Re: Federal Budget Deficit Expected to Reach Over $300 Billion Next Year

["Gary Santos" <evs@xxxxxxxxxxx>]

> This deficit does scare me.  I think it could crash the whole economy.
>
> Is Bush after devaluation of the dollar to stimulate exports?
>
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The deficit will not cause a crash, at least, not this one. The deficit
(rather, the unfunded spending/fiscal stimulus) is supposed to spur
spending. But because the way it is structured, it likely will do nothing
good except pile up more debt. (Someone even commented that the peripheral
income consumers get will be given back to the state governments since they
are raising local/city taxes in order to shore up their finances.) So many
private sector policy writers have clearly outlined that the money will
likely not go to spending. Rather, it will be put into savings (bonds being
the likely receipient) and, if I may add, with the attendant support to the
bond market. This is "needed" also since foreign holders of US bonds are
likely sellers as the dollar heads down.

The US will let the dollar slide. This is to correct the current account
deficit. (I read Catherine Mann's "Is the US Current Account Deficit
Sustainable?" way back in 1998 and she warned of this problem prior to  the
article in a book of the same title. Sheesh!) Two problems I see here.
First, it takes about 2-3 years empirically speaking for the consumer to
change his buying habits. Second, so the dollar corrects by 20%. Will people
stop buying imported jeans and sneakers made in China if the price goes from
$10 to $12? I mean to say, of course, it may take a lot more (raise trade
barriers?) than just a depreciation to stop the bleeding. Mann did want to
also encourage exports via a weaker dollar will tend to do that and in that
sense aid correcting the gap. But, there are bigger problems now -- the
problem is aggregate demand. Exports never were and will not be in the short
term a major component of the American economy. So making America more
competitive abroad is secondary to closing the current account gap.

The fight is now, given the speeches of Greenspan and Bernanke, on the
deflation front (aggregate demand). Both speeches are available at
www.federalreserve.gov. I also enclose two other articles worth reading to
form your own opinion of what could possibly happen. The first from a MLynch
analyst the second from Krugman, a favorite columnist.

--------------------
U.S. war on deflation threatens global economy

Jesper Koll Special to The Daily Yomiuri

Around the world, a growing number of economists are trying to forecast
movements in financial markets on the basis of predictions about what will
happen to economies. Unfortunately, much of this may be a waste of time.
More often than not, the financial markets determine the future course of
economies.

Given the dramatic decline in global stock markets and the relentless drop
in interest rates during 2002, this should make economic forecasting for
this year easy: The world economy may be headed toward a deflationary
decompression. The good news is that central banks around the world are on
to this and are beginning to mobilize for a fight against it. The prospects
for a real fight are serious because the war is being led by the U.S.
Federal Reserve--the very center of the global financial system.

On Nov. 21, Ben Bernanke, who was appointed to the U.S. Federal Reserve
Board in August, made an extraordinary speech titled "Deflation--making sure
it does not happen here." Bernanke made it very clear that the Fed would not
hesitate to implement radical and unorthodox policy to ensure that "any
deflation would be mild and brief."

Bernanke stated that the Fed would not hesitate to buy corporate bonds or
make zero-rate loans to banks against corporate commercial paper collateral,
in addition to being ready to buy foreign government debt.

These are important policy statements that ***mark a true regime shift***.
(Emphasis mine. This says hang on, fellows, we thought we knew what we were
doing but now, we don't know. Sorry for that.) The U.S.-centered war against
deflation is starting. Global central bankers will have no choice but to
follow.

For Japan, the key implication could be negative. There is no historic
precedent of an economy pulling out of deflation, however mild, without a
currency depreciation. So the greater the risk of deflation in the United
States, the harder it will be for Japan to prevent an appreciation of the
yen. The coming U.S.-centered war against deflation may very well force a
sharp acceleration in deflation in both Japan and Europe.

