|NY Times, May 8, 2005
The Perfect Storm That Could Drown the Economy
By DANIEL GROSS
WE seem to be living in apocalyptic times. On NBC's "Revelations," Bill
Pullman and Natascha McElhone seek signs of the End of Days. In the Senate,
gray-haired eminences speak of the "nuclear option."
The doomsday theme is seeping into the normally circumspect world of
economics. In April, Arjun Murti, a veteran analyst at the investment bank
Goldman Sachs, warned that oil could "super-spike" to $105 a barrel. And
increasingly, economists are prophesying that the American economy as a
whole may be sailing into choppy waters.
Just look at the many obvious and worrisome portents. The government each
year spends much more than it brings in, and so the nation has a large
budget deficit ($412 billion in fiscal 2004, and growing). Americans also
import far more goods than they export, and so the nation has record trade
and current account deficits.
As consumers, Americans personally spend significantly more than they earn.
Worse, some imbalances are eerily reminiscent of conditions that helped
touch off recent economic crises: Mexico in 1994, Asia in 1997, Russia in
1998 and Argentina in 2002. Throw in rising interest rates, warnings of a
housing bubble and the potential for higher inflation and slower growth (a
k a stagflation) - and you can understand why some economic analysts may be
plumbing the New Testament for inspiration.
The forces propelling and buffeting the economy are like a series of
interrelated and interconnected weather systems. Could they be setting the
conditions for a perfect storm - a swift series of disturbances that causes
lasting damage? If so, what would it look like?
"There's a pattern that is familiar from so many other countries that have
gotten into debt problems," said Jeffrey A. Frankel, an economist at
Harvard's Kennedy School of Government. "A simultaneous rise in interest
rates, fall in securities prices and depreciation of the currency."
Of course, economists, always armed with bandoliers of caveats, are quick
to warn that the economy is relatively healthy. Job growth numbers released
on Friday were strong, with 274,00 new jobs created in April.
And they warn against drawing parallels too sharply between the mighty
United States and emerging markets. The dollar remains the world's reserve
currency, and the United States is a global military and political hegemon.
And the nation has been able to borrow huge amounts for years without
suffering a crisis.
That said, how might a perfect storm be created? It would likely gather
overseas, and wouldn't necessarily take the form of a terrorist strike or
oil shock. The United States finances its spendthrift ways by selling
dollars and dollar-denominated securities (like Treasury bills) to foreign
creditors, mostly to central banks in Asia. To sustain growth, the United
States needs foreign creditors to continue to add to their piles every day.
Any signs to the contrary are worrisome. In February, when the Korean
government suggested that the Bank of Korea might diversify its foreign
exchange holdings, "this seemingly innocuous statement set off a small
panic in our stocks and bond markets," said James Grant, editor of Grant's
Interest Rate Observer.
If the Bank of China, which has been accumulating dollars at the rate of
$200 billion a year, decides to cut back on new purchases, either to
diversify or to let its currency appreciate, the United States would
quickly have to offer sharply higher interest rates to retain existing
investors and entice new ones. Nouriel Roubini, an economics professor at
New York University's Stern School of Business, estimates that if China cut
its rate of accumulation by half, long-term interest rates in the United
States could rise by 200 basis points over a few months and the value of
the dollar would fall.
Such a rising tide - the yield on the 10-year bond shooting from 4.25 to
6.25, the average 30-year mortgage rising from 6 percent to 8 percent -
would mean instantly higher borrowing costs for the government, businesses
and consumers. It would drench Wall Street, soaking the stocks of giant
interest-rate-sensitive blue chips like Citigroup and making life difficult
for speculative, debt-ridden companies. Some highly leveraged hedge funds
or investment banks caught on the wrong side of trades would incur
The United States weathered a sharp decline in the stock market just a few
years ago, in large part because of the housing market's strength. But a
sharp rise in interest rates would literally hit home. For new home buyers,
or for people with adjustable rate mortgages, 200 extra basis points of
interest on a $400,000 mortgage would represent $8,000 a year in extra
payments. If mortgage rates were to rise sharply, housing prices would
level off and perhaps do the unthinkable: fall.
Suddenly, the mechanisms that have allowed consumers to keep the economy
afloat - the ability to realize profits from selling homes, to refinance
mortgages at lower rates and to borrow cheaply against home equity - would
be broken. In the absence of sharply rising wages, that $8,000 in extra
interest would be $8,000 less to spend at Home Depot, or at the Cheesecake
Factory, or at Disney World.
"Personal expenditures in the past 15 months have been largely financed by
borrowing," said Wynne Godley, a Cambridge University economist who is
affiliated with the Levy Institute at Bard College. "And even a reduction
in the pace of debt creation will force people to start spending less, on a
If the dollar weakens and consumption falls, the trade and current account
deficits would start to narrow. But the United States economy would slow
and, perhaps, even shrink.
"The result would not be a full-blown financial crisis most likely, but it
would still be a major recession," said Barry Eichengreen, a professor of
economics and political science at the University of California at Berkeley.
What would create the full-blown crisis? When the slowdown starts to
radiate across the globe, said Catherine L. Mann, senior fellow at the
Washington-based Institute for International Economics.
For years, the American consumer has been the engine of global growth, by
gobbling up the output of oil wells in Saudi Arabia and factories from
Mexico to China. "The slowdown in consumer spending is going to have a
negative influence on the global economy through reduced international
trade," Ms. Mann said.
What's more, a recovery would be comparatively slow in coming. When the
global economy came to a screeching, synchronous halt in 2001, the United
States led much of the world back to growth because the federal government
went on a stimulus binge for several years: Congress significantly
increased government spending while cutting taxes, and the Federal Reserve
slashed interest rates to historic lows, and held them there.
But in the perfect economic storm, none of these three powerful levers
would be readily available. Today's deep budget deficits make both
significant tax cuts and spending increases unlikely. And rising interest
rates would make it difficult, if not impossible, for the Federal Reserve
to reduce the cost of borrowing.
It sure sounds alarming. But as the clouds gather and the wind stiffens, we
sail onward, with no apparent adjustment in course, full steam ahead.
Why aren't we rushing to take evasive action? Why is Congress adding new
spending while it passes new tax cuts? Why aren't financial institutions
encouraging Americans to pay down their debt rather take on more?
A lot of it has to do with timing. While many economists are willing to
imagine in detail what a perfect storm would look like, virtually none will
forecast precisely when - or if - it will start. And so it remains a vague
and distant possibility.
Besides, adds Jeffrey Frankel, "some of us have been warning of this
hard-landing scenario for more than 20 years."