On the Causes and Possible Outcomes of Our Financial Mess

There are three good and overlapping state of global finance pieces tonight; they all have worthy ideas and I’ll integrate them as best I can.

The first is a post by Thomas Palley, “The Subprime – Trade Deficit Connection,” which is a companion piece to th Financial Times article by Stephen Roach yesterday. Roach depicted global imbalances (the US borrowing like mad from the rest of the world to fund consumption) as the result of our low savings rate, and that is turn is the result of serial asset bubbles, which encouraged citizens to view their appreciated assets as a substitute for cash in the bank. Roach stressed that the dollar had already fallen aplenty yet had not corrected the low savings/high current account deficit problem; letting asset prices fall was the needed solution.

Palley also sees global imbalances as our problem, rather than pinning it on those evil oversaving Chinese and Japanese. But he sees the culprit not as asset inflation but as failed trade policy (in his view, the overstimulus that led to the asset bubbles was a compensation mechanism that only made matters worse:

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.

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…..

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.

Palley’s characterization has some merit relative to Roach’s; he depicts the overly cheap credit as a response to weak growth early in the new century. However, Greenspan’s comments around the time of the 2003 rate cuts suggest he saw economic weakness more as a result of the dot-com hangover than a trade problem. But it might be more accurate to look at the mid-1990s period onward and see it as a time of a big gain in productivity and tech investment that masked the deterioration in trade and manufacturing, at least at a macro level.

Switching gears a bit, Martin Wolf has an article in the Financial Times. “Challenges for the world’s divided economy,” which in turn points to a must read paper (( am not kidding, click on the link now) by Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard , “Is the 2007 US Sub-Prime Financial Crisis so Different? An International Historical Comparison.”

The Reinhart/Rogoff paper is deceptively simple; it identifies 18 postwar banking crises in advanced economies and identifies a subset of 5 big nasty ones for separate comparison, then looks at the two data sets versus the state of affairs in the US so far. It has a couple of grim charts that I am not adept enough to extract (Figures 1 and 3). Comments:

Once again, the United States looks like the archetypal crisis country, only more so….The correlations in these graphs are not necessarily causal, but in combination nevertheless suggest that if the United States does not experience a significant and protracted growth slowdown, it should either be considered very lucky or even more “special” that most optimistic theories suggest. Indeed, given the severity of most crisis indicators in the run-up to its 2007 financial crisis, the United States should consider itself quite fortunate if its downturn ends up being a relatively short and mild one.

Martin Wolf also found the Reinhart/Rogoff analysis sobering, but he took comfort from the World Bank’s Global Economic Prospects:

For this the Prospects report indicates three explanations: first, the high-income countries as a whole grew at an estimated rate of about 2.6 per cent last year, partly because of the buoyancy of the eurozone; second, the momentum of emerging economies and above all of the giants is formidable, with the expansion of the Chinese economy estimated at 11.3 per cent and of India at 9.0 per cent; third, economic integration continues apace, with world trade growing 9.2 per cent in 2007…..

The soaring prices of oil and other commodities make this picture of broadly shared growth yet more noteworthy (see chart). These have had remarkably little impact on global growth. It is far more plausible to view them as a consequence of growth than as a constraint upon its continuation.

Moreover, soaring commodity prices have had remarkably little impact on inflation. The World Bank notes, for example, that consumer price inflation averaged a mere 1.7 per cent in 2007 in the group of seven leading high-income countries, even though non-oil commodity prices jumped 15 per cent, measured in the (admittedly tumbling) dollar. The bank forecasts inflation at the same rate this year. Successful control over inflation and, still more, over inflationary expectations has given central banks at least some room to respond to falling house prices and credit market mayhem.

So what happens next? More of the same seems to be the expectation: weak growth in the US (quite possibly a recession) and in many other high-income countries, but buoyant expansion elsewhere. Thus the bank forecasts growth in the high-income countries at just 2.2 per cent this year. But developing economies are expected to expand by 7.1 per cent on average, with 10.8 per cent in China, 9.7 per cent in east Asia, 8.4 per cent in India and 7.9 per cent in south Ásia.

This then would be a brave new world in which emerging countries would pull high-income countries behind them. I suspect the outcome will not be quite as benign as that. Nevertheless, the growth process in the large emerging economies is indeed sufficiently autonomous and the freedom of manoeuvre of their governments sufficiently large to make this view reasonable. If China’s export growth slowed, for example, it would be simple for the Chinese government to expand domestic spending. It is no longer a question of capacity; it is far more one of will.

This is all a bit too sunny for my tastes. First, I am not sure I trust the benign inflation statistics Wolf cites. Inflation has become so bad in China that the government has imposed a price freeze, a lending freeze, and is finally letting the yuan rise a bit. It is also raging in the Gulf states for similar reasons as to the China, namely, the impact on money supply of (largely? entirely?) unsterilized dollar purchases. Consumer inflation reporting in the US clearly understates real consumer inflation by design (its calculation was rejiggered in the 1990s with the effect of lowering it by 0.5-1.0% per annum so as to lower entitlement payment increases that key off of CPI); Wolfgang Munchau has similarly commented that the official Eurozone inflation figures don’t adequately reflect recent cost pressures. If this is how advanced economies operate, there is every reason to expect reporting is similar to worse in emerging economies.

