It's easy to think that the U.S. current-account deficit is an accident waiting to happen. And like all good bear cases, Wall Street's latest worry is elegant in its simplicity.
Foreign countries are holding as great a share of U.S. wealth as they did in 1987. No surprise there -- with Japan mired in recession and European growth hampered over the past couple of years, the U.S. has been the place to put your money. Yet current-account imbalances can't go on forever. As
economist Paul Krugman noted in a recent article, "Eventually the U.S. deficit and the rest-of-world surplus must be sharply reduced, perhaps even reversed, and while this adjustment could take place in other ways, it is likely that much of it will occur via a decline in the value of the dollar vis-a-vis the yen, the euro and so on."
The fear is that recent strength in the yen and the euro -- triggered by a brightening growth picture in Japan and Europe, along with U.S. interest-rate gloom -- has prompted a turn in the account balance, and that things will get out of hand.
Foreigners, worried about exchange-rate losses, will cut back on dollar investments, which in turn will force the dollar lower. A weakened dollar will spark inflation jitters -- import prices will rise and domestic producers will gain pricing power -- damaging the bond and, in turn, stock markets. The
will be hamstrung. Unable to ease because an easy monetary policy would potentially both trigger more inflation and send the dollar even lower, the Fed might even be forced to prolong its tightening course.
The Current Account Deficit Gets Big
Source: Commerce Dept.
If all of this seems naggingly familiar, it's because it is. As the current-account deficit ballooned in the mid-1980s, the same hard-landing scenario got a lot of airplay. Stephen Marris, formerly chief economist at the
Organization for Economic Cooperation and Development
, was its main proponent. He authored a book outlining the danger --
Deficits and the Dollar: The World Economy at Risk
-- and worked the circuit.
The hard landing never really materialized, but worries about it were one of the (many) things to which people ascribe the October 1987 crash. Recall that the Fed's tightenings in September and October of that year and the bond-market falloff were prompted by worries over the dollar's weakness. Note that, looking at the earnings yield against the Treasury yield, the stock market was overvalued by more than 30%. It's never been that overvalued since -- until this year, that is. So here we are again.
A Seductive Creepiness
"Over the last 10 years, I have heard so many theses on what would go wrong, what could go wrong," says John Manley, portfolio strategist at
Salomon Smith Barney
. "There is a certain seductive creepiness about them."
It is not that Manley isn't ready to admit that if the dollar went into free-fall, trouble in the market would follow. It's just that such a rapid decline in the dollar seems so darn unlikely.
For one, such a fall would hurt not just the U.S. economy, but other economies as well. Japan's recovery would get snuffed. Europe, on the cusp of improved growth, would also suffer. It is unlikely that world governments would stand idly by and let such a steep decline happen. And as the millennium gets ready to put the chairs up on the tables and turn out the lights, flows out of the U.S. could reverse. "With Y2K about three months in front of us, the dollar will probably be an attractive place to be New Year's Eve," Manley says.
currency strategist Jim McCormick notes that "you don't have the same extreme levels on the dollar" as in the mid-1980s, when it was not only the current-account deficit that dragged down the greenback, but also that its purchasing power was way out of whack. McCormick does think that there will be a steady decline in the dollar -- a result of the rebalancing in global growth -- but doubts that it could fall in a rapid fashion.
The kicker would be if inflation data begin to come in much worse than people are forecasting. If that happens, "suddenly you have an environment where it looks like the Fed is behind the curve," McCormick says. "That is by far the big risk and the difference between a gradual decline and a market collapse." McCormick doesn't think that's about to happen.
Worries Alone Are a Worry
Other arguments against the hard landing abound. In the 1980s, there were the "twin deficits"; now, with the U.S. running a budget surplus, there is only one. A good portion of the trade deficit -- the major contributor to the current-account deficit -- comes from the foreign subsidiaries of U.S. companies. Any outflows would be, in some ways, self-correcting, because they would weaken foreign economies and send money scurrying back to the U.S.
Maybe the best argument against the scenario is that because people are worried about it, it won't happen. It's like the
character who, realizing that reality rarely coincides with what we imagine beforehand, infers "that to foresee any particular event is to prevent its happening." Manley compares it to the worries that Y2K would spark a worldwide recession. Because people like
Deutsche Banc Alex. Brown
Chief Economist Ed Yardeni were saying it would happen, action was taken. Now it looks like the world will sail through Y2K relatively unscathed.
Yet just because the hard landing is not very likely does not mean that it is not a problem for the market, where a theory of what might happen can be as dangerous, in the short term, as any actual event. Heading into October, Wall Street is in the habit of inventing demons. This is one of them.