Economic Dreams - Economic Nightmares

What About the Deficit?

Here in the US, the libertarian right tells us that we are doomed by a federal debt that will soon wreak havoc on the world's financial system, with much pain to be felt here at home. Perhaps they are correct, but I doubt it. If anything a debt problem will be chronic, not acute and near-term calamity is not likely. Their argument gains traction each year as budget deficits add to the debt, and no new jobs (net) seem to be an ongoing tragedy. Even if you don't buy their arguments, there may be other reasons to at least shift spending, if not both shift spending and reduce deficits. So it is at least time to begin to parse various proposals to cut into deficits and debt.

This week President Obama unveiled his budget. There wasn't much to cheer about, for those who hope to trim back a bit on our public debt. Obama and Co. trotted out the same old "let's whittle away at that small percent of government that has served for years as the politically correct set of "touchables," leaving Defense and Entitlements at minimum in the "untouchable" category. Nobody is buying Obama's offering as much more than political posturing w/r/t deficit reduction. So we'll have to look elsewhere for substantive suggestions.

Recently, Mother Jones' David Corn talked with David Stockman (Ronald Reagan's Budget Director) to get his ideas on tackling the problem, a problem Stockman dealt with, unsuccessfully, way back when. Stockman offered up a few ideas: First, cut military spending by $100 to $150 billion a year. Second, apply a means test to Medicare and Social Security. Third, massively raise taxes. On the third, Stockman suggested a Tobin Tax on financial transactions, adding that it might generate $100 billion annually. He also suggested a value-added tax on consumption.

I would add in a few others. Why not try to get another $100 billion/year from the Medical Industrial Complex? I suspect that if we were to seriously look at "end of life" excessive health care we might find that much there. But if not, we might look at excessive profits in the "Complex", and or excessive insurance costs, etc.

Why not get another big number by beginning to phase-in a gas tax? That way we would be hitting the Energy Industrial Complex, to compliment the hits already proposed to the Military, Finance, and Medical Industrial Complexes.

And we might get a bit by raising the tax, progressively, on America's top 5%.

What else might we tag on? We might as well begin developing lists, while we wait and wait for our politicians to do anything beyond "tax and spend" or "borrow and spend."

Note that Stockman also advocated for a "means test" on Social Security. I have thought this a good idea in times past, but now suspect that it wouldn't be worth the fight. Just raise taxes on the rich, and let them collect their pittance from Social Security.

Eric Tymoigne on Three Important Questions

I have been recently trying to better understand where I stand on financial economics and have been quiet for some months. Time to begin blogging again. After spending my youth as a Friedman libertarian then moving on to Hayek (whom I still admire in part, while disagreeing with most contemporary "Austrian economists"), I'm now working to better understand Keynesian philosophies, particularly as practiced by those most label post-Keynesian. In particular I spend a bit of time these days reading Economic Perspectives from Kansas City and Bill Mitchell's Blog, along with Steve Keen's Debtwatch along with other favorites.

Over at Economic Perspectives from Kansas City, Eric Tymoigne recently asked  Can we spend our way out of recession? Is the fiscal deficit unsustainable? Is it time to cut government spending?.  His answers, in short: Yes. No. No, not yet. I'm in agreement, but add that we dare do it — in the face of a mountain of debt — only if we are also going to re-regulate the banking and finance (and insurance) industries. And if we are going to claw-back some of the excess profiteering that went on. And if we are going to seriously investigate the fraud that was no-doubt part of the problem. And if we are going to begin to reign-in the medical industrial complex (and related so-called insurance), and reign-in the energy industrial complex, and reign-in the military industrial complex. What else?

Here is a bit of Tymoigne's reasoning:

So can we spend our way out of a recession? Yes we can; provided that spending is high enough. Will a sovereign government go bankrupt by doing so? No, it will not. Does government spending lead to inflation? No, it does not. Does bigger government spending mean that the government will take over the economy? No, it does not. Does it mean that all types of spending are equally beneficial? Definitely not. Government spending can be wasteful if there is no improvement in the welfare of society through infrastructure spending, better social programs, and other government spending, preferably employment-enhancing, that improve the standard of living of the population. …

In the early 1930s, President Roosevelt first criticized President Hoover for engaging in deficit spending and driving the country down the road to ruin, and then proceeded to implement policies that further increased the fiscal deficit of the federal government to about 5% of GDP (a historical record at that time). These policies greatly helped the economy to get out of the Great Depression, but were the subject of ferocious attacks on the ground that the "massive" deficits would lead to the insolvency of the country, uncontrollable inflation, wasteful spending, the taking over of the economy by the government, and, ultimately, the rise of Communism. …

