09.29.08
The meltdown — Why global markets punish poor economic policy.
A number of months ago, I blogged about the interconnectedness of modern financial markets. The events of the last month have clearly demonstrated this.
We have to look back about a decade for the origins of the crisis which had its origins in the US policy to promote home ownership. In 1997, the US changed its rules on capital gains to allow individuals to avoid (on two properties no less) capital gains tax on less than $500,000. (Remember that the US allows a personal tax deduction on interest only for those associated with a home mortgage.) After that, banks and other lenders began liberalizing the documentation required to get home loans and lots of people qualified for loans that previously couldn’t. People do react to the economic incentives around them and the prices of houses in real terms began to soar — who couldn’t afford to be part of the great bonanza provided by Uncle Sam.
A second enabling factor was the huge fiscal deficit by the United States. George W. Bush decided to fight two global wars without a tax increase. The result was over a trillion dollars injected into the economy.
Next, the expansive fiscal policy was complemented by an accommodating monetary policy. From early 2001 when the tech downturn took place and accelerating after the 9/11 attacks, the Fed cut and maintained interest rates at very low levels. From their point of view, the Fed looked at domestic inflation and saw little impact, but did see a continuing weak economy. It continued its accommodating monetary policy into 2005-7.
Both the White House and Fed saw the positive impact of their policies in a steady US expansion. What they missed were the negative results. First, despite the grossly expansionary fiscal and monetary policies, there was little US inflation as measured by the CPI or WPI. Why — first of all housing prices were not included in the CPI — only rental prices as a proxy. Secondly, Washington didn’t look at the role of international markets. - specifically tradable versus non-tradable goods and services.
While US prices have not move dramatically over the past years, the subsets have. Internationally traded goods — like food, clothing and consumer goods — have shown little growth and in the case of electronics, prices have fallen. Why? Because as international trade barriers have fallen, cheaper international goods have flooded the US marketplace. The consumer has profited from lower prices. There have been negative effects for those workers in those industries who saw their jobs move overseas. Non-traded goods, like health care and education, soared since consumers had extra money in their pockets (often after having taken out second mortgages on their homes that suddenly were worth much more). And the non-traded good with the largest price increase — houses — were excluded from the index. In short, we exported part of the inflation (and at the same time lots of US jobs) and we were baffled at why education and health care continued to rise far faster than the CPI.
As Americans purchased more goods and services from overseas, the trade and current account deficits soared. Suddenly there were lots of US dollars flooding world currency markets. Here comes in the last element — normally, the rates of exchange would have corrected themselves by making dollars cheaper, pushing exports and decreasing imports. However during most of this time, China wanted to keep its exchange rate fixed to ensure continued export competitiveness. The Chinese were able to support the RMBI only by buying up the excess dollars, with which they bought US Treasury notes.
US home prices started turning down in late 2006 and accelerated this past year. As a result, many found their home prices less than the mortgage, causing defaults. That cascaded from the mortgage holders to the guarantors of the mortgages (Fannie Mae and Freddie Mac) to the investment banks (Bear Stearns, Lehman Brothers) to the insurers of the derivatives (AIG). At the same time, the Chinese government lost the capacity to control the influx of cash and resultant inflation. It has let the RMBI appreciate at a 15% per year rate and took severe measures to restrict the leverage of the Chinese banks. When the financial crisis hit in the US, the Chinese were also worried about buying US securities, accelerating the global credit crunch.
What’s the moral in this? Bad economic policy catches up with you. In this interconnected world, the results may be less easy to see, but the markets eventually punish excesses. So for all those who say Wall Street greed led to the collapse, you missed the essential elements. The bubble couldn’t have built up except for huge fiscal deficits, tax policy pumping up one sector, accommodating monetary policy and attempts internationally to fix exchange rates. Wall Street firms are supposed to be greedy — it’s the job of the politicians and ordinary citizens to make sure that this doesn’t happen.
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