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With the stock market showing signs of life, I thought I would try to put down in writing my thoughts on the general economic picture we face and its likely consequences. Part of this exercise is just to assist my own investment decisions, and part of it is because I think we are in a fascinating period of economic history and thought I would share some of my thoughts about it with those here. I welcome any rebuttals- I could very well be wrong and hopefully am.
Part 1. How did we get here?
As I see it, there are two central problems in the global economy/world trade system which have led us to our current crisis. The first is that globalization has driven down wages in the US while, at the same time, the world economy relies upon US consumer spending as its engine for economic growth. There is obvious tension between these two facts. Americans with stagnant wages will only be able to borrow so much until their purchasing power, even aided by liberal credit, will run dry. As we all know, that credit has now evaporated.
The second problem is that the status of the dollar as the world’s reserve currency makes it inevitable that huge flows of dollars will come cascading back into the US economy from overseas, in a way that results not in healthy growth or sound investment, but rather in asset/credit bubbles, fraudulent financial products and the like. With the dollar as reserve currency, China (which I will use in this post as the shorthand for all similarly-situated emerging markets) has no choice but to use its dollars to buy dollar-denominated assets, unless they want to convert their dollars into their local currency. The latter step would cause their currency to appreciate and to make their goods less competitive on the world marketplace, so that’s a step they have been unwilling to take so far.
The “Chimerica” trade relationship would have collapsed long ago if the US still pegged the dollar to gold, as it did prior to 1971, when Nixon took us off the gold standard. There is only a finite supply of gold, but the US has an near-infinite ability to make promises to repay debt, and this has allowed the US trade deficit to persist far longer than would have been possible under the pre-1971 framework (i.e. the Bretton-Woods framework). I’m far from a gold bug, but the fact is that if the dollar were pegged to something “real,” then this torrent of dollars leaving the US would have long ago caused a recession in the US, inflation in China, and the trade imbalance between the two countries would have corrected itself. That’s how things worked for hundreds of years, and we are really in uncharted water dealing with the Chimerica relationship. The Chinese government has made the situation worse by keeping the yuan artificially weak and by failing to invest in their own economy and people, so they share a lot of the blame for this situation. Richard Duncan describes this phenomenon very well in his excellent 2002 book “The Dollar Crisis,” which I quote directly from later in this post.
The fact that the “Chimerica” trade arrangement is unsustainable long-term is bad enough, but it is made much worse by the fact that it produces huge economic dislocations even while it continues to exist. This trade relationship, with its reliance upon cheap Chinese workers making cheap products, puts an effective cap on the wages of many US workers, so that the dollars that are being recycled into the US don’t find their way into most US workers’ wages (with certain obvious exceptions such as financial sector workers). If they did, then the Chimerica relationship, with its reliance upon the purchasing power of US consumers, might be more sustainable. As it stands, however, it is completely unsustainable. Credit bubbles collapse when the purchasing power of consumers fails to keep up with the excess capacity created by credit-driven manufacturing or asset appreciation, and that is part of what has happened in our economy today.
There is another subtle flaw in the Chimerica trade relationship which made our situation worse. The Chinese workers toiling for $5/ day made sure that consumer price inflation in the US stayed low, which allowed Alan Greenspan to delude himself that inflation was in check so that he could keep the Fed Funds rate very low. Like other central bankers, Greenspan decided that it wasn’t his job to worry about asset bubbles like the housing bubble. This was obviously a crucial mistake, and Ben Bernanke has assured us that he recognizes this error and will “take away the punch bowl” by raising the Fed Funds rate the next time a housing bubble starts to form. Unfortunately, Bernanke shows every sign of planning to help inflate the final bubble we face: the US Treasury bubble. Under the guise of fighting deflation and assisting the housing market, Bernanke has indicated that he will likely print money to buy longer-dated Treasury bonds such as the 10-year Treasury bond with which mortgage rates are so closely correlated. While this will likely have the desired effect of driving down mortgage rates, it can only be regarded as the perpetuation of the housing bubble and the creation of yet another bubble in Treasury bonds. Apparently, our economic powers-that-be judge our economy to be incapable of growing in the absence of artificially-created bubbles. That should be very disturbing in and of itself.
