[wordup] James K. Galbraith's Comments on the US Economy

[Adam Shand]

Provoked by Alan Greenspan's latest comments about the US economy my 
dad and I have been poking around asking people in the know what they 
think.   What's the actual chance of a collapse, if there was a 
collapse what would it mean, and what's the most likely scenario?

I like this article a lot, it seems sensible and does a fairly good job 
of explaining what's going on in understandable terms.

Adam.

Via: Brett Shand <brett at earthlight...>
From: http://www.tompaine.com/articles/apocalypse_not_yet.php

Apocalypse Not Yet
James K. Galbraith
December 06, 2004

TomPaine.com asked noted economist James K. Galbraith to reflect on 
the falling dollar, the chiding from Beijing, and the response from 
Washington. We got what we asked for...and then some. Galbraith 
explains how we got here, assess the likelihood of different 
apocalyptic scenarios, and predicts Greenspan, the GOP and the Dems 
will all fumble. The reason? Salvation lies not in better macroeconomic 
management, but in generating a new industrial policy for America.

James K. Galbraith is Lloyd M. Bentsen Jr. Chair in government/business 
relations at the Lyndon B. Johnson School of Public Affairs, The 
University of Texas at Austin, and senior scholar at the Levy Economics 
Institute.

Editors Note: A highly excerpted version of this article appeared in 
Newsday on Dec. 3, 2004.

With the euro touching $1.33 and the pound so high I couldn't bear to 
look at the rate, my thoughts on a flight home from across the pond 
turned painfully to the decay of the once-almighty dollar, and to the 
cries of fear emanating these days from Wall Street.

How We Got Here

The current jitters are no surprise; the few Keynesians left in the 
economics profession have long thought them overdue. Here are the most 
important reasons why this is so:

We have, over many years, worn down our trade position in the world 
economy, from overpowering supremacy 60 years ago, to the point where 
high employment in the United States generates current account deficits 
well over half a trillion dollars per year. We have become dependent 
for our living standard on the willingness of the rest of the world to 
accept dollar assets—stocks, bonds and cash—in return for real goods 
and services, the product of hard labor by people much poorer than 
ourselves in return for chits that require no effort to produce.

For decades, the Western World tolerated the "exorbitant privilege" of 
a dollar-reserve economy because the United States was the 
indispensable power, providing reliable security against communism and 
insurrection without intolerable violence or oppression, thus 
conditions under which many countries on this side of the Iron Curtain 
grew and prospered. Those rationales evaporated 15 years ago, and the 
"Global War on Terror" is not a persuasive replacement. Thus, what was 
once a grudging bargain with the world's stabilizing hegemon country is 
now widely seen as a lingering subsidy for a predator state.

In the late 1990s, the United States position was held up by the 
glamour of the information-technology boom, which brought capital 
flooding in from more precarious perches in Russia, Asia and other 
parts of the world. Then, as so often on other occasions in history, 
America was the wave of the future. But that too has turned to dust and 
ashes. While major gains from new technology were achieved, few now 
think that silicon chips are the solution to the world's economic 
problems, and Silicon Valley has receded to an investment backwater.

Since 1979, China, migrating slowly from the other side of the Iron 
Curtain, has become one of our largest trading partners, while the 
relative position of other Third World countries (more wedded to the 
free market and less effectively managed) has eroded. The concentration 
of our manufactures trade on China and Japan now means that those two 
countries now hold preposterous dollar reserves, and their actions 
substantially determine the dollar's value. However, the actions or 
potential actions of other players, including Russia, India and the 
European Central Bank, can also have important effects.

China and Japan are constrained in their behavior by creditor's risk. 
If they sell dollars aggressively, the value of the remainder of their 
portfolio plummets and they inflict large losses on themselves. This 
consideration prompts caution. But everything depends on what everyone 
else does. The rising unpredictability of U.S. policy—including foreign 
policy—doesn't help. If one major player gets wind that others may 
dump, then the urge to join in becomes hard to resist. This is exactly 
analogous to an old-fashioned stock panic or run on the bank.

Situation Unpredictable, If Not Perverse

The current account is strongly linked in a triangular relationship to 
the budget deficit and also, critically, to the savings-investment 
balance of American households, as readers of the invaluable strategic 
papers by Wynne Godley (see www.levy.org ) will know. In the present 
environment, with households on average near financial balance, the 
current account and the budget deficits are nearly equal. But this does 
not mean—as leading Democrats appear to believe—that reducing the 
budget deficit will save the dollar. A bank, hit by a panic, cannot 
save itself by cutting its advertising budget, raising its fees or 
firing its staff.

And once a rush gets going, jacking up interest rates won't stop it 
either. Small interest rate hikes do normally affect exchange rates, 
but only when no player has the kind of extreme market weight now 
enjoyed by China and Japan. When they do, reactions are unpredictable 
if not perverse. The Fed's moves earlier this year could well have been 
aimed, mainly, at deterring the Japanese and Chinese from dumping. 
Think of them as a petty bribe—a percent or so on a few trillion 
dollars. Or you might call it a reaction to blackmail, deemed expedient 
in view of the election. But the election is now past, and that game is 
up.

