Dollar Crisis? Economic Forecasts Differ by Ideology

Brad DeLong sometimes gets quickly to the essence of things. In the aftermath of the Fed’s annual meeting in Jackson Hole he leaves us to ponder the warring perspectives/ideologies of various economists that come into play when dealing with monetary and fiscal policy issues. If you are puzzled as to how economists differ, and they do differ widely, DeLong’s The Coming Dollar Crisis? might help. Even if you are a seasoned observer the post will likely help. And the still-building comments are well worth a look too.

DeLong’s staging, in part:

… My conversations quickly exposed a deep fault among the conference attendees. Those who analyzed or forecast the U.S. domestic macroeconomy agreed that a steep decline in the value of the dollar sometime in the next five years was overwhelmingly likely, but by and large they did not think that such a decline would pose a big problem for the U.S. economy. (They agreed that it might well pose a very big problem for some of America's trading partners.) By contrast, those who analyzed or forecast the international economy as a whole were typically terrified by the prospect of a steep (30% or more, perhaps much more) decline in the value of the dollar: they thought a severe U.S. recession was a definite possibility, and that the situation would require exceptionally skillful handling to keep from becoming a serious economic problem. …

And at this point the response of the international economists fragmented:

1. Some said that the falling dollar would create inflation--with imports at 1/6 of GDP, a 40% fall in the dollar would, if fully passed through to import prices, add 6% to the U.S. price level. The Federal Reserve would feel honor-bound to maintain its reputation as an inflation-fighter, and so would allow interest rates to go high enough to produce enough unemployment to push nominal wages down far enough to offset this rise in import prices. Thus the Federal Reserve would welcome the spike in interest rates as appropriate, and take no steps to offset it.
2. Others said that the adjustment to the fall in the dollar would require that ten million workers shift out of construction, retail, and consumer services occupations and into export and import-competing manufacturing industries. You cannot move ten million American workers from one sector to another in a matter of a year or two without creating lots of structural unemployment.
3. Still others said that financial stress would be the key: perhaps some major Wall Street firms would discover big unhedged risks in their derivative books; perhaps perhaps others would find that the values of their portfolios were more responsive to changes in long term interest rates than they had thought. In either case, it is financial distress and chaos that really triggers the recession.

And the domestic side had rebuttals to each of these three points:

1. If the Federal Reserve announces now that it is targeting a measure of inflation that is not grossly affected by import prices--that it is targeting nominal wage growth, say--there is no need for the Federal Reserve to defend its credibility by attacking the economy. Just as the Federal Reserve has trained observers that it is more important to worry about 'core inflation' than 'headline inflation', so the Federal Reserve ought to be preparing observers to recognize that inflation produced by rising import prices is a one-time event, not an inflationary spiral that needs to be fought by triggering a deep recession.
2. A large structural shift will cause high unemployment only if the transition is quick and brutal, and only if workers are pushed out of job-losing rather than pulled into job-gaining sectors. Whether it is quick or gradual and whether it is push or pull depends, once again, on the path of interest rates. Only if the Federal Reserve fails to do its job and allows for a massive interest rate spike is there a problem.
3. Financial stress is something that can be managed: if the Federal Reserve keeps the path of interest rates smooth, great financial stress is unlikely.

… Martin Feldstein said something very smart just after we had both taken off our shoes at Jackson Hole airport. He said that the domestic-side economists were keying off the past experience of the U.S. after 1985 and of Britain after 1982, and so were saying "no big deal"; while the international finance economists were keying off of the experiences of developing countries that had run large current-account deficits--Mexico 1994, East Asia 1997, Argentina 2001. Each side had its own preferred models that functioned very well at explaining the past historical cases that they focused on. But there was no way right now of settling, empirically, whether a model built to explain the U.S. in 1985 or Korea in 1998 was more applicable to the U.S. in 2006--you had to make a bet, either that continuities in U.S. economic structure were important, or that financial globalization was important, in choosing your model and your terms of analysis.

It was very interesting. And very disturbing. Brilliant economists, thinking hard, unable to reach even the beginnings of analytical agreement about how to model the distribution of possible futures.

For more on the workings of the Fed and other government workings (often done in lights less bright than some deem appropriate) take a look at two of Toni Straka’s (The Prudent Investor) lastest posts titled, WSJ - Greenspan Sternly Warns Of GSE risks and Money Firm Claims Wall Street Is Rigged By The Government (long post). The latter post will no doubt be disputed by some. Such is life when talking through politics and the political economy. When Toni put it out I thought to myself: Hummm! Such reasoning is likely why William Greider wrote Secrets of the Temple: How the Federal Reserve Runs the Country and Who Will Tell the People: Betrayal of American Democracy