As we all know, the result of this huge inflow of foreign dollars has been the repeated inflating of asset price bubbles - first the tech bubble and most recently the housing/stock market bubble. This is entirely predictable when one considers that the globalization cap upon the wages of US workers prevents any healthy outlet for growth in our economy. In the absence of a healthy outlet for growth, we simply built an entire phony economy based upon imaginary wealth in the form of asset appreciation. Wall Street added toxic waste to the mix in the form of credit default swaps, special investment vehicles, collateral debt obligations, and many other toxic products which allowed banks to foist their worthless debts upon gullible investors. A collapse was inevitable.
II. What has changed after the credit bubble collapse?
Having noted the causes of the collapse, the question arises: how have things changed now that the crash has occurred? To answer this question, I would refer you to chart F.107 on the Fed’s March, 2009 “Flow of Funds” publication to see how foreigners have been recycling their debt into the US in recent years and how that has changed since the collapse of the credit bubble.
http://www.federalreserve.gov/releases/z1/Current/z1.pdf
Under the heading “Net Acquisitions of Financial Assets” you will see that, in the year 2006, at the height of the credit bubble, the rest of the world acquired the following amount of US financial assets.
2006:
Treasury securities: 150.4 billion
Agency and GSE- backed securities: 222.7 billion
US corporate bonds: 541.0 billion
US corporate equities: 119 billion
Securities Repurchase Agreements (RPs) 109.4 billion
It is commonly assumed that countries like China have been recycling their dollars into the US economy by buying Treasury securities, but the above chart makes it clear that, in recent years, most of the overseas dollars were being recycled into the US private sector, largely through corporate stocks and bonds.
Pay particular attention to the notation for Securities Repurchase agreements. Such so-called “repo” agreements are the mechanisms that large Wall Street investment banks use to finance their operations. The large banks will use their assets as collateral to roll over their loans (made by huge mutual funds and other big Wall Street players) on a daily basis. Bear Stearns died because its counterparties suddenly stopped trusting their collateral (largely mortgage-backed securities) and so would not roll over their tens of billions of dollars in ongoing repo loans.
Let’s compare those acquisitions made in 2006 to those made in the 4th quarter of 2008, after the collapse:
2008 (4th Quarter)
Treasury securities: 1094.0 billion
Agency and GSE-backed securities: negative 1006.4 billion
US corporate bonds: 2.4 billion
US corporate equities: 18.1 billion
Securities repurchase agreements: negative 1273.1 billion
As you can see, there was a huge stampede out of Fannie and Freddie debt in the fourth quarter of 2008, a stampede into US Treasury bills/bonds and very little purchase of US corporate bonds and stocks compared to prior years. Incredibly, 1.2 trillion dollars in foreign money went flying out of securities repurchase agreements, indicating a massive deleveraging of the financial sector in the US. This exit of $1.2 trillion is even worse for Wall Street than it may appear, since the Wall Street banks use the RP securities as collateral for even more leverage. These numbers look very bleak for Wall Street, and there is no doubt an element of karma in that. Unfortunately, a lot of innocent US stockholders are going down with the ship.
The lesson of these statistics is clear. With the bursting of the credit bubble, foreign nations are only willing to recycle their dollars into investments backed by the full faith and credit of the US government. As a result, the “stimulus package” passed by Congress was a virtual inevitability if we are going to have any kind of functioning economy at all. When the only thing a nation has to offer is governmental debt, then that will inevitably be the basis for its economy. I suppose that the “good news” in all this is that, for all its wasteful spending, Congress will do a better job allocating the recycled dollars than Wall Street did. They would have to try extremely hard to do otherwise.
While that is the limited “good news,” the “bad news” comes in at least three parts. The first part of the “bad news” is that the kind of deficits that the US government will be required to run to keep this latest Treasury bubble alive are not sustainable. The IMF generally starts raising red flags when a nation’s budget deficit exceeds 5% of GDP. With Obama projecting a $1.7 trillion deficit in an economy with a GDP of around $11 trillion, we will obviously be greatly exceeding that. In the event (as seems likely) that there are not enough customers out there for all our massive Treasury issuances, the Federal Reserve will likely have to print money to buy Treasuries, which will set the stage for inflation whenever the economy does start to improve. In his 60 Minutes interview, Bernanke assured us that he would mop up any excess liquidity (presumably by selling the Treasury bonds the Fed bought) when any recovery arrives, but that would require a great deal of political courage since doing so would likely put the country back into a recession. Either way, the result will be dire.
