February 21, 2006
WHICH ONE BLINKS FIRST: INCOME OR INTEREST RATES?
Fear not--the U.S. will not go bankrupt, legally or otherwise, opines James Galbraith, senior scholar at University of Texas, in a new essay published by the Levy Economics Institute. Joe Sixpack's finances, however, are another matter.
Yes, the U.S. government is running a large and growing current account deficit. And yes, that deficit portends trouble, at least in theory, in part because it could send the dollar tumbling even as the American government avoids bankruptcy in any practical sense of the word. Still, Galbraith counsels such a potential outcome wouldn't be the end of the world, at least not any time soon. "First, it is not in the interest of key players outside the United States to permit [the dollar] to collapse in the near term," he writes. "Second, there is no good and ready alternative to the dollar; that of the euro remains for now on the horizon."
Elaborating on the second point, he reminds that if, say, China started dumping dollar-denominated bonds in exchange for euro-based replacements, the limited supply would create challenges for effecting the transaction. Galbraith explains:
There are, in fact, no proper European bonds on the market, only euro-denominated bonds of individual countries, such as Italy. A major effort to buy those up would, of course, drive the euro up and drive the dollar down. This in turn would hurt the Europeans, with the likely result that they would buy dollar assets—the bonds that China, Japan, and other nations would be seeking to sell. The net result would be a redistribution of dollar asset holdings, no doubt with some decline in the dollar’s value, but that alone would not put an end to the dollar system.
When it comes to household finances, Galbraith is far more cautious. He notes that consumer debt relative to income is at record high levels. "Debt service remains manageable only because incomes have been growing, however slowly, while interest rates have remained low," he observes. Alas, "one or the other of these conditions is not likely to endure," he concludes.
Therein lies one of the great strategic questions for the future, namely, Which will falter first: Income or interest rates? Expecting incomes to continually grow or long rates to stay perennially low may be asking too much. Cycles endure, rates change, things happen.
Still, perhaps the hope that incomes will rise indefinitely enjoys favorable odds. America, after all, has a lengthy history of elevating Joe's paycheck in real (inflation adjusted) and nominal terms over time. But in an age of rising global competition, advancing Joe's real spending power arguably faces its greatest challenge in the modern era.
If there's any hope of keeping spending power buoyant, and/or interest rates low, the front line in the battle necessarily returns to inflation. Winning the war on income and/or interest rates is possible only by conquering inflation. Looking backward, there's much to celebrate. Looking forward, as every investor must, is open to debate.
As such, how is the war on inflation going these days? That depends on which market you ask. The bond market is clearly in the camp of optimism. The benchmark 10-year Treasury yield continues moving sideways, and in fact took a healthy dive yesterday below 4.55%. In fact, 4.55% is a zone that's become familiar terrain for the 10-year in recent years. As a long-term chart of the 10 year reveals, the price of money by this measure has been going nowhere fast.
Quite the opposite can be found in the price of gold, which has soared in recent years, implying in no uncertain terms that higher inflation is due for a return engagement in the economy. One could argue that the Fed is on board with that outlook, to the extent the central bank keeps raising short-term interest rates, which so far is a trend intact. Accordingly, a long-term chart of the precious metal offers a stark contrast to the relative nonchalance founds in bonds.
Rest assured, one market will be proven wrong, and will pay dearly for its mistaken outlook. Figuring out which one's which deserves more than passing attention.
Income and inflation, bonds or gold. There are choices in the global economy of the 21st century, and no shortage of opinion. It's the answers that are in short supply. Some things, at least, never change.
Posted by jp at February 21, 2006 7:29 AM
first point, why would Chiina, which is pegged to the $ both economically and technically choose to switch to Euros which a) yield less - remember that the Chines mainly hold the higher yielding agancy paper b) are in countries which have even worse budget deficits than the US and c)are subject to a non zero risk of the euro breaking apart? Second - 80% plus of US household debt is mortgage debt and 80%+ of that is fixed rate and re-financeable (the losers being the chinese holding the agency paper!)for in excess of 10 years. Short rates can do what the heck they like and the US household is immune - in fact with $4trillion plus in cash deposits, they are actually a net beneficiary of short rate increases. This particular brand of US economic self loathing has been wrong for a decade or more since it ignores both the state of the balance sheet and the relative position of the US to the rest of the world. Anything you think is bad economically in the US is ten times worse in Europe!
Posted by: Mark T at February 22, 2006 3:01 AM
I guess I would like to start with some facts. First, the US Government deficit is trending down. It looks like we will trend down for sevral years assuming we keep the economy growing. Second, US consumers are not living in negative savings. Updated number show we are net positive. In addition, HH wealth is growing. You cannot grow HH wealth when debt is moving up faster. Third, unemployment is still trending down. This suggests that American are finding work despite all the gloom and doom. I gues where I am headed is either we use a model that accurately captures trends or we stop using economic terms when we re speaking about this topic
Posted by: carla at February 21, 2006 9:35 PM