August 26, 2009
Reflections on the Causes and Consequences of the Debt Crisis of 2008
In late 2008, the world's financial system seized up. Billions of dollars worth of financial assets were frozen in place, the value of securities uncertain, and hence the solvency of seemingly rock solid financial institutions in question. By the end of the year, growth rates in the industrial world had gone negative, and even developing country growth had declined sharply.
This economic crisis has forced a re-evaluation of deeply held convictions regarding the proper method of managing economies, including the role of regulation and the ideal degree of openness to foreign trade and capital. It has also forced a re-assessment of economic orthodoxy that touts the self-regulating nature of free market economies.
The precise origin of this breathtaking series of events is difficult to identify. Because the crisis is such an all-encompassing and wide-ranging phenomenon, and observers tend to focus on what they know, most accounts center on one or two factors. Some reductionist arguments identify "greed" as the cause, while others obsess about the 1990s era amendments to the 1977 U.S. Community Reinvestment Act that was designed to encourage banks and other financial institutions to meet the needs of the entire market, including those of people living in poor neighborhoods. They also point to the political power of government-sponsored entities such as Fannie Mae and Freddie Mac, agencies designed to smooth the flow of credit to housing markets.
In our view, such simple, if not simplistic, arguments are wrong. Rather, we view the current episode as a replay of past debt crises, driven by profligate fiscal policies, but made much more virulent by a combination of high leverage, financial innovation, and regulatory disarmament. In this environment, speculation and outright criminal activities thrived; but those are exacerbating, rather than causal, factors.
Figure 2: Current account to GDP ratio (blue, left axis) and end-year net international investment position to GDP ratio (red, right axis). Source: BEA June 2009 release, 2008 NIIP release, author's calculations.
The subsequent sections are: (1) History Repeats, Again; (2) The United States; (3) Facilitators of American Excess; (4) Consequences, and; (5) Long Term Prospects. From Long Term Prospects:
We are now witnessing the unwinding of this process of debt accumulation. Households and firms are busily trying to reduce their debt loads, in the face of dimmer prospects for income and profits. For households, savings rates are rising, but at the cost of stagnant consumption. For firms, the reduction of debt load is consistent with a reduced rate of investment in plant and equipment.
In some sense, this process of retrenchment is necessary. For many years, the United States consumed more than it produced. We borrowed and for a while thought that the old rules had been suspended. But now it turns out that we do have to pay back what we have borrowed. The attendant higher saving rate and lower investment rate will lead to a substantial improvement in the current account balance, or in other words, the paying off of our debt.
More broadly, though, this also means that the United States cannot rely upon the driver of growth that has sustained it over the past three decades-- namely consumption. But the consequences extend beyond the nation's border. The world can no longer rely upon the American consumer. Who will take up this role remains to the next big question.
The entire article, which draws on a book the authors are writing, can be read here.
Posted by Menzie Chinn at August 26, 2009 09:17 PMdigg this | reddit
Just read the first part of the article, and will get to rest, but this just reminded me of a question I've been wondering about lately. I'm sure we covered this in my econ 101 class, but that was a long time ago and those brain cells have left the premises.
Lately I've been hearing about the resurgence in personal savings rate, and how that means we don't need foreign investment anymore because the previously referred to "US consumer" will now finance the federal fiscal deficit. Just so I don't sound too naive, I did have a good guffaw at the thought of $1.6T/year coming from new personal savings.
But I did want to get a handle on how far off are we.
So I used a figure of $60K for median household income, which I think is pretty accurate. Then I picked a savings rate of 7%, close again, and it fluctuates anyway. What I'm not sure about is does that mean 7% pretax and before existing debt?
If so, $4200 per median household?
Then the next piece of data of interest is I hear there was, at least fairly recently, $8800/ per household in "consumer credit". This I think means credit card debt, but excludes a first mortgage, and probably also HEW or anything of that nature. But again I'm not sure on that point.
So if that is all correct then that means probably close to three years(12% compound interest?) for the median household to pay off the credit card. Then he and she can start buying Treasury bonds. But not till 2012 sometime.