The second part of the “bad news” is that we’ve still got to clean up the mess from the collapse of our banking sector, and this will be enormously expensive. The example of nations that have had similar collapses (such as Sweden and Japan) makes it clear that the recession resulting from a banking collapse is likely to be very severe (if the US bites the bullet and de facto nationalizes the banks, as Sweden did) or very prolonged (if the US tries to muddle along with “zombie banks” as Japan did.)
The third - and arguably worst - part of the bad news is that the recapitalization of our banks, at enormous cost, will not change the fact that the huge growth in lending we saw in the last 15 years or so was not caused by increased bank lending. Instead, the increased lending was caused by huge surges in the marketplace for securitized debt, which marketplace has simply disappeared and will not be coming back in any kind of comparable form. It was also caused by increased lending from Fannie/Freddie, and they have both collapsed. These ominous facts are buried in Federal Reserve statistics going back decades, and I will quote from Richard Duncan’s 2002 “The Dollar Crisis” for a good summary of this data:
The growth in the debt of the financial sector has been extraordinary over the last two decades. Jumping from US $578 billion in 1980 to US $9.6 trillion in early 2002, the debt of the financial sector in the United States has soared from 21% of GDP to 93%. Equally important, in terms of debt outstanding, the institutions that traditionally supplied credit - commercial banks and savings institutions - have been dwarfed by the rise of federally related mortgage pools, government-sponsored enterprises, and asset backed securities over that period. For example, in 1980, the debt of the federally related mortgage pools and GSEs amounted to 4% and 6% of GDP respectively, while the asset-backed securities market had not yet come into existence. By early 2002, the combined debt of those three groups had risen to 71% of GDP, whereas the debt of the traditional lenders had hardly changed relative to GDP.
Duncan, “The Dollar Crisis” at p 105.
I wish I could include some kind of ominous music at the end of that quote by Duncan, because it seems pretty scary to me. The data already showed in 2002 - and Fed data shows that this accelerated in the few years since - that the huge increase in credit in our economy was caused not by increased bank lending, but rather by an enormous surge in the marketplace for asset-backed securities which has irrevocably collapsed and by lending by GSEs which have been put into government receivership! As noted above, over a trillion dollars in foreign funding for GSE such as Freddie and Fannie dried up in the fourth quarter of 2008 alone.
This data suggests that even if we bite the bullet and spend enormously to recapitalize the banks back to a “normal” level of lending, this won’t even come close to addressing the impact of the collapse of the ABS marketplace and the demise of Fannie/Freddie since they, and not increased bank lending, were the cause of our huge increase in lending in recent decades. That is, even if we give Bank A enough money to recapitalize it and make it a “healthy” bank, it is still only going to want to put loans on its balance sheet that it knows are very likely to be repaid.
The truly pernicious effect of the ABS marketplace was that banks were able to make loans they knew would not be repaid, but they didn’t care because they knew that they, with an assist from the ratings agencies and Wall Street investment banks, would be able to foist those loans on unsuspecting investors in the form of dodgy securities. Those investors have wised up, and it’s safe to say that no one is going to want to buy securities comprised of mortgages, credit card debt, auto loans, or student loans anytime soon. The 50% drop in US auto sales since last year is no doubt due partly to the collapse of the market for securitized auto loans, and there are ominous signs that the credit card industry will be next to fall. The Fed may well try to keep the ABS marketplace alive with printed money, but that will do nothing more than perpetuate, for a while longer, an unsustainable bubble that is bound to pop eventually.
III. The Final Bubble
The aforementioned effects of the credit bubble and securitization collapse are dire, but they will eventually be overcome. The “big picture” remains what it has been since the Chimerica relationship developed: what happens after the creditworthiness of even the United States government is exhausted? What happens when even China decides that it can no longer afford to sell us goods in exchange for increasingly worthless debt instruments? This is now the crucial question in the US economy since we are requiring the federal government to do the heavy lifting in sustaining, for as long as possible, the Chimerica cheap-goods-for-debt-instruments relationship.
