The US economic crisis – status report at 18 months

Brad Setser, economist at the Council on Foreign Relations, explains how we have weathered the economic crisis that started (arbitrarily) in December 2006.  He shows that we have avoided a recession or currency crisis, but at the cost of global imbalances growing even larger.  That just defers the date of eventually re-balancing, and ensures the cost will be larger.

As I described here, this resembles our forest management policy.  After a century of successful fire prevention much of the western US consists of dense forest with layers of dead wood. Tinderboxes ready for the next drought to spark uncontrollable fires.  What can be done?  Not much.  Each year the problem grows worse, forest by forest, until Nature finally takes action.

Too big to fail? Or too large to save?“, 24 July 2008 — “Thinking about the US one year into the subprime crisis.” Excerpt:

Economic activity has slumped, but not fallen off a cliff. US households are pinched (and unhappy), but spending hasn’t collapsed. The US current account deficit has fallen, but not by much – the rise in the oil deficit has offset the fall in the non-oil deficit. … Residential investment has fallen significantly as a share of GDP.

But in other ways, the US hasn’t adjusted.  Or rather, US policy adjusted so that the economy didn’t have to adjust as much. And other key countries – notably the countries that finance the US – didn’t adjust the policies (notably dollar pegs) that effectively compel them to finance the US. Many key countries – notably China – have exchange rate regimes that seem to require that they provide more financing to the US when the dollar is under pressure.

The US went into its crisis with a large current account deficit. And – as the Levy Institute (see Figure 2 here, and more here) and others, including Martin Wolf, have documented – the external deficit corresponded with a large deficit among America’s households. Households didn’t save. They also invested in new homes. As a result, US households were net borrowers from the financial system – and ultimately from the rest of the world.

… The resulting overall external deficit was financed, at least in part, by the buildup of dollar reserves by the world’s central banks – not by a buildup of dollar-denominated financial assets among private investors abroad.

… A year or so later, and not all that much has changed.

  1. The US household sector still runs a deficit. Household savings isn’t falling anymore, but it also hasn’t really increased. Rising oil bills have eaten into spending on other items, but overall spending is holding up. Residential investment is down. But the household sector as a whole still runs a deficit – though a somewhat smaller deficit than before.
  2. The fiscal deficit has expanded. The government is borrowing, in a sense, to provide funds to cash-strapped households to support demand.
  3. Mortgage lending hasn’t even collapsed. Demand for “private” mortgage-backed securities has disappeared. But the Agencies stepped in and bought mortgages both for their own book and for the mortgage-backed securities that they guaranteed.

These steps avoided a super-sharp emerging-market style adjustment.

But a country that runs a large external deficit doesn’t need to just keep credit flowing inside its own economy so that existing “deficit” sectors can continue to run deficits – it also needs an ongoing flow of funds from the rest of the world. The US has gotten that, too.

Why has so much credit been available to the US during its crisis, when similar credit wasn’t available to emerging markets facing trouble? My answer is simple: other countries didn’t adjust their macroeconomic policies even as the US adjusted its policies – lowering rates, loosening limits on the Agencies so that they could expand their books and adopting a counter-cyclical stimulus – and the interaction between the shift in US policy and limited policy changes abroad produced the flows the US needed.

Europe kept its rates up. It even raised them recently.

.. And while China didn’t follow the Fed’s rate cuts, it kept rates more less unchanged as inflation rose, pushing real rates down. That supported investment in China even as higher rates than in the US led to a surge in capital inflows and reserves growth. The RMB’s depreciation against Europe – and the boom in resource exporting economies – kept China’s export growth up. Net exports contributed positively to China’s growth in q3 07, q4 07 and q1 08 (we still don’t know for q2 08).

No adjustment there.

The Gulf kept its peg to the dollar (or in Kuwait’s case, a dollar heavy -basket); Russia kept its euro-dollar peg. Both increased spending and government-sponsored investment as well. The combination of wildly negative real interest rates, a nominal depreciation and fiscal expansion generated an enormous boom. But with oil prices rising faster than spending and speculative pressure on dollar pegs, it also required a huge increase in the foreign assets of the oil-exporting economies government. The oil-exporters basic macro policy stance – dollar pegs, fiscal expansion when oil is high (and contraction when it is low), and monetary policy imported from the US – didn’t change.

{FM comment:  No adjustment there}

Kevin Drum – rifting off Dr. Duy’s Magnus Opus – argues that the system will be stable so long as foreign investors continue to have “faith …. in America as a good place to invest their money.”

