Bleeding Money

Richard Haass, president of the Council on Foreign Relations, writing in The Economist:

The economy is growing at a reasonable clip, but the foundation of this growth is vulnerable. When Mr Bush ran for president four years ago, the budget was in surplus to the tune of $236 billion; now the annual deficit is more than $400 billion. Calls to reduce growth in federal spending will put pressure on funds available for defence, foreign aid, HIV/AIDS and homeland security.

Add the fact that the current-account deficit is expected to be more than $600 billion this year, or around 5.5% of GDP. All this leaves the economy at the mercy of bankers in Asia and elsewhere who have accumulated massive dollar holdings. As Herb Stein said, that which can’t go on forever, won’t. A day of reckoning could well come over the next four years. If it does, Alan Greenspan or his successor will have to put up interest rates sharply.

And from The Buttonwood column:

. . .the most serious of all the questions facing the long-term prospects for the American economy, and by extension the stock and bond markets: the rising tide of red ink that is washing over it. . . .In its latest outlook, in September, the CBO predicted a deficit over the next ten years of $2.3 trillion. But that projection assumes, among other unrealistic assumptions, that most of the tax cuts are allowed to expire. With Mr Bush back in the Oval Office, that hope will almost certainly prove as optimistic as right-thinking people thought it was in the first place. Mr Bush has said that he wants to halve the deficit, but nothing he has said or done, nor any half-baked plan that he has come out with, gives any cause for hope on this score whatsoever. Independent number-crunchers think that the deficit over the next ten years will be $5 trillion-$6 trillion–more than twice the CBO’s estimates. . . .In the past, most of the appetite for dollars came from private investors. Recently, however, private demand has evaporated, and the dollar has been supported by gargantuan purchases from Asian central banks anxious to keep their currencies from rising too much against the dollar. Since 2001, the foreign-exchange reserves of Asian central banks have increased by $1.2 trillion–or about two-thirds of America’s accumulated deficit over the period. These purchases have kept the dollar stronger than it would otherwise have been and American interest rates lower. Foreign central banks will not carry on financing this deficit for ever. But what will happen to the dollar, to interest rates and to the American economy when they stop?

On these questions Buttonwood finds it hard to be sanguine. A good outcome would be a gentle but sustained fall in the dollar. A bad outcome would be a dollar crisis. Even then, bond yields might stay relatively low because of disinflationary pressures, but Buttonwood has no certainty about this: they could rise sharply because of a general shunning of dollar assets. Short-term interest rates might have to rise, again sharply, to attract the necessary saving. A combination of lowish long-term bond yields and much higher short-term rates would hit corporate profits hard, because perhaps half of them come from financial firms of one sort or another, and financial firms benefit hugely when short-term rates are much lower than long-term ones. Sharply higher rates would also bring an economy laden with debt to a juddering halt. Demand would shrink as consumers saved more. This would also hit corporate profits hard, presumably bringing an overvalued stockmarket down with them. Defaults, both individual and corporate, would increase. Bad debts would rise at banks; yields on riskier bonds, which have fallen to extraordinarily low levels, would rise sharply.

That, admittedly, is perhaps the gloomiest scenario, though it doesn’t even mention an escalation of the worsening problems in the Middle East, nor another terror attack. It may not happen, it may happen slowly, or America’s nine-lives economy may carry on muddling through: it is, after all, humming along quite nicely at the moment. But the re-election of Mr Bush does nothing to ease Buttonwood’s long-term fears. That would take an administration with far greater intellectual clout and economic literacy than the bunch that has just kept control of the White House.

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