This post is a continuation of 2009 Outlook Part I – The Depression's Long Shadow
Our debt problem
At this point it's pretty obvious that the primary problem facing the United States in this financial crisis is our high level of indebtedness and the threat of debt deflation. In order to understand how to get out of our debt problem, it makes sense to look at how we got into the problem in the first place. The operative metric to look at is total debt to nominal GDP.
Of course, there's no real way to know what the ideal total debt to GDP figure is. If as a people we feel our government has gotten better at managing the risk in our economy, that recessions will be less frequent and shorter, that inflation will be consistently low and positive, that interest rates consistently low, and that asset prices will keep rising, we will be comfortable carrying a higher level of indebtedness. That is until we push it so far that the amount of risk increases and the level of indebtedness at which we're comfortable comes crashing down. As can be seen in the chart above, there have been two periods since 1952 during which the level of debt to GDP increased rapidly: (1) 1981-1989, when the level of debt to GDP increased from about 150% to 225%; and 1997-2008, when the level increased from 240% to 340%. If the history of investment manias is any guide, we should expect the financial effect of at least the entire 1997-2008 boom to be wiped away.
In order for our nation's debt to grow faster than GDP, we can (1) borrow money from abroad or (2) increase the leverage in our financial system. Increased leverage in the financial system can be measured by total financial debt to nominal GDP, which I will discuss in a later post. All the rest (consumer, business, government) is in nonfinancial debt to nominal GDP.
The debt stair steps
It's pretty easy to see the pattern in this graph. Nonfinancial debt rose from 120% of GDP to 140% of GDP by the mid 1960s, coming off a pretty low base during the postwar boom. It stays in a range of 135%-140% all the way to 1982 and then shoots to about 180% by the end of 1987. Then it basically stays at about 180% until the end of 1999, after which it climbs to 225% by the end of 2007. These were both about 25% increases.
What did these two periods have in common? They both had tax-cutting Republican presidents who also spent heavily on the military. They both had rapidly falling interest rates. They were both periods during which the US was running large trade deficits. Trade deficits coexist with an inflow of capital, as the current account deficit (mostly the trade deficit) by definition must equate to a capital account surplus (a purchase of US securities).
Why do we run trade deficits?
If the trade deficit is a major cause of our debt problem, it is worth understanding why we run trade deficits. The periods where the trade deficit starts to widen in the early 80's and late 90's clearly correlates with periods of a rising dollar. When the dollar returns to its equilibrium range between 85 and 95 on the real broad trade-weighted dollar index, the trade deficit begins to close.
Why did the dollar rise during those two periods? During both periods there were relatively high real interest rates, plus an explicit policy favoring a stronger dollar. During the 1980's, the US wanted to wring 1970's inflation from the system. During the mid 1990's, Robert Rubin imposed the "strong dollar" policy for no discernable reason whatsoever.
Why was the trade deficit in the 2000's were more severe than the deficit of the mid 1980's, when the dollar spike was more subdued? The answer is foreign intervention.
Source: Bank Credit Analyst
Clearly, you tend to get foreign official flows into dollar assets when the dollar is weakening. During the late 1980's and early 1990's, foreign official flows accounted for virtually all of the US's modest trade deficit of 1% or less of GDP. During the early 1980's and late 1990's, there was very little official foreign flow, as the rising dollar attracted private investment flows. From 2002 to 2008, however, there was a systematic effort by foreign governments to accumulate dollar reserves to promote a trade deficit in the US. The vast majority of the blame can be heaped on China, Japan and the oil producing countries, who from 2003 to 2008 were contributing 2.5% to 3% of GDP points to our trade deficit each year. Without these flows, our trade deficit would have run at a more modest 1-3% of GDP. What did the majority of these funds purchase in the last several years? Fannie Mae and Freddie Mac agency debt, which flowed into, you guessed it, the US housing bubble.
So we should blame China and Japan for the housing bubble, then, right? Partly, but not completely.
The role of Japan
Japan had a massive investment and real estate bubble in the late 1980s, like our NASDAQ and housing bubbles all rolled into one. When it popped, Japan was unable to stimulate domestic demand, because its consumer base was overleveraged from the real estate bubble. Also, because Japan was a more egalitarian society than the US during the roaring twenties, it couldn't follow the New Deal policy of taxing the savings of the rich to stimulate demand in the middle class. Japan had massive overcapacity in its business sector and a badly damaged banking sector, so it was difficult to stimulate investment there. Japan also suffered from deflation, not only a slow-rolling debt deflation as the government propped up wobbly banks, but also absolute price deflation caused by a strong currency.
The yen doubled in value against the dollar from 1985 to 1988 (at our urging as part of the Plaza Accords) and rose in value against gold all the way into the late 1990s. With domestic demand hobbled and prices falling, Japan instituted a massive infrastructure building program during the 1990s, most of which is now acknowledged to have been wasted on politically-connected projects. By the end of the 1990s, Japanese government debt to GDP has risen to around 100% of GDP. In the 2000s, Japan switched gears to focus on printing money ("quantitative easing") to fight deflation and support exports by holding its currency down. Printing money in the case of Japan meant printing yen to buy dollars. With zero percent official interest rates and an explicit pledge to hold down the currency against the dollar, the Bank of Japan issued a notice to hedge funds to short the yen and buy assets in other, higher-yielding foreign currencies like the dollar, pound, Australian dollar, New Zealand dollar and Icelandic Krona.
