Thursday, March 31, 2005

This week the top center-left economics blogs have been wrestling with the question of the basic stability of Bretton Woods II, in particular the ability of Asian central banks to support the dollar under a worst-case scenario. Brad Setser and Brad DeLong have weighed in heavily on the "hard landing" side; Kash at AngryBear is undecided but leaning towards a "soft landing" outcome. My contrary nature pushes me towards the "hard landing" group, but I'm convinced that this landing is further off than either of the Brads seem to suggest. Here's why.

I don't put much stock in DeLong's concerns over Asian central bank defections from the current regime. Following earlier arguments by Nouriel Roubini, DeLong argues
The first central bank to decide that the game is up wins and escapes all risk. The rest are left holding the rotting hot potatoes.
As far as the Big Four players in the current dollar regime go, this statement is flat out false. The big four are, in order: Japan, China, Taiwan and Korea. More importantly, they move as a block. Korea's tenuous and ultimately abandoned attempts to defect from the bloc in 2004 and again in early 2005 demonstrate as much. In short, Korea tried to defect and found the won rising precipitously in a matter of days. The reserve devaluation risk is far off and nebulous, dependent upon a conversion of dollars into the local currency (which does not necessarily have to occur). The local currency appreciation, especially vis-a-vis other Asian currencies, is on the other hand rapid and concrete. The latter risk is clearly more important than the former -- Korea is case in point.

Thus these four move together, with China the de facto leader. I cannot see any plausible scenario in which any of the three followers defects first; because of their growing economic dependence on and integration with China, they will move only when/if China moves. If China moves, that signals the end of BWII altogether, quite a different story from the 'defection' scenario drawn out by DeLong.

What about private investors? DeLong in particular thinks they can be the trigger to this house of cards collapsing, but with US interest rates rising in the face of stable interest rates elsewhere in the world, why would private capital flee US assets? The spread between US and German bonds, for example, is at its highest point in years. The real threat of private capital dumping US assets involves Asian capital more than European or North American, since it is unlikely there will be a permanent drop in the dollar's value vis-a-vis the euro, pound or Canadian dollar in the near future whereas there is a high likelihood that there will be a permanent drop vis-a-vis the renminbi or other Asian currencies. But in the past the Japanese government has proven itself very capable of pressing "private" capital into US assets even in the face of real exchange rate losses and can do so again.

In addition, there is the strategic-military argument about Japan, Taiwan and Korea supporting the dollar which I still think has merit.

What the hard landing scenario really has going for it, in my view, is a US debt trap. In 2004:IV US net investment income dropped to a mere $2.1bn, less than one-half the level of 2004:II and III and less than one-fifth of 2004:I. Based on both the incredible volume of US debt being sold off to foreign capital in addition to rising US interest rates relative to the rest of the world, that number finally will be turning negative, probably this year. With investment income on a growing net outflow, the current account deficit will start to swell regardless of what happens to the trade deficit. Perhaps a combination of higher interest rates and a weaker dollar will indeed push monthly trade deficits back under $50bn, but if quarterly net investment income deficit rises to say $15bn, that will cut in half the gains made through lower trade deficits. And unlike trade, investment income is a snowball rolling downhill.

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