And there is no reason to believe that demand from developing countries, in the near term, can make up for a sudden fall in US consumption. One reason their savings rates are high is necessity: anyone who has sufficient income to establish a cushion makes it a priority to do so, due to the lack of social safety nets. That behavior is not going to change simply because it would be better for the world economy for them to suddenly spend more. And goods geared to emerging markets are often quite different than those destined for the US, so demand isn’t neatly fungible either. Witness Tata’s $2500 car as an extreme example (not that Indian consumers don’t consume first world cost and quality goods, but not in sufficient degree).

Indeed, in another recent article, Thomas Palley discussed that global imbalances were the result of shortsighted development policies (giving too much weight to selling to export markets rather than building domestic consumption) and indicated that it would take considerable structural change to generate more internal demand in emerging markets:

In the modern era of globalization export-led growth is supplemented by policies to attract foreign direct investment (FDI), a pairing that has been particularly successful in China. Such FDI policies include investment subsidies, tax abatements, and exemptions from domestic regulation and laws.

These policies encourage corporations to shift production to developing countries, which gain modern production capacity. This increases developing country exports and reduces their import demand. Meanwhile, corporations reduce home country manufacturing capacity and investment, which reduces home country exports while increasing imports. Once again, China provides clear evidence of these patterns, with almost sixty percent of Chinese exports being produced by foreign corporations.

This is a fundamentally different story from both the saving shortage and saving glut hypotheses, and it leads to dramatically different policies. Developing countries need to grow, but in today’s globalization it is easier to acquire capacity and grow through FDI than it is to develop domestic mass consumption markets. Consequently, rather than facing a saving glut problem, the global economy faces a problem of market demand failure in developing countries.

The challenge is getting corporations to invest in developing countries, but for purposes of producing for local consumers. That requires expanding markets in developing countries, which means tackling income inequities and getting income into the right hands. That is an enormous organizational challenge that is off the radar because economists focus exclusively on saving and supply-side issues.

Labor standards, minimum wages, and unions are part of the solution. That is the unambiguous history of successful developers. Unions have historically been especially important since they engage in decentralized wage bargaining that tie wages to firm productivity. Consequently, wages are market sustainable.

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  1. RK

    You mention something which many of us have understood intuitively, that being the intentional under-reporting of U.S. inflation in order to underpay entitlement recipients by.5% to 1%. You
    refer to the “re-jiggering” of the calculations in the 1990’s to accomplish this. Can you provide any source, readable to a non economist, which gives the historic account of this development?

  2. "Cassandra"

    It’s worth noting that a meaningful share of the ire about the growth of 1960s great-society social spending and programs from fiscal conservatives in 1970s was the result of what often began as modest programs compulsorily indexed to a CPI genuinely reflective of prevailing goods and service price inflation. The compounding effect of just small real program growth combined with double-digit CPI really got appropriations committee members’ knickers in a twist!

  3. Independent Accountant

    In the late 1990s the US adopted the “Boskin Commission” report which changed the CPI calculation, reducing it by about 1.3% per year.

  4. Aron Roberts

    RK asks: “You refer to the “re-jiggering” of the [US consumer inflation] calculations in the 1990’s to accomplish this. Can you provide any source, readable to a non economist, which gives the historic account of this development?

    Probably more readable than the Boskin Commission reports :-) are writings by and interviews with private economist John Williams, which you can find summarized in Fleck’s column here:


    And here, a succinct three point summary:


    Williams maintains a pay site with some public content:


    On that site, he provides his estimates of what reported consumer inflation would be today, as it would be if were still calculated, on an apples-to-apples basis, using the methods used by the Bureau of Labor Statistics (BLS) during the Reagan Administration in 1990, and during the Carter Administration in 1980, respectively. The Reagan-equivalent figures are on the home page; you’ll need to click the “Alternate Data Series” link to find the Carter-equivalent CPI.

    Some background on those two graphs:


  5. Aron Roberts

    In the previous post, I wrote: “during the Reagan Administration in 1990 …” Mea culpa; that should have read “during the first Bush Administration in 1990 …”

    One should also note that not every economist and money manager agrees with John Williams regarding the extent to which the BLS’s reported CPI figures would change, if they were calculated using previously-used methods.

    For instance, you can find varying estimates of the understatement of CPI in articles in the newsletters of money managers at fund families such as Pimco and Morgan Stanley. Some of those managers aren’t, like Williams, trying to account for (“back out”) the three major changes since 1980 in the BLS’s methodology for calculating the CPI, but rather they have their own techniques for estimating the extent to which the CPI may be understated.

  6. Steve Diamond

    the key to this whole mess is domestic Chinese demand – if it rises on a scale of South Korean or Japanese demand in the 70s-80s, it would force rebalancing. how to get Chinese demand up? Legalize independent unions to force up wages dramatically. of course, the PRC communist regime might fear things could get out of hand. but there is no other way out.

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