The Most Likely Scenario

Brief consideration was given to weighing in on the discussion amongst a gaggle of economics professors with blogs regarding a recent commentary by Larry Kudlow, in which the dean of supply side economics played fast and loose with government statistics.

But during the process, something much more interesting regarding mainstream economic thought was happened upon that will be shared instead.

Before we get to that, here's a brief summary of the Kudlow Kontroversy:

In Larry's most recent column at the National Review, after praising the superb economic growth of recent years, he touts recent job growth using the household survey portion of last Friday's labor report, citing a robust entrepreneurial spirit that is not getting enough media attention.

For many years, the establishment survey (better known as the non-farm payrolls) has been a much more widely accepted measure of job creation, however self-employed workers and a few other groups are not included in this survey, and apparently their ranks are swelling.

The Angry Bears objected loudly on a number of fronts, then Larry's assertions that the BLS was considering averaging the household and establishment surveys in order to come up with bigger job gain numbers were refuted at Blah!, and naturally Brad Delong weighed in pointing out errors made at Instapundit.

It was an intriguing discussion, since the count of self-employed workers within the household survey has been calling out for attention from spreadsheets at this blog, but ultimately the only conclusion that could rightfully be drawn was that too many of our nations educators have too much time on their hands this summer.

What was found to be much more interesting than the politically heated debate amongst supply siders and their detractors was an item stumbled upon in the process of trying to sort out the Kudlow Kontroversy.

It seems there's a community college dean with a blog somewhere in the Northeast, who, while not an economist, wonders about the world's economic imbalances and drew a reply from one of the above economics professors with a blog:

First off: I’m not an economist. Readers who actually understand economics are invited to explain why I’m off my rocker on this one. And I’ll try to refrain from my usual Bush-bashing, since that’s not really the point of what I’m trying to figure out.

From what I’ve been reading, the U.S. is running nasty and increasing deficits at the government level, the household level, and the international level. We owe more to other countries than we ever have, and much of that debt comes from selling government securities to foreign central banks (esp. in Asia). Household debt is skyrocketing, and the interest rate increases of the last year or two are poised to nab anybody stupid enough to have taken out an adjustable-rate mortgage in the great housing boom of the last five or six years. The national debt grows apace, and has been refinanced over the last few years to progressively shorter-term loans, meaning that higher interest rates will hurt badly and quickly. Think of it as putting the national debt on an ARM, then watching interest rates go up.

Since we import most of our oil, and the price of oil keeps going up, our trade deficit is likely to keep increasing. (The folks who study ‘peak oil’ are becoming increasingly convincing.) Plus we don’t manufacture very much, so we don’t export very much. We also borrow money for wars of choice, which themselves actually interrupt the flow of oil. We borrow money to pay for causing our own supply disruptions, which is uniquely stupid by any standard.

China is keeping its currency artificially low, to keep its exports cheap. Then it lends us the money to buy those exports. It underpays its own workers so that we can have cheap stuff. How long its own workers will stand for that is anybody’s guess. I know the Chinese government isn’t exactly a champion of civil liberties, but from what I’ve heard on Marketplace, riots are becoming markedly common. The fact that the Chinese government is as repressive as it is makes the outbreak of riots all the more impressive. If it makes concessions to its workers, we’ll feel immediate inflationary pressure.

Since there are so many U.S. dollars flowing out of the country, their value is dropping on the world market. (According to the Bank of Canada website, a Canadian dollar was worth about 63 cents American at the beginning of 2003. Now, it’s about 90 cents. Rates for savings appear to be significantly lower there. Coincidentally, Canada exports oil.) The only way to entice foreigners to keep buying a depreciating currency is to raise interest rates to compensate for the depreciation. Raising interest rates kills the folks with ARMs, increases our national debt payments, and hurts the business climate. (It also pretty much wipes out the ‘refi’ market, which has been a major economic engine for the last few years.)

Although productivity has been going up, real wages haven’t. I know it’s gauche to talk about income distribution, but there’s no other way to explain how those can both be true at the same time. Corporate profits are going gangbusters, with an astonishing amount of the profits being spent on taking ‘public’ companies ‘private’ (that is, buying up their own stock). As opposed to, say, investing in productive capacity, or paying workers some small fraction of their increased productivity.