Did any of those problems actually materialize? As the saying goes "the proof is in the pudding." There was no government takeover, no rise of Communism, and no insolvency. In fact, Roosevelt proceeded to increase government deficit over 20% of GDP during WWII without any of those problems arising. …

The overall cost of running [US depression era] programs was extremely small, less than 1% of GDP. Despite their limited scope, they helped millions of people to make a living, helped to avoid waste of resources (if they had been left idle), and promoted the growth of U.S. infrastructures. In addition, the large deficit spending flooded the private sector with cash; thereby, restoring profitability and willingness to employ. War deficit spending reinforced this trend by flushing banks and private businesses with money and by creating a long period of financial stability. All this without any sign of insolvency of the federal government.

A final complaint is usually that government deficit always creates huge inflation and even hyperinflation. There is here a ton of data going against this argument. One just needs to look at Japan over the past 20 years: massive debt, very low interest rate, deflation or stable prices. But we do not have to go that far. Here is the United States, the "massive" deficits of the 1930s and 1940s did not generate high inflation. …

None Dare Call it Fascism: Moyers and Galbraith

Last Friday, Bill Moyers sat down with Jamie Galbraith to talk about The Predator State and our current mess relative to 1929-. Galbraith says that like 1929-,

The situation today is very similar to the moment of panic and collapse that we saw in 1929. And for very similar reasons. An abandonment of the supervisory responsibility that should have been applied to keep the speculation and the fraud and the abuse from getting out of control. So there's going to be a major period of correction. And dad, [John Kenneth Galbraith, The Great Crash 1929 writing] in 1955, talks about how memory fades and how eventually, although so long as people remembered '29 it wouldn't be repeated, eventually it would be forgotten and the underlying speculative impulse would come back.

Galbraith differs from many who blame our current mess on"the deficit", on the US Government living beyond its means:

BILL MOYERS: But even Barack Obama's website calls the deficit America's "Domestic Enemy." Even he's aware of the fact that the deficit's beyond sight.

JAMES GALBRAITH: Well, the deficit isn't beyond sight. The deficits in the Bush administration in relation to the size of the economy were never all that large. They were certainly larger than they were under Clinton, but that was in part necessary because of the changed economic situation, the collapse of the dot-com bubble in 2000.

The United States government's credit is good. The deficit is a financial number that people are going to have to get used to because there is no way in these circumstances of avoiding an increase in the deficit. One of two things can happen. The government can take action and help stabilize the economy in which case we will have more spending but also more employment.

Or the government cannot take action and let the economy collapse in which case we will have much less tax revenue. The deficit is going to be larger either way. There is no way of avoiding that. The only question is do you work to have a good economy or do you accept a terrible economy?

BILL MOYERS: What are the negative effects of a soaring deficit?

JAMES GALBRAITH: Well, the one thing I would have worried about is that we might not find lenders who are willing to provide funds to the U.S. government, that the Chinese or the Japanese might decide that they would rather be in some other currency and that we'd then have trouble with inflation. But that's not going to happen. It's not going to happen because, as it turns out, the major alternative, the euro, simply isn't viable as a reserve asset for the rest of the world. It's the dollar or nothing. So the United States basically can finance itself to the extent necessary to deal with this crisis. And I'm right now quite sanguine about that, quite confident that we won't face a problem.

At the end of the interview, Moyers gets to Galbraith's new book, The Predator State, and how some like Steve Forbes are already beginning to blame the mess on reformers like Galbraith. Here's a snip

BILL MOYERS: [T]here are capitalists like Steve Forbes, … of "Forbes Magazine," who argue that people like you are going to go too far and that it was actually the government's excesses and failures in the '80s and '90s that contributed to what began to happen in 2007 with the meltdown. And that if you have your way, people like you have your way, you will criminalize business. You will raise taxes and dry up the economy. You will take government unchecked into the same kind of catastrophe that unchecked Wall Street has carried us. How do you answer a Steve Forbes?

JAMES GALBRAITH: Well, first of all, I very much agree with him, that it was failures of government that were responsible for this. It was the actual failure, the abandonment, the neglect of the supervisory regulatory responsibility. That's at the root of this.

Just as you cannot prosper without a private economy, you cannot prosper without an effective autonomous government capable of thinking for itself, capable of balancing things out, of standing for other interests, of standing for labor and consumers and for the public interest as a whole. If you don't have that, you're going to get these pyramids, these bubbles, these epidemics of fraud and abuse, and ultimately the collapse of trust and the collapse of the economy itself. That's what's happened in the predator state.

