Monday, December 7, 2015

The International Role for the United States in the Current Financial Crisis

As promised, this post will be on the international aspects of the financial crisis of the United States. There's been much talk on how this crisis was a domestic crisis caused by bad banks or something of the sort. While there were a lot of issues in the American banking system in this crisis, the cause of the crisis was not the banks and it certainly wasn't "deregulation" or the removal of Glass-Steagall. The cause of the crisis had more to do with international capital flows and how these international capital flows were resolved on the domestic side (which led to domestic imbalances) rather than what the banks actually did.

In this post, I'll start off by splitting this post into four parts:
1. The role of regulation in exacerbating the 2008 financial crisis
2. International Aspects of the 2007-08 American Financial Crisis
3. The Domestic Crisis as a Response to International Capital Flows and the Role of China
4. Restoring Healthy Household Balance Sheets MUST Involve Changing International Imbalances

The Role of Regulation in Exacerbating the 2008 Financial Crisis :
In 2008, the US experienced a financial crisis. Of course leftists, socialists, and statists would immediately claim that the problem is "deregulation" or "financialization". As I've stated, this is completely nonsensical. When a leftist, socialist, or a statist points out how the removal of Glass-Steagall "created" the crisis and that we need to protect commercial banks from the "gambling" of investment banks, they seem to forget that commercial banking is more dangerous than investment banking. Of course, the leftists, socialists and statists never mention that the largest bank failure in American history came from Washington Mutual, which was a savings and loan thrift (a commercial bank with deposits backed by the FDIC) making regular loans in a bad area. They didn't diversify anything and were lending into one of the worst hit areas in the financial crisis. Since Washington Mutual was a commercial bank, the bank had no ability to hedge and got absolutely crushed.
Note: Commercial banking is basically when a bank issues regular loans and takes in deposits.

Also note that leftists, socialists, and statists always leave out the role that Fannie Mae and Freddie Mac had in securitizing mortgages. Around 50% of total mortgage securitization in 2008 went through Fannie Mae and Freddie Mac. The leverage ratios for Fannie Mae and Freddie Mac were also worse than any banks and their bailouts were also larger than any financial institution. Keep in mind these were GOVERNMENT AGENCIES whose sole purpose was to securitize mortgages as a way to increase home ownership for lower-income people and the poor by making them take on debts they couldn't afford. Simply put, it was government regulation that created incentives for turning lower income people into debt slaves. Of course, leftist "logic" tells them that we need more rules to tell people what to do because what we told them to do last time didn't work. As such, it's obviously not logical thinking.

So what actually caused the depression and the downturn in the American economic and financial system? The impact on unemployment and household balance sheets along with the sluggish recovery came from over-indebted households that were sustaining unsustainable consumption levels by borrowing money and using their houses as ATMs. So how did this situation come to be?

The International Aspects of the 2007-08 American Financial Crisis:
As I've discussed before, the role of the US Dollar as the world's reserve currency must take primary importance when discussing the 2007-08 financial crisis. By definition, a country that's the world's reserve currency implies that all international payments are cleared in its currency. Thus, in order for foreign countries' accounts to be resolved, other countries must--on the net--accumulate dollars or dollar backed assets. So this accumulation of USD assets by foreigners necessarily means the United States is running a capital account surplus. Since the capital account balance+current account balance=0, a capital account surplus is necessarily a current account deficit. In other words, the US Dollar as the world's reserve currency forces the US to run persistent current account deficit (see chart below).

As we know Y=C+S=C+I+NX (where C=C_p+C_g, S=S_p+S_g, I=I_p+I_g), so a persistent current account deficit forces a demand leakage that creates a persistent lag and fall off in the total income of the United States. In order to maintain this income at a high level and maintain GDP growth rates until 2008, the US used the capital account surplus to lend money to consumers to consume beyond their means to sustain higher levels of income, sustain higher aggregate demand, and thus reduce unemployment.

The decision between higher unemployment or higher income from 1998-2005 was really in the hands of the Federal Reserve. If the Federal Reserve took up monetary tightening, the current account deficit would've resolved itself as lower income, lower aggregate demand, and higher unemployment. Since the Federal Reserve took up monetary easing, the current account deficit resolved itself as higher income, higher aggregate demand, higher employment, and a massive credit-fueled consumption bubble.

Household debt levels increased at a very rapid rate from ~1999 to 2007 and these debt levels kept increasing until US households effectively hit debt-capacity ratios, which means that debt servicing costs were too high for current income levels to maintain. When this happened, the US consumer could no longer consume what the rest of the world was overproducing which created a domestic adjustment in the United States.

The Domestic Financial Crisis As a Response to International Capital Flows and the Role of China:
Simply put, the domestic financial crisis is nothing more than a response to the shifts in international capital flows and the way in which American policy makers chose to resolve the effects of international capital flows. Due to the US Dollar being the world's reserve currency, the international capital flows of USD and USD-backed assets created domestic imbalances. The domestic imbalances were merely a response to international imbalances created by the role of the USD as the world's reserve currency.

