When I was in high school there was a national discussion of economics. Actually, there was a national discussion about one economic question. The question was, “are we in a recession?” We can predict the movement of the stars, but here we are, in 2007 and 2008, and the great question of the time was, “is the boat sinking?”
Today I want to frame the coming international economic discussion. First, I’m going to talk about the Great Recession. Second, I will introduce problems with economics. Last, I’m going to make some simple recommendations.
This shows United States GDP growth from 2003 to 2010. This red part is quite obvious. It is the start of the “Great Recession.” Before 2007 American banks approved mortgages to people who couldn’t make payments. Then banks used those mortgages as assets for other liabilities or as bets, because mortgages were seen as safe assets. Who wouldn’t pay for their house? When people didn’t make payments, banks lost money on the mortgages and the liabilities those mortgages were bet against. Of course this is a large simplification. There are many other note worthy stories, but this blog post if only interested in the most essential fundamentals.
The biggest questions after the recession was, “why did banks make these high risk loans?” Ben Bernake, who served as American Federal Reserve chairman from 2006 to 2014, had an answer before the crisis. Mr. Bernake knew there were economic problems in America, and he knew it from this.
This is America’s trade deficit. In 2005 Ben Bernake wrote that America’s trade deficit was a sign of major concern:
Investment by businesses in equipment and structures has been relatively low in recent years and because the tax and financial systems in the United States and many other countries are designed to promote homeownership, much of the recent capital inflow into the developed world has shown up in higher rates of home construction and in higher home prices.
-Ben Bernake
The inverse of a nation’s trade account is a nation’s capital account. If America has a trade deficit, America must also have a capital account surplus.
- 2006 U.S. current-account deficit: $856.7 billion
- Foreign-owned assets in the United States increased $1,764.9 billion in 2006
- U.S.-owned assets abroad increased $1,045.8 billion in 2006
- U.S. capital account surplus = $719.1 billion in 2006
This means that countries invest more in America than America invests in other countries. This means that America’s banking system, as evidenced through its trade surplus, had huge amounts of excess cash.
Bernake worried foreign money lowered interest rates and lending standards. When Bernake saw the trade deficit, he worried about America’s capital account.
Discussion of economics changed quite a bit since I was in highschool. Now, the discussion is centered on changing rules of trade. The current discussion is focused on two aspects: trade accounts and technology competition.
However, little attention is paid to capital account flows. Remember how Bernake saw the trade deficit and worried about the foreigners investing in America? Well America’s capital account was worse than Bernake realized.
The downward-pointing bars before 2008 indicate large outflows of capital from the US through the banking sector, which then re-enter the United States through the purchases of non-Treasury securities. The gross capital inflows to the United States represent lending by mainly European banks via the shadow banking system through the purchase of private label mortgage-backed securities, the same securities that caused the recession.
1.) By mid-2008, 50% of the assets of U.S. prime money market funds were short term obligations of foreign banks, with the lion’s share owed by European banks.
2.) Since the Eurozone has a roughly balanced trade account while the UK is actually a deficit country, their collective net capital flows to the United States do not reflect the influence of their banks in setting overall credit conditions.
3.) USA trade deficit 2006 – 6.5% of GDP
Gross capital account flows to the USA 2006 – 23% of GDP
The central message of this post is that the current account may not be as informative about overall credit conditions as gross capital flows, especially gross capital flows generated by the banking sector.
A new discussion of economics that will change the way we trade will soon happen, and it cannot only focus on trade and technology. International capital accounts must be studied. There must be new rule sets regarding current account balances, technology theft and distribution, and capital account balances. Capital account activity is no longer the residual of fair trade in tangible goods.
The sky in Beijing is grey today. Have a good weekend.
Writing in Grey 