Affordable Housing Institute : US

Which is cause, and which effect?

 

For every effect, there must be at least one cause.  For there to have been a massive runup in the prices of financial assets, aside from a massive compression in risk spreads, there must have been a glut of money – specifically dollars – to buy them. 

 

Where those dollars came from is the subject of a provocative and compelling Financial Times article, Asia’s Revenge, by Martin Wolf, who as the author of Fixing Global Finance knows whereof he speaks.

 

Wolf: ready to fix what’s broken?

 

“Things that can’t go on forever, don’t.”

– Herbert Stein, former chairman of the US presidential Council of Economic Advisers

 

Money is a commodity like any other, and like those other commodities, money is useless if idle, where it not only receives zero nominal return but also suffers slow depreciation (through inflation).  As Sir Francis Bacon put it, “Money is like muck, not good unless spread.“  Money is useful only if put to work – in the form of hard debt or hard equity.  

 

Being a commodity, money has a demand – people who go to the money store needing it for investment – and a supply, people who come to the money store looking for yield. 

 

 

When the supply of money (that is, people who want to invest) exceeds its demand (quality investments to make), two things happen:

 

* Yields go down because money becomes cheaper.

* Investments increase as new products are invented and come into the marketplace.

 

If the world has more wine drinkers than vineyards, marginal soils are planted and plenty of plonk is sold and drunk.

 

If only securities had been so accurately labeled

 

That, in essence, is how Wolf sees our current credit mess – as the inevitable consequence of enormous global money supply over global financial demand.  As he writes:

 

What confronts the world can be seen as the latest in a succession of financial crises that have struck periodically over the last 30 years.  The current financial turmoil in the US and Europe affects economies that account for at least half of world output, making this upheaval more significant than all the others.  Yet it is also depressingly similar, both in its origins and its results, to earlier shocks.

 

Basically, anyone who makes a ton of money faces the problem of what to do with it.  Banks don’t pay a statutortily mandated return; they raise and lower their deposit rates to get the money they need for the loans they want to make or have made.

 

To trace the parallels – and help in understanding how the present pressing problems can be addressed – one needs to look back to the late 1970s. Petrodollars, the foreign exchange earned by oil exporting countries amid sharp jumps in the crude price, were recycled via western banks to less wealthy emerging economies, principally in Latin America.

 

Using oil as a bath product didn’t work so well

 

In crude terms of barter, oil pumped out of the Arabian desert was turned (via the intermediation of money) into high-rise blocks and expanding businesses in Latin America.  The net capital flow was south-to-south, except for a detour to be ‘refined’ in the north’s banking houses.

 

This resulted in the first of the big crises of modern times, when Mexico’s 1982 announcement of its inability to service its debt brought the money-centre banks of New York and London to their knees.

 

At the international level, when you have big mismatches of capital flows, you balance them – money moves, in bulk, from one country to another. 

 

Something’s out of whack here

 

That leads, in the recipient country, to supply (of money) over demand (for money).  The result, in that country,

 

Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard University identify the similarities in a paper published earlier this year.   (Is the 2007 US subprime financial crisis so different? An international historical comparison. Working paper 13761, www.nber.org.)   They focus on previous crises in high-income countries. But they also note characteristics that are shared with financial crises that have occurred in emerging economies.

 

The Reinhart/ Rogoff paper is well worth the $5 it may take you to get a download.  It’s short, accessible, and compresses enormous data sets into visually comprehensible presentations like this one:

 

From Reinhart/ Rogoff: housing price inflations compared with previous crises

 

The graph visibly illustrates two features of the US housing rise: It was bigger, relative to previous inflation, than the previous developed-world crises, but house prices were coming down (in real terms) a little even before the crunch hit.  While the timing may help us – as may the world’s appetite for US assets, which is distinctive compared with the other large nations – having risen so high is not exactly confidence-inspiring relative to the potential downturn.

 

The higher you rise, the bigger the splash?

