Brad Setser

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Robert Rubin still worries about the risk of a hard landing …

by Brad Setser
January 24, 2006

From Rubin's Wall Street Journal oped:

The effects of these fiscal conditions are exacerbated because they occur, uniquely in the U.S. amongst the developed nations, in combination with a very low personal savings rates, high levels of personal debt and enormous current account deficits (currently in excess of 6% of GDP, and caused at least in part by our fiscal deficits).

….  And the far greater danger is that these various imbalances could at some point lead to fear of fiscal disarray and concern about our currency, causing sharply higher interest rates in our bond markets and the risk of a sharp exchange-rate decline. ….  The adverse impact on interest and currency rates has not yet occurred, partly because business has had relatively low levels of demand for capital — but most importantly because of vast capital inflows from abroad (until recently, predominantly from central banks supporting the dollar to subsidize their exports). This is not indefinitely sustainable; at some point, which could be near in time or still some years out, continued imbalances, increasing fiscal debt levels and ever-greater overweighting of dollar holdings abroad are highly likely to lead to loss of confidence, and trouble.

There are lots of reason to worry about this scenario.  But one is that any reduction in foreign confidence in the US would undermine one the economy's key shock absorbers: the tendency of interest rates to fall as US economic activity slows, helping to moderate the fall in economy activity.

A savings "supply shock" that reduced the flow of global savings to the US could imply that US interest rates would rise even as the US economy slows.  The Fed would cut short-term rates in response to the slowdown, but foreign investors would not be willing to add to their dollar balances at those low rates.

The market would find an equilibrium:  policy rates might fall, but market (long-term) interest rates might not.  So a US slump might not lead to lower US rates.  Or in the worst case scenario, might be accompanied by higher long-term rates.

Remember, the US will still run a very large current account deficit even if the economy slows.   It will still need to attract very large flows of savings from abroad.   The price the US has to pay (the interest rate) to attract that saving matters.

There is an obvious analogy to an oil supply shock.   If higher demand leads to higher oil prices, that's one thing.  If demand falls, price should fall.   Rising oil acts as a brake on the expansion, and falling oil prices help soften any contraction.  Not so with a supply shock.   A supply shock can drive up price even as demand and activity are falling.   Or more precisely, a supply shock prices up the price, leading to a fall in demand and activity.

Thomas Palley is right:  "Foreign flight" (a shock to the United States ability to borrow savings from abroad) is very different from "Consumer burnout" (a slowdown in US demand growth).   In both the foreign flight and the consumer burnout scenarios, the US economy slows and the dollar falls.  But in the foreign flight scenario, as Palley notes, the fall in the dollar and rise in US (market) interest rates triggers the US slowdown, while in the consumer burnout scenario, the US slump triggers dollar weakness.    Foreign flight would combine dollar weakness with higher US (market) interest rates, consumer burnout combines dollar weakness with lower interest rates.   

Bill Gross sure seems to be betting on consumer burnout – driven by a slowdown in .home froth and home equity withdrawal.  

Actually, he seems to be betting that consumer burnout won't give rise to foreign flight.  Consider the following scenario.  Consumer burnout could cause the US economy to slow and the Fed to start cutting rates.  But as US rates start to fall, foreign investors lose interest in lending even more to the US.  Rather than adding $1 trillion or so to their portfolio of dollar denominated bonds at 4.5%, they want to add only say $600 billion or so … Reduced foreign demand for US dollar assets ends up pushing US interest rates up. 

At least those interest rates that are set in the market.  The Fed's response to consumer burnout could trigger foreign flight. 

That is a bad scenario. It implies that the US economy wouldn't benefit from some of the stabilizers that normally buffer the US from really bad (economic) outcomes.  

The risk of an oil supply shock that would keep oil prices from falling as US demand slows sure seems to be rising.  And underneath the surface, I suspect that the risk of a "savings" supply shock that would keep interest rates from falling even as the US economy slows are rising as well.


  • Posted by Joe Rotger

    One final thing,

    Borrowing is a way to spend today, future income.

    There’s a lot of room here, mortgaging future generations to continue present spending.

    I also feel long term bond sterilization is an excellent way to remove USDs from the present…which is why long term bond buying is crowded and their rates low.

    Borrowing by mortgaging the future can go on for a very long time…

  • Posted by DF

    the yeld curve :

    THis article offers another self deserving explication : rising retirements and changing pension accounting rules explain rising demand for long term bonds. Hence the fall in long term rates. And there fore the inverted yeld curve does not mean anything

    Joe rotger you wrote
    n sum, I don’t feel it’s correct to preach different roads to heaven to different people; it’s either that it’s good to save or we all go out on a spending spree?

    I think you need to realise that when you say to one guy save more and to another save more you are not preaching different roads to heaven. You are teaching exactly the very same road, the middle road.
    It’s dangerous to oversave overinvest, this create overproduction crisis. It’s dangerous to undersave under invest, this creates stagnation.
    And it’s dangerous to overlend overborrow, this ensure future crisis.

    if there’s one road to heaven and some are on the left of it, you ask them to move to the right … and vice versa.

  • Posted by Joe Rotger


    I understand what you’re trying to convey.