That means we will be relying on the Chinese to plow back the lately decreasing trade deficit($400B and shrinking) and also dip into US personal net worth for quite some time yet.
Am I doing this correctly????
Posted by: Cedric Regula at August 26, 2009 11:23 PM
Hi Professor Chinn and Professor Hamilton,
Can you share your thoughts on the debate of inflation vs. deflation.
Going forward, this is the singular most important question to sort out for the global economy. Sometime next year, either inflation or deflation issues will come to a head. It would be great if you guys can share your insights and how to navigate the turbulence.
Posted by: silly things at August 27, 2009 01:12 AM
"In late 2008, the world's financial system seized up."
What happened to those nice smooth supply and demand curves i see in my textbooks?
"Billions of dollars worth of financial assets were frozen in place."
If so, there must have been a serious underlying problem that the 'freezing' of those financial assets reflected. Simply trying to unfreeze those assets was not necessarily the right thing to do. The (attempted) remedy was superficial. Lending rates slightly fell after the intervention - it did not work. Just a 400 fold increase in bank reserves. Benanke did not 'save the market', it saved itself.
Posted by: Drewfuss at August 27, 2009 01:21 AM
Here another view on US consumers spending beyond their mean. Take a look at the 2nd chart in this graph from calculated risk.
Apparently, US personal consumption expenditure (PCE) minus health care has been flat since the 60s relative US GDP. In other words, excluding health care, Americans have been consuming about the same proportion relative to what they've produced for the last 50 years!
Americans today did spend beyond their mean. Their excess spending is on the US health care monstrosity.
Posted by: silly things at August 27, 2009 01:25 AM
For many years, the United States consumed more than it produced. We borrowed and for a while thought that the old rules had been suspended. But now it turns out that we do have to pay back what we have borrowed.
...More broadly, though, this also means that the United States cannot rely upon the driver of growth that has sustained it over the past three decades, namely consumption.
I am always amazed when economists do not connect the dots. The authors recognize that the problem was over consumption, "the United States consumed more than it produced," but then in a huge leap of Keynesian faith, against the what the authors openly recognize in the preceeding paragraph, this very over consumption is praised as "the driver of growth."
The real driver of growth was a change in tax and monetary policy in the 1980s. The draconian growth in the progressive tax code going all the way back to the Wilson administration had been compounded by the chronic inflation created by Nixon's break with gold and the institution of an international fiat currency system. Each increase in inflation pushed taxpayers deeper into the prohibitive range of the Laffer curve.
In the 1980s the Reagan administration engineered moving the tax code from almost 100 different tax brackets down to 3 greatly reducing the highest tax rate from 70% down to 28% (it has since moved back up somewhat). If consumtive stimulus was "the driver of growth" the 1970s should have been an economic boom. Instead the 1980s and 1990s were the economic boom. This is real world experience where classical economics based on the supply model works to create economic growth.
The recent crisis is just another example where artificial stimulus of consumption has not and cannot generate growth. The case could even be made, as implied in the article, that the artificial stimulus was the reason for the crash. Note: if that is the case current policy is pushing us toward a deeper crash not toward recovery.
Belief dies hard especially when it is the foundation of one's life work.
Posted by: DickF at August 27, 2009 06:11 AM
"Apparently, US personal consumption expenditure (PCE) minus health care has been flat since the 60s relative US GDP"
I think the relevant part here is "relative US GDP". Since the US GDP has been greatly inflated the last few years due to consumer debt (for whatever reason) then PCE minus health care has been similarly inflated.
Posted by: John Smith at August 27, 2009 06:11 AM
What concerns me most is that no one in the press is asking WHY the entire global financial system almost completely collapsed - particularly in regard to the coverage over Bernanke's re-appointment (Ta da! I fixed the problem. Just ignore the fact that I helped create it!)
Also, WHY none of the mainstream economists saw this coming. Does this not scream out that current models and theories need revision or to be thrown in the trash bin? More disturbing, is that with these so called "green shoots" we now seem to be back to business as usual - as witnessed by the re-levering of Goldman, Morgan Stanley, and other banks in their most recently reported balance sheets. Unless there is a rather dramatic paradigm shift here, this crisis will only re-occur again; and next time, the magic just might not work.