I agree with Galbraith on much, including the fact that both private (e.g. so-called "rating agencies") and public regulators (e.g. government agencies, the US Congress, and US Adminsitrations dating back to Ronald Reagan) were asleep at the wheel. I hope Galbraith is right about the US dollar's non-endangered "reserve currency" status for the near term. I also hope he and other reformers are able in the next few years to restructure the world's financial systems to set a stage for thoughtful investment rather than unbridled speculative excess.

Note: My title might better have been written "None Dare Call it Corporatism." Here is a Wikipedia link to Corporatism. See also Wikipedia on The Economics of Fascism.

The Debt and the Deficit

I am a big fan of Peter Bernstein. I recently re-read The Debt and the Deficit to refresh my mind as to where we stand relative to both. Bernstein co-authored the book with Robert Heilbroner back in 1989. Heilbroner and Bernstein argue that, by itself, cutting the American budget deficit will not increase private savings, indeed it might help make it worse. In response to the question, "Can we raise the national savings rate by cutting the budget deficit?", they say:

The answer is no if that will result in a further squeeze on household and business income. The answer is yes if at the same time we are committed to measures to improve the productivity and international competitiveness of the American economy. And the achievement of these goals is critically dependent on a high level of public as well as private investment.

I highly recommend this little book to any who struggle with our current and historical debt and deficit problems. Too bad Heilbroner and Bernstein's insights were not followed. Here in the USA, we might have turned around our slide into household sector "dissaving". We might have rethought our using the military-industrial complex for purposes of Military Keynesianism (to whatever extent this very controversial proposition may have been employed (see also Republic or Empire)). We might have imposed a gas tax, as they then advised, in an era long before allegations of corporate wrong-doing and price gouging became fashionable.

All of it might have been done while keeping an eye open to the need to move more slowly into Globalization with some form of nation-to-nation capital flow controls to keep "hot money" from creating ever-bigger bubbles to later burst wreaking havoc afterwards. All of it might have been done with some form of policy to moderate the waves of outsourcing and offshoring that have plagued middle-class workers in the "more developed" countries. Oh well!

Love the Deficit or Fear the Deficit?

In his latest Credit Bubble Bulletin, Doug Noland counters Bear Stearns' David MalPass's recent, optimistic Wall Street Journal article "Embrace the Deficit." Here's a sampler:

Credit Bubble Bulletin, Doug Noland 122706: …Financial historians will reflect back on this period’s prevailing complacency, especially with respect to the massive U.S. Trade and Current Account Deficits, with astonishment and disbelief. Yet for now years of Credit and asset inflation — parceling out unimaginable financial rewards along the way — have Wall Street reassured that There's Simply Not an Imbalance Not to Love. The Street now appreciates that massive and intractable Trade Deficits provide the fountainhead of global liquidity overabundance. Moreover, the markets keenly recognize that the Bernanke Fed (like Greenspan's) is content to acquiesce to deficit and liquidity excesses. There is today no constituency for reining in the Bubble(s).

This week's release of a record quarterly Current Account Deficit ($225.6bn in Q3) garnered little attention from the media and even less in the markets. This despite the Deficit having now reached $900 billion annualized, or 6.8% of GDP. For perspective, the deficit for all of 1998 was $229 billion. At $877 billion, the Current Account Deficit over the previous four quarters compares to 2005's $812 billion, 2004's $664 billion, 2003's $537 billion, and 2002's $506 billion. And it is worth noting that the third quarter's deficit was up 36% from Q2 2004's $166 billion, back when the Fed commenced its fateful "tightening" cycle.

Bear Stearns' chief economist David Malpass provided commentary this week to The Wall Street Journal — "Embrace the Deficit." Mr. Malpass did a commendable job articulating Wall Street's dangerously flawed analysis of Credit Bubble-induced imbalances. …

Mr. Malpass: "For decades, the trade deficit has been a political and journalistic lightning rod, inspiring countless predictions of America’s imminent economic collapse. The reality is different. Our imports grow with our economy and population while our exports grow with foreign economies, especially those of industrialized countries. Though widely criticized as an imbalance, the trade deficit and related capital inflow reflect U.S. growth, not weakness — they link the younger, faster-growing U.S. with aging, slower-growing economies abroad. Since the 2001 recession, the U.S. economy has created 9.3 million new jobs, compared with 360,000 in Japan and 1.1 million in the euro zone excluding Spain. …"

