Subprime disease a traded
infection By Thomas Palley
In recent months, the US 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 lenders 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 US trade deficits of the past
several years. Those deficits played a critical
role
generating the distorted interest rate environment
that created the subprime 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 US trade
deficit has persistently drained spending from the
US 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 counterpart of
these deficits was trade surpluses in the rest of
the world, which provided the conduit for
distributing subprime 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 US 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
US financial markets.
The vast scale of
foreign accumulation of dollar assets means that
other countries are now vulnerable to US 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, US households are burdened with
debt, and there is a massive overhang 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 US 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 US trade deficit
will be worst for the US, 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 US 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.
Thomas
Palley is founder of the Economics for
Democratic and Open Societies Project.
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