Saturday, August 12, 2006

Pearlstein and Taggart on the "soft landing" scenario

Steven Pearlstein, one of my favorite columnists, wrote a good piece this week laying out the risks which the US faces in the global finance system (one of my favorite topics). Directly below I give a citation and some extracts. Still lower down I've added further information from a long article (by R. Taggart Murphy, Professor, Graduate School of Business Sciences, University of Tsukuba, Tokyo) which treats the same topic from a different point of view.

Both articles restate cautions issued by the International Monetary Fund (and many other reputable sources) over the past few years. (I'm particularly partial to the analyses of Raghuram G. Rajan, the head of the IMF's research department, who, like Pearlstein and Taggart, writes to be understood not to impress.)

Pearlstein expresses the risks for Americans in terms of twin evils: slow growth and creeping inflation. Taggart reminds us that the most likely long-term scenario has the Chinese Yuan replacing the Dollar as the world's hegemonic currency, with the result that Americans will no longer be able to count on foreigners to finance their hyper-consumerism and government overspending (of course) but also with the result that Americans will be much less able to purchase imports or make foreign investments using their Dollars. They will have to use foreign currencies (Yuan and Euro mostly). And this will push up the cost of imports, bankrupting thousands of Americans who now depend upon cheap imports to make ends meet, forcing up the price of oil imports even higher than we can now imagine, putting American business under enormous pressure, generating rampant inflation (perhaps), and much more. In short, the scenario results in the decline of the US to a second-class power -- like the EC if we're lucky. The questions no one can answer are (a) whether China will be able to make an orderly transition from unbalanced (export-dependent) to balanced (able to sustain growth through internal consumption along with exports) and (b) whether the unravelling of the Dollar-dominated global finance system will be gentle or catastrophic.

The Fed Pause That Refreshes? Hardly.
By Steven Pearlstein
Washington Post, Wednesday, August 9, 2006; Page D01

Over the next two or three years, the U.S. economy is in for a period of uncomfortably slow growth and uncomfortably high inflation, and there's little the Fed can do to prevent it.

This is not the story the Fed or the financial markets want to hear. They've convinced themselves that by slowly and steadily raising short-term interest rates over the past two years, the Fed can engineer a "soft landing" for the economy

So what's wrong with the soft-landing scenario? Plenty.

there is too much cheap money sloshing around the global financial system.

This excess liquidity began to develop in 1998, when the Fed and other central banks pumped money in response to the Asian financial crisis. They did it again in 2001, after the bursting of the stock-market bubble, and again in 2003, as a defense against Japanese-style deflation.

During the last two years, the Fed has tried to sop up some of that excess liquidity by raising the short-term interest rates under its control. But to a surprising degree, those efforts have been thwarted by China's central bank, as it has sought to keep the yuan pegged to the value of the dollar.

By printing up yuan to buy all those extra dollars earned by Chinese exporters -- and then investing those dollars in U.S. Treasury bonds -- the People's Bank of China has effectively been adding to the global money supply and pushing down interest rates, even as the Fed has been struggling to do just the opposite.

But in simple terms, it means that, along with shoes and toys and auto parts, an overheated Chinese economy is now exporting inflation to the United States. This is reducing the Fed's ability to manage the U.S. economy.

For years, economists have warned that the United States cannot continue to live beyond its means by running large and persistent trade deficits. At some point, the piper must be paid. And that point is upon us. We will either pay the price through slower growth or higher inflation, or, as now seems likely, through a combination of the two.

Ultimately, both will have the same effect, lowering our standard of living until the global economy comes back into rough balance. Pause or no pause, the Fed's task is not to forestall that needed adjustment, but to see that it happens in as orderly a fashion as possible.

Here's a citation and extracts from the other article on this topic, expressed mainly from the Japanese viewpoint:

EAST ASIA’S DOLLARS, by R. Taggart Murphy {Same article in one pdf file is here.}

Americans have long been warned that running large, continuous deficits courts disaster.

With beleaguered Republicans dependent on low taxes and government largesse to remain in power, and Democrats unelectable on an explicit programme of higher taxes and spending cuts, [experts have seen] no plausible scenario other than a dollar crash for any reversal in the ever-growing-deficit trends.

At some point, the foreigners who help finance the [trade and budget] deficits would surely refuse to throw more good money after bad. They would dump their dollar holdings, leading to a crash in the dollar that would finally force Americans to live within their means.

But none of this has happened. The markets reacted to the doom-saying with the insouciance of a dog shaking itself dry. By the end of 2005 the dollar stood 15 per cent higher against the euro, 13 per cent higher against the yen, than it had in January; and this during a year when both government and trade deficits continued to set new records practically every month.

Hence the conundrum: the savviest observers pronounce the trend lines of the deficits to be unsustainable; no realistic scenario can be imagined under which those trends will be reversed through political action, leaving only a dollar crash to do the job; yet the dollar crash stubbornly refuses to occur.

China ... hopes that, if and when the dollar-centred global financial regime unravels, it will have an economy sufficiently developed to permit the yuan to take its place among the world’s major currencies without the need for external backing that the country’s dollar reserves currently provide. That will allow it to deal with the collapse in American purchasing power when the us is finally forced to live within its means.

Forecasting that collapse is, however, devilishly hard; and there can be no assurance that markets will wait politely until the Chinese financial system is sufficiently robust to cope with the fallout. For markets are jittery everywhere; their fears almost endless. Renewed inflation in the United States, an unseasoned Federal Reserve chairman who has yet to confront his first real crisis, a politically crippled Bush administration, the implosion of the us housing bubble; all on top of spiking commodity prices, the ever-present threat of calamitous disruption to the flow of petroleum by events in the Middle East, the galloping us trade and government deficits, and indeed worries over the Chinese financial system—any one of these, or yet something else, could trigger a panicked flight from the dollar that would overwhelm the ability and willingness of the East Asian central banks to contain the flood.

The collapse of the dollar will take with it American hegemony; the United States will be hard-pressed to sustain its global military reach in a world where it must earn euros or yen to pay its foreign creditors rather than fob them off with more us government paper. No matter what form it takes, the end of American hegemony will bring the return of the central Japanese political question—the right to rule—with a vengeance; particularly so because it may well be accompanied by serious upheaval in Japan’s most important neighbour. There is no obvious present substitute for the American market in providing the engine of demand to sustain the kind of growth China needs in order to manoeuvre its way past the ever-looming threat of a domestic financial crisis, unless it were to be Japan itself.

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