Part 14 (1/2)

That process may be especially violent if the dollar starts to appreciate quickly Any nus could cause it to do so: increased investors' risk aversion or eopolitical tensions could suddenly send investors fleeing for safer havens Whatever the reason, if the dollar appreciates suddenly-just as the yen did when the carry trade in that currency unraveled-a stalobal assets and short on the dollar will suddenly reverse course The bubble will then burst

This unraveling may not occur immediately The wall of liquidity and the Fed's suppression of volatility can keep the gaer But that er, setting the stage for a seriouson Debt

Until very recently, the idea that an advanced econon debt would have see markets were the ones that defaulted In the past decade alone, Russia, Argentina, and Ecuador defaulted on their public debt, while Pakistan, Ukraine, and Uruguay cah the centuries: e econoraduate” to a lobal economy

We seem to have come full circle In recent years, with a few exceptions in central and eastern Europe, e-market economies have put their fiscal houses in order The threat of default now looraded the debt of several advanced countries, and debt auctions in the United Kingdom, Greece, Ireland, and Spain found far fewer buyers than anticipated It was a less-than-friendly reminder that unless advanced econoencies-and in particular, the dreaded ”bond vigilantes”-will bring them to heel

That prospect puts many advanced econo recession have led to a serious erosion in their fiscal position Stirams and lower tax revenues have hit hard So has the decision to socialize the losses in the financial sector, effectively shi+fting the recovery and an aging population may worsen the debt burden of the United States, the United Kingdom, japan, and a handful of countries in the Eurozone

Some countries have already takenIceland, Ireland, and the United Kingdoal, and, to a lesser extent, Greece These measures will hurt in the short ter that can prevent a loss of credibility and the inevitable spike in borrowing costs Unfortunately, while putting one's fiscal house in order e a fledgling recovery On the whole, however, these countries are better off taking the pain now rather than running the risk of defaulting on their debt

Though the United States and japan will likely avoid the bond ilantes for some time to come, they too may one day incur their wrath The United States continues to run unsustainable current account deficits and has an aging population and plenty of unfunded entitle on Social Security and health care japan has an even bigger aging population and has already racked up significant debts Both countriesscrutiny of their fiscal position, a prospect that poses particular dangers for the United States, which until now has been able to borrow in its own currency

Unfortunately, it has another, less honest option The United States (as well as the United Kingdom and japan) issues its public debt in its own currency That means it need not formally default on its debt if it proves unable to raise taxes or cut govern Instead, central banks can print new currency-or its digital equivalent-and monetize the debt This ti out the real value of the debt and transferring wealth froovernht default, it achieves the saue that it kills two birds with one stone First and most obviously, a moderate rate of inflation helps erode the real value of public debt, reducing the burden At the sa the real value of private liabilities-fixed-ratethe nominal value of homes and other assets This is a in: the public and private sectors both get to wriggle free of their debts

It sounds smart, but it's not If inflation rose froits-let alone double digits-central banks could lose control of inflation expectations Once the inflation genie gets out of the bottle, it's hard to control In the process, central banks would destroy their hard-won credibility While Paul Volcker's success in fighting inflation in the early 1980s confir so comes at the considerable cost of a severe recession

Moreover, while inflation can reduce the real value of nominal debt at fixed interest rates, much of the debt in the United States and other advanced econoations with variable interest rates These include bank deposits, variable-rate overnment debt, and other short-term liabilities of households, corporations, and financial institutions Expectations of rising inflation would her interest rates The rates would effectively keep pace with inflation In the case of short-term and variable-rate debt, the inflation solution would be ineffective: you can't fool all of the people all of the ti to use inflation to erode the real value of private and public debt would carry other risks Foreign creditors of the United States would not sit back and accept a sharp reduction in the real value of their dollar-deno rush toward the exits-as investors dumped dollars-could lead to the collapse of the currency, a spike in long-term interest rates, and a severe double-dip recession The United States would not have the sway that it did the last tie, in the 1970s Back then the country was still running current account surpluses

That's no longer the case: the United States has beco 3 trillion to the rest of the world Its current account deficits-400 billion a year-have becoly leery of holding long-ter on a shorter time fraly vulnerable to the kind of crises that hit e markets in the 1990s, with the sudden collapse of the dollar more likely

The Chinese and other US creditors-Russia, japan, Brazil, and the oil exporters in the Gulf-would not accept such a loss on their dollar assets Convincing China to accept such a financial levy would require soht ask the United States for so up on its defense of Taiwan Such trade-offs would be likely in a world where the great powers on both sides of large financial ieopolitical leadershi+p

This ”balance of financial terror” would seem to rule out the possibility that China would si the US fiscal and current account deficits For China to halt its interventions in the foreign exchange markets, much less due the competitiveness of its exports But should political tensions rise, and the United States begin actively to debase its own currency, China may alk away from the table, even if its interests suffer in the short tere at the height of the Cold War, but it is not inconceivable

Given these risks, US authorities will likely not resort to the printing press to deal with the country's debt, even if the temptation to use inflation-just a little bit-to depreciate the debt will re But prudent policy e of such a solution would be significant, if not catastrophic

All That Glitters

Through 2009 the price of gold rose sharply, reflecting fears that the United States ht purposely debase and devalue its currency in order to resolve its debt probleold prices breached the 1,000 barrier and rose to 1,200 by the end of the year, before falling once s forecast that in the next couple of years gold prices could reach a level above 2,000 Is that possible? Is the recent rise of gold prices justified by fundaold prices rise sharply in one of two situations: one, when inflation starts to rage out of control, at which point gold becoainst inflation; then a near depression seely likely and investors become concerned that even their bank deposits may not be safe The history of the last two years fits both situations