…This protracted Credit Bubble would be much less perilous if our nation was expanding debt to finance sound investment. Or, if our mounting foreign borrowings were funding wealth-creating capacity — providing the ability at some point to satisfy our debt obligations with valued goods or services, or at least significantly reduce the scope of future deficits through the exchange of goods for goods — our current standard of living would not be so susceptible to the whims and fragilities of finance and global financial markets. Instead, we are the subprime borrower living beyond our means, yet for now luxuriating in our competitive advantage in issuing AAA securities in exchange for endless imports. These days, the vast majority of new debt liabilities issued to our foreign creditors are collateralized by inflated asset market prices (chiefly real estate and securities). This creates a Ponzi Bubble Dynamic where the perceived soundness of the underlying debt issued is dependent upon unrelenting Credit and Speculative excess (and resulting asset inflation). …

…U.S. household net worth has been expanding rapidly owing to Credit-induced home price and securities markets (price and volume) inflation. … $2.7 Trillion of debt instruments … created to pay for imports …$27 Trillion of debt held by households…. Our economy consumes more than it produces, financing this deficit through the endless inflation of additional debt instruments. Wall Street can stick with the fanciful tale that our Trade Deficits are instigated by "capital" inflows. It is, however, clearly a case of Credit excesses fostering over-consumption and mal-investment, creating progressively unwieldy dollar liquidity outflows to the world (that, by their nature, must be recycled back to U.S. debt instruments). …

…The U.S. Bubble economy has been sustained in 2006 only through the massive expansion of Credit (certainly including securities finance/leveraging!) — more than last year but less than next. But in no way is the Trade Deficit the "mechanism allowing consumption and investment in the U.S. to grow faster…" Instead, the deficit has evolved to become one of the prevailing unavoidable consequences of the Credit Inflation required to hold the downside of the Credit Cycle at bay. Of course, Wall Street, politicians, and the Bernanke Fed will work in earnest to avoid the downside of Credit excess. And, the way these Credit booms work, things tend to run amuck on the upside when they are turning most susceptible to faltering to the downside.

And, yes, as difficult as it is for me to accept, "they" really have come to Embrace the Trade Deficit. I guess "they" have no choice. As is often said, "people will believe what they have to believe." All the same, it's been stupefying to witness over the course of many years the seed of this spurious notion mature into a full-fledged national self-deception — ripening to the point of achieving ratification from top policymakers (including our Fed chairman), affirmation from the financial markets, and acceptance throughout. Students of economic history are all too familiar with the repeated bouts of turmoil, wreckage and revulsion — the legacies of absolutely ridiculous notions that somehow came to be readily embraced in the heat of intoxicating booms. Reading Mr. Malpass's piece yesterday ... left me again with that uncomfortable feeling that we’re living today in one of those extraordinary periods that will be studied and contemplated for many decades to come.

US Headed Toward Bankruptcy?

A recent British news headline says US 'could be going bankrupt'. The storyline might be summed up: "A ballooning budget deficit and a pensions and welfare timebomb could send the economic superpower into insolvency, according to research by Professor Laurence Kotlikoff for the Federal Reserve Bank of St Louis…."

Bill Moyers asked Peter Peterson that question in the fall of 2003 (9/6/03) {Peterson is president of the Concord Coalition}. Peterson's answer was, in part:

… There's 77 million Boomers we're talking about. A doubling of the elderly. Half of the people getting Social Security make less than $20,000 and they depend enormously on Social Security as part of that. ... Unfortunately, our country has staggering amounts of elderly that have no savings at all, about 20 percent.

Imagine politically 77 million Boomers. They don't have savings. They depend on Social Security and somebody's saying to them, "Sorry, folks, we're out of money. You're not going to get your benefits."

And they've been told -- they've been misled by politicians all their lives -- that this Trust Fund is going to take care of them. My father went to his deathbed thinking that there was real money there. And he said, "My son, I don't know what you're talking about because it's like a savings account."

And I kept saying, "Dad, there's nothing in there. It's just liabilities." So I think that political ... implications would be devastating. But more than that, the social implications. It's the richest nation in the world. And you're going to sit there and tell me we're going to throw tens of millions of Americans into a destitute situation without advanced notice? I don't think so. …

I'll give you several possible suggestions. A menu. Very gradually increasing the retirement age, because we're living much longer. If we had indexed retirement to the way life spans have gone up, we'd be getting Social Security now at 73, not at 65.

A second thing is what I call an affluence test. I don't like the word "means test," because it sounds mean. And Bill Moyers and Pete Peterson would lose some of their benefits, because we don't need them.

A thing Lady Thatcher did that I find very promising, she said, "How do we be fairer to the current retirees and to our children? How do we do that?" And she came up with the idea of indexing benefits only to inflation. And that meant that my kids would get the same benefits in dollar-- real dollar terms, but they wouldn't grow.