I don’t think that is right. The US hasn’t been a good place for foreign investors for some time, now: US rates haven’t compensated for the risk of dollar depreciation, and US equity markets generally have underperformed. That hasn’t kept foreign governments from buying. Their demand for dollars reflects their decision to manage their currencies against the dollar – not their assessment of the dollar’s attractiveness as a store of value. The worse the dollar does, the more foreign central banks tend to buy.

Foreign governments have been willing to take on the currency risk associated with financing the US. But foreign governments didn’t want the credit risk associated with lending to US households. The US government – and its intermediaries, notably the public-private Agencies – stepped in, helping the market to clear and avoiding a sharp contraction in global demand.

That, at least to me, explains in broad strokes how we got where we are.

The policy response to the subprime crisis has avoided the sharp adjustment that many feared. But it also meant that many of the underlying imbalances haven’t really corrected. The composition of the US current account deficit has changed – the oil deficit is bigger, the non-oil deficit is smaller; the fiscal deficit is bigger and aggregate deficit of households is smaller -,but the aggregate deficit remains large.

And the rest of the world’s imbalances haven’t corrected either. China’s economy remains unbalanced. The oil surplus has gotten bigger.  Hence it is possible to argue – see Yves Smith – that risks are still increasing.

Please share your comments by posting below (brief and relevant, please), or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).

For more information about this subject

  1. A brief note on the US Dollar. Is this like August 1914?  (8 November 2007) — How the current situation is as unstable financially as was Europe geopolitically in early 1914.
  2. The post-WWII geopolitical regime is dying. Chapter One   (21 November 2007) — Why the current geopolitical order is unstable, describing the policy choices that brought us here.
  3. We have been warned. Death of the post-WWII geopolitical regime, Chapter II  (28 November 2007) — A long list of the warnings we have ignored, from individual experts and major financial institutions (links included).
  4. Death of the post-WWII geopolitical regime, III – death by debt  (8 January 2008) – Origins of the long economic expansion from 1982 to 2006; why the down cycle will be so severe.
  5. Geopolitical implications of the current economic downturn  (24 January 2008) – How will this recession end?  With re-balancing of the global economy, so that the US goods and services are again competitive.  No more trade deficit, and we can pay out debts.
  6. A happy ending to the current economic recession (12 February 2008) – The political actions which might end this downturn, and their long-term implications.
  7. What will America look like after this recession?  (18 March 208)  — More forecasts.  The recession might change so many things, from the distribution of wealth within the US to the ranking of global powers.
  8. The most important story in this week’s newspapers   (22 May 2008) — How solvent is the US government? They report the facts to us every year.

To see the all posts on this subject, go to the archive for The End of the Post-WWII Geopolitical Regime.

4 thoughts on “The US economic crisis – status report at 18 months”

  1. Joseph Stiglitz has an interesting article on the Fannie Mae/Freddie Mac bailout in Financial Times. He argues that the problem with this as with the Bear Stearns bailout is that private investors have already taken their profits, while the public is now being set up to take the risks. Honestly, I dont understand the basic workings of Fannie Mae. Mawybe someone here can enlighten me.
    Fabius Maximus replies: I have not read Stiglitz’s article, but your summary seems spot on. The government sponsored enterprizes (GSEs) acted to use the government’s credit to further private-sector activity. Since there were no natural boundaries to this process, it inevitably (as many forecast along the way) evolved until collapse.

    Note that this is a global event. The US saves to little to fund a bubble of this magnitude. The US government backing (previously implied, now explicit) of the GSE’s allowed foreigners to fund the US RE bubble — which they would not have otherwise done. That is, the savings of the world were funneled into US real estate.

    As Brad Setser (economist at the Council on Foreign Relations) notes:

    “The costs of a system that channeled huge sums of emerging market savings into the US real estate market — contributing to a bubble in US housing that is now collapsing, at a significant cost to all involved (private market players who bet that housing would only go up, the US government, and emerging market governments who bet on the dollar) and now a surge in inflation in the emerging world — are now quite apparent. It has produced a massive misallocation of resources on a global scale.”

    As for an explanation of the GSE’s , try Wikipedia. They give an adequate basic overview.