Now we hear rumors of Russia trading dollars for euro, of India 
diversifying its reserves, of China contemplating the same. The 
reaction on Wall Street has been a trifle unnerved. In comments relayed 
furiously across the Internet, Morgan Stanley economist Steven Roach 
apparently told clients to gird for an "economic Armageddon." The dike, 
once solid, starts to crack; none can say just where or when it will 
break. But the little Dutch boy, Alan Greenspan, went to Frankfurt a 
few days back and plainly stated that he did not have enough fingers.

Who Wins? Bush's Base

The most stunning aspect of these events has been the insouciance of 
the Bush administration. Neither the president, nor Secretary of the 
Treasury John Snow, nor anyone else has troubled even to emit the usual 
platitudes about the greenback—not, at least with the slightest 
conviction. It's almost as if they've figured it out. It's almost as if 
they realize the awful truth. Which is that the dollar's decline is 
mainly good for their friends, and bad mainly for those about whom they 
couldn't care less.

Yet that is the truth. The dollar's decline immediately boosts the 
stock market, for a simple reason. Multinationals have earnings in the 
United States and in Europe. When the dollar falls, U.S. earnings stay 
the same but the European earnings go up when measured in dollars. Oil 
prices in dollars will stay up—at least enough to prevent the price in 
euro from falling. This too helps U.S. oil company profits, measured in 
dollars. Meanwhile, China will keep its renminbi tied to the dollar, 
and prices of Chinese imports won't rise much, so Wal-Mart isn't badly 
hurt. The American consumer will get hit, but mainly on the oil price 
rather than on the rest of the consumption basket. Many will grumble, 
but few will recognize the political roots of their problem.

Since the U.S. owes its debts in dollars, the financial blow will fall 
first on China and Japan, in the form of a depreciation of their 
holdings. Tough luck. Latin American debtor countries will get hit on 
their exports, but helped on their debt service. Those (like Mexico) 
who export almost exclusively to the U.S. will get squeezed; others 
(like Argentina) who market to Europe but pay interest in dollars will 
be hurt less. An unequivocal loser is Europe, which has been hoping for 
an export-led fix to their own, largely self-inflicted, mass 
unemployment. The Europeans can forget about that.

If Bush's insouciance works, the dollar could decline smoothly for a 
while and then, simply, stop declining. U.S. exports might recover 
somewhat, helping manufacturing, though there's no chance exports and 
imports will balance. But even so, the dollar system could stay intact, 
so long as China and Japan remain willing to add new dollars to their 
depreciated hoard. Given that their interests lie in maintaining export 
activity and the jobs it creates, they may very well make that choice. 
Large-scale dollar purchases by the European Central Bank are also a 
remote possibility (the option has been mentioned on the periphery of 
the ECB). The problems would return later on, but meanwhile, such an 
action would prove that God really does look after children, small dogs 
and the United States.

Apocalypse Considered

What could up-end the apple cart? An unstoppable panic is probably not 
yet the largest risk. There are simply too many dollars in the theater 
of the world economy, too few exits and only a few elephantine players. 
The latter would soon be discouraged from selling by the soaring price 
of the available alternative assets, and the run would fizzle out. Thus 
the final dollar crisis will probably wait until a political 
crisis—say, someday with China—sets it off.

Some fear rising long-term interest rates—and a recession—simply on 
account of the sliding dollar and price inflation. But this also won't 
necessarily happen. For an inflation premium to be built into the 
long-term interest rate, there needs to be higher expected inflation on 
a continuing basis. Notwithstanding the cheap psychology of "rational 
expectations," beloved of economists, actual inflation can rise for a 
long time before expectations do. And the inflation adjustment, coming 
(let us say) primarily through a rising dollar oil price, could come 
and go rather quickly. It need not get built into a spiral of wages and 
prices. So far, despite the substantial dollar decline that has already 
occurred, long-term interest rates have hardly budged. They have 
generally risen no more, and in some cases less, than the short-term 
rates Greenspan started pushing up last spring.

A change in European policy—toward a high-growth, full employment 
Keynesianism—could bring a decisive shift in the world balance of 
economic power. Such a shift would create profits in Europe (where 
there presently are few), attracting capital. It would open up a 
European current account deficit, where there is presently a surplus. 
Soon the euro would not be a scarce currency any longer, and the 
reduction of the dollar's reserve status could truly get underway. 
Unfortunately for Europeans, European policymakers don't see—and won't 
seize—this opportunity. Frankly, they are too reactionary and too 
stupid. That's a tragedy for Europe, though in some ways it's 
undeserved good luck for the United States.