Now those are the kinds of things we're going to have to seriously look at. …

Laurence Kotlikoff has his own list of remedies, including a national sales tax (with rebates some), Social Security Reform, Healthcare reform, and more. See his recent Federal Reserve article Is the United States Bankrupt? [PDF] , Federal Reserve Bank of St. Lewis Review, July/August 206.

I'm not sure whether or not Kotlikoff's proposals are workable and affordable even in the unlikely event that our politicians were to seriously address the issue of our current-path insolvency. But at least they ought to be given their due. Kotlikoff's proposals, ike Peterson's can be stacked up alongside others for future historians as they ponder our fate from the other side of destiny. At best, but not likely, our politicans might do something about this mess.

Note finally that Arnold Kling is likely typical of libertarian critics, not liking Kotlikoff's proposals in the main because they come from government:

… The fundamental problem, which Kotlikoff expresses in somewhat different terms, is that there is no consumer protection agency for phony government marketing. If a private company tried something as unsound as Social Security or Medicare, it would be shut down and its officers put on trial. But the voting public is ignorant of government scams, and I see nothing that will change that. …

And as to Bankruptcy, Kling doesn't buy it:

…Calling the U.S. bankrupt depends on calling future Social Security and Medicare recipients "creditors." But the government's extravagant promises can be taken away as well as given. The question is when and how. The government can wipe out its "bankruptcy" at the stroke of a pen by raising future retirement ages, although Kotlikoff probably would argue that for his tastes this does not shift enough of the burden onto the current wealthy elderly. …

The problem is, of course, politics. Yes promises can be "taken away" but not without paying a "political" price.

Note to myself: I ought to read Kotlikoff's and Scott Burns' book, The Coming Generational Storm, but who knows when. So many books, so little time!

How Close Are We to a Monetary 'Sudden Disorderly Adjustment'?

Margaret Legum is Chair of the Board for South Africa New Economics Network (SANE, South Africa). Legum published How Close are we to 'Sudden Disorderly Adjustment'? in the July 1 Post-Autistic Economics Review. Indeed, how close are we to a potential dollar collapse with attendant world-wide consequences? Does anyone really know?

Brad Delong, for example, in rethinking his long-standing opposition to a "federal balanced budget amendment" is beginning to ponder the proposition of setting up a quasi-independent board for the fiscal side of the equation—remember Dick Cheney's famous quote, "Deficits Don't Matter!"—to mirror the Federal Reserve System on the monetary side of the fence. DeLong calls his notion a "Fiscal Stabilization Board" and suggest that it might be needed since US politicians seem, going forward, incapable of fiscal responsibility. Such irresponsibility sets a stage for possible "hyperinflation, economic stagnation, or a full-blown crisis—sometimes all three at once." Time for a Fiscal Stabilization Board to Deal with the Deficit? is an excellent example of DeLong's new "morning coffee Videocast" series, by the way.

Stephen Roach, George Soros, and Paul Volker have been shrill for a while, as have most of the blogs linked here, with Roach and Soros warning of "economic Armageddon" according to Legum.

Legum's reminder came out in May (although just now published in the Post Autistic Econ review) when Gold prices were at a record high, when sword-rattling over Iran (Oil Bourse) was at a high point, and when, according to Legum "Associated Press [May 5th] quoted top Wall Street analyst Bill O’Grady of A.G. Commodities: 'If one day the world’s largest oil producers allowed, or worse demanded, euros for their barrels, it would be the financial equivalent of a nuclear strike.'"

Since that time, Stephen Roach has softened his rhetoric a bit, and said on June 23rd "…I continue to be impressed by the newfound religion of the stewards of globalization." Roach also continues to hedge his bets, saying " There’s nothing simple or painless" about implementing positive changes to ward off the worst possible outcomes from current instabilities in the rush toward globalization.

As to any 'Sudden Disorderly Adjustment', perhaps Goodwin Ginger has it about right in his July 5 post in the Canadian Observer:

Margaret Legum argues that the real motivation of current US posturing towards Iran may have more to do with Iran’s plan to open an oil market denominated only in Euros. This is a credible argument insofar as a shift to a Euro denominated oil market would undermine the US dollar as the central global currency and thereby undermine its capacity to finance both the largess of Empire and domestic spending.

Some caution should be exercised in reading such analyses .... [A]s the movement off the gold standard demonstrated long ago the move to a credit based financial order did not bring an end to the world as we know it. Nor do we suspect would an end to the monopoly the US currently enjoys on the denomination of oil in US dollars. If the end of the US as a hyper-power could be brought about by simply re-denominating oil in another foreign currency it would have happened long ago. That it has not happened also suggests that oil producing countries get something out of the current arrangement so there is more than just coercion at play here. In any case, a grain of salt is as always the curative for any analysis which concludes with the sky is falling.