Starting in the late 90's, the Chinese government decided to take an investment and export-based growth model that drove Chinese growth by expanding Chinese exports and turbo-charging their current account surplus. The expansion of the balance sheet in the PBoC (the Chinese central bank) as a means to accumulate USD assets (FX reserves since the US is the world's reserve currency) was an explicit attempt to drive up growth rates via an undervalued currency. Of course, an undervalued Chinese currency helps Chinese exporters and this produced a Chinese current account surplus. Of course, since the USD is the world's reserve currency, the capital account of the US is basically completely uncontrolled while the US is the world's largest economy. In other words, the only country large enough and willing enough to run the corresponding current account deficit to China's current account surplus was the US.
Note #2: The specific direction of the flows do not matter. What matters are the NET flows between the countries.

In other words, the Chinese government decided to hit its GDP growth rates by lending the US money to buy Chinese stuff and to finance our housing bubble. Ironically, this is exactly what the US did from 1914-1929, but that's a different topic for a different day. The 2007-08 crisis represented the moment when this international imbalance could no longer continue as American households hit debt capacity ratios. A correction occurred and the US current account deficit fell ~3% in 2008-09. China still hit GDP growth ratios by switching its model from primarily an export-driven model with moderate levels of investment to a model that was more reliant on fixed-asset investment than probably any other country at any time in world history.

Restoring Healthy Household Balance Sheets MUST Involve Resolving International Imbalances:
In order to have the American financial and economic system return back to its vitality, we must fix the problems of household balance sheets. The American economy and financial system is still highly indebted. If we continue to run current account deficits, the American financial system is still (by definition) being a net debtor, on the margin, to the rest of the world. If we want to really reduce the debt levels of the United States, we must begin by first reversing the current account deficit and turning it into a current account surplus.

In the current worldwide financial situation, we have the rich countries in the world borrowing from the poorer countries, but it's poor countries that're capital poor with domestic infrastructure and investment needs. In other words, the current account balances must shift for the current financial system to adjust. The US is the world's most capital rich country in the world. The solution must necessarily involve the US exporting its capital to developing countries, which would not only provide investors with productive assets that produce a real return, but would also help the poor and middle-classes deleverage.

There are a few ways to resolve this problem in international asset markets. One way would be with a tariff on foreign goods that would impact the capital account balance via a shift on the current account, but this isn't ideal because there's no need for the US to protect American goods from foreign competitors if you're the most wealthy country in the world. A more sensible way to resolve these issues in international asset markets would be by simply tax the accumulation of American asset abroad, which would affect the current account balance of the United States by reducing (and hopefully reversing) the capital account surplus of the US. The most ideal solution would be to simply switch to a Bancor or some other form of an international currency, but this is nothing more than idealism as of right now.

Tuesday, December 1, 2015

Capital Flows and the Impacts of International Liquidity on Less Developed Countries

I'll start off by saying that this will be my first post on financial crises, how they play out, and the international nature of these things. This post will primarily discuss how capital flows in wealthy countries affect less developed countries. The next post (which will be done by the end of this week, it's already ~60% finished as of this publishing) will discuss the specific crisis that began in 2007 and the middling through we're currently ongoing. Now, I'll begin by bashing leftists, socialists, and statists as usual.

Usually when I hear about economic crises, we usually hear people say that financial crises that were caused by factors like "deregulation" or "financialization". Of course, such ideas usually come from those who subscribe to certain political ideologies (usually leftists, socialists, and statists). Not surprisingly, most of the basis for such arguments is nonsense. Almost all financial crises (I can't think of one that wasn't) are international in nature, not domestic or national. So focusing on the domestic or national nature of these crises tells us very little about the development and occurrence of financial crises. Financial crises occur, and are triggered, by expansions and contractions of liquidity in the world's financial centers in combination with international capital flows.

Basically, financial crises aren't caused by "deregulation" or "financialization". New financial instruments will play a role in a financial crisis, but they're not the cause. The cause of any financial crisis lies in international capital flows across borders. Anyways, I'll begin by splitting this post into three separate parts:
1. Liquidity
2. Wealthy Countries Financial Centers as Drivers of Capital Flows
3. Impacts of Capital Flows on Less Developed Countries (LDCs)

1. Liquidity:
First, I'll start off with the concept of liquidity. What is liquidity? This is a difficult term to define, but liquidity is basically the amount of "cash" in the financial system. Does liquidity have to be solely defined as the amount of cash? Of course not. Liquidity can not just be cash, but can also be any sort of instrument that is basically like cash. In my post about the basics of banking, I talk about how money has a hierarchy with the short term money market rate of interest being the price of liquidity. In my post about QE and monetary policy, I spoke about how the point of QE was to create a massive pile of cash looking for somewhere to go. Basically, the purpose of QE was to create a massive increase in liquidity by a central bank coming in to swap less liquid assets for more liquid ones. In my most recent post, I discuss how the use of liquid assets in today's financial system has led to a massive decentralization in money. I basically treat these highly liquid assets as another form of money because they're convertible for cash at any point. Anyways, I'm gonna focus on the concept of liquidity for the rest of this post where I'll use liquidity to represent the "money-ness" of an asset.
However, liquid assets can be virtually any money like asset including Asset-Backed Commercial Paper or short term bills (ex. T-bills). In other words, expansions in liquidity can come in a host of ways for a multitude of reasons.

