Thursday, November 18, 2004

Lemming Dollars

The dollar is continuing its precipitous fall. Some economists say it could drop off the cliff before long. Shortly after the election, economist Brad DeLong wrote the following:
If we were going to get concrete, and, say, take the Bush tax cuts of 2001 and 2003 and try to assess their dynamic supply-side effects within a model in which the government budget constraint is satisfied as it will be satisfied, what would we have to do? I believe that we would have to model the satisfaction of the government budget constraint as a probabilistic combination of three different possibilities:

1. Recognize that there is a chance that the tax cut will be reversed. Perhaps once again, as in the early 1990s, an unwillingness to cut spending combined with mounting debt and debt servicing costs changes the complexion of politics. I would have said that the chances of this are high given the 7% of GDP long-run fiscal deficit that America appears to have, and the unwillingness of any politician to propose cuts in the growth rates of Medicare and Social Security spending. But the chances of this have dropped since Kerry reached his peak bubble value of 80% on the Iowa Electronic Markets Tuesday afternoon.
2. Recognize that there is a chance that there will be a long period of rising debt and debt burdens accompanied by cutbacks in spending shares as various institutional mechanisms force the legislature to face and try to meet the government budget constraint. We know what George W. Bush thinks of the pay-as-you-go mechanisms that restrained Congressional action so effectively in the 1990s: he thinks they are a joke: "You know what pay-go means? It means you pay--and [Kerry] goes and spends!" I would say that the chances of this have also dropped since Tuesday afternoon.
3. Last, there is the remaining possibility: that the government budget constraint itself will take its own non-policy steps to make sure that it is met, and generate an Argentina-style meltdown. By the principle that probabilities sum to one, I conclude that the chances of this have risen since Tuesday afternoon.

Now it seems to me that the Ramsey model is likely to be far off in its assessment for any of these three scenarios, even the second.

In the absence of *effective* institutional constraints on Congressional action along the lines of the 1990s Budget Enforcement Act, and given the current complexion of American politics, it seems to me that the paper's estimates of offsets are much more likely to be high than low. Indeed, I fear that the current Congress will ignore the government budget constraint until asset prices bring it to its attention in a striking way--which means that they will ignore it until the markets conclude that option 3 has a significant probability. If true, I would think that with the current Congress the offset would be negative--that the static revenue cost of the tax cuts understates the expected value of the burden imposed by reduced government spending and other effects.
Yesterday in the Wall Street Journal, we read the following:
"It's clear the greenback has become unhinged, compared with the world's other currencies," said French Finance Minister Nicolas Sarkozy. "Now it's up to the Americans to respond."
And in the International Herald Tribune, we read the following today:
U.S. Treasury Secretary John Snow on Wednesday warned Europeans not to expect help from Washington in slowing the ascent of the euro, whose rise to a record against the dollar added pressure on a wobbly Continental economic recovery.
I wonder how much longer it will be before possibility #3 (Argentina-type meltdown) above becomes the inexorable reality of the U.S. Treasury. Of course, I can think of no scenario richer in Schadenfreude than witnessing a humiliated President Bush (late on a Friday evening before a holiday weekend, no doubt) reluctantly calling for measures of "revenue enhancement" to forestall this impending doom.


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