  2. (a) The Fannie Mae Gang also discussed how the lobbyists insulated Fan & Fred from criticism. Where was Stiglitz or Brad Setser criticising the US real estate bubble before 2007? The Economist had been noting a housing bubble since 2003 — maybe warnings too soon are too much like crying wolf 2003 wolf! (up 10%) … 2004 wolf! (up 10%) … 2005 wolf! (up 10%) 2006 wolf! (up 10% till Dems get elected in Nov)… 2007 WOLF!!! down 10%.
    (By the way, I argued for replacing the Tax Deduction for interest with a Tax Credit on the whole equity-plus interest payment back in 2003, noting the coming bubble, no longer on TCS. Related here:

    (b) Let’s also note the coming Social Security Crisis — the one Dems keep promising isn’t real, won’t really happen, not much needs to be done, etc. It’s been broken since it was created.

    (c) Let’s look at oil prices? Here’s a great note by somebody who doesn’t know how the global balances will change due to China’s growing oil thirst: “Oil prices and economic fundamentals“, James Hamilton, Econbrowser, 25 July 2008.

    (d) But the US is inflating to stave off recession and cope with higher gas prices — as well as reducing use of gas. That higher prices finally are changing behavior is the main reason folk are angry. If they can absorb the increase with no behavior change, they do so and don’t complain so much ($1.50 … $3/gal, with good economy). When they have to change, because of higher prices, they will bitch. And change.

    (e) The Income tax should be mostly replaced by a tax on gas use, until the total use goes down to the level of US production.
    Fabius Maximus replies: I do not understand much of your comment.

    (a) Roubini and Setser (esp. the latter) are experts in global capital flows — not US asset bubbles. They did not comment about AIDS, either.

    (b) While not a fan of Hamilton’s oil work, I do not understand what you are saying about his analysis.

    (d) There is little evidence that the “US” is inflating. Growth in the key lower monetary aggreagates is low. Some prices are rising, other falling. Most imporant: de-leveraging is inherently deflationary. Defaults in residential and commercial mortgages, credit card and auto loans, and such — these are signs of a profound reversal of the post-WWII US debt supercycle.

    Discussing what you believe should be done may be interesting, but is useful only if you can describe how we get from here to there. And the effects of such massive policy changes. For instance, oil exporters might wonder why our government should benefit so much from the use of their natural resource. If we believe the price of oil is too low, they can fix that for us.

  3. Thought you’d be interested in this: Treasury called Monday for a new “covered bond” market in mortgage debt. “Treasury’s Paulson Encourages Covered Bond Market“, 28 July 2008.
    Fabius Maximus replies: Fortunately this behavior is not widespread in other vital public services. When I call the fire department, they put out the fire before discussing installation of sensors and sprinklers. When the ambulance takes me to the hospital after a heart attack, they operate before discussing diet changes.

    Total nonsense, esp. since the Obama Administration and his new majority in Congress will probably scrap these proposals. They have ideas of their own.

  4. There is a nasty dowwnside to the eventual re-valuation of the RMB , inflation. Cheap Chinese goods, along with cheap oil, were probably the major reason for low inflation during the 90/00’s.When it goes up prices of manufactured good will climb, which along with higher energy and commodity prices will have a nasty effect on prices worldwide.

    The reason it will go up (eventually of course)? Commodity prices and the impact of huge volumes of US$ on internal inflation.Maybe a case of “careful what you wish for”. Given how fragile the World’s economy is, a slow and steady rising over time would be the best option, trouble is .. that is a very hard act to pull off. Similarly with the oil producers coming off the US $, a slow and steady transition would definately be preferable for everyone, but the nature of these things seems to be ‘jumps’ and sharp transitions.

    Problem is also that these are in many ways interlinked. A sharp revaluation of the RMB could push, at least some, of the oil producers to rapidly switch from the US$ as their inflation rates skyrocket even more than they have been doing. Bit hard to have ‘slow and steady’ transitions, when there are riots in the street.

    What is needed now is another ‘Bretton Woods’ moment and a clear plan by the major economies for a smooth transition.

    The US wins out of this, in the longer term of course, the short term is awful. With a educated, still quite well trained workforce, a low dollar and the need to earn foreign currency you’ll see a manufacturing boom in the US that would rival the 40’s. Done right, the World’s economy would be far better balanced in 10 years. The real issue is the political will and frankly the sheer intellect to pull it off, not many John Maynard Keynes out there now to pull our chestnuts out of the fire (historical note: the chief designer of the Bretton Woods Agreement which usherd in an unprecedented period of prosperity for much of the World).

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