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Tom Palley's
recent article connects the subprime mortgage debacle to the trade
deficit. Here is his main point - we did not recover from the
2001 recession because trade deficits caused spending and domestic
consumption to drop, but the Fed compensated with low interest rates
which caused the housing and construction bubble spurred by spurious
subprime mortgages. When that bandaid was ripped away, the "real economy" could not compensate.
That points to the urgency of global policy mechanisms preventing
repeats of such trade imbalances, and for countries to shift from
export-led growth to domestic demand-led growth.
The full article is worth a read.
***
The Subprime - Trade Deficit Connection
Copyright Thomas I. Palley
In recent months the U.S. subprime mortgage crisis has been rippling
outward affecting other countries. British banks have made large loan
loss provisions and there has been a run on the Northern Rock bank.
German banks have incurred similar losses and Germany has suffered two
large bank failures. European banks have also become leery about
lending to each other, forcing the European Central bank to infuse
emergency liquidity. Now, Japan’s banks are feeling the heat.
These global spillovers have their origin in the huge U.S. trade
deficits of the last several years. Those deficits played a critical
role generating the distorted interest rate environment that created
the sub-prime bubble, and they also explain how subprime loans have
wound up in Tokyo portfolios. For policymakers everywhere there are
lessons about the dangers of large trade deficits. (read more)
Over the last several years, the U.S. trade deficit has persistently
drained spending from the U.S. economy. As a result, much of
manufacturing failed to recover after the recession of 2001, making for
a weaker than usual recovery. This weakness prompted the Federal
Reserve to push interest rates to historic lows in 2003, keep them
there for an extended period, and then only raise rates gradually for
fear of undermining the economy.
The Fed’s “easy money” policy succeeded in avoiding a relapse into
recession, but it came at the price of a housing bubble and a twisted
expansion. The hallmarks of this twisted expansion were house price
inflation, a construction boom, explosive growth of non-traditional
subprime mortgages, a debt-financed consumer spending binge, and yet
larger trade deficits.
The counter-part of these deficits was trade surpluses in the rest of
the world, which provided the conduit for distributing sub-prime
holdings globally. Moreover, these trade surpluses persisted because
many countries actively pursue export-led growth, and they therefore
blocked appreciation of their currencies against the dollar to maintain
competitiveness in U.S. markets.
These large surpluses in turn sought an investment home, which helps
explain why long-term interest rates did not rise as predicted when the
Fed eventually raised short-term interest rates after 2004. More
importantly, artificially low short-term interest rates promoted a
“chase for yield” among investors, who started lending at diminished
risk premiums.
This chase affected both American and foreign lenders. In Japan,
interest rates have been close to zero for a decade, while European
interest rates have been below US rates since the end of 2004. Japanese
and European investors therefore willingly bought subprime mortgage
loans, which spread holdings around the world and also elicited
additional supply.
Ironically, owing to bureaucratic inertia, China is the one country
that did not get caught up in the frenzy. Instead, it has invested in
Treasuries, while capital controls have limited individual Chinese
investor access and exposure to U.S. financial markets.
The vast scale of foreign accumulation of dollar assets means that
other countries are now vulnerable to U.S. credit market losses.
Paradoxically, that may support the dollar. However, other countries
are better placed in terms of economic fundamentals. Though they will
bear financial losses, their households are in better financial shape -
except in countries that have also had house price bubbles.
Contrastingly, U.S. households are burdened with debt, and there is a
massive over-hang of house supply that promises to drive down house
prices, further erode financial wealth, and further undermine economic
activity.
The sting in the tail is that a troubled U.S. economy will likely come
back to haunt other economies because of their reliance on export-led
growth and investments aimed at supplying US consumers. And that sting
may hurt China most owing to its heavy reliance on export-led growth
and foreign direct investment.
From a policy perspective there are several big lessons. First, failure
to address problems in one area (trade deficits) can trigger policy
responses elsewhere (monetary policy) that ultimately create even
bigger problems. Second, large trade deficits cause real distortions,
the consequences of which are costly, albeit slow to emerge.
The consequences of the distortions caused by the U.S. trade deficit
will be worst for the U.S., but they will also affect surplus countries
that have accepted dollar-denominated financial assets in payment.
Moreover, many countries are vulnerable to the extent that they depend
on the U.S. market. That points to the urgency of global policy
mechanisms preventing repeats of such trade imbalances, and for
countries to shift from export-led growth to domestic demand-led growth.
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