Wednesday, April 23, 2008

Pearlstein on burst bubbles

I've written before about how low interest rates have fueled consumption in the US and how, in turn, this consumption has helped countries that export to the US, notably the oil producing nations and China. I've been a little fuzzy about one aspect of this bilateral binge. The cycle of accelerating indebtedness and import frenzy has been accompanied by the purchase of huge chunks of US debt by foreigners (among them the oil producers and China). But with low interest rates these investors in American debt might have sought to put their money elsewhere, where it would earn a greater return.

Why have foreigners continued to invest in US debt when there has been more money to be made through investments elsewhere at higher return?

To some extent they put money into the US financial markets because that enabled Americans to continue buying from them. To some extent because the huge imbalance of trade between the US and other nations resulted in huge stores of US dollars that needed, one way or another, to be repatriated. To some extent since the US dollar is the defacto medium of exchange across the globe and, because of that, all nations have an interest in preventing its collapse. (A collapse that would probably result from failure of foreign nations to finance US deficits and its those foreigners financing US deficits enabled the US to keep interest rates low.)

But to some extent the put their money into the US financial markets because they see the US mainly as a customer for their output (whether oil or t-shirts). They see themselves as producers more than as investors. Their dollar hoards are more of a problem for them than an opportunity. Yes, they represent wealth, but -- such is their abundance -- these hoards need to be carefully managed to insure that the main business -- production -- continues to grow.

All this is long preamble to a link to a current article by Steven Pearlstein. He writes today about how the habit we Americans have of living beyond our means is a main source of the financial crisis we have created and the world now suffers from. In doing so he draws attention to the phenomenon I've just drawn attention to. I urge you to read the article.

Its upshot is what many have already said, global prosperity cannot be sustained simply by the huge amounts of over-consumption we've seen in the US over recent years. There has to be an international rebalancing. He says we Americans have been living way beyond our means, consuming more than we produce and investing more than we save. Other nations, such as China and Saudi Arabia have been willing to finance our trade deficit on easy terms because it allows them to peg their currencies to the dollar in a way that generated higher job creation and economic growth in their home markets. This mutually advantageous imbalance in trade and investment flows has created a huge supply of cheap dollar-denominated credit that virtually invited the bankers and brokers and rating agencies and private-equity firms in U.S. markets to throw caution to the wind and make ill-advised lending and investing decisions.

Some excerpts:
If this is the case -- if the story of the credit bubble and its bursting is more fundamentally about macroeconomic imbalances than microeconomic failures -- that has very different implications for where we go from here.

For what it means is that things won't be "fixed" simply by having the financial sector write off its losses and bad loans and promise to do a better job next time with risk management. Rather, it will require a reduction in the overall standard of living in the United States so that the country as a whole begins to live within its means.

What does that mean exactly?

In practical terms, it means that households will have to reduce consumption, increase savings and stop piling up credit card debt or using home equity as an ATM.

It means that the federal government stops running huge operating deficits by raising taxes or dramatically cutting national security and entitlement spending.

Such a broad reduction in wealth and living standards will take many forms. It will come in the form of higher unemployment and stagnant wages and falling income, which take statistical form in slower or even negative economic growth. It will come in the form of inflation and its first cousin, a lower value for the dollar. And it will manifest itself in lower values for pension funds, 401(k) accounts, university endowments and house prices.

You don't have to have a PhD in economics to see that this adjustment is underway. But it would be folly to assume that it is anywhere near completion. After all, it took many years for our collective standard of living to get out so far out of whack, and it's highly unlikely that we are somehow going to reverse things in a couple of quarters. And the bubbles in commodities and commercial real estate are still to pop.
What Pearstein doesn't say, because it's not his subject, is that the producing nations whose exports we have been consuming are becoming disenchanted with the US market and the US dominance in world finance. China is diversifying its manufacturing, finding a growing number of customers outside the US, and, by the growing prosperity of its citizens, making its own internal markets. Saudi Arabia and the other oil producers are finding other markets as well, notably within the newly-emerging economic powerhouse countries -- that is China, India, much of South-East Asia, and, eventually within Latin America as well. Along with this the decline in value of the US dollar is encouraging money men to think of international finance in terms of a market basket of currencies, including notably the euro as well as the dollar. The evolutionary impulse of these two shifts will reinforce the changes that Pearlstein predicts.

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