 

Back to Martin Wolf’s international perspective:

 

This time, most emerging economies have been running huge current account surpluses. So a “large chunk of money has effectively been recycled to a developing economy that exists within the United States’ own borders”, they point out. “Over a trillion dollars was channelled into the subprime mortgage market, which is comprised of the poorest and least creditworthy borrowers within the US. The final claimant is different, but in many ways the mechanism is the same.”

 

Thus oil pumped out of the Middle East has been bartered into subprime and CDO slices in the US. 

 

Quite reasonably, the energy exporters were transforming one asset – oil – into another – claims on foreigners.

 

There’s a cynic’s equity here: we overpay for oil, with our overpayments you buy our overvalued financial concoctions. 

 

Who out-traded whom?

 

The links between the financial fragility in the US and previous emerging market crises mean that the current banking and economic traumas should not be seen as just the product of risky monetary policy, lax regulation and irresponsible finance, important though these were. They have roots in the way the global economy has worked in the era of financial deregulation.

 

Any country that receives a huge and sustained inflow of foreign lending runs the risk of a subsequent financial crisis, because external and domestic financial fragility will grow.

 

Financial flows have their edges

 

This statement, sharp as a sword, cuts two ways, and if true has enormous implications not just for capital markets but for housing globally.

 

Basically, Mr. Wolf is saying that trouble always ensues when there is a huge imbalance between a nation’s production of money and its ability to absorb that money productively (into income-producing assets).  If they are out of balance, capital flows out of Country A and into Country B, inflating Country B’s asset values.  (If you have trouble with A and B, imagine Country A is China and Country B is America.  It’ll become very clear.)

 

Joined at the flag?

 

In explaining what had happened, Ben Bernanke, when still a governor of the Federal Reserve rather than chairman, referred to the emergence of a “savings glut”. The description was accurate. After the turn of the millennium, one of the striking features became the low level of long-term nominal and real interest rates at a time of rapid global economic growth. Cheap money encouraged an orgy of financial innovation, borrowing and spending.

 

Yield hunger drives investors out of Country A; it drives investment bankers in Country B to create new products to soak up the demand. 

 

 

That means both inflating asset prices and a decline in asset quality as more money chases fewer quality assets.

 

That was also one of the initial causes of the surge in house prices across a large part of the high-income world, particularly in the US, the UK and Spain.

 

Inflating asset prices is the sword edge that cuts the capital recipient country; infrastructure and asset under-investment is the sword edge that slices the capital exporting country.  In the US, we found that if corporations or financial institutions pull money out of an area, through deposits or profits, that they reinvest elsewhere, the result is unintentional but debilitating disinvestment within the community.

 

Despite being a huge oil importer, China emerged as the world’s biggest surplus country: its current account surplus was $372bn (£215bn, €272bn) in 2007, which was not only more than 11% of its gross domestic product, but almost as big as the combined surpluses of Japan ($213bn) and Germany ($185bn), the two largest high-income capital exporters.

 

If you’re making all your money in Country A (China) and investing it in Country B (America), by definition you’re not reinvesting enough in Country A, and sooner or later – probably sooner – that gets you.

 

Last year, the aggregate surpluses of the world’s surplus countries reached $1,680bn, according to the IMF. The top 10 (China, Japan, Germany, Saudi Arabia, Russia, Switzerland, Norway, Kuwait, the Netherlands and the United Arab Emirates) generated more than 70% of this total. The surpluses of the top 10 countries represented at least 8% of their aggregate GDP and about one-quarter of their aggregate gross savings.

 

Meanwhile, the huge US deficit absorbed 44% of this total. The US, UK, Spain and Australia – four countries with housing bubbles – absorbed 63% of the world’s current account surpluses.

 

The world was awash in cash.

 

You might have thought that a good thing:

 

I thought selling my stock was a good thing …

 

[Concluded tomorrow in Part 2.]

 

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