from Follow the Money

Too big to fail? Or too large to save? Thinking about the US one year into the subprime crisis

July 24, 2008

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Emerging market financial crises in the 1990s followed a fairly consistent pattern.

The country lost access to external financing.

The sector of the economy that had a large need for financing – firms in Asia, the government elsewhere – had to dramatically reduce its need for financing. Asian investment collapsed. Argentina swung from a fiscal deficit to a fiscal surplus (helped along by its default on its external debt). Turkey began to run large primary surpluses.

Financial balance sheets shrank; credit dried up.

The country’s currency fell sharply. And its current account swung into balance, if not a surplus.

That process was incredibly painful. Falls in GDP of 5% or more were not unknown. It also meant that after a year or so, most emerging markets had reached bottom. Their economies had adjusted, as had their currencies.

A year – almost – after its crisis, the US economy hasn’t endured a similar period of adjustment. Economic activity has slumped, but not fallen off a cliff. US households are pinched (and unhappy), but spending hasn’t collapsed. The US current account deficit has fallen, but not by much – the rise in the oil deficit has offset the fall in the non-oil deficit. Banks have depleted their capital, but I don’t think that they have – in aggregate – shrank their balance sheets. Then again some of the expansion of their balance sheets may not have been entirely voluntary, as off-balance sheet assets and liabilities moved on to the formal balance sheet.

Residential investment has fallen significantly as a share of GDP.

But in other ways, the US hasn’t adjusted.

Or rather, US policy adjusted so that the economy didn’t have to adjust as much. And other key countries – notably the countries that finance the US – didn’t adjust the policies (notably dollar pegs) that effectively compel them to finance the US. Many key countries -- notably China -- have exchange rate regimes that seem to require that they provide more financing to the US when the dollar is under pressure.

The US went into its crisis with a large current account deficit. And – as the Levy Institute (see Figure 2 here, and more here) and others, including Martin Wolf, have documented – the external deficit corresponded with a large deficit among America’s households. Households didn’t save. They also invested in new homes. As a result, US households were net borrowers from the financial system -- and ultimately from the rest of the world.

US firms weren’t all that exuberant in the run-up to the crisis. They weren’t investing all that much. PE firms were more exuberant, but their business strategy was based on gearing up existing cash flows to increase equity returns, not new investment. That is likely why the rise in business borrowing (see figure 3) late in the last cycle didn’t prompt a strong rise in business investment or overall growth.

The government was running a structural fiscal deficit. However, that doesn’t explain the persistence of the US current account deficit after 2004. From 2004 to 2006 the fiscal deficit shrank. In 2005 and 2006, the growing deficit of the household sector drove the expansion in the overall deficit.

The resulting overall external deficit was financed, at least in part, by the buildup of dollar reserves by the world’s central banks – not by a buildup of dollar-denominated financial assets among private investors abroad. Someone in London was buying US corporate bonds -- a category that includes a wide range of asset-backed securities. But the crisis has revealed (I think) that much of that demand came from vehicles sponsored by US and European financial institutions that funded themselves by borrowing dollars. They took on credit risk, not currency risk.

A year or so later, and not all that much has changed.

The US household sector still runs a deficit. Household savings isn’t falling anymore, but it also hasn’t really increased. Rising oil bills have eaten into spending on other items, but overall spending is holding up. Residential investment is down. But the household sector as a whole still runs a deficit -- though a somewhat smaller deficit than before.

However, the fiscal deficit has expanded. The government is borrowing, in a sense, to provide funds to cash-strapped households to support demand.

Mortgage lending hasn’t even collapsed. Demand for “private” mortgage-backed securities has disappeared. But the Agencies stepped in and bought mortgages both for their own book and for the mortgage-backed securities that they guaranteed. The Economist wrote last week:

"With the credit crunch, Fannie and Freddie have become more important than ever, financing some 80% of mortgages in January. So they will need to keep lending. Nor is their scope to offload their portfolio of mortgage-backed securities, given there are scarcely any buyers of such debt. And if the Fed has to worry about safeguarind Fannie and Freddie, can it afford to raise interest rates to combat inflation?"

The Economists thinks the Agencies’ financial weakness is a constraint on US monetary policy. The same might be said of the financial weakness of many private financial institutions. Even if US monetary policy isn’t constrained, there is little doubt that the Fed has stepped in to help the banks and broker dealers meet liquidity pressures without dumping their existing assets. A lack of confidence in “private” collateral that increased demand for treasuries in the US financial sector has been met by allowing a number of institutions to borrow the Fed’s Treasuries.

These steps avoided a super-sharp emerging-market style adjustment.

But a country that runs a large external deficit doesn’t need to just keep credit flowing inside its own economy so that existing “deficit” sectors can continue to run deficits – it also needs an ongoing flow of funds from the rest of the world. The US has gotten that, too.

