Economics, Politics, Social Commentary and occasionally Superstring Theory.

Tuesday, November 30, 2004

Why Hasn't The Other Shoe Dropped Yet?

Alot of people have been wondering why the U.S. dollar is only sliding now, after a few years of the government printing a mountain of money. After all, it should simply be a matter of supply and demand: more dollars on the market means less demand for them and scarcity equals value. So, why just now? Brad DeLong thinks the private holders are waiting for the central banks to make a move, because the value of betting against the dollar before they do is small. The bond market, however, remains a mystery. My proverbial two cents (if worth even that):

1. I think some of the central banks have already started making these moves through private channels (undisclosed principal transactions.) Russia has even made a public announcement of its abandonment of the dollar.

2. The holders of most of the debt (Japan and China, respectively) cannot afford to let the dollar go into a free fall. Their economies are too tied into U.S. demand. Let's focus on China. Because the Chinese peg their currency to the dollar, slides in one are slides in both. This smooths out (theoretically) any demand problems for Chinese exports in the U.S. and vice versa. However, it makes third country imports into China more expensive. This lowers their savings rate, as more Chinese liquidate savings into consumption to pay for the higher cost goods. Their lower savings rate means they can't purchase as much U.S. debt. U.S. debt is partially driving U.S. demand for Chinese exports, and a drop in exports leads to increased unemployment. So, China would be facing lower export demand, higher real prices for imports, and increased unemployment. As long as Chinese savings is financing U.S. consumption of Chinese exports, the Chinese will continue to lend as much as they can. However, stories like this don't bode well.

3. It's also possible that foreign central banks thought Kerry had more credibility than Bush on reducing the deficit and are now reacting accordingly to a Bush re-election. A run on a currency typically trickles for a while until something happens that unleased the tsunami. It's possible that we're just watching the trickle right now and the tsunami is on its way.

4. I share Brad's mystification as to the bond market. The only other explanation I can give is that there's a capital glut right now that's giving bond traders a cushion against future risk. Other than that, no clue.



Will A VAT Spur Economic Armageddon?

The Bush Administration is rumored to be considering a value added tax (VAT) to replace the current income tax. A VAT is essentially a national sales tax, assessed at every point there's a cash transaction. Apart and away from the regressive nature of such a tax, I have the following concerns.

1. While I agree that something needs to be done to spur more national saving in the U.S., I am not convinced a VAT is the way to go. I think the national savings needs to occur more at the governmental, rather than the individual, level. Individuals can save all they want, but if the government keeps borrowing it for unsustainable deficits, then it really doesn't do any good. Does it really matter if the governmental debt belongs to Americans or Chinese?

2. A VAT will functionally increase prices for everything. This will drive down demand for non-essential goods. A chunck of non-essential goods are manufactured in China. A shortage of demand for Chinese produced goods will have a significant impact on their economy. If Chinese employment slackens because of downward demand for their goods manufactured for export to the U.S., then China's savings rate will go down. This will mean they will lose their ability to absorb our debt at current levels. That means higher interest rates in the U.S. to try to attract others to absorb the debt. So, we have higher prices across the board and higher interest rates.

3. A VAT is going to put upward pressure on wages because prices for almost every product will go up. An increase in wages without a corresponding increase in productivity means that companies will have to increase their prices irrespective of the VAT to afford to keep the workers they don't end up laying off. This looks like it could set off a dangerous cycle of inflation. Think of a VAT like the Oil Shocks of the 1970's. Both have the effect of suddenly reducing disposable income by increasing prices for essential products.

4. The U.S. seems to have adopted an implicit policy of demand and consumption-led growth. A VAT dampens demand.

5. A recession is defined as when demand falls below supply. The U.S. has just clawed itself out of a relatively shallow recession partly by (extemely inefficiently) cutting taxes and printing money. The recovery to this point has been fragile. Anything that serves to dampen demand at this point would probably plunge the economy back into a recession.

How far off base am I here?

Inaugural Post

Welcome to the newest blog to join the fray. Having been inspired by such blogs as www.marginalrevolution.com, I have decided to launch my own. I have an abundant interest and no formal training in economics. Never taken an econ class in my life, although I have taken some related classes in law school. I hope to bring some fresh eyes to traditional economic thought and hope to stimulate discussion in some small way. So, to those of you happen to traipse across my blog, welcome and bear with me.

-B