Long, but very interesting (hell, scary)
Back in my update post on the currency situation, a poster named Mike asked:
Maybe I'm a numbskull.....
I find these economics articles very interesting...and potentially quite enlightening.
But I guess I'm just too dumb to really get how some of these issues (like the falling dollar, huge deficits, et.al) affect the little guy?
What exactly would happen if there were a "currency crash"? A little education along with the writing would be very, very helpful to me.
Posted by: Mike at November 17, 2004 09:44 PM
So to answer Mike's justifiable question, just how would it effect the average person?
I think I'll give first bat to Col Lounsbury who responded:
Well, since I was mentioned....
What it means to the little guy depends on how it happens and when.
First, a long term slide in the dollar, if it is slow may not mean much other than foreign vacs become really expensive for you, some mfg and the like picks up in the US (US exports become more competitive), and imported goods become a lot more expensive. That is, Wal Mart stops being so bloody cheap (or so I would guess, I don't live in Wal Mart land, can't say I know what they're like).
There are a lot of trajectories. The article cited in the Economist article has some grim analysis, as it points out that among the major reasons for dollar weakness and current account deficits is both US private and public sectors are undersaving or overconsuming. That is not a moral statement (bd consumers, bad! Consumerism bad.... leave that for ignorant lefties like Klein) rather it's an objective observation given the amount of demand for savings versus what Americans save (very little) either in governmentally (you have noted the deficits, I am sure) or privately.
The article rather makes it clear that there are not terribly easy and painless ways to unwind this. A sudden rise in saving implies an equal drop in consumption, suggesting... recession.
However, Argentina is NOT a good model for how a curency crash would effect the US, the differences are enormous, including the fect that US liabilities are almost entirely n dollars. Much of the pain, as the article notes, would be externalized to "Rest of the World" holding US assets who would see trillions in value evaporate.
On the other hand if the Fed decided to try to defend the dollar at some point by ratcheting up interest rates (in the context of a dollar free fall), one should probably expect a 1980 like spike of a recession. PErhaps preceded by stagflation driven by rapid nominal price increases in tradeable goods.
Ugly, very ugly.
Posted by: collounsbury at November 18, 2004 09:31 AM
Let me try to bring that down to very specific terms. What we're talking about principally on the market side is called "capital flight". Capital flight is a very innocuous word, but it has very harsh connotations. On the consumer side what is going to happen is "consumer inflation". What that means is that basic everyday stuff you buy becomes more expensive.
Consumer Inflation from Devaluation
Let's tackle the consumer side first. As the dollar devalues that effectively makes other countries' goods and services more expensive. How much more expensive depends on the initial gap and how much the devaluation happens. For instance we probably won't stop offshoring jobs to India. Why? Even after a devaluation their skilled labor is still likely to be less costly than our skilled labor. However the cost goes up. That means that telecom and computer companies have to pay more for their services.
What that means is that in many of these cases, things will get more expensive as the companies have to charge us more but we don't really get jobs back to compensate for it. Sorry but anyone promising you jobs from Southeast Asia from a devaluation is probably trying to sell you a unreliable story. So that means inflation for basic services.
Likewise, it is highly unlike for third world labor in say the clothing production fields. A few years ago Walmart was paying laborers in Haiti about a quarter, 25 cents, or less an hour to make clothes. Even with a 200% currency devaluation you're not going to be able to compete with 75 cents an hour wages. The most likely outcome is a slight uptick in clothing costs - a few percent to offset directly the wage costs. What's an extra buck on a 30 dollar pair of jeans right?
For large ticket items like t.v.'s, European or Japanese brand cars, etc. however the case will be far different. A Honda Accord costs minimum 20,000 plus dollars. More like $25k. Now imagine that same car retailing at $35k or $40k. You don't even want to think about what will happen to Beamers or luxury car class vehicles. Imported Japanese electronics of any type will become considered expensive high cost items.
The biggest whack the average consumer will have is fuel costs. By that I mean gas prices will rise to easily $4.00 a gallon and over the long term as oil demand trends higher it will push $5.00 to $6.00 a gallon. However residential electricity, natural gas heating, air-conditioning, and heating oil costs will go up by quite a bit. A lot of the new generation power plants are fueled by natural gas. With the distirbution grid wobbly and low surplus on peak usage periods there isn't any way except to not use electricity to stop from getting raped by that. A lot of people aren't going to be able to afford their air-conditioning bills. We may also see families already on the edge increasingly not be able to afford their winter heating bills. Plane ticket prices are already feeling pressure from jet fuel prices and in the future I would expect air travel to not be as commercially accessible simply because industry consolidation and high jet fuel prices are going to force things in that direction no matter how much protectionism the government gives in bankruptcy courts.
Deisel prices will probably rise more as well, and generally since food production is already a low margin business for farmers expect more corporate farming and higher food prices. This food inflation will be based upon domestic energy inflation and based upon higher prices for stuff shipped in from around the world. Cheese prices will go up. Fruit out of season will become a treat rather something to be taken for granted unless you're well off. Just about the only good news is that cotton prices probably won't rise much because they're already overpriced because of the subsidies to the American cotton industry keeping it alive.