Not thanks to private investors. Private demand for US debt has almost certainly dried up, though the limits of the TIC data make it hard to demonstrate this conclusively. The last survey concluded that all "private" demand for US Treasuries and Agencies came from financial intermediaries who sold their Treasuries and Agencies to central banks (there wasn’t an increase in private holdings from mid-2006 to mid-2007). If that is still true, central banks total purchases of US financial assets over the last 12 months are now running at close to $680 billion ($330 billion in recorded official inflows -- counting short-term flows -- and $350 billion in "private" purchases of Treasuries and Agencies). Private demand for US corporate bonds and equities, by contrast, has fallen sharply. Corporate bond purchases over the last 12ms were only $170 billion or so -- down from an annual pace of over $500 billion a year before the crisis. Demand for US equities is also down ($65 billion in the most recent 12ms v $175 billion in the preceding 12ms)

And remember, some "private demand" comes from funds that are investing for sovereign wealth funds.

Why has so much credit been available to the US during its crisis, when similar credit wasn’t available to emerging markets facing trouble? My answer is simple: other countries didn’t adjust their macroeconomic policies even as the US adjusted its policies – lowering rates, loosening limits on the Agencies so that they could expand their books and adopting a counter-cyclical stimulus – and the interaction between the shift in US policy and limited policy changes abroad produced the flows the US needed.

Europe kept its rates up. It even raised them recently. That pushed the euro up – and helped the US export sector. It also put pressure on countries maintaining dollar pegs, whose currencies were depreciating against the euro and whose central banks faced pressure to lower rates.

The PBoC didn’t exactly follow the Fed, and the RMB didn’t exactly follow the dollar. But the RMB generally fell v the euro. And while China didn’t follow the Fed’s rate cuts, it kept rates more less unchanged as inflation rose, pushing real rates down. That supported investment in China even as higher rates than in the US led to a surge in capital inflows and reserves growth. The RMB’s depreciation against Europe -- and the boom in resource exporting economies -- kept China’s export growth up. Net exports contributed positively to China’s growth in q3 07, q4 07 and q1 08 (we still don’t know for q2 08).

No adjustment there.

The Gulf kept its peg to the dollar (or in Kuwait’s case, a dollar heavy –basket); Russia kept its euro-dollar peg. Both increased spending and government-sponsored investment as well. The combination of wildly negative real interest rates, a nominal depreciation and fiscal expansion generated an enormous boom. But with oil prices rising faster than spending and speculative pressure on dollar pegs, it also required a huge increase in the foreign assets of the oil-exporting economies government. The oil-exporters basic macro policy stance – dollar pegs, fiscal expansion when oil is high (and contraction when it is low), and monetary policy imported from the US – didn’t change.

The overall result was an increase in official asset growth -- which has been running at close to $400 billion a quarter recently, or over two times the size of the US deficit. A tiny bit of that went into US and European financial institutions during the early stages of the crisis – at considerable cost to the sovereign funds that made the investment. But most has gone into safe US Treasuries and into Agencies.

Kevin Drum – rifting off Dr. Duy’s Magnus Opus – argues that the system will be stable so long as foreign investors continue to have "faith .... in America as a good place to invest their money."

I don’t think that is right. The US hasn’t been a good place for foreign investors for some time, now: US rates haven’t compensated for the risk of dollar depreciation, and US equity markets generally have underperformed. That hasn’t kept foreign governments from buying. Their demand for dollars reflects their decision to manage their currencies against the dollar -- not their assessment of the dollar’s attractiveness as a store of value. The worse the dollar does, the more foreign central banks tend to buy ...

Foreign governments have been willing to take on the currency risk associated with financing the US. But foreign governments didn’t want the credit risk associated with lending to US households. The US government – and its intermediaries, notably the public-private Agencies – stepped in, helping the market to clear and avoiding a sharp contraction in global demand.

That, at least to me, explains in broad strokes how we got where we are.

The policy response to the subprime crisis has avoided the sharp adjustment that many feared. But it also meant that many of the underlying imbalances haven’t really corrected. The composition of the US current account deficit has changed – the oil deficit is bigger, the non-oil deficit is smaller; the fiscal deficit is bigger and aggregate deficit of households is smaller - but the aggregate deficit remains large.

And the rest of the world’s imbalances haven’t corrected either. China’s economy remains unbalanced. The oil surplus has gotten bigger.

Hence it is possible to argue -- see Yves Smith -- that risks are still increasing.

Or it is possible to argue that the existing system has demonstrated its resilience under stress, and there isn’t good reason to think it will break now if it survived the stresses of the last year.

So far, the US has been both “too big to fail” and “too big for the emerging world to save" without incurring real costs.

The costs of dollar pegs are more and more apparent. But the costs of letting go now – before private demand for US assets has materialized or the US deficit has shrunk to a level that could plausibly be financed by a modest pickup in private demand for US assets – are also high.

I have no clue how long an equilibrium based on not letting go can last. Policy makers have succeeded -- even the absence of overt coordination -- at avoiding the worst. That is a good thing. But I would be a bit more comfortable if a bit more adjustment had happened over the past year.

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