I admit that I don’t have a clear picture of what will happen, and I doubt anyone does. I do think that the most likely US reaction to its increasing debt will be to inflate it away by having the Federal Reserve print money. There is simply no political will, on the part of either political party, to implement the sort of tax increases and spending cuts which will be necessary after the Baby Boomers start to retire in earnest around 2017 and demand that the Medicare and Social Security promises be kept. So it’s pretty clear that the US will take the only step open to it (short of outright default): to decrease the real value of its debt by having the Federal Reserve print money and create inflation. The 64 dollar question is how China will react to being repaid in cheap dollars. I have few insights into the Chinese mind or the options that are available to them to offer an accurate appraisal in this regard.
The relationship we have with China is kind of like the arrangement at the old Appalachian coal mines. The coal companies traditionally had the only store in town, and so coal miners had no real choice but to shop there, unless they wanted to drive 2 hours over crumbling roads to get to the nearest non-company store. Many of the mines also paid workers in company script which could only be spent at the company store, and this is to some extent comparable to the dollar’s reserve currency status. With each passing year the creditworthiness of the USA gradually declines, much like an old company store that gets more dilapidated and less competitive each year. At some point, things will get so bad that the miners will bite the bullet and pick up and move to Ohio and the mine will go bankrupt.
It is not inevitable that the Chinese will pack up and move, however, and it’s important to emphasize the huge advantage that we have right now by forcing them to shop at our company store. They clearly don’t want to pack up and move, which is understandable considering the huge economic gains they have experienced in the last decade by virtue of their relationship with the US. That being the case, it is certainly plausible that we will be able to keep China shopping at our store simply by making some reasonable concessions, such as by acting in a more fiscally responsible manner. It is not inevitable, in my view, that this situation will end in catastrophe, although there is little doubt that future generations are going to be paying for the fiscal irresponsibility.
I would argue that the most important thing we can do is to try to build a “real” economy with workers paid decent wages so that the dollars that get recycled into our economy go to support average US consumers instead of hedge fund managers and real estate speculators. As noted above, the “good” part of our current fiscal stimulus spending is that the dollars being recycled into our economy are not going through Wall Street (although recapitalization of banks is sadly necessary), and this gives us an opportunity to provide for a fairer allocation of our national resources. For all the flaws in the stimulus package, it seems to me that it will clearly result in more capital reaching ordinary Americans than was the case in prior years. The key challenge will be weaning ourselves off of this reliance upon fiscal stimulus, because it can not be sustained indefinitely.
Part 1. How did we get here?
As I see it, there are two central problems in the global economy/world trade system which have led us to our current crisis. The first is that globalization has driven down wages in the US while, at the same time, the world economy relies upon US consumer spending as its engine for economic growth. There is obvious tension between these two facts. Americans with stagnant wages will only be able to borrow so much until their purchasing power, even aided by liberal credit, will run dry. As we all know, that credit has now evaporated.
The second problem is that the status of the dollar as the world’s reserve currency makes it inevitable that huge flows of dollars will come cascading back into the US economy from overseas, in a way that results not in healthy growth or sound investment, but rather in asset/credit bubbles, fraudulent financial products and the like. With the dollar as reserve currency, China (which I will use in this post as the shorthand for all similarly-situated emerging markets) has no choice but to use its dollars to buy dollar-denominated assets, unless they want to convert their dollars into their local currency. The latter step would cause their currency to appreciate and to make their goods less competitive on the world marketplace, so that’s a step they have been unwilling to take so far.
The “Chimerica” trade relationship would have collapsed long ago if the US still pegged the dollar to gold, as it did prior to 1971, when Nixon took us off the gold standard. There is only a finite supply of gold, but the US has an near-infinite ability to make promises to repay debt, and this has allowed the US trade deficit to persist far longer than would have been possible under the pre-1971 framework (i.e. the Bretton-Woods framework). I’m far from a gold bug, but the fact is that if the dollar were pegged to something “real,” then this torrent of dollars leaving the US would have long ago caused a recession in the US, inflation in China, and the trade imbalance between the two countries would have corrected itself. That’s how things worked for hundreds of years, and we are really in uncharted water dealing with the Chimerica relationship. The Chinese government has made the situation worse by keeping the yuan artificially weak and by failing to invest in their own economy and people, so they share a lot of the blame for this situation. Richard Duncan describes this phenomenon very well in his excellent 2002 book “The Dollar Crisis,” which I quote directly from later in this post.