Transport prices will go up, and thus you can expect to see urban prices aleady high for everything that needs to be shipped in go up. You can expect to see real estate prices go up ironically. With higher gas prices and gas car price increases it will constrain the expansion of the viable commuter distances. This will compress more people into a smaller area. So real estate prices on the periphery of high population density zones will drop. Real estate prices in the core to fringes of high population density zones will increase.
That's the consumer inflation side. We can probably depend on consumer inflation rising about 5% across the board. That means if the Fed wants to control consumer inflation it has to raise Fed Funds interest rates to 6-7%. Prime will be 8-9%. What you will pay is higher than that. And Credit cards are going to be ungodly. Whoever has an Adjustable Rate Mortgage in the last 10 years unless they've paid it off is going to have massive pain. Most of them will be forced to liquidate and let the banks foreclose. Some will trade down, but unless they're already in a high-population density zone and can move outwards it won't be easy.
The "good news" is that US manufacturing will pick up some but not a whole lot. We will also get some jobs from Europe. But that's not a real good way to go, European offshoring. Because of the second half of the equation which is likely to wipe out any net benefits from European jobs and then some.
Financial Inflation and Capital Flight
Okay that above scenario is pretty tough but it's bearable. That's the scenario we would have if choose to invest in some sort of alternative energy future. It would be expensive and hard short term but in the long term we would pull it out, and grow out of it. What happens if we stick to tried and true oil? Or if a panic hits and there is capital flight?
With the drop in demand for the dollar, as less and less people accept the dollar or accept it on less favorable terms, the devaluation will take down the value of a lot of foreign investments in America. Essentially there are two scenarios. One is the Hold scenario and the other is the Sell scenario.
In the Hold scenario, people accept the devaluation which effectively kills their invested assets in the United States. It'll wipe out a third to half of their value probably. If they hold then things won't be that bad. What will happen is that the Treasury will have to offer a lot higher interest rates to float debt. Debt service will increase, and become a major part of our budget. As for how big it is, well the military budget is $400 billion base not counting wars such as Iraq. The debt service budget item is something like $300 billion with interest rates at about 2%. If interest rates rise for Treasuries just to say 6% which would be entirely reasonable we will end up paying nearly a trillion dollars a year just for debt service. That will cripple Federal spending. The reason why interest rates will have to rise is that they will need to compensate to attract new foreign investment.
That's the good news scenario. Believe it or not that is the White House fallback plan, such as it is. Their main plan is to play chicken with Europe and bully Europe into eating inflation through lowering the ECB (European Central Bank) interest rates for the EU. That won't work. So the White House fallback plan if it works is the most likely outcome, except that it's not. The bad news scenario is if capital flight happens. That's the Sell Scenario. In this scenario people sell here and buy elsewhere in order to premptively prevent their investment assets in the US to prevent devaluation.
That means Treaury interest rates will have to be in the double didgits, there's a stock market crash, and the equity premium upon which the economy of scale for middle-class retirement portfolio investments rely will vanish - 401ks will only be for six figure plus people. It also means that the budget will have to be cut. Even if they could raise interest rates high enough to maintain foreign investment after a Sell scenario the debt service at higher interest rates would kill us. It would eat the entire Federal Budget alive.
That would mean a recession like that in the eighties and seventies combined. A Depression is pretty much the only way to desribe it properly. Think "Grapes of Wrath". My description of it ran like this:
Stuff at Walmart will no longer be cheap. Japanese cars become luxury cars. Gas goes to $5.00 a gallon. Coffee and hot chocalate and candy becomes a holiday treat. People start candying apples again for halloween. People stop emmigrating here except for the really desperate ones and the Mexicans. European vacation becomes synonymous with six figure incomes. Interest rates for everything jump up from car loans, house loans, credit cards, etc. Stock market no longer is a credible source of retirement income for middle class - all those 401k's cya so long bye bye. And you have your choice between 25% across the board cutbacks in all government services or runaway inflation. People lining up out the door to get a chance to sign up to go to a foreign country and kill people for a paycheck. Whoring becomes a highly competitive profession as a lot of women try to get into the field because of a lack of other opportunities. There is no more middle class to speak of. Medical treatment becomes so expensive and coverage so bare that people start dying because they can't find a doctor to take them rather than having a terminal disease.
How likely is that outcome? Well as I estimated earlier if Dubya doesn't take the hint and at least stop digging, easily 2-3 years. The problem is that the current accounts deficit is so huge that it dwarfs most proposed solutions. I've seen estimates of a $75-$90 billion dollar injection from Social Security Looting. I would say not big enough.