So my question to my economics-literate readers: how are we _not_ screwed? (That’s the technical term.) If China lets the yuan float, we get inflation. If the Euro starts to displace the dollar as the denomination for international trade, demand for dollars drops and we get higher interest rates, eventually tipping us into a nasty recession. (If we’re really lucky, we get a burst of 70’s vintage stagflation: inflation and unemployment at the same time. Oh, goody.) If oil stays high or goes higher and we don’t get really serious really quickly about alternative energy, we continue to bleed money. If somebody manages to blow up a key pipeline or refinery, the sky’s the limit.

I’m instinctively inclined to doubt doomsayers, so I’m thinking I must be missing something really basic and wonderful that will reduce these concerns to nothing more than blips on the screen. I don’t foresee a complete collapse, like a Weimar or Depression scenario, but something as icky as the 70’s is starting to look awfully likely.

Please tell me why I’m wrong. I’ll sleep much better if I can dismiss this as the ravings of someone who just needs a vacation.

No. You're not wrong and Brad DeLong will tell you why.

No. You're not wrong. You're not raving. Nevertheless, the most likely scenario is one in which we come out of all of this OK.

What is this most likely scenario? It is of (a) gradual inflation in China and elsewhere (maybe 5% per year for five years), (b) gradual reductions in the value of the dollar (maybe 5% per year for five years), accompanied by (c) gradual interest rate increases in the U.S. so that the dollar decline never turns into a (d) sudden dollar crash.

If that is the case, then--gradually--U.S. housing prices deflate, construction and consumer spending fall, and imports drop. U.S.-made products become more competitive at home, and so manufacturing production and employment for domestic uses rises. The falling real value of the dollar leads to an export boom, which causes export manufacturing to boom as well. Over five years or so, we see a net of eight million jobs (relative to trend) in construction and consumer services (and supporting occupations) vanish, and eight million jobs (relative to trend) in manufacturing (and supporting occupations) appear. If the expanding sectors expand fast enough, we see a tight labor market that brings real wages back to their normal share of production. And moving an average of 1.6 million jobs a year from sector to sector--the U.S. economy can do that without any sort of uproar.

Of course, people are still likely to be unhappy with the process. Rising interest rates and rising import prices will make people feel poor--something in this process has to reduce Americans' total spending on consumption, investment goods, and government purchases from 107% of income to 100% of income, and whatever it is will crimp spending by making Americans feel poorer. But even so it is a "soft landing."

As I said, that's the most likely scenario. But there are other scenarios--the ones that you fear: stagflation, recession, financial crisis, oil shock, global depression, panic, revulsion, and discredit. The other scenarios become more probable every day.

You see, to achieve a soft landing requires that a huge number of people around the world watch the real value of their dollar-denominated assets melt away slowly for half a decade without ever being impelled to sell off the dollar-denominated positions in their portfolios. It could happen. It happened in the late 1980s, thanks to the Japanese central bank and the collected investors of Japan. It will probably happen again. It requires mammoth irrationality on the part of investors, and an extraordinary eagerness on the part of central banks to eat enormous losses on their dollar reserves. It is not a rational-expectations equilibrium. But it will probably happen.

But if it doesn't happen again--if there comes a day when the world's central banks and investors all decide that it is time to sell their dollar-denominated assets, then... Well, then we get to see how good a central banker Ben Bernanke really is. There is a really bad global equilibrium out there, which the world economy might jump to at any moment.

The wondering of the community college dean should strike a chord with many today. The global economy seems to be spinning further and further out of control and no one wants to do anything about it, perhaps thinking that whoever does try to do something about it will surely make a bad situation much worse, and then get blamed for the whole mess.

The comments by Brad DeLong are enlightening because it probably represents mainstream economic thought today - no one has a vested interest in the wheels coming off of the global economy (except perhaps Iran, Russia, and a few others), so the most likely scenario is a grudging re-balancing of current imbalances resulting in the proverbial "soft landing".

Housing prices will go down slowly, consumer spending will throttle back, real wages will gradually rise, the dollar will lose value, import prices will rise, and exports will increase. Employment in the U.S. will shift from construction and consumption back to manufacturing, and people will stop talking about "dark matter" since we will be exporting tangible products at an increasing rate to square the current account.

Of course, there are many things that could happen to derail this most Polyannaish of all outcomes, the most likely scenario being an ugly competition for energy, a topic which, curiously, is only mentioned in passing in the response.

In the end, credit must be given to Brad DeLong for acknowledging the fragility of the world economy today and the myriad of "hard landing" possibilities, but like others in the dismal set, his optimism seems unfounded.

My advice to the community college dean? Buy some gold coins, just in case.