Gambling With the US Dollar; The Interest Rate Gambit

Today in Brad DeLong's Semi-Daily Journal there is a link to his upcoming article in The Economist's Voice. He presents a cohesive analysis of the debate about the stability of the world economy in view of America’s huge current-account deficit. The question is, who is going to be pinched? I think the Bush Administration strategy is to pinch the US worker and the world economies that export to the US and the US worker will suffer the consequences if the Bush Administration gets it's way. Here is the essense of the debate.
J. Bradford DeLong (2005) "Divergent Views on the Coming Dollar Crisis", The Economists' Voice: Vol. 2: No. 5, Article 1.

International finance economists see a far bleaker future. They see the end of large-scale dollar-purchase programs by central banks leading not only to a decline in the dollar, but also to a spike in U.S. long-term interest rates, both nominal and real, which will curb consumption spending immediately and throttle investment spending after only a short lag.


But, according to the domestically oriented macroeconomists, this devaluation is not a large problem for the United States. (However, it is a very big problem for economies that export to the United States.) As the dollar’s value declines, U.S. exports will become more attractive to foreigners and American employment will rise, with labor re-allocated to the newly-vibrant export sector. It will be like what happened in Britain after it abandoned its exchange-rate peg and allowed the pound to depreciate relative to the Deutschmark, or what happened in the U.S. in the late 1980’s, when the dollar depreciated against the pound, the Deutschmark, and—most importantly—the Japanese yen.


Is the U.S. vulnerable to a full-blown dollar crisis? Why are international finance economists scared and jittery, but domestically-oriented macroeconomists much less concerned?


To be sure, international finance economists also see U.S. exports
benefiting as the value of the dollar declines, but the lags in demand are such that the export boost will come a year or two after the decline in consumption and investment spending. Eight to ten million workers in America will have to shift employment from services and construction into exports and import-competing
goods. This cannot happen overnight. And during the time needed for this labormarket adjustment, structural unemployment will rise.
Moreover, there may be a financial panic: large financial institutions with short-term liabilities and long-term assets will have a difficult time weathering a large rise in long-term dollar-denominated interest rates. This mismatch can cause
financial stress and bankruptcy just as easily as banks’ local-currency assets and dollar liabilities caused stress and bankruptcy in the Mexican and East Asian crises of the 1990’s and in the Argentinean crisis of this decade.


When international finance economists sketch this scenario, domestically oriented macroeconomists respond that it sounds like a case of incompetent monetary policy. Why should the Federal Reserve allow long-term interest rates to spike just because other central banks have ceased their dollar-purchase programs? Should not the Fed step in and replace them with its own purchases of long-term U.S. Treasury bonds, thereby keeping long-term interest rates at a level
conducive to full employment?


To this, international finance economists respond that the Fed will not wish to do so. When forced to choose between full employment and price stability, the international finance economists say that the Fed will choose price stability, because its institutional memory of the 1970s, when inflation ran rampant, remains very strong. A fall in the value of the dollar raises import prices, and thus is as an inflationary shock to the supply side of the economy just as the oil shocks of the 1970s were. The Fed today puts preserving its inflation-fighting credibility as priority one. The Fed will want to raise, not lower, interest rates; to sell, not buy, bonds; and thus to reinforce rather than damp the interest rate rise coming from the shift in the exchange rate.

Although I'm not an economist, I have great faith in a principle of wide disagreements with which many are familiar. The truth always lies between. Both the domestic and the international economists are right and wrong. The Fed has never been too worried about unemployment as long as there is a risk of inflation. However, they will not allow large financial institutions to panic either. They will instead balance the risk of inflation with a floating cap on high interest rates.
Meanwhile, China and Japan will not allow their economies to suffer under a falling dollar. They will continue to purchase dollars at a rapid although reduced rate, as much as their economies will allow.
The US imports the lion's share of the world's international trade, exporting a relative small proportion of it's imports. Meanwhile, the US is steadily borrowing most of the world's surplus income. The US consumer has been saving next to nothing and running up his own debt. The US consumer like the US government, is living well beyond it's means.
There is a reason for this consumer debt. Wages have stagnated and show all signs of begining to fall. Consumers have developed an sense of entitlement to a standard of living that appears to be unsustainable in the future. The cost of living will continue to rise driven by increasing interest rates and inflation, while wages fall because of the worldwide competition of Globalization.
The US worker is probably the least resilient of those involved. As interest rates rise the housing price bubble will deflate or collapse, depending on the speed of the interest rate increase. Workers will be saddled with mortgages that will not pay off upon selling the homes. Foreclosures will skyrocket, bankers will acquire property like mad. Mortgage equities, largely owned by pension funds will crash. The pension fund crisis will be universal and the US worker will be left without a retirement income beyond Social Security, just as it is a target for cutting.
The Fed and the international bankers in China and Japan will ride the teeter totter, while the American worker sees his buying power dip drastically at first when unemployment peaks, followed by re-employment at a lower wage. The US economy will resurge in a much better competitive position in the international market but in a world with a slower growth pattern and higher worldwide chronic unemployment.
And what happens if some part of this balancing act panics and turns the wrong way? Worldwide ecomonic chaos could be the result.