Wolfgang Munchau writes in the Financial Times that we are experiencing only Act I of a more global, longer term crisis.
Unfortunately, I fear this is only going to be the end of Act I. Act II plays out in the real world. Act II begins with a sharp slowdown in US economic growth. The two obvious questions that arise from this scenario are: how bad will the US downturn be and how contagious will it be?
It looks as though it will be bad. Some optimists had hoped that the rest of the world could easily withstand a US recession and invented the infamous de-coupling theory. What they did not count on was the rapid decline of the US currency as expectations of a US recession were rising. A weak dollar is going to be the main global transmission mechanism.
Munchau sites a prescient analysis by Ken Rogoff and Maurice Obstfeld in an NBER paper they co-wrote in 2004, called “The Unsustainable U.S. Current Account Position Revisited.“It’s a really a great paper. Though grounded in theory, Rogoff and Obstfeld model out how the U.S. current account deficit will resolve itself — possible scenarios, direct and indirect impact on other economies and currencies. For a great summary of the paper, see this article in the Economist – if you had invested on this little piece of knowledge in late 2004, you would have been making some good money over the past two years (though you would have been early on the housing bubble popping).
A new paper by Maurice Obstfeld, an economist at the University of California, Berkeley, and Kenneth Rogoff, of Harvard, a former head of research at the International Monetary Fund, predicts that the dollar will fall by another 20% in real trade-weighted terms even if America’s external deficit unwinds gradually. If the adjustment is more abrupt, the dollar will dive by more than 40%.
…Mr Obstfeld and Mr Rogoff argue that… America’s current-account deficit reflects inadequate domestic saving. Cutting it therefore requires that American saving rises or that demand in the rest of the world increases. A fall in the dollar would be a by-product of this adjustment. But without an increase in saving, even a big fall in the dollar would make only a small dent in America’s current-account deficit.
The two economists assume that the current-account deficit shrinks as a result either of increased saving by American households (because, for instance, the country’s house-price boom ends) or of a strengthening of demand in Asia and Europe. Then, using a model of the global economy, they focus on the changes in relative prices of traded and non-traded goods needed to ensure that demand matches supply in domestic product markets as the current-account deficit narrows.
Not bad….. Let’s hope it’s the gradual, 20% number, not the sharp, 40% number.