Posted by: K at August 27, 2009 06:24 AM
Cedric Regula asked some good questions. I too would like to know...
Posted by: DasKapital at August 27, 2009 06:32 AM
Menzie states that monetary policy was a "contributing factor" because the Fed left interest rates low for "too long".
The critique losses the forest for the woods.
There was a reason Greenspan promised to raise rates at a slow, "steady pace" after he promised to keep rates low for an "extended period". The economy was undergoing a fragile, jobless recovery primarily led by the housing sector. Simply put, the Fed NEEDED to go "too long" before it normalized rates, or the recovery would abort.
Look across the cycle: the Fed bought us a recovery at the expense of a lopsided, interest-rate sensitive, leveraged economy. Now the Fed is "saving" us again. What do you think will happen in this recovery? The Fed is effectively promising to keep rates low for an "extended period". How is this different than 2003-2007? Why should the result be different? Notwithstanding tough talk at Jackson Hole, what makes you think the Fed will risk aborting a recovery -- with more severe risks than the last time -- in 2010 or 2011?
Monetary policy is being used to manage our economy into bubbles and out of recessions. The problem is the strategy, not the tactics.
Posted by: David Pearson at August 27, 2009 06:46 AM
Cedric Regula: You might find the calculations here of interest.
Posted by: JDH at August 27, 2009 07:31 AM
What did Greenspan do yesterday that Ben is not doing today?
As David points out, they both say the same thing, keep rates [artificially} low for a log time.
Posted by: Mattyoung at August 27, 2009 07:37 AM
Cedric Regula: I haven't checked the numbers, but one has to remember the national income accounting identity:
CA ≡ (S-I) + (T-G)
Where S is both household and firm saving; T-G is the budget balance. Net borrowing from the rest of the world equals negative of CA, and that borrowing can fall if S rises, I falls, even if T-G falls.
Note further there is a distinction between flow (net additional borrowing) and stock (what proportion of debt is held by foreigners).
DickF: The two are consistent if (1) one believes that potential GDP and current output can deviate, and/or (2) there is some two way feedback between potential and the rate of capital accumulation (which depends on investment) and the labor force (which depends on the participation rate). Since you continue to disbelieve (1), then I can understand completely your utter confusion.
Posted by: Menzie Chinn at August 27, 2009 08:44 AM
I agree with your prognosis that the US will have to pay-down its total debt load (currently at about 315% of GDP) in order to regain economic stability. However, if debt load is to be reduced, does this not also imply that the money supply will also be reduced? Is it not true, that our fiat money regime is based on the promissory notes generated by the banking system?
It seems obvious to me, that if the US debt load decreases, then we will have to experience deflation, as credit thus the money supply shrinks. I see government policies like stimulus spending, Cash for Clunkers, and tax rebates, as methods of mitigating deflation not eliminating it.
Your question about who the world will rely on rather than the American consumer, is a loaded question. I interpret it to mean: What countries have the will and the wealth to leverage up their assets to create more debt (thus more money) in the international banking system? A quick look at the data
(from Credit Suisse)
would indicate that Mexico, Turkey, Russia, Indonesia, China as well as several other countries have sufficiently low total debt/GDP loads to allow increased banking expansion. Whether or not their governments are foolish enough to allow the debt load to increase to the unsustainable levels of much of Europe and the United States is a different matter.
Posted by: MarkS at August 27, 2009 10:08 AM
Slight mod to your statement on money and credit. We have money supply, but live in a credit based economy. The two in a fractional banking system are related by the velocity of money(transactions) and the money multiplier.
Some numbers to show scale:
Pre-crisis, base money was $800B and GDP was over $14 trillion, and total US debt/gdp actually hit 375%. This figure totals consumer, corporate and government debt.
During the crisis the Fed expanded base money to $1.8T. The velocity of money dropped in half. This is the classic Keynesian liquidity trap, where banks don't lend, and probably most biz and consumers didn't want the money anyway.
This is when government spending takes over.
