From Brad DeLong:
Barry Eichengreen Stitches the Short Run to the Medium Run and Sees Recession
Writing in the FT, Barry Eichengreen tries to stitch together the current short run of U.S. savings much lower than investment, a large current account deficit, and low interest rates with the medium run we all foresee of savings roughly equal to investment, a current account in rough balance, and higher interest rates. His message: DOOM (or at least recession):
Narrowing the US [trade] deficit... require[s]... increased savings and lower investment. The falling dollar will bring this about by tending to drive interest rates up.... Asian central banks... sell some of their existing holdings... upward pressure on US Treasury yields.... [A]s the dollar falls, there will be upward pressure on US import prices.... [T]he Federal Reserve will have to raise interest rates faster than currently expected. Higher interest rates will make borrowing more expensive and slow investment growth. They will have a negative impact on... house prices. US households... will have to start saving again. With investment down and saving up, the current account deficit will narrow.
Unfortunately, this happy observation is not the end of the story. A significant decline in both consumption and investment will mean a recession in the US. This conclusion is so obvious that the only question is why the markets are not forecasting it already.
The answer, presumably, is that investors do not believe that the dollar's decline will produce a significant increase in inflation. The historical data say that a 10 per cent fall in the dollar produces 3 additional percentage points of inflation, which in turn implies a 450 basis-point increase in the discount rate. Clearly, we have not seen anything like this yet.... Maybe the... traditional relationship between dollar depreciation and inflation no longer holds.... But... [this] just means that the dollar will have to fall further to generate enough inflationary pressure to force the Federal Reserve to raise interest rates. At the root of the dollar's decline is the view that the US current account deficit is unsustainable. Foreigners will therefore keep selling dollars until it narrows. This in turn means that the dollar will keep falling until US inflation heats up to the point where the Fed does indeed have to raise interest rates. The implication, that the US economy will slow or more likely succumb to recession, is unavoidable.
The question is whether there is anyone to take up the slack.... Europe is stagnant, and the European Central Bank has shown no awareness of the need for monetary stimulus. China is cooling off.... Japan's modest recovery will disappoint now that it has to raise taxes to control its own spiralling debt. Countries outside the Group of Four nations (the US, the UK, Japan and Germany) are simply too small to make a difference. The implication is that the correction of the US current account deficit that is now getting under way will mean a recession not just for the US but for the rest of the world. The optimists who are welcoming the dollar's fall should think again.
That's the thing about accounting identities like S - D - I = NX. Either you craft economic policies that make them hold at full employment, or the market takes care of making sure that they hold for you--but usually not at full employment. Stagnant or falling wages that boost corporate profits could boost savings S by boosting retained earnings. A Bush administration serious about cutting the deficit could provide financing for investment and keep interest rates from rising. Big booms abroad could raise U.S. exports and reduce investment as the Fed took steps to shrink investment to avoid inflationary overheating. Otherwise, it is indeed hard to argue with Barry just across the north wall of this office: the dollar falls; has the fall produced enough inflationary pressure to lead the Fed to raise interest rates and so reduce investment and the current account deficit? no? then repeat.
