[Marxism] Perfect storm?

Louis Proyect lnp3 at panix.com
Sun May 8 08:30:54 MDT 2005

NY Times, May 8, 2005
The Perfect Storm That Could Drown the Economy

WE seem to be living in apocalyptic times. On NBC's "Revelations," Bill 
Pullman and Natascha McElhone seek signs of the End of Days. In the Senate, 
gray-haired eminences speak of the "nuclear option."

The doomsday theme is seeping into the normally circumspect world of 
economics. In April, Arjun Murti, a veteran analyst at the investment bank 
Goldman Sachs, warned that oil could "super-spike" to $105 a barrel. And 
increasingly, economists are prophesying that the American economy as a 
whole may be sailing into choppy waters.

Just look at the many obvious and worrisome portents. The government each 
year spends much more than it brings in, and so the nation has a large 
budget deficit ($412 billion in fiscal 2004, and growing). Americans also 
import far more goods than they export, and so the nation has record trade 
and current account deficits.

As consumers, Americans personally spend significantly more than they earn. 
Worse, some imbalances are eerily reminiscent of conditions that helped 
touch off recent economic crises: Mexico in 1994, Asia in 1997, Russia in 
1998 and Argentina in 2002. Throw in rising interest rates, warnings of a 
housing bubble and the potential for higher inflation and slower growth (a 
k a stagflation) - and you can understand why some economic analysts may be 
plumbing the New Testament for inspiration.

The forces propelling and buffeting the economy are like a series of 
interrelated and interconnected weather systems. Could they be setting the 
conditions for a perfect storm - a swift series of disturbances that causes 
lasting damage? If so, what would it look like?

"There's a pattern that is familiar from so many other countries that have 
gotten into debt problems," said Jeffrey A. Frankel, an economist at 
Harvard's Kennedy School of Government. "A simultaneous rise in interest 
rates, fall in securities prices and depreciation of the currency."

Of course, economists, always armed with bandoliers of caveats, are quick 
to warn that the economy is relatively healthy. Job growth numbers released 
on Friday were strong, with 274,00 new jobs created in April.

And they warn against drawing parallels too sharply between the mighty 
United States and emerging markets. The dollar remains the world's reserve 
currency, and the United States is a global military and political hegemon. 
And the nation has been able to borrow huge amounts for years without 
suffering a crisis.

That said, how might a perfect storm be created? It would likely gather 
overseas, and wouldn't necessarily take the form of a terrorist strike or 
oil shock. The United States finances its spendthrift ways by selling 
dollars and dollar-denominated securities (like Treasury bills) to foreign 
creditors, mostly to central banks in Asia. To sustain growth, the United 
States needs foreign creditors to continue to add to their piles every day.

Any signs to the contrary are worrisome. In February, when the Korean 
government suggested that the Bank of Korea might diversify its foreign 
exchange holdings, "this seemingly innocuous statement set off a small 
panic in our stocks and bond markets," said James Grant, editor of Grant's 
Interest Rate Observer.

If the Bank of China, which has been accumulating dollars at the rate of 
$200 billion a year, decides to cut back on new purchases, either to 
diversify or to let its currency appreciate, the United States would 
quickly have to offer sharply higher interest rates to retain existing 
investors and entice new ones. Nouriel Roubini, an economics professor at 
New York University's Stern School of Business, estimates that if China cut 
its rate of accumulation by half, long-term interest rates in the United 
States could rise by 200 basis points over a few months and the value of 
the dollar would fall.

Such a rising tide - the yield on the 10-year bond shooting from 4.25 to 
6.25, the average 30-year mortgage rising from 6 percent to 8 percent - 
would mean instantly higher borrowing costs for the government, businesses 
and consumers. It would drench Wall Street, soaking the stocks of giant 
interest-rate-sensitive blue chips like Citigroup and making life difficult 
for speculative, debt-ridden companies. Some highly leveraged hedge funds 
or investment banks caught on the wrong side of trades would incur 
significant losses.

The United States weathered a sharp decline in the stock market just a few 
years ago, in large part because of the housing market's strength. But a 
sharp rise in interest rates would literally hit home. For new home buyers, 
or for people with adjustable rate mortgages, 200 extra basis points of 
interest on a $400,000 mortgage would represent $8,000 a year in extra 
payments. If mortgage rates were to rise sharply, housing prices would 
level off and perhaps do the unthinkable: fall.

Suddenly, the mechanisms that have allowed consumers to keep the economy 
afloat - the ability to realize profits from selling homes, to refinance 
mortgages at lower rates and to borrow cheaply against home equity - would 
be broken. In the absence of sharply rising wages, that $8,000 in extra 
interest would be $8,000 less to spend at Home Depot, or at the Cheesecake 
Factory, or at Disney World.

"Personal expenditures in the past 15 months have been largely financed by 
borrowing," said Wynne Godley, a Cambridge University economist who is 
affiliated with the Levy Institute at Bard College. "And even a reduction 
in the pace of debt creation will force people to start spending less, on a 
big scale."

If the dollar weakens and consumption falls, the trade and current account 
deficits would start to narrow. But the United States economy would slow 
and, perhaps, even shrink.

"The result would not be a full-blown financial crisis most likely, but it 
would still be a major recession," said Barry Eichengreen, a professor of 
economics and political science at the University of California at Berkeley.

What would create the full-blown crisis? When the slowdown starts to 
radiate across the globe, said Catherine L. Mann, senior fellow at the 
Washington-based Institute for International Economics.

For years, the American consumer has been the engine of global growth, by 
gobbling up the output of oil wells in Saudi Arabia and factories from 
Mexico to China. "The slowdown in consumer spending is going to have a 
negative influence on the global economy through reduced international 
trade," Ms. Mann said.

What's more, a recovery would be comparatively slow in coming. When the 
global economy came to a screeching, synchronous halt in 2001, the United 
States led much of the world back to growth because the federal government 
went on a stimulus binge for several years: Congress significantly 
increased government spending while cutting taxes, and the Federal Reserve 
slashed interest rates to historic lows, and held them there.

But in the perfect economic storm, none of these three powerful levers 
would be readily available. Today's deep budget deficits make both 
significant tax cuts and spending increases unlikely. And rising interest 
rates would make it difficult, if not impossible, for the Federal Reserve 
to reduce the cost of borrowing.

It sure sounds alarming. But as the clouds gather and the wind stiffens, we 
sail onward, with no apparent adjustment in course, full steam ahead.

Why aren't we rushing to take evasive action? Why is Congress adding new 
spending while it passes new tax cuts? Why aren't financial institutions 
encouraging Americans to pay down their debt rather take on more?

A lot of it has to do with timing. While many economists are willing to 
imagine in detail what a perfect storm would look like, virtually none will 
forecast precisely when - or if - it will start. And so it remains a vague 
and distant possibility.

Besides, adds Jeffrey Frankel, "some of us have been warning of this 
hard-landing scenario for more than 20 years."

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