The total US debt/equity ratio is still 375%, even tho the consumer and biz is de-leveraging. The government made up the difference.
They do this because of a couple reasons.
1)Keynes said to and no one has figured out a better way.
2)If they don't do it we could get a "deflationary debt spiral", conceivably all the way down to zero, where we would all be running around barefoot, shooting rabbits for dinner.
As far as who in world takes up the slack from the US consumer is a difficult question, but may be more of a problem for the rest of the world than the US. So I don't sweat that one too much.
Posted by: Cedric Regula at August 27, 2009 10:44 AM
"By 2004, the federal budget deficit was more than $400 billion, the largest in history. As shown in Figure 1, this deficit rivaled those of the Reagan deficits of the early and middle 1980s."
By your own chart, the deficit was what, under 2% late in the Bush administration before the meltdown? What 'profligate fiscal policies' are you referring to? It's just not there.
The financial sector was by no means unregulated. I was doing an IPO at the time, and I can assure you, dealing with the SEC is no picnic. The whole investment banking area is hyper-regulated. But important sectors were unregulated from a conceptual point of view. Regulators were concerned with compliance, not systemic risk--and this is a non-market failure. Regulation will always be about following the rules, not managing underlying risks. By the way, if as a regulator you think you might have a systemic risk, one option is to pick up the phone and call some of the bankers. Most the guys on the inside know if there's a problem, and they're happy to tell you. As a rule, they are very well educated, reasonable people who are as interested as anyone else in sustainable business. True, 5% of the guys are cowboys; the rest have wives, kids and consciences.
In any event, the Fed was asleep at the switch. Whether because they failed to increase interest rates, regulate institutions or because they couldn't perform a simple what-if analysis on the implications of mean reversion for the Case-Shiller index, they blew their mandate.
Posted by: Steve Kopits at August 27, 2009 11:00 AM
For Cedric Regula and Menzie:
What about income/wealth inequality?
Does national income accounting need to be broken down to include income/wealth inequality (have a group called the rich and another one the lower and middle class and do that with foreign countries too)?
Posted by: Get Rid of the Fed at August 27, 2009 11:08 AM
MarkS said: "However, if debt load is to be reduced, does this not also imply that the money supply will also be reduced?"
It depends on your definition of money supply. Should the "fungible" money supply's composition be changed?
Posted by: Get Rid of the Fed at August 27, 2009 11:11 AM
From the post:
"We borrowed and for a while thought that the old rules had been suspended."
Who is "we"? I don't really recall lots of people saying the old rules had been suspended or that we didn't have to pay back what we borrowed. This seems like a very convenient redefining of the arguments that had been made, or a narrow cherry-picking, in order to chastize or speak as though chastened.
"Lately I've been hearing about the resurgence in personal savings rate, and how that means we don't need foreign investment anymore because the previously referred to "US consumer" will now finance the federal fiscal deficit. Just so I don't sound too naive, I did have a good guffaw at the thought of $1.6T/year coming from new personal savings."
I've never seen anyone make this claim. I have seen plenty of economists and analysts who believe we wring our hands far too much over whether foreign buyers will appear, particularly the Chinese, and I have seen commentary discussing the swapping role domestic savings may play, lessening reliance on foreign lenders, but I have never heard anyone suggest that domestic savings would entirely or even mostly replace foreign cash.
"Then the next piece of data of interest is I hear there was, at least fairly recently, $8800/ per household in "consumer credit". This I think means credit card debt . . ."
With regard to credit card debt, the last time I looked the majority of households were nowhere near that level, while a small minority had astronomical debt. According to various sources compiled here (at the bottom of the page):
About a quarter of families don't even have a credit card. As of 2007, a majority of families had no credit card debt. Of those households with credit cards, 58% do not carry a balance. About 40% of card holders carry a balance under $1000. About 15% have balances in excess of $10,000.
58% of those families who do carry a balance. By 2008 the average credit card debt per household was $8300.
Posted by: BKarn at August 27, 2009 11:15 AM
Sorry about that last part in my post, doesn't make a lot of sense, not even sure why it's there.