The fact that the “Chimerica” trade arrangement is unsustainable long-term is bad enough, but it is made much worse by the fact that it produces huge economic dislocations even while it continues to exist. This trade relationship, with its reliance upon cheap Chinese workers making cheap products, puts an effective cap on the wages of many US workers, so that the dollars that are being recycled into the US don’t find their way into most US workers’ wages (with certain obvious exceptions such as financial sector workers). If they did, then the Chimerica relationship, with its reliance upon the purchasing power of US consumers, might be more sustainable. As it stands, however, it is completely unsustainable. Credit bubbles collapse when the purchasing power of consumers fails to keep up with the excess capacity created by credit-driven manufacturing or asset appreciation, and that is part of what has happened in our economy today.
There is another subtle flaw in the Chimerica trade relationship which made our situation worse. The Chinese workers toiling for $5/ day made sure that consumer price inflation in the US stayed low, which allowed Alan Greenspan to delude himself that inflation was in check so that he could keep the Fed Funds rate very low. Like other central bankers, Greenspan decided that it wasn’t his job to worry about asset bubbles like the housing bubble. This was obviously a crucial mistake, and Ben Bernanke has assured us that he recognizes this error and will “take away the punch bowl” by raising the Fed Funds rate the next time a housing bubble starts to form. Unfortunately, Bernanke shows every sign of planning to help inflate the final bubble we face: the US Treasury bubble. Under the guise of fighting deflation and assisting the housing market, Bernanke has indicated that he will likely print money to buy longer-dated Treasury bonds such as the 10-year Treasury bond with which mortgage rates are so closely correlated. While this will likely have the desired effect of driving down mortgage rates, it can only be regarded as the perpetuation of the housing bubble and the creation of yet another bubble in Treasury bonds. Apparently, our economic powers-that-be judge our economy to be incapable of growing in the absence of artificially-created bubbles. That should be very disturbing in and of itself.
As we all know, the result of this huge inflow of foreign dollars has been the repeated inflating of asset price bubbles - first the tech bubble and most recently the housing/stock market bubble. This is entirely predictable when one considers that the globalization cap upon the wages of US workers prevents any healthy outlet for growth in our economy. In the absence of a healthy outlet for growth, we simply built an entire phony economy based upon imaginary wealth in the form of asset appreciation. Wall Street added toxic waste to the mix in the form of credit default swaps, special investment vehicles, collateral debt obligations, and many other toxic products which allowed banks to foist their worthless debts upon gullible investors. A collapse was inevitable.
II. What has changed after the credit bubble collapse?
Having noted the causes of the collapse, the question arises: how have things changed now that the crash has occurred? To answer this question, I would refer you to chart F.107 on the Fed’s March, 2009 “Flow of Funds” publication to see how foreigners have been recycling their debt into the US in recent years and how that has changed since the collapse of the credit bubble.
http://www.federalreserve.gov/releases/z1/Current/z1.pdf
Under the heading “Net Acquisitions of Financial Assets” you will see that, in the year 2006, at the height of the credit bubble, the rest of the world acquired the following amount of US financial assets.
2006:
Treasury securities: 150.4 billion
Agency and GSE- backed securities: 222.7 billion
US corporate bonds: 541.0 billion
US corporate equities: 119 billion
Securities Repurchase Agreements (RPs) 109.4 billion
It is commonly assumed that countries like China have been recycling their dollars into the US economy by buying Treasury securities, but the above chart makes it clear that, in recent years, most of the overseas dollars were being recycled into the US private sector, largely through corporate stocks and bonds.
Pay particular attention to the notation for Securities Repurchase agreements. Such so-called “repo” agreements are the mechanisms that large Wall Street investment banks use to finance their operations. The large banks will use their assets as collateral to roll over their loans (made by huge mutual funds and other big Wall Street players) on a daily basis. Bear Stearns died because its counterparties suddenly stopped trusting their collateral (largely mortgage-backed securities) and so would not roll over their tens of billions of dollars in ongoing repo loans.