Downward pressure on the dollar is indeed mounting. For years, global
investors put their trust in the United States' future. They regarded the
United States as the best bet for a combination of new technology, new
entrepreneurs and solid policymaking to pull off a super productivity and
growth cycle. They regarded it as the world's largest and richest developing
economy and emerging market.

Think about it: The U.S. economy has low savings and lots of potentially
profitable investment opportunities. Return on capital must thus be high to
attract this investment. In contrast, Japan and Europe are mature developed
economies ensnared in a combination of high savings, excessive domestic
investment and inflexible labor markets.

As a result, Japan and Europe offer a relatively low rate of return on
capital. In the real world, surplus savings thus flow from where returns are
low to where they are high. This was the fundamental bullish case for the
dollar.

Whether a strong dollar is in the best interests of the United States or not
is debatable, but a strong dollar certainly reflects global confidence in
U.S. economic leadership.

However, before long, the dollar may become an overvalued currency, with an
unsustainably large current account deficit and falling import prices
fueling deflation. Thinking the unthinkable, the real concern for the global
economy at the start of 2003 is that the United States will be the last and
largest economy to suffer an emerging market crisis, in which foreign
capital inflows become outflows and the dollar collapses. To defend the
currency, Fed Chairman Alan Greenspan would have to raise rates, causing
Wall Street to crash and the property bubble to burst, and other negative
side effects.

One prescription for such a U.S. crisis would be an International Monetary
Fund-style package. The IMF approach to crisis-hit developing economies says
that the elimination of a current account deficit must be achieved through
deflation rather than through devaluation. The IMF would almost certainly
mandate that the Fed raise interest rates even further, and the budget
deficit be cut to reduce excessive domestic demand.

In reality, of course, the opposite is poised to happen. This is because the
Fed's primary focus is the opposite of the IMF prescription. It wants to
inflate and will do so in a clear, decisive and ruthless manner. Too much
has been learned about the collapse of asset bubbles and the threat they
pose in destabilizing the financial system and unleashing unpredictable
forces of deflation through negative wealth effects.

No, the most likely response to a crash on Wall Street is that rates will be
slashed even further and the world will be flooded with U.S. dollars. The
yen could shoot to 80 yen to the dollar or even higher. This really would
kill any hopes of a global recovery.

Clearly, the United States will not lift a finger itself to stop the
dollar's fall. It has not got sufficient foreign currency reserves to do so.
If private borrowers of nondollar currencies go bankrupt, the U.S.
government will not take responsibility for these private foreign
liabilities--it will simply allow them to default.

Unlike poorer and smaller developing countries such as Thailand, South Korea
or Russia, the United States as the world's largest developing debtor
country can and will force its creditors to deal with the problem.
Specifically, if default causes problems for Japanese banks and life
insurers, the Japanese will have to bail them out. If the yen gets too
strong, the Japanese will have to intervene to support the dollar. The
United States will not borrow from the IMF or deflate domestic demand to
bail out foreign lenders. Instead, the United States will force creditor
countries to reflate demand.

Already over the past few months, the global decline of the dollar may be
signaling that Japan and Europe will be forced to shrink their trade
surpluses--exporting less and importing more--while the United States
exports more and imports less.

To make up for their loss of exports, both Japan and Europe will have to
reflate domestic demand. In other words, right now the world economy is
under the threat of major deflation risk stemming from the U.S.-centered war
on deflation.

Of course, none of this will happen as long as global and U.S. investors are
willing to finance the dream of the United States' superior entrepreneurs,
relentless technological innovation and outstanding policy leadership.

However, if the enthusiasm stops--and history suggests that the higher the
expectations, the greater the room for disappointment--the world's central
bankers and policymakers will have a real policy coordination problem to
deal with.