Posted by: BKarn at August 27, 2009 11:30 AM
BKran and Get Rid of the Fed
BKran"I've never seen anyone make this claim."
I have, try listening to CNBC. I've also seen a couple real economists get temporarily excited about the prospect. But I'll protect the names of the innocent.
But my thrust here is firstly to see if I can use some of this reported data we get along with some simple arithmetic to get an idea of how long the "median" consumer will take to get to the point where they really do have savings that may go towards federal debt finance. I'm looking for shortcuts rather than going back to national accounting identities and trying to figure out where I get the data to plug in there. So far I quickly scanned the paper posted by JHD, but I think I need to re-read that again and try to find any analytic detail.
This all is "median household" data, and real distributions are interesting and may be important because a $150K household may buy bonds and a $50K household may default on credit cards. But I'm just trying to do a quick SWAG to determine if this is at all probable.
But you did answer my quest on the at least somewhat recent "median household" credit card debt figure. The number I remembered came from the Flow of Funds report a while back, but your $8300 is close enough for horseshoes and hand grenades.
As far as the Chinese go, we have had a "golden handcuffs" relationship for a long time, but they have been making comments lately that they are looking for options. The commodity stockpiling this year rather than treasury stockpiling is a small example so far.
But I didn't want this to turn into a huge research project, because the USG will just raise taxes and solve the problem for us anyway by increasing the National Savings Rate.
Posted by: Cedric Regula at August 27, 2009 12:04 PM
We have seen the consequences of the Debt crisis in 2008-2009 but can anyone suggest me the time by when this crisis will end?
Posted by: Dianne Kotkin at August 27, 2009 12:29 PM
Forgive me for forgetting to thank you. Your article with Jeffry Frieden was the most readable and succinct synopsis of the financial crisis I have thus far read.
Congratulations on an extremely well crafted essay!
Posted by: MarkS at August 27, 2009 01:52 PM
From "Reflections on the Causes and Consequences of the Debt Crisis of 2008,":
This disaster is, in our view, merely the most recent example of a “capital flow cycle,” in which foreign capital floods a country, stimulates an economic boom, encouragesfinancial leveraging and risk taking, and eventually culminates in a crash.
In this quote the theory is correct but the players are wrong. The "foreigners" in our real estate bubble were the FED and congress as they used money illusion (FED) and bond illusion (congress) to pump cash into the real estate market. Investment from outside the country was only in response to the FED creating dollars sent overseas to fund imports then the GSEs (congress) as the mechanism for the dollars to return to the US add to the pumping of the bubble.
It is not possible for foreigners to create bubbles in our country without the collusion of our government.
Posted by: Anonymous at August 27, 2009 01:53 PM
I guess I'll call my dilema solved.
Studied the paper posted by JHD and I guess the key answer is in this paragraph. My basic question started with what does personal savings rate mean, and if it is reported at, say, 7%, 7% of what? And can you be in debt and have a savings rate. Yes you can! So here they did not present the actual model, but that's OK. So knowing the above assumptions, we can conclude that the median consumer will never be buying treasuries(at least till a couple decades from now), but instead be reducing total consumer debt. I still think we have that National savings Rate problem too...
"A simple model of household debt dynamics can be
used to project the path of the saving rate that is needed to push the debt-to-income ratio down to
100% over the next 10 years—a Japan-style deleveraging. Assuming an effective nominal interest rate on existing household debt of 7%, a future nominal growth rate of disposable income of 5%, and that 80% of future saving is used for debt repayment, the household saving rate would need to rise from around 4% currently to 10% by the end of 2018.A rise in the saving rate of this magnitude would subtract about three-fourths of a percentage point from annual consumption growth each year, relative to a baseline scenario in which the saving rate did not change.
Posted by: Cedric Regula at August 27, 2009 02:04 PM
Here another view on US consumers spending beyond their mean. Take a look at the 2nd chart...
Alas, that doesn't even begin to cover it. Remember that counting the "implicit debt" -- unfunded obligations for Medicare, Social Securuity, Medicaid, and federal-military pensions, discounted to present value -- total US debt at the end of 2008 was $64 trillion. As of the end of this year it will be closer to $69 trillion.