This brings us to the next question: how does a massive increase in liquidity affect asset markets? When you expand liquidity, by definition, we see an increase liquid assets. This can come about for various reasons, but the most common reason usually stems from central bank balance sheet expansion. So how exactly does this work? Recall from my post on the basics of monetary policy and QE that central banks can buy assets by issuing new deposits (or reserves). When central banks expand their balance sheet, it shows up as an asset swap on the private sector balance sheet. So the end result is that the private sector ends up with a bunch of cash looking to go somewhere as short term money market rates fall (assuming you're not at the ZLB). So the cost of financing short term drops while there's a whole bunch of cash looking to go somewhere for a yield. The end result is often times mistaken to be inflation, but the end result often times is asset market dislocation, asset bubbles, massive increases in debt, and the longer term consequences are often deflationary, not necessarily inflationary (although it does depend on the balance sheets and supply-side structure of the different economies in question).

2. Wealthy Country Financial Centers as Drivers of Capital Flows:
So now that we have a basic understanding of liquidity and what drives liquidity, we can see that the largest expansions of international liquidity can only come from the world's largest and most powerful economies because they're the largest and most powerful. Today, that role is played by the Federal Reserve (and has been played by the Fed since either 1914 or 1919 depending on how you look at it).

From September 2008 to December 2014, the balance sheet of the Federal Reserve has increased from $900 billion to $4.5 trillion (it's held flat since). So the net increase in cash for the private sector from the Federal Reserve has been $3.6 trillion. So during this expansionary phase, we've had a $3.6 trillion increase in cash that's looking for a yield. This pile of cash looking for an interest bearing asset goes into both domestic and foreign assets. Due to the sheer size of the American economy, even the smallest capital flows into foreign assets creates huge distortions. For example, a country like Nigeria (with a population of ~150 million people) has NGDP of ~$500 billion. So even a small shift in capital flows by the Federal Reserve can have a HUGE impact on the finances of the country.

When you get a massive expansion of liquidity in the international financial centers, it means there's plenty of cash available for whomever (usually foreign firms/governments) to issue liabilities to get access to international financing. On the other hand, when the wealth country financial centers start to contract liquidity, the amount of cash available for foreign firms/governments becomes very tight. So what we start to see is that the capital that flew into these countries during the expansion phase tends to fly right out in the liquidity contraction.

Simply put: liquidity expansion in the world's financial centers leads to capital inflows and economic expansion in LDCs while liquidity contraction in the world's financial centers leads to capital outflows and economic contraction in LDCs.

3. Impacts of Capital Flows on LDCs:
During the liquidity expansion in the wealthy countries financial centers, financing is available in large amounts for any LDC that cannot finance investment (or consumption) out of current income. So firms and governments can access financing easily for either investment or consumption. If the investment is productive, the future increase in real income is usually well more than enough to pay back the debt and then some. So if an LDC uses foreign financing well to fund productive investment opportunities, they may experience an economic contraction, but they will not be in horrible shape. They may still have a financial crisis (and usually do), but the impacts of the financial crisis will be limited.

Inversely, if the foreign financing is used to finance unproductive investment or unsustainable consumption, the economic activity creating by the unproductive investment or unsustainable consumption stops immediately as financing as dried up which will trigger a financial crisis. Unlike the case where the foreign financing is used well, this time the financing is used poorly while debts still need to be serviced which will usually lead to either private bankruptcies or an increase in government debt which could, and often does, trigger a government debt crisis in LDCs that have poorly managed incoming capital flows.

Note that if the debt taken on by the LDC is denominated in foreign currencies or via a currency peg, the country will usually run out of FX reserves trying to pay off the foreign debt or maintain the peg and eventually, the country will experience a currency crisis along with a sovereign debt crisis and private bankruptcies. Even if the foreign currency debt of the LDC is used productively, there's still a VERY HIGH chance of large private bankruptcies, a banking crisis, a currency crisis and a sovereign debt crisis simultaneously.
Note: If the total financial system of the LDC holds FX reserves larger than their foreign currency obligations, they'll usually be fine, but that's rarely the case. Even when it is the case, things can still get screwy. The only way for a financial system to protect itself against the risks of having foreign currency debt is to not have debts denominated in a currency you can't control.