Musing About "Hard Landing" Scenarios

Brad Setser muses about the sitch:

RGE - A hard landing in 2006 -- just not in the US?: Brad Setser | Jun 18, 2006

Nouriel and I postulated back in early 2005 that there was a meaningful risk that the next "emerging market" crisis might come from the US -- and it might come sooner than most expected.... Why the emphasis on central banks? Simple: they have been the lender of last resort for the US, financing the US when private markets don't want to.... [A] truly bad scenario for the US seemed to require a change in central banks' policies.... It sure doesn't look like sudden stops in financial flows and sharp markets moves have been banished from the international financial system. Certainly not this year. They just didn't strike the US, but other countries with large and rising current account deficits.

Iceland's currency is way down.... The Turkish lira is way down....

Currency collapses do not necessarily translate into economic slumps. That was a key point that the Federal Reserve has made in response to fears about a US hard landing. A fall in the currency doesn't always translate into higher interest rates, at least in post-industrial countries.... The US, thankfully, has financed itself by selling dollar-denominated debt, pushing currency risks onto its creditors....

[...]

My hypothesis is threefold.

In April, the G-7 communique triggered a fall in the market's willingness to finance US deficits.... Central banks financed the US when markets didn't want to. In May and early June, folks who borrowed dollars and yen to buy emerging market equities... sold their emerging market equities... deleveraging. The net effect has been to help finance the US....

My question: What happens once this process is over?...

If I had to guess, I would say Bill Gross (quoted in Business Week) is right.
It's like Peter Pan who shouts, "'Do you believe?' And the crowd shouts back, in unison, 'We believe.'" You can believe in fairy tales and Peter Pan as long as the crowd shouts back, "we believe." That's what the dollar represents, a store of value that people believe in. They can keep on believing, but there comes a point that they don't.

Greenspan was here two months ago and talked with us for two hours. The most interesting point was his comment that there will come a time when foreign central banks and foreign investors reach saturation levels with their dollar holdings, and so he sort of drew his hand across his neck as if they've had it. Why can't they keep on swallowing dollars? Logic would suggest that these things start to fray at the fringes. Once the snowball starts it can really get going....

A big fall in the dollar isn't bad for the US. A big fall in financial inflows that led to a rise in US interest rates though is another story. A 200 bp move is not so big for emerging economies, but it is big for the US. And because the US financial system is much more leveraged, it would also have much bigger consequences...