But I didn't want this to turn into a huge research project, because the USG will just raise taxes and solve the problem for us anyway by increasing the National Savings Rate.
Figure out the tax increase needed to service $69 trillion of debt, as the current $62 trillion of implict debt converts to explicit, cash-interest paying debt, to finance the baby boomers sailing off into retirement.
That's a serious tax increase.
Posted by: Jim Glass at August 27, 2009 02:33 PM
Cedric R said: "My basic question started with what does personal savings rate mean, and if it is reported at, say, 7%, 7% of what?"
Can the lower and middle class have a savings rate of 0% (zero) and the rich have a savings rate of greater than 20% (twenty)?
Posted by: Get Rid of the Fed at August 27, 2009 03:03 PM
I'm curious as to why the ratings agencies do not feature in these reflections. Isn't the fact that the ratings agencies awarded AAA ratings to senior tranches of mortgage-backed securities at all relevant to the crisis?
To a considerable extent, wasn't the crisis a reaction to the realization that these AAA ratings were undeserved? To the realization that this meant that banks (and other institutions) were holding risky paper rather than nearly riskless paper as capital reserves?
Posted by: Bill at August 27, 2009 03:05 PM
Cedric Regula's post said: "a future nominal growth rate of disposable income of 5%"
5% for the lower and middle class? I doubt it. What if the lower and middle class have a future nominal growth rate of disposable income of 1% or lower and their (based on a lower or middle class person's budget) price inflation rate is 2% or higher?
Posted by: Get Rid of the Fed at August 27, 2009 03:07 PM
"The attendant higher saving rate and lower investment rate will lead to a substantial improvement in the current account balance, or in other words, the paying off of our debt."
We are not paying off the foreign debt, we are still adding to it, and at the unustainable rate of 3% of GDP annually.
Menzie, methinks you systematically (here as in earlier posts) understate the effects of Asian currency interventions (including implicit intervention policy for Japan post-2004 that enabled the yen carry trade). These interventions artificially encourage local savings. The resultant savings glut 'enabled' the U.S. borrowing. I admit my argument may be symantic - who is responsible for irresponsible borrowing, the borrower or the enabling lender? How much blame goes to irresponsible U.S. homebuyers and thier poorly regulated U.S. lenders, and how much goes to the supply of savings from artificial currency interventions in Asia?
Regardless of how one rules on this question, I think it is time to severely discourage the AD-robbing policies of foreign currency interventions, before the 'full faith and credit of the U.S. government' becomes a joke.
Cedric R. - In addition to your last observations, you might note that you used the average debt level but the median income and savings rates. Average income will be higher than the median, whereas median debt will be below the average.
Posted by: don at August 27, 2009 04:18 PM
David Pearson said:
"There was a reason Greenspan promised to raise rates at a slow, "steady pace" after he promised to keep rates low for an "extended period". The economy was undergoing a fragile, jobless recovery primarily led by the housing sector. Simply put, the Fed NEEDED to go "too long" before it normalized rates, or the recovery would abort".
Remember there is no divine right to economic growth. If the private savings rate is 0% or less, then solid growth cannot be expected to occur. The Fed can try to stimulate it with artificially low rates, but apparently this only blows bubbles.
There is a fallacy in the whole concept of monetary policy guided by targets - in that it is falsely assumed that the underlying foundations for meeting the targets are always in place. Wrong!
Unfortunately, now that the U.S. public has finally started to save again, the goverment has deemed it appropriate to divert these new savings into bonds, and spend the proceeds. Alas.
Posted by: Drewfuss at August 27, 2009 06:05 PM
Right. Or a easy way to tell when consumer oriented companies will ever make a earnings comeback would just be to watch the "consumer credit" line item of the Flow of Funds release. The paper posted by JDH lumps all debt together, but realistically people don't usually pay off mortgages early.
But we definitly shouldn't believe the savings rate has anything to do with funding the USG.
Surprised no one questioned this statement from JDH's paper. They use savings rate as an input in this model and have it rising from 4 to 10% by 2018. Then conclude this. Can't make that compute in my head no matter how hard I try.