Still, I worry about derivative markets, hedge funds, risk concentration and other stuff that I don't understand enough about to be convinced that the long-term chronic problem is the only one we are likely to face. My worries linger, even though this particular long-term problem includes the risk of losing America's middle class. That risk is sufficient worry all by itself.

Finally, like DeLong I believe that the idea of using deficit spending to regularly stimulate short-term economic euphoria is much like "Crack"—it feels good now, but "someday—not today, not tomorrow, but soon and for the rest or your life" it will be regretted. "What to do about it?" remains the big question.

Three Bears: One Softening, Two Holding Strong

I listen to many economists, but mostly toward the bearish side of the economic balance beam. I read Stephen Roach, Paul Kasriel, Nouriel Roubini and Brad Setser, Doug Noland, and Michael Shedlock, among others. Imagine my surprise when I saw Brad DeLong announce: "After seven years as a global economy bear, Stephen Roach is now optimistic." DeLong was playing off:

FT.com / World / International economy - Former bear turns bullish on global economy: By Jennifer Hughes in New York: The world economy may be able to unwind its current imbalances without serious disruption, Stephen Roach, Morgan Stanley's famously bearish chief economist, predicted on Monday, in a remarkable revision to several years of gloomy prognosis. Mr Roach had long warned that the US current account deficit and Asian central banks’ ballooning currency reserves risked destabilising the global financial system.

But on Monday, in a note to clients, he said: "I must confess that I am now feeling better about the prognosis for the world economy for the first time in ages." His comments came as the dollar hit a one-year low against the euro and seven-month low against the yen, as investors remained confident the US Federal Reserve was nearing the end of its interest-rate-tightening cycle. Mr Roach said the tipping point had been last month’s decision to mandate the International Monetary Fund to begin multilateral discussions with the aim of resolving the largest trade imbalances.... "I’ve been wringing my hands over the mounting global imbalances for longer than I care to remember," said Mr Roach. "The world is finally taking its medicine - or at least considering the possibility of doing so. The risk is that this is so far only on paper, but it’s a critically important first step."

So I dug up Roach's article, Global: World on the Mend, and found a bit of hope on his part, but not "former bear turns bullish." Roach's conclusion:

No, I am not prepared to give an unbalanced world the green light. But it’s time to give credit where credit is due: First, to globalization for holding down inflation. Second, to central banks for collectively embarking on policy normalization campaigns. Third, to the stewards of globalization for facing up to the imperatives of architectural reform. And fourth, to Asia -- especially China -- for recognizing the unsustainability of export-led growth models. Notwithstanding the risks noted above -- all of which need to be taken very seriously -- I am delighted that the global economy finally seems to be taking its medicine. Let's hope the cure works.

Latest views from Noland and Shedlock serve up a much darker prognosis. Shedlock says,

...Bernanke is in serious trouble and I wonder if he knows it. If he pauses, gold silver and commodities may do a "moonshot" and whether or not he does, housing and the economy is "burnt toast". … What the market does not seem to like is the idea of more rate hikes. The homebuilders do not seem to care much for it either.

Meet the real world Ben Bernanke. You are damned if you do and damned if you don't. By the way, I would appreciate it if you keep hiking. A truly fantastic long entry on the 10 yr treasury would be appreciated.

$Ben, just so that I am not misunderstood, let me state flat out that you and I both know that you are scared half out of your pants. It seems the scenario you now face is this:
1. Inflate or Die
2. Inflate and Die ...

And Doug Noland concludes his 4/28 Time to Pause? :

...The Bernanke Fed is in one hell of a predicament. There is today no way to rein in escalating global excesses without a serious bout of U.S. financial and economic tumult. These days, such a scenario is simply unthinkable. Yet the status quo fosters only more problematic Monetary Disorder. Mortgage Credit growth is likely to approach last year's stunning $1.4 Trillion level, while energy and M&A-related borrowings surge. Global leveraging of commodities, securities markets, and real estate is creating unfathomable liquidity excesses. Bull markets create their own liquidity until they don’t.

More than ever before, U.S. consumer retrenchment and resulting recession are required for the commencement of the long-overdue and unavoidable adjustment process, although the Fed is more determined than ever to maintain the boom. At this point, boom-time conditions are sustained only by ongoing massive Credit inflation (dollar debasement), with this inflation/debasement exacerbating the increasingly destabilizing non-dollar speculative flows.

We are indeed witnessing The Critical Policymaker Credit Bubble Dilemma: the bigger and more vulnerable the Bubble, the greater the propensity for policy acquiescence and accommodation. The present course guarantees ongoing $800 billion-plus Current Account Deficits. Unconvincingly, Dr. Bernanke too loudly declares that our deficit is a global issue and – especially considering the backdrop - too conspicuously is content to do nothing.