And the fourth possibility is that Alan Greenspan could change his 
mind, raise interest rates and inflict on us all a monumental "defense 
of the dollar." Morgan's Roach worries about this with some good 
reason; I've worried about it too. While sharply rising interest rates 
could cure both inflation and the weak dollar—as they did in the early 
1980s—the resulting slump would be even more disastrous than it was 
then, because debt levels are higher now than they were. Just as the 
slump then destroyed Latin America and Africa, a new one could bring 
China, Japan, India and others into worldwide recession. There would be 
no easy way out.

A Strange New World

Such folly is possible, but now I don't expect it. I rather think 
Greenspan will take a pass on all the past decades of Federal Reserve 
myth-making. That means that he will actually sit on his hands while 
oil and some other import prices drive upward. Given the alternatives, 
it's probably the right course of action. But let no one say, afterward 
and with a straight face, that our Central Bank takes all that 
seriously the bunkum it spreads, about fighting inflation.

For this reason, we're more likely to enter a strange new world, where 
Republicans in office behave like 1970s Democrats on meth. In a 
stagflation economy, budget deficits are inevitable and there is no 
strategy that will end them. It's obvious that adding large near-term 
tax increases to the mix would merely slow growth further, while there 
isn't enough federal public non-defense spending left to cut. So the 
Republicans will make excuses, and let the deficits run on, and incur 
the scolding of the IMF and the OECD. If we're lucky. It's far from the 
worst thing the Republicans could do.

Sadly, the Democrats will respond as badly as possible, like 1930s 
Republicans on downers. In a touching devotion to dogma, they will call 
for fiscal discipline to close the budget deficit. This will undermine 
the case for relief to working families, for aid to state and local 
government, and the defense of Social Security benefits that they might 
otherwise make. Our jobless compatriots won't find this endearing. 
Faced with higher inflation, Democrats may demand to know why Greenspan 
has done nothing. Households struggling to manage their debts will not 
be greatly amused. Then Democrats will say that things were better 
under Clinton. That's thin gruel; in the 1930s you could have said the 
same of Coolidge.

What Should Be Done?

The reality is that budget deficits cannot be controlled until the 
trade problem is fixed. So what should be done? It's a long-term 
project, but it's not difficult to assemble the start of a real 
program. Oil companies are likely to earn high profits in the 
turbulence ahead. Let's tax them (and other windfalls), perhaps with a 
variable import fee. Let's plough the proceeds back to state and local 
governments, so they can maintain services and vital investments. Let's 
cut payroll taxes for now, to help working people cope. And let's start 
our next technology boom, focused on new energy and reduction in 
per-unit GDP consumption of oil. These would be useful beginnings on 
the home front.

The big action, however, must come on the international side. My 
supply-side friends pine for the gold standard, and they make a serious 
point. The experiment of worldwide floating exchange rates, inaugurated 
by global monetarists in 1971, has failed disastrously. The world was 
better off when we had fixed exchange rates. Indeed, in the most 
successful arena of global trade and finance we have fixed exchange 
rates right now, thanks to the unappreciated but sensible 
dollar-pegging of the Chinese. Fixing exchange rates in Europe (through 
the extreme measure of creating a single currency) also proved a boon 
for the poorer countries of Europe, eliminating speculative currency 
risk. Even though, overall, European policy remains terrible, 
unemployment has dropped sharply in Spain and Greece since the euro 
came in.

Global fixed exchange rates would help developing countries, by sharply 
curtailing the destabilizing role of private currency markets. They 
would therefore also help us, by creating stronger and more stable 
markets for our exports. But there is no simple return to global fixed 
exchange rates. It would be a terrible mistake to create a system that 
imposed deflationary pressure on us and through us on the world as a 
whole—the problem of the classical gold standard. To get where we need 
to go, we must also recreate a global financial network oriented toward 
the support of development and growth. When we have that, growth 
policies around the world will help rather than hurt each other. At 
that point, we could profitably put real effort into reintroducing full 
employment economics to Europe and Japan.

For such a policy to succeed, America must also change. Specifically, 
we must turn away from our present over-reliance on armed forces and 
private bankers, far away from the fantasy of self-serving dominance 
for which, the markets are clearly telling us, the world will not agree 
to pay. We need instead an industrial strategy based on technological 
leadership, collective security, and smart use of the world's 
resources. The financial counterpart must be a new source of liquidity 
for many developing countries, permitting them to step up their 
imports, and correspondingly our exports and employment. This will 
probably require a new network of regional regulatory agents, empowered 
to enforce capital control and to take responsibility for successful 
development strategies among their members.

No Viable Alternative

The point is not that any of this would be easy. Nor can it be done in 
the lifetime of this administration or of the political dominance that 
Bush now seeks to achieve. The point is, rather, that there is no 
viable alternative, so far as I know. Absent a fully articulated 
strategy, the attempt to pretend otherwise with a few slogans is an 
economic and also a political dead end.

Two steps are thus required. The first is thought, and the second, when 
the opportunity arises, will be action. The scope of action cannot be 
small, for the problem now exceeds six hundred billion dollars every 
year. But only by dealing with it, over time, can we hope to regain 
full employment without witnessing, sooner or later, the final run on 
the dollar.