First, gold prices started to rise sharply in the first six an to overheat, commodity prices skyrocketed, and fears of inflation in these hs Then the bubble burst, coold prices fell too

The second spike in gold prices occurred at the tiold was not driven by concerns about inflation; indeed, deflation had become a probleered a global financial cardiac arrest, investors became sufficiently scared about the security of their financial assets-including bank deposits-that soold

The G-7 contained that depression scare by widely insuring deposits and bailing out and backstopping the financial systeold then drifted doard, as the near depression gripping the global econoold, as well as the consuold bounced back, spiking above 1,000 in the early spring of 2009 as concerns about the solvency of the financial systerew that governments could not bail out the entire financial syste to fail” was now ”too big to save” At that point growing concerns about an econoold prices That's hardly surprising: when you begin to worry that your governuarantee bank deposits, it's tiold bars, and hunker down in a relobal old prices drifted doard again later that spring, as additional policy lobal econoold prices spike in response to concerns about either inflation or depression In both cases, gold ainst risk, particularly extrenal a total systeenerally drift doard

Howforward? Any nuh it's unlikely to hit 2,000 per ounce For exaht try to monetize their deficits could stoke fears of inflation, sending prices higher Likewise,around the financial systeold In addition, carry trades funded by dollars have pushed the value of the dollar sharply doard There's an inverse relationshi+p between the relative value of the dollar and the dollar price of coe of coold, increase

Other factors old Central banks in India, China, and other countries have increased their holdings of gold Private investors who have lingering fears of low-probability events-high inflation or a crippling double-dip global recession-old, central banks and private investors need old in their portfolios to increase its price significantly A single event-a sovereign debt default, for exaold prices to move upward into bubble territory So-called herd behavior andwould only inflate the bubble still further

Nonetheless, a doard correction in gold prices carries significant risks The dollar carry trade will likely unravel at some point, and central banks will eventually exit quantitative easing and abandon near-zero policy rates Both these developments will put doard pressure on coenerally, anyone who has blind faith in gold as a hedge against risk should understand that crises don't always drive people toward gold The prospect of sovereign debt defaults in sold The sa as the dollar itself is not the focus of a crisis, gold prices do not autos are afoot

For the sake of argues into a near depression, and investors steer clear of dollars Should they therefore put all their old has little intrinsic value You can't eat it, heat your house with it, or put it to good use It is what Keynes called a ”barbaric relic” While you could exchange gold for soht make more sense to stock up on commodity futures or, if you can stoold The recent swings in its price-up 10 percent one month, down 10 percent the next-underscore the fact that its price movements are often a function of irrational beliefs and bubbles Holding soainst inflation overnold iven the likelihood that inflation will reht of the recent crisis, concerns about deflation drove overn Zero interest rates and quantitative easing would norer a round of inflation, but that did not happen in 2009 Deflation crept into the United States, the Eurozone, japan, and even so-market economies The reason was simple: banks held most of their excess liquidity in the for it out

Deflationary pressures will persist in the short ter-oods and labor rees Inventories of unsold goods get liquidated at low prices, and workers facing record une cuts in wages in exchange for job security

Inflation has shown so economies, which have enjoyed a swifter recovery from the financial crisis At the end of 2009 oil, food, and real estate prices were rising in China and India For these economies, which may soon overheat, inflation could become a problem, far more so than in advanced economies

Still, advanced econo in 2012 It could happen for one of three reasons One, if governments opt to monetize their deficits, expectations that inflation will soar, pro prices and wages Two, the glut of easyan asset bubble in co a return of inflation Three, if the dollar continues to weaken, the price of coo up: as we've seen, there's a negative relationshi+p between the value of the dollar and the dollar price of commodities Oil producers, for example, will raise the dollar price of a barrel of oil if the dollar weakens Otherwise, they will see a decline in the purchasing power of the dollar they receive in revenue

In all likelihood, neither deflation nor inflation is likely to be pronounced in the next year or so Absent a severe double-dip recession, deflation will likely reain momentum under certain circumstances

Globalization and Its Discontents

In the last few decades the world has becooods and services has becoration of workers and the diffusion of inforical innovation, each reinforcing the other For example, financial capital now moves around the world at a much faster pace thanks to the widespread adoption of infory

As a result, countries can now provide services to other countries on the other side of the world: think of India's call centers, for exa of US white-collar jobs Likewise, China has been able to join colobe Increasingly, countries on the economic periphery are connected to advanced econoht a sharp increase in the standard of living in e economies Hundreds of millions of Chinese, Indians, Russians, Brazilians, and other citizens of e-market econoher-paying blue-collar jobs, or even reater access to necessities and luxuries alike In turn, citizens of advanced econooods and services becolobalization and innovation are not without risks Take, for exa billions of people to the global labor supply China and India contain nearly 25 billion people, and other eration could cause a backlash against globalization and free trade in advanced economies Unfortunately, this sort of transition will not likely be slobal econo prevalence of financial crises-are in no s lobal econorowing inequalities of inco-market economies alike Debate simmers over why this has happened Soress has left solobal prosperity (for example, if you don't kno to use a computer, you can't i co oods

Whatever its causes, this increased inequality has caused a growing lobalization and free trade It began with blue-collar workers, for understandable reasons, but has spread to white-collar workers, as outsourcing enables firms to shi+ft service jobs fro economies like India In tilobe to another, causing serious disruption This kind of ”creative destruction” may be inevitable, but it will cause considerable strife unless properly lobalization may well usher in far more frequent and virulent crises The speed hich financial capital and hot money can move in and out of specific markets and economies has increased the volatility of asset prices and the virulence of financial crises Unfortunately, while finance has gone global, its regulation remains a national affair All of this increases the likelihood of future crises that could assulobal proportions