We're now into year four of the Great Dollar Bear Market. Importantly, the Financial Sphere has by this point had ample opportunity to adapt and devise myriad instruments, avenues and strategies to profit from a declining greenback (inflating non-dollar prices). Speculators and investors have played and won overseas, and these strategies are now widely accepted as mainstream (a deepening "inflationary bias"). Global markets today capture the majority of U.S. mutual fund flows, while American stocks are bolstered by massive company buybacks. The ballooning pool of global speculative finance is more than comfortable playing global equities, emerging market debt, and commodities; and the more favorable the relative out-performance versus dollar returns, the greater the (self-reinforcing) flows from dollars to non-dollars. Additionally, pension funds are now keen to participate in the easy outsized returns. Derivatives markets and other leveraging strategies have evolved to meet booming institutional demand across all markets.

Meanwhile, scores of new mutual funds, ETFs (exchange-traded funds) and other instruments have sprouted up to provide less "institutional" investors easy access to the commodities and emerging market booms. Pimco's Bill Gross even recommended an Asian ETF (twice) yesterday in a Bloomberg interview. I don’t believe the ramifications for the powerful and intensifying Inflationary Bias toward non-dollar asset classes garners the analytical attention it deserves.

The Fed is playing a losing hand and keeps wagering our currency. Accommodating the current Credit Bubble guarantees massive Current Account Deficits, as well as heightened speculative flows out of dollars and into commodities and global markets. The expectation that a declining dollar would help rectify global imbalances has failed to come to fruition, a circumstance not the least bit surprising to Macro Credit Analysts. Flawed policymaking (accommodating Financial Sphere excesses) ensured escalating Credit Inflation and only more and bigger Bubbles. As buyers of last resort, foreign central bank reserves have ballooned about $1 Trillion over the past 18 months. Ominously, this incredible support has only stabilized the dollar's freefall. Time to pause?

It is today ridiculous for chairman Bernanke and Fed officials to state that changes to our trading partners' policies (chiefly to stimulate foreign domestic demand) and currency exchange values will assuage the U.S. Current Account Deficit (and other global imbalances). We've already witnessed the consequences of wholesale Global Credit Inflation: a ballooning and more unwieldy pool of global speculative finance, along with wildly inflating commodities and asset markets. Global inflation is the problem and not the solution.

The higher energy and commodities prices surge, the greater U.S. Credit expansion and resulting dollar outflows necessary to satisfy (monetize) our dependency. The more foreign asset markets inflate, the greater the tide of speculative outflows to non-dollar markets and assets. With foreign central banks fully loaded to the gills with dollars and not all too tickled about it, it is not an easy exercise to contemplate a backdrop more conducive to a run on our currency. And how ironic would it be if such a run was instigated by our own institutions and citizens, as opposed to our foreign creditors?

Time for the Federal Reserve to contemplate pausing? Of course not. Chairman Bernanke just committed his first mistake; the dollar got clobbered; and the flight to the safe-haven (non-dollar) metals intensified. The bond market froze (deer in the headlights?). And, as one would expect, global markets turned increasingly unsettled this week and are surely poised to become only more so.

Here's a bit more from Roach:

US on Slippery Slope: Consuming Beyond its Means

Stephen Roach, Chief Economist at Morgan Stanley, spoke at the China Development Forum in Beijing on March 19:

...The United States is flirting with protectionism at a time when its need for foreign capital has never been greater. At work is a highly combustible mixture of macro and politics. America's saving shortfall has led to a massive trade deficit, and China happens to account for the biggest portion of that deficit. Meanwhile, a growing sense of angst has gripped the middle-class American workers. This has triggered a classic political blame game, with China being increasingly singled out as the scapegoat. The drumbeat of China bashing is growing louder and louder.

There is a very simple and extremely powerful macro point that is being overlooked in this debate: America no longer has the internal wherewithal to fund the rapid growth of its economy. Suffering from the greatest domestic saving shortfall in modern history, the United States is increasingly dependent on surplus foreign saving to fill the void. The net national saving rate the combined saving of individuals, businesses, and the government sector after adjusting for depreciation fell into negative territory to the tune of -1.2 per cent of national income in late 2005. That means America doesn't save enough even to cover the replacement of its worn-out capital stock. This is a first for the United States in the modern post-World War II era, and I believe a first for any great power over a much longer sweep of world history. ...

