In my not too well informed judgment, at least, the big systemic vulnerability is that bond and currency markets do not seem to be pricing the full distribution of future possibilities. The most likely and central-case scenario for 2010, in my macroeconomic view, is one of medium-run equilibrium. Such a scenario sees:
1. A U.S. trade account near balance as foreign investors on net decide that they have a large enough share of their wealth invested in the U.S., and a stable U.S. current account deficit with net foreign assets growing at the rate of U.S. national product.
2. Consequently, a trade-weighted value of the dollar consistent with roughly balanced trade--that is, a trade-weighted value of the dollar 30% or more below what it is right now.
3. Some recovery of wages to their trend as the economy approaches closer to full employment, hence lower profits--and lower retained earnings to finance investment.
4. Continued large and growing federal budget deficits.
5. A great reduction in capital inflows and continued high budget deficits together diminish the supply of savings flowing into the financial markets, and a reduction in retained earnings increases firms' demand for outside capital. The implication is long-term interest rates in 2010 that are not low but high--supply and demand, you know.
This is the most likely future that I see: the central case. And the markets are not pricing it. The foreign exchange markets are not registering the likely large decline in the trade-weighted dollar out there in the medium-run future. The bond markets are not registering the likely large fall in long bond prices as insufficient savings supply runs into expanded investment demand.
I think I understand why the foreign exchange markets are not yet pricing the big dollar decline to come. As long as central banks are large actors in the market, the big foreign-exchange bets against the dollar undertaken by private businesses that are needed to drive the dollar down to medium-run equilibrium are very risky indeed. It's better for large private players (or they think it's better) to wait until it's clear that central banks are about to start dumping their dollar reserves for euros, yen, and renminbi before dumping their own dollar-denominated assets for euros, yen, and renminbi. Central banks are, after all, governments--and so private businesses think that it will be easy to anticipate what they are about to do and to front-run them when it's about to happen. Prematurely betting against the dollar takes on lots of risk for no real significant gain. That, at least, is how I think the big private players in foreign exchange are thinking.
I don't, however, understand the bond market. Do they expect the wage share to stay this low forever, and corporate profits [and] retained earnings to be abundant? Do they expect the capital inflow to continue forever? Do they expect the Bush administration to get serious about balancing the budget? None of these seem plausible as expectations, as modal scenarios, as central cases. But then why isn't the long bond market already pricing the supply-and-demand for loanable funds imbalance that seems inevitable in medium-run equilibrium? It's a mystery.
DeLong doesn't think the bond and currency markets are behaving rationally. (By extensions, since recently stocks track bonds, neither is the stock market.) He's worried that hedge funds are amplifying these miscalculations. If he's right, and the dollar falls quickly enough, the consequences may be severe.