Robert Rubin's wave of destruction
In the mid-1990s, a number of Asian countries (ex. Japan) were doing pretty well. Their currencies were pegged to the dollar. They were following the classic development model of running capital account surpluses as they received high levels of investment from abroad. Much of the investment was in the form of dollar-based loans. The dollar spent 8 years in a relatively tight trading range, so that wasn't an issue. With the exception of Japan, most of the world economy was expanding in a relatively balanced fashion and the US was running only modest trade and budget deficits along with stable, low inflation.
In 1995, however, US Treasury Secretary Robert Rubin began cheerleading for a stronger dollar. As the dollar began to rise, it put pressure on emerging market currencies in Asia and Latin America that were trying to maintain currency pegs and had borrowed in dollars. Hedge funds began (rightly) betting that the currency pegs would be broken. Starting with the Thai Baht in 1997 through the Ruble default in 1998, the world currency system collapsed, saddling emerging market economies with huge dollar-based loans relative to their collapsed currencies. The IMF then imposed punishing austerity measures on these countries in exchange for bailouts. Emerging market countries can be forgiven for seeking a different policy path this decade after they were needlessly impoverished in the late 1990s.
The China model
The Chinese witnessed what happened to Japan (rising currency/deflation) and what happened to Korea and Southeast Asia (trade deficits/collapsed currencies) and decided to take a different path. They would emulate the export-based development model successfully utilized by Japan. Instead of allowing their currency to consistently rise over time (which has the effect of raising living standards and holding down prices, but can also lead to an unstable investment bubble and encourages imports and discourages exports), they would hold down their currency. To prevent their currency from rising, the Chinese limit currency convertibility. The central bank recycles export earnings into dollar-based securities, building reserves to protect their currency in times of distress. China has built up more than $1.2 trillion of reserves. Building currency reserves directly promotes a trade surplus for China and a trade deficit (via a capital account surplus) for the country issuing the reserve currency (mostly the United States). Such a strategy can only last so long, of course. Eventually, inflation pressures in China would become too great and/ or the United States would stagger under the weight of its increasing debt load. Both began to happen in 2007, with the US's debt burden becoming the greater of the two forces.
Reining in the trade deficit
As US demand has collapsed and energy prices have plunged, the US trade deficit has begun to narrow sharply. The problem is that now US exports are falling too. The goal going forward for the US needs to be to figure out how to restore domestic demand without having that demand spill abroad in the form of renewed trade deficits. I'll leave discussing how the mix of demand needs to change for a later post. Foreign countries also need to figure out how to stimulate domestic demand so that they become less reliant on exports to the US and import more from the US. A return to trade balances would at least help stabilize the US's debt to GDP ratio.
The US would bring its debt levels down if it began running trade surpluses. Given the current structure of the global economy, that may be a bridge too far, unfortunately. What the US can no longer tolerate, however, is foreign governments to purposely manipulating trade flows via the building of currency reserves. After 8 years of using diplomacy alone to try to deal with this issue, it may be time for the Obama administration to take a tougher line, perhaps via broad-based tariffs to offset the effect of currency manipulation. While I am a free trader by disposition, we can't stand by and allow other countries to basically cheat our businesses and workers.
A global solution to a global problem
The problem of global trade imbalances and currency instability is a global one, yet most currency and monetary policies are determined at the national level. The US Fed operates as if it serves the US alone. Since the dollar is the global currency, however, the Fed functions as a de facto global central bank. The US allows its currency to fluctuate widely to suit its own purposes, with dolorous effects on emerging market economies and US businesses. Yes, China, Japan and various petro-states are systematically manipulating their currencies, but in many ways these policies are a response to past interest rate and currency instability caused by the US Fed and Treasury.
While the US could seek to punish offending countries with tariffs, such a solution alone could result in retaliatory measures, a collapse of global trade and global depression. Instead, the US should offer to lead a global currency system based on stable currency values. Such a solution would by definition require coordinated global monetary policy, particularly between the US, Eurozone, Japan and the UK. Other emerging countries could allow their currencies to float against, or be pegged to, the major currencies. All currencies would need to be freely convertible and countries would not be allowed to build currency reserves beyond what may be needed to provide for currency stability. The IMF could also return to its traditional role of promoting currency stability. Emerging market countries should be given a seat at the table and most decisions should be made through the G-20 type of group as opposed to the anachronistic G-8.
I hope this essay establishes that (1) a large portion of our national debt problem comes from running trade deficits; (2) a major cause of the trade deficits has been artificial dollar strength, driven by US policy; and (3) that another cause of our trade deficits has been currency manipulation by foreign governments building large currency reserves. To fix the trade deficit problem, US currency policy should be (1) to promote a stable dollar, not a rising or widely fluctuating dollar; (2) to prevent foreign governments from building large dollar reserves; and (3) ideally create a global currency framework that would promote currency stability and reduce global imbalances, particularly by brining the emerging market countries in to the process as major stakeholders.