Re: Anxious Krugman: "The Bond Market Warning Us of TurbulenceAhead" (was Re: NY Times: clueless on Argentina)

[Yoshie Furuhashi <furuhashi.1@xxxxxxxxxxx>]

Henry:

>Krugman is on target that the US ecnomy is heading for a credit
>crisis.  This is
>particularly true for the communication sector.
><snip>
>Might be some
>interesting things coming up soon....

Thanks for your post.  I forwarded it to PEN-l, & Jim Devine sent
this note of agreement:

*****   Date: Sat, 25 Nov 2000 08:54:12 -0800
To: pen-l@xxxxxxxxxxxxxxxxxxx
From: Jim Devine <jdevine@xxxxxxxxxxxxxxx>
Subject: [PEN-L:4954] Re: Re: Anxious Krugman: "The Bond Market
Warning Us of Turbulence Ahead"

I'm not going to comment on the details of Henry's notes, but
[interrupted by Eudora's malfunctioning] a lot of it makes sense to
me. If the Fed pursues low-interest policies, that can cause the
quality of loans to fall, raising the risk premium that banks charge
and bond-buyers insist on getting. This in turn means that the Fed
has to lower rates again if it wants to prevent a hard landing. There
are limits to how far the Fed can and is willing to go with rate
cuts, so that recession is quite likely. Given the accumulation of
corporate and private debt, this recession is likely to be more
painful than usual (probably worse than the 1990 one).

The reason that may explain a broad-based rise in the risk premium is
that if the economy relies increasingly on credit creation to expand
aggregate demand in the non-Wall Street "real" economy and also
emphasizes volatile types of spending (luxury consumption, real
investment), the economy's growth path becomes increasingly fragile.
[My article in the 1994 issue of RESEARCH IN POLITICAL ECONOMY
explains the background to much of my analysis here.] The fragility
of the economy is likely to cause widespread riskiness of paper
assets.

(BTW, another reason for growing unease in the corporate bond market
is that the supply of safe treasury issues is shrinking -- as the
government "pays down" the debt -- so that speculators can't
diversify away the risk of corporate debt as easily.)

One thing that could help here is if the profit rate rises and stays
high (as suggested by the data in the most recent issue of LBO). The
problem with this is that the rise in the profit rate is based on the
stagnation of wages relative to labor productivity, and thus the
stagnation of consumer spending that's not based on debt
accumulation, so that the volatile types of spending mentioned above
have to become more important to keep the economy growing. And a
little glitch in aggregate demand -- which is more likely due to the
economy's emphasis on volatile spending (and the fact that the stock
market seems way out of whack in terms of price-earnings ratios) --
can cause a realization failure that smashes profit rates, which also
kills luxury spending and real investment. Then it's hard landing
time.

All of this is less likely to occur if exports or the government pick
up the slack. Exports seem unlikely to do so in an era when the
dollar is high (and are likely to change slowly in response to the
dollar's fall, so that the balance of trade and the current account
deficit are likely to get _worse_, following the famous "J-curve"
effect) and so many countries are pursuing austerity (what I've
called competitive austerity, egged on by our friends at the US
Treasury and the IMF). If the non-US world recovers, that would help
the US tremendously, but that seems unlikely. If the US goes into a
funk, on the other hand, that likely would pull the "consumer of last
resort" prop out from under their slow recoveries or intensified
their continued stagnations. So it's a world hard landing. We should
hope that "the worse the better" logic works (so that depression
encourages socialist movements), though it seldom does.

The government might solve the problem by reversing its pre-Keynesian
policies of "paying down the debt" (budget surpluses, which hurt
aggregate demand), which seems quite unlikely, no matter who ends up
as President. (By the way, why can't George W. and Uncle Albert
settle this thing in the old-fashioned way? it worked for Aaron
Burr.) If I were to guess, Gore seems more likely to stick to
pre-Keynesian economics than is Bush, so that a Bushie victory is
more likely to help the economy (with tax cuts). In any case,
gridlock seems likely to prevail, since neither of these worthies
will have a "mandate." Cockburn likes the idea of a Washington
deadlock, but there is a downside... Of course, it's unlikely that
we'd see a mass re-conversion over to Keynesian economics. The
original conversion took a decade or two (from 1936 to 1962 or so).
(I'm not counting FDR's conversion at the start of WW2, since wars
have _always_ overridden the pre-Keynesian commitment to a balanced
budget.)

The most likely way that the US government could deal with the
problem is via automatic stabilization, in which government deficits
rise (surpluses shrink) automatically as the economy falls. The
problem is that the automatic stabilizers have weakened. More and
more of the so-called "entitlements" (e.g., Aid to Families with
Dependent Children) have been shifted to the states, most of which
must balance their budgets (due to their constitutions) and thus
would have to raise taxes or cut benefits in response to the surge of
applicants that occurs in a recession. The states are part of the
recession problem, rather than being part of the potential solution.

as Doug says in the most recent LBO, we live in interesting times...

[Speaking of computer malfunctions, when I woke up this morning, my
PC had forgotten the D drive, the extra hard-drive I installed last
year. Luckily, resetting it brought the drive back into existence,
but it's quite a mystery how such a thing could happen. On the same
general subject, I recently called the Palm Pilot People's technical
support to complain about my Palm's malfunctioning. Said I: "I don't
know whether it's still under guarantee or not." Said he: "we can't
tell, since our software's not working." Luckily, he decided that
he'd send me a replacement anyway. The problem, BTW, was that I had
to hit the damn thing to make it work, like with an old TV.]

Jim Devine jdevine@xxxxxxx & http://bellarmine.lmu.edu/~JDevine   *****

Yoshie