    But, I don’t see Warren Buffet hurting too much b/c he’s gone too far to one side of the road, nor China for that matter; and yes I do see the hurting on the guy that’s taken too much debt and is spending more than his income.

    I tend to think we should be leaning a bit more on this strayed poor fellow than the Buffet Treasury saving kind…

    Middle of the road? Why?
    Could it be the tainted glass perspective of the guy in trouble?

    Is it bad to have a wad of USDs in your purse?
    I’m looking forward to someday being able to answer this question with first hand experience.

  • Posted by Joe Rotger

    I just read the Bloomberg note, interesting article.

    So, additionaly there are demographic reasons for a low long term rate too. BTW, China has an enormous aging population…

    BTW, I woudn’t discount totally the significance of the inverted yield curve.

    It is basically saying that the Fed’s effort to hamper liquidity through short term rate increases is being unravelled by a loose end at the long term rates; where the PBoC and other foreign CBs are using a different method to remove liquidity, long term lending at very low rates to promote present consumption.

    It further says that the Fed cannot sustain these rates in the face of an increasing trade deficit, brought about by an increase in the USD due to higher Fed rates.

  • Posted by DF

    Joe, basically saving is good depending from how much your neighbor saves.
    If there is a production of 100, Investment of 20, Consumption 80, wages are 60,And people who earn returns on their assets get 40. wage earners do not save, spend 60, asset holder spend 20 and save 20.

    Suppose, suddenly, all wage earners start to save 10% of their wages, bam, consumption falls to 74. That may happen because say they fear for retirement, they have debts, whatever.

    What happens to production ?
    Suddenly there’s too much production, then prices fall, lay offs etc. The example looks like the USA now.

    You may say : OK but it started because people saved not enough.

    True in that case, but the opposite can happen,

    If there is a production of 100, 50 final goods, 50 investment goods, Investment of 50, Consumption 50 wages 60 And people who earn returns on their assets get 40, wage earners save 20 and spend 40, asset holders spend 10 and save 30.

    The next year, production has doubled because of investment, but people encouraged by the success, save even more : there’s not enough demand for the products, the country needs to export, then, there’s not enough demand,… And suddenly the country realises it has tons of new plants coming on the market, and there are no consumer for them…

    Saving more than your neighbour is always good, however when dealing with a country and even better with a world economy, it’s better to have a balanced saving rate ensuring stable growth.

    It’s exactly the same as university and shooling, if all people go to university and get a bachelor then you have to go their and get a master. That’s how

  • Posted by Joe Rotger


    Just so we have it straight, I’m not giving one hiota of my future wad of USds, say what you will…

  • Posted by dave iverson


    Have your concerns about deflation and credit bubble dynamics been adequately discussed here? I wandered over just now to Nouriel Roubini’s blog just now and found this in a 1/27 post titled “Global Imbalances, the US Dollar and Globalization Challenges at Davos…” which in my mind doesn’t discount what you’ve been arguing. At least I don’t think that Stephen Roach would deny the possiblity for a deflationary outcome post bubble burst, and I suspect that Nouriel Roubini would not either.

    “… At the initial panel on the global economy only long-term bear Steve Roach from Morgan Stanley repeated the bearish outlook on dollar, the US economy and the risks of a disorderly adjustment triggered by the bursting of the US housing bubble. I happen to share the concerns of Roach even if, now, rather than a hard landing I predict for 2006 a significant US and global slowdown and a significant fall of the dollar but not a free fall. …

    “[Larry] Summers argued that the two forces driving markets are “hope and fear”. His concern is that, on cyclical issues there is too much hope – i.e. complacency about the global imbalances – and not enough fear that asset bubbles and imbalances may lead to a disorderly adjustment. On long term issues such as the emergence of China and India he argued that there was too much fear (that China and India will take over the world with severe effects on unskilled labor in advanced economies) and not enough hope that the emergence of China and India and their intregration in the global economy will have long run beneficial effects. Summers went as far a suggesting that the emergence of China and India (and more broadly of the BRICs and emerging market economies) may be the third most important development in the last millenium, next to the Reneissance and to the Industrial Revolution. This is quite a bold statment that may have some truth.

    “But Tyson warned of the potentially negative implications of the emergence of China and India for unskilled labor in the advanced economies. With two billion plus workers in China and India joining the global economy this increase in the global supply of labor should lead, based on simple trade theory, to a long run reduction in the relative equilibrium real wage for unskilled workers in advanced economies. This reduction in real wages and increase in income inequality such as the once observed in the US in the last few years is a source of fraying of the ‘social contract’ that, in exchange for accepting globalization and freer trade guaranteed to manufacturing workers good wages and good benefits; for auto workers and other blue collar workers such manufacturing jobs were the ticket to entry in the middle class but both employment, real wages and benefits are being significanttly erored by globalization.
    Summers echoed the concerns of Tyson when he said that we have a serious problem when globalization is associated with ‘local disintegration’ in places such as Flint (home of former now closed down US auto plants), with the emergence of failed states and with with struggling middle classes. To be successful globalization needs to lead to local integration not local disintegration.”

    PS.. Brad.. I don’t think I’ve participated in any of your discussions since you change formats. For whatever reason I only see a partial “preview” rendering of my comment. Perchance that is intended to keep comments short. Or perhaps not.