How big is big enough? Well the US borrows over half a trillion dollars a year because of its current accounts deficit. So domestic savings either have to increase to cover that or we have to incentivize foreigners to do that for us. According to this PDF in 2001 the peak year for net mutual fund inflows the size of the entire net inflows to domestic equity funds was 260 billion (page 27 top graph). That means that even if you could come up with the money, you would have to have double the monetary inflow of the peak bubble year for domestic equity funds. That would be a massive bubble and clearly be unsustainable. The PE and MB values would goo through the roof, instantly. Earnings just can't support that kind of money sloshing around for too long.
And it's doubtful that they can scrounge up 500-600 billion every year from now on. So that's clearly a pipe dream. Sure 500+ billion once. But every year?
That's why the Hold scenario is only stable with Europe lowering their interest rates and going inflationary. At that point no capital flight will occur. However as Stirling noted, that's not what Europe wants. What Europe wants is:
What should be happening, in otherwords, is Europe attracting money and investing that in improved production which would keep pace with the weakening dollar. Every other nation that has pursued devaluation, other than the US, has run into this problem. Devaluation is a form of protectionism: taxing other goods and encouraging internal consumption. Which means more oil is burned and costs as much as the devaluation saved. The books balance and devaluation merely ends up taxing those who can't get assets to flee the country.
This means that Europe is being increasingly put on the horns of a dilemma. If buying dollars does not give them improved leverage, why not stop? After all, the Asian economies will, for some time, have to continue the mefo-cycling. Betray. This would of course create an explosive situation - which the Europeans could manage if they could become the access point for oil. Namely, by buying of Iran and Iraq.
The reason why Europe can't attract the investment capital is that it's already locked up in the US. There are no more savings flows anywhere to be diverted to Europe. So if Europe raises more capital it must be at the expense of the US. That's why Snow's "Strong Dollar" policy on the back of European inflation and lowered interest rates is doomed. And that's why without ECB cooperation the Hold Scenario is not stable. Because the Sell scenario actually gives Europe what it wants - investment capital.
All Europe has to do is start selling US assets. That will trigger the sell scenario. That in turn will increase dramatically the chance of capital flight from the US. Capital that can now flee because it has an alternative place where it can go. As long as there was no place else to go, the US could devalue as much as it liked and the foreign investors had to put up with it. If Europe becomes the new safe haven however, well then they're outta here.
However these sorts of decisions are rarely made on a purely economic basis. If they were Europe would already be selling us. That's what a purely rational and purely economic agent / decision maker would have already done. But people are rational over many different priorities. That's why the Middle-east situation is crucial. Once Europe decides that politically and geostrategically that an alliance with Russia and China is a better way to ensure access to the Middle-east then it's over. The one thing that could tip them toward that point in the short run is a US invasion of Iran.
Likewise for military reasons the invasion of Iran would verge on suicidal. Certainly there would be much social injustice and high casualty rates. At this moment my information is that Iran is already dispersing part of its armor amongst mountainous regions. They are not unaware though they are not fully mobilized. This is the moment when sooner rather than later could have the best possible chance of degrading their conventional military forces, before they are completely positioned for a Russia-heartland Asian landwar fall back and then surround your enemy strategem. However precipitiously attacking at this very moment also has the best geostrategic probability of turning Europe, China, and Russia against us and creating a coordinated economic warfare strategem that would destroy our capital base to make war with.
It is not merely economic wealth but capital investment that is required to win large scale hi-tech modern wars.
This is why I have proffered in the past a pragmatic Iraqi stabilization and Cold War strategy. This is the only strategy that buys the US enough time to logistically change its energy basis and place its markets on a new capital investment basis. Not a petro-currency basis but a metaproduction microproduction economy of scale fueled by alternative energy (including nuclear). This is the kind of economy that makes money not on production but on the economy of scales associated with the means of production. You don't sell the CD's you sell the CD burners and blank CD's and musical authoring software. You let people make their own CDs. You don't promote a few big music stars and mass produce them. You produce many musicians and let people cheaply sample your stable and charge for access to your stable to produce their own CD's and then sell them to each other. People become big stars not because of commercial promotion but because lots of people word of mouth prefer that artist, which get's rid of marketing overhead. The better locals will become the neocrafters, able to charge a premium because they can sample and anticipate popular trends better.
The Cold War strategy is also the only strategy that can convince Europe to give us more time to clean up our fiscal act and start a new investment basis to attract sufficient savings to close the current accounts deficit without massive trauma. Nuclear Proliferation can be countered by an aggressive next generation intelligence and assassination program more effectively than by state to state military action. The key to getting ourselves out of this mess is killing people, but one on one and up close and personal, rather than with aerial bombardment of civilian zones.
This is why I'm afraid that Bush in his moment of euphoric hubris over a manufactured "mandate" will lead the country straight over a cliff and after X-mas declare that we have to go after Iran. Oh yeah and they were in with with Osama too - at least that'll be part of the rationalization: that they hid and are hiding Alqueda terrorists. It's even true, but the proper response would have been to lift sanctions as a carrot to get full cooperation on Alqueda and Da Bomb. Not to invade to prevent nuclear proliferation.
Anyone know more about economics and can analyze?