The Topic Today: Bubbles in the Economy

Steven Roach and Paul Krugman are on the same page, at least in terms of today's topic, another bubble cycle. And where will this take us?

Steven Roach:

It's hard to know where and how this all ends. The Fed's strategy seems to be aimed mainly at buying time -- hoping for a gradual and benign endgame to the post-bubble workout. That's certainly possible. But there's also the distinct possibility that the Fed is hoping against hope. I would personally assign equal odds to the chance that there will be a more treacherous moment of reckoning. My concerns in this latter regard stem from the increasingly ominous current-account implications of a saving-short US economy. Courtesy of outsize Federal budget deficits and massive multi-year tax cuts just enacted by Washington, it is not that farfetched to envision a net national saving rate that falls from a record low of 1.3% in the second half of 2002 to "zero" over the next 12-18 months. If that were to occur, the current-account deficit could widen sharply further from its record 5.1% of GDP just reported for 1Q03 into the 6.5% to 7.0% range by the end of 2004. Such a massive and ever-widening US current-account deficit could well set the stage for the ultimate post-bubble endgame -- a full-blown dollar crisis that would deal a lethal blow to the global economy and world financial markets. (Emphasis added)

Krugman agrees:

But even if that happy scenario comes to pass, it's hard to justify current stock prices - because if the economy booms, the low interest rates that might conceivably make stocks worth buying at 30 times earnings will soon go away. If and when businesses start borrowing again, they'll have to compete for funds with the federal government, which will be running $400-billion-plus deficits as far as the eye can see. Meanwhile, foreigners won't keep lending us $500 billion each year; in fact, private investment inflows into the United States have already dried up.

Oh, and the banana-republic policies now being followed in Washington won't just drive up interest rates; they'll probably generate a full-blown fiscal crisis one of these years. That can't be good for equity prices.

Both of these articles mention the growing federal deficits. Right now we have an enormous current account (primarily trade in goods) deficit with the rest of the world. Foreign persons, corporations, and goverments have lots of dollars. And, right now, they like them and use them to buy dollar-denominated securitys in the U.S. But as our national savings goes down, we depend more and more on foreign sources to finance our government deficits. And if they decide they don't want any more dollar-denominated securities, because of weakness in the dollar, they will sell the dollar, driving its value even lower. It becomes a vicious cycle, as we saw in South Korea, Thailand, and Indonesia in the late 1990's.

We've got two respected economists today pounding on us about asset bubbles. I think they're right, and I'm not sure how in the hell we can dodge this bullet. About any policy that would deflate the bubbles would be contractionary, taking money out of the economy right now when we need it in there to help prop it up. Trouble is, that money is just contributing to the latest bubble cycle. And these two esteemed economists don't give us any advice on how to deal with this.