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How overproduction caused the financial crisis

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Bloomberg reports that American savings are on the rise given the recession and worries of the future:

In the recession following a borrowing binge that sent consumer debt to the highest level ever, Americans are shutting their wallets and building their nest eggs at the fastest pace in 15 years.

While the trend will put the country’s finances in better balance and reduce its dependence on Chinese investment, it may also restrain economic growth in 2010 and beyond, said Lyle Gramley, a senior economic adviser with New York-based Soleil Securities Corp. and a former Federal Reserve governor.

“There’s been a fundamental change in people’s behavior,” he said. “It will affect the economy for years.”

The article notes that this effectively reduces dependence on China and other neo-mercantilist countries such as Singapore who deliberately depress their domestic consumption with policies which also encourage exports in order to build up sizeable foreign reserves with their trade surpluses with the United States.

This point is worth elaborating.  In 2005, current Fed Reserve chair Ben Bernanke presented what is now famously known as the Bernanke thesis; a theory which some have invoked to explain the origins of “easy credit” which was widely blamed for real estate speculation in the United States which burst calamitously resulting in the worst recession since the Great Depression itself.

According to Bernanke, in the aftermath of the Asian financial crises and various other crises such as the Russian crisis, the 1980s Latin American foreign debt crisis, developing nations around the world started to accumulate sizeable foreign exchange reserves by adopting neo-mercantilist economic policies by placing undue emphasis on exports.  One country which has been doing so all along since its independence was Singapore.  These reserves were meant to buffer against foreign speculative attacks as well as sudden capital outflows in the case of a regional financial crisis.  These foreign reserves in turn were then in turn invested in developed financial markets.  Some of them inevitably made their way into the US housing sector and helped inflate the housing bubble.  Others purchased US Treasury bonds and depressed yields, prompting American investors such as investment banks and hedge funds to re-balance their portfolio in favour of mortgage-backed securities (which were made up primarily of collateralized debt and other derivatives) which promised higher returns.

As a consequence of the asymmetry in global saving due to these economic policies, Western countries such as the United States and the developed European Union countries developed trade deficits as consumer spending soared along with rising house prices.  Consumers were leveraging themselves with accessible credit made available due to low Fed-controlled interest rates as well as invested funds from developing countries by borrowing against the value of their homes.

Then Fed Chairman Alan Greenspan’s decision to repeatedly lower Fed fund rates (from 6.5% in 2001) until they hit a low of 1% in June 2003 exarcerbated the problem of excess liquidity.  Consumption soared in the US, as savings inversely plunged.  Over time, foreign investors increased their holdings of mortgage-backed securitires (MBS) to about $1 trillion in 2006 (data by IMF).

At this point some may think that Austrian criticism that the Fed Reserve’s manipulation of interest rates were the cause of the recession were correct. Not quite so.  As mentioned above, the influx of funds due to foreign investors from reserve-rich developing nations lowered Treasury yields.  It is for this reason that Greenspan was only partially culpable for the low interest rates under his watch at the Fed.  Greenspan himself made the same point in an op-ed in the WSJ dated Mar 11th 2009.

In short, export-oriented economies such as China and the other East Asian countries were flooding developed markets with their cheap goods whilst investing the foreign reserves accumulated from such exports in the American housing sector.  American consumers were riding the boom by increasing consumption at the expense of savings whilst borrowing against inflated home prices to consume even more.

All the euphoria has to come to an end of course.  This happened when subprime loans defaulted with increasing frequency in 2007 when the bubble finally burst in mid 2006.  The supply of foreclosed houses put up for sale decreased housing prices even more.  When housing prices fell, consumers who felt poorer as a result of decreased total wealth cut back on consumption, leading to under-consumption of goods produced by the neo-mercantilist nations. It is for this reason (among others) that a slump in the US housing sector could somehow propagate throughout international borders into a worldwide recessions.  Other reasons include foreign investors reducing their exposure to securities which suddenly became toxic when the house prices fell and mortgage owners defaulted.  The decrease in valuation of such holdings, coupled with falling American demand for imported goods meant that the recession was effectively exported to foreign countries.

Global output fell as a consequence of decreased demand.  Now as Bloomberg reports, a shift in consumption and saving attitude in America effectively means that the Asian economic growth model is broken.  It matters not if Singapore diversified its economic growth engines by branching out into a financial hub if its sovereign wealth funds such as Temasek Holdings and GIC Singapore suffered the high exposure to the subprime fallout when they bought into Merill Lynch, UBS, Barclays and Citigroup; financial institutions who were most exposed to securities linked to mortgage debt.

How does this story end?  I don’t know for sure.  Would Asia willingly tweak a growth model which has paid off for them for decades?  Will America’s sudden thrift last for a generation?  No one knows.

Written by defennder

June 29, 2009 at 3:35 PM

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