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.
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.
What if the US (or any reserve currency) simply creates money (or lowers taxes, etc) instead of letting debt expand.
ReplyDeleteMoney is usually (almost always) a financial asset, which means that it's a liability on the other side of the balance sheet. In other words, money is debt.
DeleteThere's a lot of stuff thrown out about "new" theories on "political economy", by which I'm primarily referring to something called modern monetary theory. Ironically, it's not modern. It's some old idea that goes back, as far as I know, at least 225 years and probably dates back further than that.
Anyways, governments in today's financial systems don't really have their own payment system. In reality, they use the private financial and banking system. They have incoming funds and outgoing cash flows like anyone else. Yes, the Treasury has an account at the Fed, but so does basically every bank and many other financial institutions.
Also, since the US is the reserve currency, the shift in issuance of government assets by the American government affects the current account balance. When the US government issues a T-bill or--to a lesser degree--a T-bond, it's creating a safe, liquid asset for the FX sector to hold. So by doing so, you're expanding liquidity (or money, depending on how you define money).
Also, the Federal Reserve cannot finance the Treasury at auction by law. So the Fed only operates through the secondary Treasury market.
Increasing the government deficit doesn't create money. It CAN create money under a monetary system with given conditions (like Alexander Hamilton's monetary system in the 1790's), but not in the current one. The Treasury is like every other firm in the country: it must acquire financing before it can spend and finances its deficits by issuing Treasuries at auction.
Please don't read stuff like MMT (I'm not saying you are, but it sounds like you are) because there's a lot of assumptions that're simply assumed away and can't be assumed away. Stuff like MMT is really pernicious and comes from people who don't understand geopolitics since most "political economy" or theories based on political economy really are nothing but a complete waste of time.
If you wanna know how the world works, imposing geopolitical constraints on financial systems will tell you way more than economic or political economic theories that are written by people who either don't fully state their assumptions or make implicit assumptions they don't even realize and such is the case with MMT.
Agreed. All i'm suggesting is that the world doens't HAVE to work this way and may change.
ReplyDeleteGood comment, and I agree. I actually think the kind of monetary system that you're thinking of is better for developing countries because they can centralize finance for investment and development needs while still having a decentralized consumer base. It's a much better model than the USSR/Communist model of turbocharging savings rates and targeting GDP growth that much of the developing world took up in the past 100 years.
DeleteSuch models just make the monetary system more centralized, which does carry benefits. I also don't think it's a sustainable situation to have the country with the most guns and strongest military to consistently run current account deficits into perpetuity (quite frankly, this scares me).
Essentially, such models centralize money creation. Right now, we have something much closer to free banking (it's not completely free banking, but it's really close and this is what my previous post was on).
Also, if the intent of central banks is to buy govt bonds and simply hold them to maturity without ever selling them, isn't that essentially money printing? Seems like that's the state of the world whether CBs admit it or not.
ReplyDeleteCentral banks buying any assets by expanding their balance sheets is technically printing money, and that includes government bonds. The only thing about the way the Fed has currently been operating is that it's essentially become the world's largest hedge fund. In a way, QE is nothing more than seigniorage by the feds.
DeleteI was referring to thinking of government deficits as money in my previous comment, which can be under certain conditions, as we both seemed to agree.
I like the suggestion of the bancor use! However the biggest opposant of such bancor is the US congress and US government. You see how it's difficult to give even a small % of voting right to China in the IMF. Realistically we must wait for another big scale Financial crisis, or USD currency crisis before any serious talking of a new international monetary system.
ReplyDeleteTechnically, it doesn't have to be a Bancor. A simple way to reconcile this problem would be to tax the accumulation of American assets abroad for all accounts bigger than, say, $5 billion.
DeleteAs for the US government and Congress, I both agree and disagree. With regards to the old elite, you're absolutely correct. Within the fringes of the parties with the demographic shifts, there is the exact opposite shift. There's a reason why trade is becoming such a huge issue in this upcoming election and if it's not resolved, it'll be a bigger issue in the next election. For example, someone like Donald Trump (for all his clownish behavior and his absurdity) has basically built an entire campaign off this post. When he says "we don't win anymore" and points to trade deals, this issue is exactly the one he's referring to. This is coming from a person who doesn't like Trump.
If you listen to Trump's interviews, he consistently points out trade deficits the US has with every other country and goes on to attack other countries governments and central banks. He may be coming off like a clown, but he has a point.
Delete