Up The River Without A Paddle

9/20/2008

BY: STANTON BRAVERMAN

copyright 2008

Today is September 20, 2008 and the US is in the midst of a very serious financial crisis. It is difficult to determine who is primarily responsible for it. A number of people point to Bush and his policy of leaving the financial institutions significantly unregulated. Others point to Greenspan who kept interests rates artificially low for a long period which gave a significant implied subsidy to the banking industry. But actually the crisis was slowly brewing for many years and is indicative of the weakness of the international trade, finance and economic system.

What brought the crisis to a boil was a perfect storm. First, the artificially low interest rates in the US encouraged significant economic distortions. It encouraged the boom in the housing market and the creation of a variety of financial securities that should never have existed. The other storm was the willingness of many foreign countries to accumulate US Treasury notes and other US securities at excessively high levels. There seemed to be an insatiable need for these securities by central banks, the amount of which was given to the IMF as a measure of the countries economic performance. The third storm was the reckless behavior of the Bush administration in running up the national debt to levels that had never been reached before. It was these there elements that came together to cause the crisis.

The question is what would have happened if any one of these elements had not occurred. Suppose the Fed let interest rates go to their real market level? Suppose China and other countries refrained from accumulating huge dollar reserves? Suppose the US debt was kept in limits? These are interesting questions but difficult to answer. It can be argued that that if all of these storms had not existed, it is probable that sooner or later the crisis would have occurred and that is because of an inherent weakness of the international trade system. This weakness is that the system has been operating under two different economic concepts. The first is an old concept that many economist claim has been dead for a long time which this writer feels is not true. That system was known as mercantilism. It is a concept of trade where a country measures its wealth based on the amount of gold in its treasury. Economic policy focuses on protection of local markets and the accumulation of gold. While today the gold trade is not a serious aspect of the international market and has been replaced by US dollars, many countries still maintain economic policies based on the concept that as long as foreign reserves are growing the economy is in good shape.

The other economic theory that existed is referred to as free markets or international comparative advantage. The idea is that the country that produces a particular product the cheapest should be the source of the product for the world. If China which has a highly protected market sells an item on the international market for less than a US manufacturer then the market goes to China. This concept was followed by the US since WW II while mercantilism to varying degree has been followed by almost every other country in the world. The system allowed the US to buy huge amounts of foreign goods and pay for them with dollar securities. The excess dollars floating around the world that resulted from huge US budget and trade deficits were gladly accumulated by central banks and turned into Treasury bonds and other obligations of major US companies. This interplay between two different systems allowed Western Europe to rebuild after the war and then allowed for many less developed countries to significantly develop. The dollar accumulations in the central banks of the less developed countries gave the country the confidence to proceed with major industrialization. The two systems worked side by side for over fifty years in a way that seemed to benefit both sides. But sooner or later the system had to fail. The US could not go on forever paying for imports with dollar securities while at the same time the over valuation of the US dollar slowly killed off almost all of US manufacturing. What the perfect storm did was show the weakness of the system and that some how or some way it must end – but how?

The current crisis in large part was pushed by the concerns of many foreign countries as to the value of their foreign exchange reserves. As the price of the dollar has fallen in the international market in recent years, the real value of dollar reserves has also fallen. This fall in value is expected by central banks. Add to this the sudden loss in value of many dollar denominated securities because of the financial insecurity of the underlying banks. The clear example of this is with Fanny and Freddy with over 4 trillion dollars in outstanding debt in sub prime loans and other securities. It was the pressure of the central bankers on the USG to find a way to guarantee these securities that led the Treasury to nationalize these two companies. (About that time there was a NYT article that reported that one official in China had said that their monetary losses in real value were enough to fund 200 nuclear powered aircraft carriers which cost about $4 billion each.)

Right now the US financial industry and the US government are running around trying to find a way to further patch up the weaknesses in the US and ignoring the world wide problems. It is not clear if they will be successful but unless certain changes are made in international economic behavior then sooner or later (probably sooner) the pot will boil over again. The weakness is that the US is considered to be the world powerhouse in that everyone looks to the US. China, Japan and other countries look to the US to sell their goods. It is important to them that they maintain a surplus in their trading accounts. Failure to do so is seen as a threat to their long term competiveness.

In these countries the savings level by the public is high, industrialization leads to the creation of a huge amount of goods that have to be sold some place and the best place to sell it is in the US. This is the country where the saving rate tends to be low and demand for goods is very high. The US is the market and they are the producers. The US paid for a lot of what it bought with dollars and the producers were happy to get it. But now they have too many dollars and do not want more and the US does not have a way to pay of all that we want from the producing countries. Yet the producing countries have to go on producing and their products have to be sold someplace. In effect the international system is out of kilt and confused.

What a time for the pot to boil over. The US budget deficit is over $400 billion and it is getting difficult to finance this deficit. Add to that the cost to the Treasury of the Fanny and Freddy takeover, the cost of buying every defaulted mortgage in the US, the cost of guaranteeing the money market for the next year, to cost of the Bear Sterns buyout. The US debt which is currently at all times high has now more than doubled after assuming all the debt of defunct US companies. Nobody knows what to do or what is ahead for the banking industry. This writer believes that things will not get better until the international community recognizes that it is not a US problem but an international problem and that the way two different concepts of international trade have to be changed. That is a situation that will not be recognized until the whole international community is affected by the events in the US and they should be felt sooner than later.

Many commentators on TV and the newspapers comment that US officials know what to do from reading lessons of the Great Depression. Unfortunately this may not give much useful advice. When the New Deal came into office and saw the economy going down a rapid and uncontrolled river they had two oars to use. One was monetary policy. This was possible because interest rates at the time were relatively high and by increasing the money supply they could force the rates down to levels that could attract investment. The second oar was fiscal policy. This was possible because the federal debt was at low levels. The administration planned to spend up to $80 billion to deal with the situation. Today we are in the same river that is rapidly taking us into serious waters but we do not have either monetary or fiscal policy oars to use. Interest rates are at such low levels that lowering them will not excite anyone to invest and the federal debt is so high that it is not possible for the Treasury to borrow which means continued deficit spending can be very inflationary. In effect this time we are up the river without a paddle.

What is required to get out of this mess is for the international community to accept the fact that the US dollar has to be devalued to allow for US products to be internationally competitive. This means that the US will no longer be the dumping ground for massive products produced abroad and allow the US manufactures to once again be part of the international market. At the same time the US government has to reduce the budget surplus and to the extent there is a surplus then it has to be funded by the US economy and not by foreign central banks. But this is a very painful way of adjusting the world economy and cannot be done over night. In the meantime, as the world changes in this direction the foreign central banks need to continue accumulating US securities but at lower and lower levels.