Q: Historically, has there been any country that can sustain a growing large amount of trade deficit for more than 30 years?
A: This is really unprecedented and it started with the breakdown of the Bretton Woods Agreement. During the 70’s the U.S. deficit was relatively moderate. In the 80s, however, President Reagan started to cut taxes and to increase the military expenditure, while sustaining a large budget deficit. The budget deficit stimulated the economy and lead to a larger trade deficit, which reached 3.5% of the GDP by 1985.
That was an alarming number at the time and global policy makers met to reach the Plaza Accord in 1985. Following that agreement, the Yen and the German Mark appreciated by 50% against the dollar over the next two years. That was enough to prompt a correction of the U.S. current account deficit, and by 1990 it was back in balance.
Then, globalization began to facilitate trade between countries like China and the U.S., or between countries with very high and very low wages. With the fall of communism, the political tensions were removed and international trade was boosted. China’s trade surplus with the US started to grow significantly to reach more than 10% of its GDP last year. In the 1990s Mexico and all the Asian crisis countries were allowed to devalue their currencies against the dollar.
These developments had a negative impact on the U.S. trade deficit, which has now reached 7% of the GDP, or is twice as high as at the time of the Plaza Accord. Today, however, there is no clear solution because the discrepancy between the wages in the U.S. and China is huge, i.e. $200 per day versus $5 per day. Even if the Yuan appreciates by 50%, that would only take Chinese wages up to $7.50 per day and wouldn’t prevent the Chinese surplus from growing further. So the imbalances today are not only larger, but also much more difficult to resolve.
Q: You use three very important words in the title of the book - causes, consequences, and cures. If China cannot correct the imbalance by appreciating its currency by 50%, what else could happen?
A: As long as the imbalances persist, the global financial system will become increasingly unstable. We have seen the bubbles on the surplus side blow up in Japan and Asia, and I believe that will see the bubble in China blow up. More interestingly, on the deficit side we are now seeing the U.S. bubble beginning to implode. This has potentially very severe consequences, such as a large sector of the mortgage market defaulting, combined with troubles in structured finance products.
It seems that the U.S. government will have to intervene further and all the Western central banks have to inject liquidity into their credit markets to prevent a systemic meltdown. So far, the injections have been close to half a trillion dollars, which is significant, but it only addresses the fear gripping the credit markets. It doesn’t address the fundamental problem with the U.S. economy, where all the dollar surpluses have been reinvested in dollar assets, thus facilitating the property bubble.
The annual current account deficit of $850 billion roughly equals the amount that global central banks accumulate as foreign exchange reserves each year. Treasury bonds are typically the first choice for reinvestment, but the budget deficit was only $160 billion last year. Even if the surplus countries had bought every new Treasury bond issued, they would still have $700 billion to invest somewhere else.
In other words, the imbalance provided financing for the entire sub-prime market because there were ready buyers for those loans. Now that the loans are blowing up, we are finding that the losses are much greater than anyone on Wall Street had been brave enough to estimate. Countrywide Financial has fallen from about $45 to roughly $5, and this company originated one of every six mortgages in the U.S. last year. You can imagine the amount of debt they have issued and the repercussions of a possible default on such a large amount of bonds.
In addition, Fannie Mae and Freddie Mac, the agencies that own or guarantee 43% of all the mortgages in the United States, have a very thin level of capitalization. With mortgage defaults becoming so high, there is a clear risk of erosion on whatever capital they have. The share prices of the insurance companies that guarantee the bonds are also dropping and there is considerable speculations about their solvency. These are big organization with an enormous role in the financial system. If any of them fails to meet its obligations on their bonds, we would face a systemic financial sector crisis. In my view, these imbalances are a direct consequence of the U.S. current account deficit.
Q: Based on preliminary numbers, we potentially face losses of $250 billion related to sub-prime loans. What scenarios do you foresee here?
A: The defaults would not affect just the subprime loans, but also the prime mortgage market, the credit card industry, the automobile loans, and the structured finance products. So, it is a much bigger problem than the $250 billion in sub-prime losses and it will require government intervention.
Basically, credit growth drives economic growth, and we have had excessive credit growth, which led to unsustainably high economic growth. The total credit in the U.S. has been going up steadily and rapidly to reach about 360% of the GDP today. If the credit/GDP ratio contracts due to defaulting, it is quite certain that the economy will have a severe recession, and the government will quickly realize that it has a limited number of options.
One of the options is to allow Fannie Mae and Freddie Mac to buy up more mortgages in the country and grow their balance sheets. If they do, however, they will push up the property prices and issue more debt. This is a very short-term fix because it’s not possible to keep the property bubble inflated indefinitely.
Direct government spending is a viable solution, but a very uncomfortable one because it will require increasing government debt. So the money spent to keep the economy out of a recession should be spent wisely and for projects that generate returns for future generations, such as infrastructure or sustainable energy projects or on education. Ultimately, the future generations are the ones who will end up repaying this debt.
In that sense, I don’t think that the government should be bailing out the people who default on their mortgages or the bankers who lent them the money for mansions they cannot afford. There is moral hazard involved, and it wouldn’t work anyway. The bubble would still pop, but the bill would be much larger when it does.
Q: If the U.S. doesn’t find its way out of the recession, can Asia continue to grow on its own? Do you believe in the arguments on decoupling?
A: In this case Asia would have a prolonged recession, as there is no decoupling. The mild recession in 2001, when U.S. imports went down by only 6%, caused global commodity prices to collapse. Asia went into a recession, the stock market crashed, and interest rates fell to very low levels. Nothing has changed in the last five or six years. The U.S. economy represents about one-third of the global GDP, and if there is a recession in the U.S., the world has a recession too.
Q: How likely is a global demand for restoring the gold standard? |
