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[Mark Rousseau <markrousseau AT yahoo.com>]

Interesting Read from Sunday 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 significant losses.

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 big scale."

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."