Saturday, December 04, 2004

Macroeconomics 101 via American Prospect Online

there is a growing risk of a financial meltdown with the following elements:

First, as foreign confidence in the dollar keeps shrinking, so does the dollar. The Federal Reserve then has to raise interest rates defensively to make investments in U.S. securities more attractive to foreigners.

But high interest rates slow U.S. economic growth, hurt the stock market, and could contribute to a long-anticipated crash of housing prices.

We could face a serious recession with no easy cure, since the usual fix is to run temporary deficits plus low interest rates. But in this case, overly large deficits were part of the problem, and higher interest rates would be necessary to prevent a further dollar collapse. But won't the Japanese and Chinese central banks, whose economies rely so heavily on exports to the United States, keep buying American bonds? Perhaps -- it's a kind of co-dependency in which they willingly buy paper that is losing its value because the exports help develop their real economies.

On the other hand, the United Staates is not just dependent on foreign central bank purchases of bonds. Because our budget deficit eats up so much domestic savings, our stock market and venture capital markets also are net borrowers from abroad. In the past we have counted on the fact that the American economy was so productive that foreigners, despite the trade deficit, saw the United States as a smart place to invest. But if the dollar is weak enough long enough, that investment starts drying up. U.S. financial markets have been quavering lately because foreign investment flows are dwindling.

How likely is this dire scenario? None other than Paul Volcker has said that he thinks that the odds of a dollar crash in the next few years are something like three in four.


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