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.