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Over at Equitable Growth: Is the Fed in a Trap?: I Really Cannot See It...: Daily Focus

Over at Equitable Growth: The very sharp and smart Stephen Roach is seriously alarmed--and I think he is wrong.

Stephen Roach:

Stephen S. Roach: The Fed Sets Another Trap: "America’s Federal Reserve is headed down a familiar...

...and highly dangerous path... the same incremental approach that helped set the stage for... 2008-2009. The consequences could be similarly catastrophic... incremental approach... condoning mounting excesses in financial markets and the real economy.... [The] macro-prudential tools... approach... fails to address the egregious mispricing of risk brought about by an overly accommodative monetary policy.... READ MOAR

The Fed’s $4.5 trillion balance sheet... no inclination to scale back... passed the quantitative-easing baton to the BoJ and the ECB.... The longer central banks promote financial-market froth, the more dependent their economies become on these precarious markets.... What do independent central banks stand for if they are not prepared to face up to the markets and make the tough and disciplined choices that responsible economic stewardship demands?... Now it is time for the Fed and its counterparts elsewhere to abandon financial engineering and begin marshaling the tools they will need to cope with the inevitable next crisis...

A financial crisis happens when something leads to a sharp fall in the risk tolerance of the market; that fall in risk tolerance reduces the price of risky assets in such a way that highly-leveraged financial intermediaries become illiquid and possible insolvent; that possible insolvency produces a sharp shift in the riskiness of assets as many previously classified as safe are no longer so; thus the fall in the demand for risky assets (and the rise in the demand for safe assets) triggers a huge rise in the supply of risky assets (and a huge fall in the supply of safe assets), and the downward spiral commences.

Those of us watching financial markets in 2005 worried about such a financial crisis triggered by a full-scale run on the dollar. See, for example, me from March to May:

Perhaps the clearest statement I made is this: Our Twin Financial Puzzles: The Long Run May Come Like a Thief in the Night:

The optimists... have only one economic argument: long-term interest rates are relatively low, and are not pricing the dollar-collapse and the U.S.-interest-rates-spike scenarios as having any substantial probability at all. The pessimists on Wall Street are puzzled at why this economic argument is supposed to have force. From their perspective, demand for long-duration dollar-denominated securities is high because the Asian central banks are buying as if there were no tomorrow in order to keep the value of their currencies down, the U.S. Treasury is borrowing short (it is not issuing that many long-duration securities), and U.S. companies are cautious and are not undertaking the kinds of investments that would lead them to issue lots of long-duration bonds.

We economists respond by saying that for every market mispricing there is an open profit opportunity: if long-term interest rates are indeed too low--if long-term bonds are indeed priced too high--there is money to be made by shorting long-term U.S. bonds, parking the money in some other investment vehicle that is not underpriced [and] waiting for bond prices to return to fundamentals.... But the Wall Street types have a counterargument: For any one financial institution to make the international bet--to bet on the decline of the dollar against the yuan over the next five years in a very serious, leveraged way is to put its survival at risk should the trades somehow go wrong. And trades do go wrong....

We economists believe that market forces drive prices to fundamentals. But we are not careful enough to distinguish situations in which equilibrium-restoring forces are strong from those in which equilibrium-restoring forces are weak. At the moment those forces are weak. And this adds an additional danger: at any moment those forces may become strong. The long run in which the dollar falls and U.S. long-term interest rates rise may come like a thief in the night as a very sudden shock.... On that day the long run future will be, as football coach George Allen (not the "macaque" one) used to say, now.... Should that day come, keeping a financial crisis from becoming a major disaster may well require swift and rapid action by a Federal Reserve and a Treasury Department that have powerful and unconditional White House and Congressional support....

That is me back in 2005. Was I then sounding enough like Stephen Roach sounds now--in 2014?

So why am I so much more sanguine now?

Note what I said then: "Should that day come, keeping a financial crisis from becoming a major disaster may well require swift and rapid action by a Federal Reserve and a Treasury Department that have powerful and unconditional White House and Congressional support..." May well require--a full-blown run on the dollar could, I thought, be successfully managed by competent technocrats. In fact, I put the chances of a truly hard landing conditional on a major dollar crisis at only 10%. Why so low? Back then I wrote down the argument at an undergraduate level:

Some Simple Analytics for a Hard Landing:

Web archive org web 20140326173802 http www j bradford delong net movable type pdf hard landing pdf

Web archive org web 20140326173802 http www j bradford delong net movable type pdf hard landing pdf

Web archive org web 20140326173802 http www j bradford delong net movable type pdf hard landing pdf

Web archive org web 20140326173802 http www j bradford delong net movable type pdf hard landing pdf

Web archive org web 20140326173802 http www j bradford delong net movable type pdf hard landing pdf

Web archive org web 20140326173802 http www j bradford delong net movable type pdf hard landing pdf

Web archive org web 20140326173802 http www j bradford delong net movable type pdf hard landing pdf

Web archive org web 20140326173802 http www j bradford delong net movable type pdf hard landing pdf

Web archive org web 20140326173802 http www j bradford delong net movable type pdf hard landing pdf

Web archive org web 20140326173802 http www j bradford delong net movable type pdf hard landing pdf

Web archive org web 20140326173802 http www j bradford delong net movable type pdf hard landing pdf

Web archive org web 20140326173802 http www j bradford delong net movable type pdf hard landing pdf

Web archive org web 20140326173802 http www j bradford delong net movable type pdf hard landing pdf

I still think that looks pretty good as a thinking-through back in 2005 of how a financial crisis could be generated by a run on the dollar, and why it probably would not produce a hard landing.

What is the equivalent argument at the undergraduate or graduate level supporting Stephen Roach's fears? I just do not see it.

Of course, we did not get the dollar-run crisis: we got a very different one...

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