Let’s compare those acquisitions made in 2006 to those made in the 4th quarter of 2008, after the collapse:
2008 (4th Quarter)
Treasury securities: 1094.0 billion
Agency and GSE-backed securities: negative 1006.4 billion
US corporate bonds: 2.4 billion
US corporate equities: 18.1 billion
Securities repurchase agreements: negative 1273.1 billion
As you can see, there was a huge stampede out of Fannie and Freddie debt in the fourth quarter of 2008, a stampede into US Treasury bills/bonds and very little purchase of US corporate bonds and stocks compared to prior years. Incredibly, 1.2 trillion dollars in foreign money went flying out of securities repurchase agreements, indicating a massive deleveraging of the financial sector in the US. This exit of $1.2 trillion is even worse for Wall Street than it may appear, since the Wall Street banks use the RP securities as collateral for even more leverage. These numbers look very bleak for Wall Street, and there is no doubt an element of karma in that. Unfortunately, a lot of innocent US stockholders are going down with the ship.
The lesson of these statistics is clear. With the bursting of the credit bubble, foreign nations are only willing to recycle their dollars into investments backed by the full faith and credit of the US government. As a result, the “stimulus package” passed by Congress was a virtual inevitability if we are going to have any kind of functioning economy at all. When the only thing a nation has to offer is governmental debt, then that will inevitably be the basis for its economy. I suppose that the “good news” in all this is that, for all its wasteful spending, Congress will do a better job allocating the recycled dollars than Wall Street did. They would have to try extremely hard to do otherwise.
While that is the limited “good news,” the “bad news” comes in at least three parts. The first part of the “bad news” is that the kind of deficits that the US government will be required to run to keep this latest Treasury bubble alive are not sustainable. The IMF generally starts raising red flags when a nation’s budget deficit exceeds 5% of GDP. With Obama projecting a $1.7 trillion deficit in an economy with a GDP of around $11 trillion, we will obviously be greatly exceeding that. In the event (as seems likely) that there are not enough customers out there for all our massive Treasury issuances, the Federal Reserve will likely have to print money to buy Treasuries, which will set the stage for inflation whenever the economy does start to improve. In his 60 Minutes interview, Bernanke assured us that he would mop up any excess liquidity (presumably by selling the Treasury bonds the Fed bought) when any recovery arrives, but that would require a great deal of political courage since doing so would likely put the country back into a recession. Either way, the result will be dire.
The second part of the “bad news” is that we’ve still got to clean up the mess from the collapse of our banking sector, and this will be enormously expensive. The example of nations that have had similar collapses (such as Sweden and Japan) makes it clear that the recession resulting from a banking collapse is likely to be very severe (if the US bites the bullet and de facto nationalizes the banks, as Sweden did) or very prolonged (if the US tries to muddle along with “zombie banks” as Japan did.)
The third - and arguably worst - part of the bad news is that the recapitalization of our banks, at enormous cost, will not change the fact that the huge growth in lending we saw in the last 15 years or so was not caused by increased bank lending. Instead, the increased lending was caused by huge surges in the marketplace for securitized debt, which marketplace has simply disappeared and will not be coming back in any kind of comparable form. It was also caused by increased lending from Fannie/Freddie, and they have both collapsed. These ominous facts are buried in Federal Reserve statistics going back decades, and I will quote from Richard Duncan’s 2002 “The Dollar Crisis” for a good summary of this data:
The growth in the debt of the financial sector has been extraordinary over the last two decades. Jumping from US $578 billion in 1980 to US $9.6 trillion in early 2002, the debt of the financial sector in the United States has soared from 21% of GDP to 93%. Equally important, in terms of debt outstanding, the institutions that traditionally supplied credit - commercial banks and savings institutions - have been dwarfed by the rise of federally related mortgage pools, government-sponsored enterprises, and asset backed securities over that period. For example, in 1980, the debt of the federally related mortgage pools and GSEs amounted to 4% and 6% of GDP respectively, while the asset-backed securities market had not yet come into existence. By early 2002, the combined debt of those three groups had risen to 71% of GDP, whereas the debt of the traditional lenders had hardly changed relative to GDP.
Duncan, “The Dollar Crisis” at p 105.
I wish I could include some kind of ominous music at the end of that quote by Duncan, because it seems pretty scary to me. The data already showed in 2002 - and Fed data shows that this accelerated in the few years since - that the huge increase in credit in our economy was caused not by increased bank lending, but rather by an enormous surge in the marketplace for asset-backed securities which has irrevocably collapsed and by lending by GSEs which have been put into government receivership! As noted above, over a trillion dollars in foreign funding for GSE such as Freddie and Fannie dried up in the fourth quarter of 2008 alone.
