I’m back to my original opinion here: the US’s CA simply will not adjust without significant price changes: higher interest rates, lower asset prices, and a weaker dollar. Due to the nature of international financial speculation, I fear that it will be impossible for such price changes to take place gradually. So those price changes will not happen gradually, but instead will happen quickly. And rather painfully, I fear.