America, in general, and its consumers, in particular, treat rapid economic growth as an entitlement. That leaves the United States with little choice other than to pursue the second option - drawing heavily on the global saving pool in order to fund economic growth. Once the United States started down the slippery path of consuming beyond its internal means, it got harder and harder to break the habit. Ironically, it has become exceedingly difficult for Washington to accept the consequences of that habit - a nation that has become beholden both to external funding and production. And yet that's exactly how China fits into America's macro equation.

That underscores a key attribute of the savings-short, deficit nation: It is forced to run current account deficits in order to attract the requisite foreign capital. And in the case of the United States, where external funding needs are so massive - now closing in on US$800 billion per year, or about US$3 billion per business day - most of the current account imbalance shows up in the form of a huge trade deficit. In 2005, the trade deficit in goods and services accounted for fully 93 per cent of the total current-account gap. ...

Meanwhile, the United States does next to nothing to shoulder its share of the problem a staggering shortfall of domestic savings.

{Hat Tip to Steve Hsu, Information Processing}

Financial Contagion Afoot? Ask Roubini

Nouriel Roubini is one of my favorite financial reads. Yesterday he laid out the similarities between the US and countries hit by recent financial "panics" including currency and debt markets of Turkey, Hungary, Australia, New Zealand, evidently all stemming from financial woes in Iceland.

What do all these countries have in common with the US? Roubini explains:

First, a large (relative to GDP) current account deficit, a large (relative to exports) external debt and a significantly overvalued exchange rate.

Second, an asset bubble in the housing sector.

Third, a fall in the private savings rate and an increase in the consumption to GDP rate, as well as a boom in real estate investment that are all driven by the housing bubble; these, in turn, lead to a worsening of the current account.

Fourth, a credit boom that has fed this asset bubble and that can make their banking system vulnerable to a housing bust.

Fifth, a partial cross border financing of the current account deficit via the short-term cross border flows to the banking system that currently is mostly in domestic currency (but that in some cases used to be in foreign currency).

Sixth, a relatively low stock of liquid foreign exchange reserves relative to the cross border foreign currency liabilities of the country (the U.S. and advanced economies being an exception as they have little forex reserves but also little foreign currency debt).

On top of all these vulnerabilities, some but not all of these countries - the U.S. in particular - have also a large fiscal deficit. ...

...Suddenly, in all these countries [excepting the US] investors are realizing that the force of gravity of a large current account deficit eventually dominates the carrry trade of interest rate differentials. It is true that the large current account deficits of these countries and their housing bubbles have been known for a while. But markets and investors have a strange way of sometimes waking up - as they did in Thailand in 1997 - and realize that the problems in one country - Iceland today (Thailand in 1997) - are very similar to those in other countries (East Asia in 1997 and the "usual suspects" above today).

The US is not yet "hit," but warns Roubini:

...[Y]ou can play your luck only for so long, especially when - unlike all these other economies - you also have a large and growing fiscal deficit and you are increasingly financing it with new short term debt that is 100% purchased - on net - by non-residents that are now subject to a serious currency risk. It used to be argued that short term foreign currency debt is dangerous when you have little foreign currency reserves as liquidity runs can occur; while domestic currency debt is less risky as you do not have the same rollover/liqudity risk; it was also argued that, as the currency risk is held by the non-residents holding your local currency debt, no nasty balance sheet effects of a devaluation can occur.

But these arguments are probably flawed: if most of your domestic debt is in local currency and is held by non-residents, these investors face a large currency risk. Thus, once they start to expect a large depreciation of your currency, their incentive to hedge their currency risk and dump your assets and your currency becomes very large. Then, both a currency crisis and a run on your assets - be it liquid bank deposits or short term government debt -may occur - with nasty effects on your financial system and the ability of your government to finance itself. So, the fact that U.S., Spain, Australia, New Zealand and now even emerging markets such as Turkey and Hungary are financing themselves in local currency may be of little comfort. Runs on currency and liquid local assets may still occur with severe and disruptive effects on currency values, bond markets, equity markets and the housing market. …

…The developing events in Iceland and, possibly, in other emerging market economies, suggest that it was wishful thinking to believe that currency crisies, contagion, financial crises and runs were a thing of the past.

In the meanwhile U.S. policymakers - both at Treasury and even some, but not all, at the Fed - live in this LaLa Land dream that the U.S. current account deficits and fiscal deficits do not matter and that the U.S. external deficit is all caused by a global savings glut or is actually a "capital account surplus" as it allegedly represents the foreigners' desire to hold U.S. assets. They - and financial markets and investors - may soon wake up from this unreal dream and face a nightmare where the U.S. looks like Iceland more than they have ever fathomed.

Meanwhile, The US and China are "playing with fire," says Roubini in a March 22 post, on a collision course perhaps as early as this year: