naked capitalism

A wide range of commentators, including your humble blogger, have worried about the clearly untenable system known as global imbalances, or more formally, Bretton Woods 2. That was the tacit arrangement under which the US ran significant current account deficits which were financed by large purchases of Treasuries and more recently, Agency securities by foreign central banks in countries running big trade surpluses, namely China, Japan, Taiwan, and the Gulf States.

Even though economist Herbert Stein famously declared, “That which is unsustainable will not be sustained,” there were plenty who argued this arrangement would continue, just as dot com valuations had their defenders in 1999.

Brad Setser, who with Nouriel Roubini has given this topic considerable thought, had identified one factor that doomed this arrangement. America’s foreign creditors aren’t simply funding its current overconsumption; they are also funding the interest payments on past overconsumption. Once the interest component became too large relative to the trade deficit, our friendly funding sources would start to question the merits of this arrangement. Indeed, there is already infighting in China between the central bank and the finance ministry over what the policy on the dollar should be (letting the dollar fall relative to the RMB would eliminate the need to buy Treasuries to keep the currency low, but would also considerably reduce the trade surplus with the US).

Setser writes today in a very important post that the system is on its last legs, but not for the reasons he anticipated. Even though the arrangement has been colloquially described as “China funding our trade deficit” that is not the mechanism at work. China’s central bank is not lending to credit card issuers and banks that provide home equity loans. China buys Treasuries. A series of intermediate processes allows this foreign largess to result in support for consumer borrowing. Everyone expected our once-indulgent creditors to wake up and start demanding higher interest rates, which would wreak havoc on the US. Instead, the US financial system broke of its own accord under the weight of too much debt.

You must read the whole post, but here are some key sections:

In some sense Bretton Woods 2 has been on life support for a while now. China’s recent export growth has depended far more on Europe than on the US. US demand for non-oil imports peaked in 2006. One irony of the past year is that the US was borrowing far more from China that it was buying from China. Campaign rhetoric that the US was paying for Saudi oil with funds borrowed from China isn’t far off – though it leaves out the fact that the US also borrows from Saudi Arabia to pay for Venezuelan, Mexican and Nigerian oil….

The US and European banking system collapsed before the balance of financial terror collapsed. Dr. DeLong writes:

All of us from Lawrence Summers to John Taylor were expecting a very different financial crisis. We were expecting the ‘Balance of Financial Terror’ between Asia and America to collapse and produce chaos. We are not having that financial crisis. Instead we are having a very different financial crisis. Catastrophic failures of risk management throughout the entire banking sector caused a relatively minor collapse in housing prices to freeze up global finance to a degree that has not been seen since the Great Depression.

Yves here. I wouldn’t call the reversal of a housing bubble that pushed prices nationally to 30% to 35% over their long-standing relationship to incomes and rentals a “relatively minor collapse.” The fall in US net worth August 2007 to August 2008 was greater in percentage terms than during any 12 month period in the Depression, and is due mainly to the fall in home prices. The 12 months September to September, which would pick up the worst of the stock market swoon, are certain to be more dramatic. But each to his own characterization. Back to Setser:

The end result of this crisis though could be rather similar: a sharp contraction in credit, a fall in US economic activity, a fall in US imports and a fall in the amount of foreign financing the US needs.* The US government is (possibly) trying to offset the fall in private demand by borrowing more and spending more — but as of now there is realistic risk that the fall in private activity will trump the fiscal stimulus.

Consequently, this still strikes me a crisis of the Bretton Woods 2 system. In retrospect, Bretton Woods 2 depended on two things: ongoing flows from the emerging world’s governments to the US Treasury and Agency market, and the ongoing ability of the US financial system (broadly defined to include the dollar-based “shadow” financial system operating in London and other offshore centers) to transform these flows into loans to ever-more indebted US households. US investors** effectively sold their holdings of Treasuries and Agencies to the world’s central banks, and then redeployed their funds into private-label mortgage-backed securities. Between the end of 2003 and q2 2007 (three and a half years), the stock of mortgages held by private issuers of asset-backed securities rose from about $1 trillion to around $3 trillion. That demand meant that credit was available to any household that wanted it – even those without much ability to pay if the housing market ever turned.

Or, to put it more succinctly, Bretton Woods 2, as it evolved, hinged both on the willingness of foreign central banks to take the currency risk associated with lending to the US at low rates in dollars despite the United States large current account deficit AND the willingness of private financial intermediaries to take the credit risk associated with lending at low rates to highly-indebted US households.

The second leg of the chain collapsed before the first. And it collapse looks set to deliver a nasty shock to everyone – including the countries that supply the US with vendor financing.

In some sense, the vendor finance analogy never really worked. The “vendor” financers didn’t actually lend directly to the US households that were buying their goods. The big emerging market central banks were willing to take on currency risk associated with lending to the US but not the credit risk associated with lending to US households.

That didn’t matter so long as US financial institutions were willing to take the credit risk.

But now US financial institutions are neither willing nor able to take on the risk of lending even more to US households….

In retrospect, the fact that (reported) bank profits didn’t fall as the Fed raised rates should have been a clue that risks were building. An inverted yield curve isn’t good for institutions that borrow short and lend long – but it initially didn’t seem to have an impact on financial sector profitability. It is now clear how the financial sector kept profits up: it took on more risk…

Many have highlighted the role that loose US monetary policy played in supporting the housing boom. And there is no doubt much truth in this story: pushing rates down to help “clean” up the bursting of the .com bubble and holding them down for several years certainly helped induce the rise in home prices and the housing boom. At the same time, this story leaves out what to me is a crucial part of the story: the housing boom didn’t end when the Fed reversed course and raised long-term rates. The really risky loans were made in late 2005, 2006 and early 2007 – after policy rates had increased…..

I hope that the process of adjustment now underway isn’t as sharp as I fear. The US economy gradually can shift from producing MBS for sale to US investors flush with cash from the sale of safe securities to China and Saudi Arabia to producing goods and services for export – but it cannot shift from churning out complex debt securities to producing goods and services overnight. Indeed, in a slowing US and global economy, improvements in the US deficit will likely come from faster falls in US imports than in US exports – not from ongoing growth in US exports….

US taxpayers are going to be hit with a large tab for the credit risk taken on by undercapitalized financial intermediaries. Chinese taxpayers may get hit with a similar tab for the losses their central bank incurred by overpaying for US and European assets as part of its policy of holding its exchange rate down. The TARP is around 5% of US GDP. There are plausible estimates that China’s currency losses will prove to be of comparable magnitude. Charles Dumas puts the cost at above 5% of GDP:

Charles Dumas of Lombard Street Research estimates that China makes 1-2 per cent on its (largely) dollar reserves. It then loses up to 10 per cent on the exchange rate and suffers a Chinese inflation rate of 6 per cent for a total real return in renminbi of about minus 15 per cent. That is a loss of $270bn a year, or a stunning 7-8 per cent of gross domestic product.

I have estimated that the annual cost of adding $600b (15% of China’s GDP) of unneeded reserves to China’s stockpile is roughly 5% of China’s GDP — though the exact loss depends on the size of the RMB’s eventual appreciation. Others have calculated large losses to Chinese households on the basis of the very low rates China has maintained on domestic deposits to support the RMB.

Yves here. Note that Chinese households have taken huge losses indirectly as a result of the very low rates on Chinese bank accounts. With inflation at over 7% and bank deposits paying only 0.5%, it was rational to pile into the stock market. Many households put funds which were really savings rather than investment (as in, it included the reserves they needed for bad times) into shares and many have taken sizable losses.