The best safety net for both Japan and Europe is to speed up deregulation
and foster an entrepreneurial revolution that creates jobs, wealth and the
dream of a productivity explosion. Japan and Europe must start beating the
Americans at their own game and become emerging markets offering high
prospective returns. The more Tokyo and Brussels do to create domestic
growth opportunities, the less they have to fear from U.S. growth
sputtering--and the dollar falling.

Koll is chief economist of Merrill Lynch Japan Securities Co. January 17,
2003.




Crisis in Prices?
SYNOPSIS: An excellent description of how we got caught in a deflationary
trap

Some fuzzy math: In the first 30 days of December 2000, according to Nexis,
only six articles in major news sources contained both the word "deflation"
and the phrase "United States"; none of those articles suggested that
deflation in this country was a real possibility. In the same period last
year there were 292 hits; this past month there were 566.

Will deflation be even more on our minds a year from now? About five years
ago economists realized that monsters from the 1930's were once again
walking the earth: Japan, the world's second-largest economy, was trapped in
a cycle of falling prices and rising unemployment. But not many people in
the U.S. cared about the woes of a faraway country. Like big-time corporate
malfeasance, deflation didn't seem like something America had to worry
about.

But like corporate malfeasance, deflation has turned out to be something
that can happen here. It's by no means a foregone conclusion: Federal
Reserve officials assure us that they can and will steer us away from a
Japanese-style black hole. But we're close enough to such a black hole that
it's already warping our economic space.

Here's how it can happen: First, for whatever reason, the economy becomes
depressed. The central bank responds by cutting interest rates - but it
turns out that even cutting rates all the way to zero isn't enough to
restore more or less full employment.

At that point the economy crosses the black hole's event horizon: the point
of no return, beyond which deflation feeds on itself. Prices fall in the
face of excess capacity; businesses and individuals become reluctant to
borrow, because falling prices raise the real burden of repayment; with
spending sluggish, the economy becomes increasingly depressed, and prices
fall all the faster.

We know from Japan's experience that the descent into such a black hole is a
gradual process. Although most economists now date the beginning of Japan's
malaise to 1991, the Japanese economy actually grew, albeit slowly, until
1998 - and it wasn't until 1998 that Japanese officials appreciated the
severity of the problem.

So we shouldn't take too much comfort from our own sort-of recovery in 2002.
Yes, the U.S. economy grew, but too slowly to employ an expanding and increa
singly productive labor force. The output gap, the difference between what
the economy could produce and what it actually produces, continued to widen.
And so the threat of deflation is worse now than it was a year ago.

In fact, by some measures deflation is already here. Prices paid by
consumers are still rising, but those received by many businesses aren't:
the government's index of the prices received by nonfinancial corporations
has been falling since the third quarter of 2001.

As a result, we've moved closer to the event horizon. The Fed funds rate is
only 1.25 percent, yet nothing suggests that the economy is about to close
the output gap. The back of my envelope says that G.D.P. would have to grow
at least 4.5 percent over the next year to bring an end to deflationary
pressure. That's well outside the range of consensus forecasts.

And the pull of the black hole is increasing. Consider: A Fed funds rate of
3 percent was low enough to get the economy moving in the early 1990's, so
why isn't a rate of 1.25 percent low enough now? In part because back then
business prices were rising, while now they are falling, discouraging
borrowing even at very low rates. What if a year from now the Fed funds rate
is zero, but prices are falling even faster?

O.K., let's take a deep breath. Nothing I've said is news to Fed officials -
a group that now includes my Princeton colleague Ben Bernanke. Also, the
black hole metaphor can be pushed too far; as Mr. Bernanke points out, the
Fed has other weapons in its arsenal besides low interest rates. The
policies he describes haven't been tested, but in theory they should work.
Those policies would be more likely to succeed, of course, if the Bush
administration would stop playing politics with fiscal policy and . . . oh,
never mind. Anyway, the Fed will do its best.

But two years ago deflation in America seemed a prospect literally not worth
writing about. Will it be all over the newspapers a year from now?


Originally published in The New York Times, 12.31.02