U.S. May Be In for a Hard Landing

The favorite parlor game among economists these days is to speculate on the possibility of a “hard landing” for the U.S. economy under George Bush--a dramatic crunch in which the postponed consequences of budget and trade deficits suddenly become apparent, retroactively discrediting Ronald Reagan as well as Bush. Bush and his advisers are, of course, counting on a “soft landing,” in which the budget and trade deficits gradually decline, with a smooth transition to internal and external balance just in time for the 1992 election.

There are two basic hard-landing scenarios. One of them is the result of a trade deficit that fails to decline; the other, more paradoxically, the result of a trade deficit that falls too fast.

The simpler of the two scenarios begins with bad news on the trade front. Suppose that, for a number of months running, the U.S. trade deficit fails to shrink any further or actually begins to widen. Then the result could easily be a loss of foreign confidence in the dollar, starting a sharp fall--say, to 100 yen. Such a sharp fall would lead the Federal Reserve, already nervous about inflation, to raise interest rates to try to attract foreign capital and thus defend the dollar. But if the demand abroad for U.S. products that has fueled economic growth since 1986 has sputtered to a halt, and an interest rate increase is simultaneously depressing domestic demand, the result is a recession.

The more complex of the two scenarios begins, instead, with good news on the trade front. Month after month, the U.S. trade deficit falls. As foreigners buy more of our goods, and as domestic consumers switch away from imports, there is an ever-increasing demand for U.S. products. But the U.S. economy is already running pretty close to full capacity; indeed, officials at the Federal Reserve are worried that the unemployment rate may already be too low, and that the underlying rate of inflation may be gradually picking up. So, with domestic demand strong and the trade deficit falling rapidly, the Federal Reserve has no alternative except to raise interest rates sharply to rein in the economy.

Whichever hard-landing scenario you prefer, you can expand the story into a full-fledged financial crisis if you like, by pointing to unprecedented levels of corporate debt. Given how leveraged corporate America has become in this age of takeovers and leveraged buyouts, a huge wave of bankruptcies could follow if we have a recession and/or a sharp rise in interest rates.

Well, those are the scenarios. Are they likely? Or will the Bush Administration, like Reagan’s, be able to defy the grim predictions of mainstream economists?

The answer, of course, is that we do not know. All we can do is make some comparisons with other countries and try to see how the United States ranks on the scales of vulnerability.

Let’s start with the case for optimism. Although the United States has immense budget and trade deficits and is the world’s largest debtor, it is also a huge economy. In relative terms, the United States does not look that badly in trouble. The Reagan Administration’s fiscal policies have been irresponsible, of course, but the irresponsibility is not really world-class when you take the size of the economy into account--budget deficits of 3.5% of gross national product don’t compare with the double-digit deficits run at various times by Italy, Ireland and many developing countries. Indeed, for much of the past 15 years Japan ran budget deficits that were larger than ours as a share of national income, without obvious ill effects.

Nor is our trade problem too awesome when looked at from the right perspective. Our foreign debt, at about 10% of GNP, is large but not huge. For comparison, Denmark has a foreign debt that is 40% of GNP, has been running current account deficits for 25 years and still has AA-rated bonds. Our trade deficit, at less than 3% of GNP, is big for an industrial country but not unprecedented and, as with most of our problems, is small compared to those of developing countries.

So you can use the numbers to convince yourself that things aren’t too bad. Either the United States will be able to continue borrowing for a long time (so that Bush can pass the problem on to President Quayle), or it will be possible to slowly whittle down our deficits in a way that causes little pain.

Now for the pessimistic side. By some comparisons the United States does not look too good. Our budget deficit is not too large relative to GNP, but the United States has the lowest private saving rate in in the industrial world, so that the deficit does preempt two-thirds of our national savings.

Our foreign debt is not too large relative to GNP, but it is large, relative to our exports. Thus, the ratio of debt to our export earnings--arguably a better guide to our vulnerability to a speculative attack--is rapidly approaching a 2-to-1 level, comparable to that of the Latin American nations on the eve of their debt crisis.

If the United States does experience a sudden loss of confidence by the foreign investors who have allowed us to live beyond our means since 1981, there could be a serious adjustment problem. How serious? The United States is running a current account deficit of about 3% of GNP--that is, it is spending about 3% more than it earns. To reduce that deficit suddenly would require a sharp fall in the dollar that would raise import prices, adding to the burden. Add to that the strong possibility that the U.S. economy is currently operating above full employment, and it appears that the United States is living anywhere from 4% to 6% beyond its means.

That’s a big number. For comparison, the two great oil shocks of 1973 and 1979 each amounted to about 3% of GNP; so the United States could face all at once a shock as large as both oil shocks put together. The debt crisis in Brazil and Mexico amounted to an initial shock of 7% to 8% of GNP--and that was enough to stop economic development dead in its tracks, set off near-hyperinflation in Brazil, cause massive unemployment and double-digit declines in real incomes in Mexico.

So the risks of a hard landing should not be dismissed. If the United States does experience a sudden loss of investor confidence, comparable to what happened to Mexico and Brazil in 1982, the hard landing could be very nasty indeed. And, by some of the numbers, the United States looks vulnerable to just such a loss of confidence--although by others it does not.

Does Bush face a hard landing? The question probably depends on psychology. If he can convince the world that he is ushering in a new era of growing realism in U.S. economic policy, that he takes our lack of national saving seriously, that he is truly worried about our long-term prospects, then the financial markets may give the U.S. economy the benefit of the doubt.

If he seems to believe that only public relations matter and that hard choices can be indefinitely postponed if only the right calming phrases are used, the already-nervous markets will probably force a day of reckoning in the not-too-distant future.

I am pessimistic. Everything we have seen about Bush suggests that he believes his own campaign rhetoric and does not realize that a change in course is necessary. I hope that I have misjudged him. If not, get ready for a rough ride.