Deja Vu All Over Again

Today's must-read analysis comes from Tim Duy, who collects various circulating thoughts on the state of the macroeconomy into a remarkably clear post. Here's his bottom line:

Bottom Line: I want to believe that the rapid reversal of Treasury yields is a benign, even positive, event. This is likely the Fed's view; consequently, the Fed will hold steady on policy. Challenging this benign view is that the reversal appears to be lock step with a return to dynamics seen in 2007 and 2008 - exceedingly low US rates encouraging Dollar outflows, stepping up the pace of foreign central bank reserve accumulation and putting upward pressure on key commodity prices. I worry that policymakers have forgotten the external dynamic that was hidden by the crisis induced flight to Dollars last fall. Indeed, capital outflows (indicated by a foreign central bank effort to reverse those flows) would signal that much work still needs to be done to curtail US consumption to bring the global economy back into balance. Policymakers are unprepared for this possibility.

Duy echoes Brad Setser in suggesting that we seem to have found our way back to the world of 2007 and early 2008, with a falling dollar, foreign exchange reserve growth, and some upward pressure on commodities prices. The question is: will things play out differently in 2009, and if so, how?

There are a couple of good reasons to think that things will be better this time around. Back in 2007, there were two major imbalances in the economy that needed unwinding -- the debt bubble, and America's large, persistent external deficit. Significant progress has been made in unwinding both of these. The falling dollar will continue to chip away at the external deficit, improving prospects for American exporters and dampening import growth. Deleveraging will also continue. That gets to the second big advantage relative to 2007; policymakers are well aware of the threat of financial weakness and prepared to ensure that deleveraging doesn't lead to any additional systemic crises.

But there are also some ways in which we're weaker than was the case in 2007. One is obviously the country's fiscal position. The American government has less room to act to cushion economic changes, because of concern over the market's appetite for debt and because of increasing poilitical resistence to new deficit spending. Another is that high levels of unemployment have left consumers very vulnerable to new shocks. Many households are already running on shoestring budgets, such that added difficulties have a direct impact on a range of macroeconomic variables, from consumer spending to foreclosure rates. And there are lingering concerns over the ability of the banking system to fund new investments.

One way to see the line the global economy is walking is as a race between structural shifts and upward pressure on commodity prices. At present, America needs to produce more, while exporters want American consumers to pull them out of recession. The dollar is falling against the euro and yen, even as Europe and Japan struggle through extremely deep downturns led by declines in exports. They're looking to exports to get them out of their mess, but shifts in currencies are making that an uphill battle.

And meanwhile, low interest rates, a falling dollar, and an ebbing recession are pushing up oil prices. So if rising oil prices hit households hard before export growth creates some economic breathing room, then we'll probably find ourselves in situation between stagnant output and renewed decline. If the global economy adjusts more quickly, well, sustained growth is not out of the question.

Back in 2007, we had a lot of stuff to work through. Two years on, that's still the case.