Two Views About a Possible U.S. Hard Landing: Foreign Flight versus Consumer Burnout
The current U.S. economic expansion is in its fifth year. At this stage, the possibility of its ending has raised two explanations that can be labeled the â€œforeign flightâ€™ and â€œconsumer burnoutâ€ hypotheses. While both predict a recession, they rest on very different reasoning and have different implications for interest rates and exchange rate policy. The foreign flight hypothesis is also politically troubling since it can be easily tinged with xenophobia.
The foreign flight view argues that foreign lenders, who have financed the U.S. trade deficit, will eventually grow tired of doing so. Its logic is as follows. At some stage, foreigners will become saturated with U.S. assets and they will cease lending. This will cause interest rates to spike and the dollar to plunge. The result will be financial market turmoil and recession.
The consumer burnout view also predicts a recession, but its logic rests on consumers exhausting their borrowing capacity. When this happens, consumer spending will slow sending the economy into recession. Slowed spending may well link with an end of the housing price bubble since rising house prices have provided collateral that has backed consumer borrowing. From this perspective, rising house prices, household borrowing, and robust consumer spending are three sides of the same coin. Equity prices are also vulnerable owing to the prospect of diminished corporate profitability, and the dollar could fall if diminished U.S. prospects cause investors to tilt asset allocations overseas. However, interest rates are likely to fall rather than rise because government bonds will look relatively safe compared to equities.
One problem for policymakers is that the two view have many observational similarities, which tends to confuse the issue. Both predict recession, financial market turmoil, and a fall in the dollar. However, they differ regarding interest rates. The foreign flight hypothesis predicts an interest rate spike, whereas the consumer burnout hypothesis predicts that rates will fall. Interestingly, Wall Street bond traders appear to hold the latter view, as evidenced by falling long-term interest rates despite the Fedâ€™s raising of short-term rates.
There are also big differences regarding the exchange rate. The foreign flight hypothesis sees an exchange rate collapse as â€œtriggeringâ€ the downturn, whereas the consumer burnout hypothesis has it â€œresultingâ€ from the prospect of a downturn that causes investors to lose confidence in the U.S. economy. The two views have important policy differences. In an economy, every lender needs a matching borrower, and every saver needs a matching spender. The foreign flight hypothesis sees lenders and savers as the ultimate constraint on economic activity. In particular, it identifies the supply of foreign credit and foreign investor portfolios as the constraint on the U.S. economy. The consumer burnout hypothesis focuses on spenders and borrowers, and identifies the level of domestic demand and consumer balance sheets as the ultimate constraint.
At the policy architecture level, the foreign flight view recommends increasing U.S. saving, whereas the consumer burnout hypothesis recommends safeguarding the integrity and sustainability of U.S. demand generation. The trade deficit matters for both. However, the foreign flight hypothesis recommends increasing U.S. saving, whereas the consumer burnout hypothesis emphasizes switching expenditure from imports to domestic goods. Indeed, household saving need not increase. What is needed is that the composition of consumption change, thereby generating jobs and income that sustain consumer borrowing.
More specifically, the foreign flight hypothesis could suggest that the Fed raise rates to defend the dollar should it weaken. The consumer burnout hypothesis unambiguously recommends that the Fed lower interest rates and let the dollar slide in managed fashion as a way of maintaining domestic demand. However, this will be problematic for the rest of the world, which currently relies on U.S. demand.
Finally, the foreign flight view has troubling political overtones because it is easily tinged with xenophobia. Bondholders, domestic and foreign, are pretty much alike. Indeed, a run on the dollar is more likely to be triggered by better-informed domestic â€œWall Streetâ€ investors. That is the history of capital flight episodes. The trade deficit is a major problem because of its adverse impact on the structure of U.S. income and demand generation. We should talk of it in those terms, and resist talking about it in terms of foreign bogeys.