This data suggests that even if we bite the bullet and spend enormously to recapitalize the banks back to a “normal” level of lending, this won’t even come close to addressing the impact of the collapse of the ABS marketplace and the demise of Fannie/Freddie since they, and not increased bank lending, were the cause of our huge increase in lending in recent decades. That is, even if we give Bank A enough money to recapitalize it and make it a “healthy” bank, it is still only going to want to put loans on its balance sheet that it knows are very likely to be repaid.
The truly pernicious effect of the ABS marketplace was that banks were able to make loans they knew would not be repaid, but they didn’t care because they knew that they, with an assist from the ratings agencies and Wall Street investment banks, would be able to foist those loans on unsuspecting investors in the form of dodgy securities. Those investors have wised up, and it’s safe to say that no one is going to want to buy securities comprised of mortgages, credit card debt, auto loans, or student loans anytime soon. The 50% drop in US auto sales since last year is no doubt due partly to the collapse of the market for securitized auto loans, and there are ominous signs that the credit card industry will be next to fall. The Fed may well try to keep the ABS marketplace alive with printed money, but that will do nothing more than perpetuate, for a while longer, an unsustainable bubble that is bound to pop eventually.
III. The Final Bubble
The aforementioned effects of the credit bubble and securitization collapse are dire, but they will eventually be overcome. The “big picture” remains what it has been since the Chimerica relationship developed: what happens after the creditworthiness of even the United States government is exhausted? What happens when even China decides that it can no longer afford to sell us goods in exchange for increasingly worthless debt instruments? This is now the crucial question in the US economy since we are requiring the federal government to do the heavy lifting in sustaining, for as long as possible, the Chimerica cheap-goods-for-debt-instruments relationship.
I admit that I don’t have a clear picture of what will happen, and I doubt anyone does. I do think that the most likely US reaction to its increasing debt will be to inflate it away by having the Federal Reserve print money. There is simply no political will, on the part of either political party, to implement the sort of tax increases and spending cuts which will be necessary after the Baby Boomers start to retire in earnest around 2017 and demand that the Medicare and Social Security promises be kept. So it’s pretty clear that the US will take the only step open to it (short of outright default): to decrease the real value of its debt by having the Federal Reserve print money and create inflation. The 64 dollar question is how China will react to being repaid in cheap dollars. I have few insights into the Chinese mind or the options that are available to them to offer an accurate appraisal in this regard.
The relationship we have with China is kind of like the arrangement at the old Appalachian coal mines. The coal companies traditionally had the only store in town, and so coal miners had no real choice but to shop there, unless they wanted to drive 2 hours over crumbling roads to get to the nearest non-company store. Many of the mines also paid workers in company script which could only be spent at the company store, and this is to some extent comparable to the dollar’s reserve currency status. With each passing year the creditworthiness of the USA gradually declines, much like an old company store that gets more dilapidated and less competitive each year. At some point, things will get so bad that the miners will bite the bullet and pick up and move to Ohio and the mine will go bankrupt.
It is not inevitable that the Chinese will pack up and move, however, and it’s important to emphasize the huge advantage that we have right now by forcing them to shop at our company store. They clearly don’t want to pack up and move, which is understandable considering the huge economic gains they have experienced in the last decade by virtue of their relationship with the US. That being the case, it is certainly plausible that we will be able to keep China shopping at our store simply by making some reasonable concessions, such as by acting in a more fiscally responsible manner. It is not inevitable, in my view, that this situation will end in catastrophe, although there is little doubt that future generations are going to be paying for the fiscal irresponsibility.
I would argue that the most important thing we can do is to try to build a “real” economy with workers paid decent wages so that the dollars that get recycled into our economy go to support average US consumers instead of hedge fund managers and real estate speculators. As noted above, the “good” part of our current fiscal stimulus spending is that the dollars being recycled into our economy are not going through Wall Street (although recapitalization of banks is sadly necessary), and this gives us an opportunity to provide for a fairer allocation of our national resources. For all the flaws in the stimulus package, it seems to me that it will clearly result in more capital reaching ordinary Americans than was the case in prior years. The key challenge will be weaning ourselves off of this reliance upon fiscal stimulus, because it can not be sustained indefinitely.
) BECAUSE IT'S TOO REASONABLE. :eek:
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