In recent months the U.S. subprime mortgage crisis has been rippling outward affecting other countries. British banks have made large loan loss provisions and there has been a run on the Northern Rock bank. German banks have incurred similar losses and Germany has suffered two large bank failures. European banks have also become leery about lending to each other, forcing the European Central bank to infuse emergency liquidity. Now, Japan’s banks are feeling the heat.
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.
This chase affected both American and foreign lenders. In Japan, interest rates have been close to zero for a decade, while European interest rates have been below US rates since the end of 2004. Japanese and European investors therefore willingly bought subprime mortgage loans, which spread holdings around the world and also elicited additional supply.
Ironically, owing to bureaucratic inertia, China is the one country that did not get caught up in the frenzy. Instead, it has invested in Treasuries, while capital controls have limited individual Chinese investor access and exposure to U.S. financial markets.
The vast scale of foreign accumulation of dollar assets means that other countries are now vulnerable to U.S. credit market losses. Paradoxically, that may support the dollar. However, other countries are better placed in terms of economic fundamentals. Though they will bear financial losses, their households are in better financial shape – except in countries that have also had house price bubbles. Contrastingly, U.S. households are burdened with debt, and there is a massive over-hang of house supply that promises to drive down house prices, further erode financial wealth, and further undermine economic activity.
The sting in the tail is that a troubled U.S. economy will likely come back to haunt other economies because of their reliance on export-led growth and investments aimed at supplying US consumers. And that sting may hurt China most owing to its heavy reliance on export-led growth and foreign direct investment.
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.
The consequences of the distortions caused by the U.S. trade deficit will be worst for the U.S., but they will also affect surplus countries that have accepted dollar-denominated financial assets in payment. Moreover, many countries are vulnerable to the extent that they depend on the U.S. market. That points to the urgency of global policy mechanisms preventing repeats of such trade imbalances, and for countries to shift from export-led growth to domestic demand-led growth.
Copyright Thomas I. Palley
Tom
Of course, in global finance, everything is interlinked and so you could make a connection between trade deficits and the subprime mortgage crisis, albeit a minor one. Let us not forget that the number one preponderant origin and detonator of said crisis is the immense role given to the credit rating agencies in deciding over the financial flows.
The very subprime awarded mortgages to the subprime sector would never have caused more than some local ripples had it not been for the fact that the credit rating agencies giving out prime rating to securities backed with these mortgages send them traveling all over the world. This is the one and only truth, although admittedly it is a very hard to swallow truth for those who have invested so much in the crazy concept that some credit rating agencies could, in the long run provide trustworthy credit ratings without this creating it self some huge systemic risks.
Today it is the subprime but tomorrow it could be something even much worse, and so please do not help to hide the current subprime crisis behind a trade deficit argument.
Per
Thanks for your comments, Per.
I think you have misinterpreted the piece, which is about how manufacturing’s failure to recover owing to trade deficits triggered a sequence of events that included fostering the sub-prime mess. Of course the mistakes of the rating agencies also figured in to this, but the housing bubble/sub-prime mess is not a mono-causal story. I was highlighting one unappreciated (but important) dimension, which also explains why the sub-prime crisis has global implications and its effects are not restricted to the US.
Tom
i agree wholheartedly with Tom’s last point, i.e. the need for functioning global economic governance mechanisms; while obviously policy mistakes were made in the US (and elsewhere), the lack of global governance has resulted in years-long accumulation of global imbalances – which obviously “the market” has not corrected. While globalisation has contributed to rendering purely national governance institutions ineffective (this holds more for small than for large countries), at a global level these regulatory mechanisms have not been established. Do we need a crisis like WWI and WWII to establish such mechanisms, or can we establish them before a major crisis hits?
While numerous international/global institutions of all sorts exist, they were created at very different stages of global economic development and do not fit today’s globalized economies. The taste of national policy makers to establish such global institutions is rather weak (despite the success of the European Union), witness the debate on IMF quota changes or World Bank representation issues, or the Doha round. National/regional interests prevail despite an array of political lipservice to the merits of the “global village”. The UN has become cumbersome, ineffective, the various G formations usurp the ensuing vacua – but lack inclusiveness and legitimacy for global tasks.
Where do we go from here?
K.
Tom,
Thanks for this article and happy new year. Indeed, Asian nations at the center of growth in today’s global economy will see a “variety” of impacts from a recession in the US. In SE Asia, I note that the gradual decline in the role of export manufacturing as a growth engine in Malaysia could not have come at a better time. In 2007, Malaysia’s economy showed significant increased trends in domestic aggregate demand (services, private consumption, private investment, and domestic fiscal spending) share of GDP and gradual declines in export manufacturing as a share of GDP. It will be interesting to see if other Asian nations also demonstrate any “evolution” trends in their national economies in 2008, particularly in reaction to the looming slow down in the US.
[…] Subprime and the Trade Deficit: Thomas Palley on his blog examines the connection between the global subprime spillover and the U.S. trade deficit. “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.” […]
Excellent work Tom!
I’ve been skimming through your recent articles and find myself in complete agreement with most them.
One small point – it seems to me that Keynesian demand policies in U.S. may also require more than just tax cuts and public infrastructure spending – at least until problem of trade based low-wage platform outsourcing is addressed. It seems that some kind of “supply side” policies directed to stimulating real productive domestic investment and job creation may also be necessary a la the Scandinavian strategies (see Huber/Stephens book on welfare state if you haven’t already).
Also what do you think of Bob Kuttner’s latest book on re-regulating the financial sector. I find it very compelling.
Ron
Tom: You did not mention another important domestic link between the subprime mortgage crisis and the trade deficit. The trade deficit means we are no longer producing the so much what we consume, and those well paying jobs producing those goods in the U.S. have disappeared, and have gone offshore, along with the income associated with those jobs. With so many Americans making less, and property prices rising, many Americans could not afford conventional mortgages, so gimmick mortgages with low teaser rates (subprimes) were devised to keep the housing market going. And of course, loss of jobs and low incomes contribute to the ruising defauilt rates. This is the domestic jobs (and decline in domestic incomes) connection between the trade deficit and the subprime mortgage crisis. Your article focused on the overseas financial connection.
Hi Mr Palley
I read your article with interest but would greatly appreciate clarification on one key point: in what currency are are the exports and mortgage backed securities (MBS) PAID for ? The currency of the buyer or the seller?
When US importers import from overseas (e.g., Thailand), do they pay the Thai exporter in USD or Thai Bhat? If we assume importers pay in Bhat then US banks will accumulate USD and sell Bhat to US importers who then pass on to Thai exporters. Thai exporters place their Bhat with Thai banks. Thai banks use the Thai to buy USD MBS from US banks. Second point: do the Thai banks buy the MBS in USD (in which case they I presume they sell Bhat (locally in Thailand) and buy USD then pass USD to USD banks in exchange for MBS)? In this case, the US banks accumulate even more USD (first from selling Bhat to importers, and second from selling MBS to Thai investors.
Not sure if I am right or wrong but feel it is imprtant to appreciate your article more.
Regards
PS