"A rise in the this magnitude would subtract about three-fourths of a percentage point from annual consumption growth each year, relative to a baseline scenario in which the saving rate did not change."
Posted by: Cedric Regula at August 27, 2009 09:30 PM
Thanks for the link to the La Follette report and for the succinct, articulate and informative analysis. I try to analyze real estate markets and this kind of explanation is extremely helpful to me, first in understanding how this happened and, second in estimating what must occur before markets stabilize.
I do hope you can raise the warning sufficiently in advance of the next crash to enable adjustment by those who can and will listen, learn and not just argue for the sake of argument.
Posted by: Edd at August 28, 2009 07:23 AM
One more thing.
Thanks to Cedric Regula for the efforts to make sense out of the data in a way that we can develop a model in our respective markets to predict economic movement up, down or stagnant as time passes.
Cedric has a unique ability to render what is going on here useful to a non-economist who needs to understand the impact of the economy on main street.
Posted by: Edd at August 28, 2009 07:30 AM
What is always forgotten in discussions of imports and exports are the additional costs that have been created by each country having its own fiat currency (to understand consider how much additional cost there would be if each state in the US had its own currency and central bank.)
Looking only at the US and China, if Chinese goods are paid with yuan the importer must shoulder the cost of currency exchange. Usually the importer will pay with dollars. But this only shifts the cost of currency exchange to China. If China has dollars they must either use them in the US or exchange them. They have no value in China. Since there is a cost to exchanging dollars it makes more sense for the Chinese to invest in the US.
This is where Fannie and Freddie come in. The Chinese saw GSEs (which have proven to be simply a Gs) that were offering to take their dollars and even pay them interest that could be assumed was backed by the US government. In this transaction they avoid the currency conversion costs.
The US used this to facilitate government borrowing, essentially borrowing from the FED. The FED issued dollars to fund export purchases then the GSEs borrowed those same dollars and funded real estate speculation.
Posted by: DickF at August 28, 2009 07:34 AM
The actual mechanism is much less "free market" than you suggest. The basic flow is:
1)Chinese companies take payment in dollars.
2)By law they must turn them over to a state controlled bank.
3)The PBoC provides freshly printed yuan to exchange for the the dollars, at a rate the PBoC specifies. That is how the "peg" is implemented.
4)The state bank turns over the dollars to the PBoC, which makes the creative decision about whether to buy Treasuries or GSE stuff with them. Lately they are passing on GSEs, and go with 3 year or less maturity Treasuries.
This process would be inflationary in China, but then they do some domestic sterilization actions to control that.
Posted by: Cedric Regula at August 28, 2009 09:19 AM
I do not disagree with your mechanism at all. Just fit your description between the US payment for imports and the PBoC purchase of US debt and we are there. You are right about passing the GSEs. They are now government entities and so the Chinese are going directly to t-bills, but they have reduced their purchases just as their exports to the US have declined.
I believe that they are working overtime to discover a way to get rid of their dollar denominated debt. They know the FED is debasing the dollar and that it will become manifest. That is why you hear so much in the press about alternatives to the dollar as the reserve currency, but it is very doubtful that the dollar will be replaced quickly. The dollar will continue into its slow decline until it just slips into second place. No, I don't know who will be in first at that time.
Posted by: DickF at August 28, 2009 09:54 AM
Note what happened to the ratio of U.S. net foreign investment to GDP in the last year of your graph. Even though U.S. net borrowing dropped, the ratio also dropped, indicating that the net debt position worsened substantially. Apparently, we are experiencing the end of the equity premium on international investments. U.S. outward foreign investments are concentrated in equity, whereas inward foreign investment is concentrated in debt. Feldstein once remarked on this and found a net benefit to the U.S. owing to the debt-equity spread. But this benefit disappears when profits turn to loss and bonds do better than equities.
Posted by: don at August 28, 2009 11:07 AM
Loans create deposits and not the other way around. In the same vein Investment creates its own deposits and need not tap savings. So I am not sure if the crowding out argument is correct in a modern monetary syste, Thanks Econrebel
Posted by: Econrebel at September 2, 2009 01:38 PM