Wednesday, June 30, 2004

Columnist Watch: Bruce vs. Economist

This is an article that I found via Kevin Drum's site, on National Review Online. Kevin vouches for the honesty of the guy. The article discusses the upcoming budget crunch and the role of foreign debt in it.

If the Fed is able to keep to a gradual pace of tightening, financial markets should be able to adjust without trouble. But there is always the danger that mistakes will be made or that unexpected circumstances may arise that will trap the unwary and create a crisis situation. Among those risks are these:
Fannie Mae and Freddie Mac are now such huge players in the mortgage market that their combined debt is close to $3 trillion, as millions of Americans have refinanced their mortgages to take advantage of low interest rates and rising housing prices. This also means that even the tiniest mistake by these organizations could have massively disruptive effects on financial markets.

The U.S. is becoming more and more dependent on foreign capital inflows to finance the federal debt and domestic investment. Indeed, foreigners now own more than 50 percent of liquid Treasury securities. Even a slowdown in foreign Treasury purchases, perhaps due to fears of a fall in the dollar, would also be massively disruptive.

Among the largest purchasers of Treasury securities has been China, whose economy has been booming. But some analysts now believe that the Chinese bubble may soon burst, just as the telecom and dot-com bubble of the late 1990s burst here. That could force the Chinese to stop buying Treasuries and start selling them. Once again, this would be massively disruptive.

The result of any of these scenarios would be a sell-off in the stock and bond markets as great as or greater than the stock market crash of 1987. At that point, policymakers will be forced to adopt a significant deficit-reduction program. They will have no choice, because it will be the only policy action in their power to take and they will be strongly pressured to do so by the overwhelming force of public opinion.

The package will have to reduce the deficit by at least two percentage points of GDP annually to meaningfully affect financial markets and restore confidence, and it is unrealistic to think that this can all be done on the spending side. Therefore, taxes will be on the table.

As Stirling Newberry of BOP-news has point out, we have some big debt service problems coming up. We have added several trillion dollars of debt to the national debt by the liabilities incurred in the tax-cutting and spending-increase pattern since 2000. That debt is service by short term notes issued by the Federal Reserve Bank and Treasury system. The total result is that the debt service - our monthly interest payments on the national credit card so to speak - are highly sensitive to changes in the short end of the interest rate range. When the Federal Reserve raises its interest rates from a generational low currently of 1% those debt service payments will shoot up.

If we merely return to the low interest rate regime of the nineties, where short term interest rates were about 4% then we will be paying four times as much interest on our national debt as we are now. However we have added more debt since then. So paying four times as much debt service as we are currently now but on more debt than we had before is going to cause a debt payment crunch.

Part of the addiction that has fueled such a large increase in our debt has been the buying of debt by foreign banks for other than market value reasons. This government intervention was done to maintain favorable exchange rates to maintain favorable export trading conditions to the US market. It also allowed us to borrow money at ridiculously low interest rates. This easy money fueled our lack of fiscal discipline as politicians found they didn't have to make hard choices today, either taxing&spending as liberals or tax-cutting&spending as conservatives and deferring the hard choices of today toward an indefinite tomorrow.

What would it take to close that trade gap and remove the artificial incentive in order to borrow money instead of making hard fiscal choices? The Economist has a rather grim answer to that.
A recent study* by economists at the OECD illustrates the difficulty. To narrow the deficit by two percentage points by the end of the decade, they reckon the greenback would have to lose about a quarter of its current value (as measured against the currencies of America’s major trading partners) by the end of this year. Since China and Malaysia peg their currencies to the dollar, and many other Asian countries track it closely, Japan and the euro area would bear the brunt of the dollar’s fall. They would not bear it easily. America is such an important export market for both that neither would cope easily with such a loss of competitiveness. The European Central Bank (ECB) has some scope to ease the blow by cutting interest rates but the Bank of Japan has already cut them as low as they can go. As a result, the strengthening yen would cut Japan’s output in 2009 by more than 2% and condemn the country to another six years of falling prices, the study reckons...

Neither side of this debate is much willing to listen to the other. But what if they did? The OECD’s economists shed light on what would happen if each side took the advice of the other. Suppose, for example, that the governments of the euro area (and America’s other OECD trading partners) heeded Uncle Sam’s lectures and passed liberalising reforms that raised their trend rates of growth by 0.5%. This would do wonders for the euro area itself, but it would do little to narrow America’s trade deficit. The OECD economists reckon it would cut the deficit by just 0.2% of GDP by 2009. Despite what many Americans would like to believe, America’s trade gap is not simply an expression of its faster growth rate. The study found that America’s appetite for foreign goods is so much stronger than the rest of the world’s desire for American goods that even if the other rich countries raised their growth rates to match America’s, they would still sell more to America than it would sell to them.

Now suppose America gave in to the hectoring of Mr Chirac and others and put its finances back in order. The OECD’s authors imagine an administration prepared to raise taxes by 4.5% of GDP over the next six years while cutting spending by 1.5%. This would put the government into the black to the tune of 1.7% of GDP by 2009. But even such a massive fiscal turnaround, amounting to 6.6% of GDP, would knock only 2% of GDP off the trade deficit. Why? The OECD economists point out that private saving tends to fall when public saving increases. Between 1992 and 2000, for example, the Clinton administration turned a worrying budget deficit into a handsome surplus. But this only helped to unleash a private investment boom. Public saving was offset by private dissaving, ensuring that the country’s trade deficit continued to deteriorate. America’s budget and trade deficits may be twins but one, it seems, can survive without the other.

America’s deficit will not resolve itself without much pain, suggest the OECD economists. America must beggar its neighbours with a competitive devaluation of the dollar, or beggar itself with a massive fiscal contraction—or both. The consequences of letting America’s deficits continue are certainly worrisome, as Mr Chirac suggests. But he should be equally worried about the consequences of bringing them to an end.

* "Channels for narrowing the US current-account deficit and implications for other economies". Anne-Marie Brook, Franck Sédillot and Patrice Ollivaud, OECD working paper.[emphasis added]

So it's a question right now of which poison one prefers. There is such a huge imbalance in the system that no matter what resolving it is going to cause pain. A worldwide economic recession with a massive dollar devaluation and corresponding debt crisis, or a domestic depression, or possibly both are what the study concludes the general choices are. That's the probable consequence of Bruce's reduction of the debt by 2% GDP. Sounds pretty horrific right? I'm not saying he's wrong. I favor the path of taking our fiscal discipline medicine now rather than risking a systemic default crisis later when in FY2011+ the Baby Boomers start retiring in waves.

However the cost of acting now while less than delaying the decision are not inconsequential. The cost imagined in this scenario is a 4.5% of GDP increase in taxes and a 1.5% decrease overall in spending, and if military spending is increasing then the rest must decrease all the more. That's what the article from The Economist reminds us. There are no longer any painless solutions. There is only the lesser of two evils.


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