I've posted comments to several SA posts regarding the late unpleasantness in the financial markets, and I want to pull together the basis for those comments in one allegedly coherent narrative. The material sea-change that accounts for the financial crisis and its sequellae, I believe, is globalization, itself the result of ocean-shrinking technologies.
The Trade Deficit.
Americans started losing jobs to imports some time ago, but the decline really accelerated with the advent of capitalism in Communist China. That country’s governmental “technology” seems to have evolved from a totalitarian state to an authoritarian one. There is no more political freedom than before, but there does seem to be some de facto democracy, in that leaders are subject to internal criticism based on the results they achieve as perceived by constituents.
Be that as it may, the ability to export to the US and Europe has made capitalism a viable approach to Chinese development. Absent those mature consumer markets, it would have been impossible for China to develop a manufacturing base, as they would not have had the customers for the scale of production that would make the capital investment worth the trouble. But once globalizing technology made capital investment in manufacturing worth doing, and the bosses figured out that there was a political payoff in prosperity, the genie was able to escape the bottle.
International trade is based on comparative advantage. The shrinking of the oceans has created competition between US and Chinese workers. China has a comparative advantage in cheap labor and, therefore, in labor-intensive manufacturing. We have a comparative advantage in high-tech, capital-intensive manufacturing. They sell us labor-intensive goods, and we sell them capital-intensive ones. That trade follows from the usual understanding of comparative advantage.
But International trade is just a special case of a more general concept of comparative advantage. If I buy a widget from you, it’s because you have a comparative advantage in widgets (i.e., it is easier for you to produce widgets than money), and I have a comparative advantage in money (i.e. it is easier for me to produce money than widgets). It does not matter that you are richer than me. Trade operates on comparative advantage: no matter how much money you have, your ability to produce widgets is greater, relative to your ability to produce money, than mine because I can’t produce widgets at all, and, my ability to produce money is greater, relative to my ability to produce widgets, than yours because you can produce widgets if you want to.
This generalized approach to comparative advantage explains why China is willing to run so large a trade surplus with the US. Our demand for labor-intensive Chinese goods is greater than China’s demand for American capital intensive ones, and we run a major trade deficit with China as a result. Why do the Chinese tolerate this imbalance? Why don’t they sell somewhere else? The reason, I think, is that the US has a comparative advantage in the distribution of consumer goods. Compare what happens when a boatload of Chinese TV’s arrives in New York Harbor to what happens when it arrives in, say, Beijing. Where will it be more easily off-loaded, trans-shipped, advertised, sold, and financed? Even with the improvements in China’s physical infrastructure, their consumer is not yet as willing and able as ours to absorb their goods. We are better at consuming their goods than they are, so they sell them to us instead of to themselves.
Of course, the goods-for-distribution trade is inherently imbalanced. If a TV costs $100 to make and $100 to distribute, then, in terms of international trade, it’s as if American consumers are paying $200 to the Chinese for the TV, and the Chinese are paying $100 to Americans for distribution services. No matter how much the distribution costs, the amount going to China exceeds by $100 the amount “coming” to the US . The result is a soaring trade deficit with China and a loss of labor-intensive manufacturing jobs here. Defenders of free trade say that such dislocations are only temporary, that the system adjusts to create good jobs in some other industry in which we have a comparative advantage. It’s just not clear what those are or how quickly they will arise. And in the long run, as the man said, we’re all dead.
And then, of course, there’s oil. Thanks, maybe, to Three-Mile Island, and to our domestic oil industry’s political clout, and our stubborn refusal to do what’s best for ourselves, we cannot get off of foreign oil. If we got as much of our energy from nuclear energy as France, we would not be drilling in the deep water off our coasts. But we are. More to the point, we also have a significant trade deficit with oil producers. The deficit has been cooled by the recession, but the subject today is what caused the recession, not what the recession caused.
The Repatriation Challenge
The trade deficit sends dollars abroad. What are our trading partners to do with them? International trade outside the US can be conducted in dollars, so some of the dollars stay off-shore, which is bad for our multiplier, but we can always print more dollars if we need them. The bulk of the money we send abroad, however, is reinvested here. (The Chinese are running a trade deficit of their own, worldwide, so our dollars are coming back from China's trading partners, but it's coming back nonetheless.) And the larger our deficit grows, the more important those dollars become as a source of capital for US users, and the less so are the traditional sources of capital, viz., domestic banks.
This change in the source of investment capital has changed how money moves in the US. Instead of the proceeds of consumer sales finding their way to local banks and then back out as local bank loans, the money goes abroad and comes back through Wall Street to buy securities backed by the loans that the local banks make. This shift makes retail bankers into loan brokers, whose interest is not in the quality of the loan but in the price it will fetch in the secondary market. That price is a function of the rating on the securities and the demand for securities of any given rating. And the demand is based on the growing reserves held by our trading partners and their appetite for risk.
Foreign holders of US reserves are more homogeneous than the investment public at large; they want very safe paper, and so it has become Wall Street’s job to find it or make it. The demand for highly-rated paper was formalized in the Basel II accords, which prescribed capital requirements for banks that have been adopted in several places, including the European Community. Under those standards, a bank needs much less capital to invest in AAA-rated paper than in anything else, so the demand for such paper soared. The aggregate effect of these changes was tremendous pressure on Wall Street to generate AAA-rated paper.
But there is just so much AAA-quality credit. That problem can be cured in two ways. One way is to pretend that bad risks are good ones. Under the “issuer-pays” business model followed by ratings agencies, that proved surprisingly easy for investment bankers to persuade the agencies to do. But in order to do that, there had to be some investment that could at least ostensibly support that rating. Enter the subprime mortgage. Originated by someone with no stake in their performance and sold by investment banks with no stake in their performance, but bearing a political American Dream halo and AAA-ratings (at least some tranches), these securities poured out of Wall Street into the waiting maw of the world's Basel II-ized banks.
The other way to increase the supply of AAA-rated paper is to invent it from whole cloth. In 2000, Congress passed the Commodities Futures Modernization Act of 2000, which essentially allowed investment banks to make book on the performance of existing securities. A bet that an AAA-rated security will perform can be as safe as the security itself. These derivative securities and synthetic instruments – another new technology – made possible the processing of virtually unlimited amounts of money, in part because big U.S. institutions like AIG acted as counterparties on the risk.
In the search for people to blame, regulators early on identified the risky bets made by investment bankers with little capital. These bets certainly contributed to the collapse, but the dollars did have to be repatriated, and, in the financial world, leverage is bandwidth: without it, the volume of business that can be transacted could not have kept up with the demand for highly-rated paper. It might have been reasonable to argue that if bankers' leverage were restricted, foreigners would not want dollars, but recent history suggests that the foreign money would simply have gone into Treasuries, as it does now. Our trading partners really, really want to keep selling to us.
Derivative securities, especially short-side derivatives, essential to the issuance of some long-side ones, affect the financial system differently from the underlying investments on which they wager. The problem is moral hazard. In its most general version, moral hazard is the risk that a party to a bet will act so as to change the odds. The notion is usually applied to insurance, where insured people tend to take greater risks because the damage will not fall on them, but the idea applies as well to any immunity to consequence, e.g., politically mandated bail-outs, and, more important, it applies to any bet that can be rigged.
Every sports fan knows that when serious money is bet on an event, the temptation to fix the event becomes very strong. My blog started with a rant about Credit Default Swaps issued to speculators, who then worked, through naked short selling and other tricks, to bring down the subject credits. That they did, and the dominoes started to fall. Fortunes were lost, spending fell, credit froze up, and recession set in. The Congress is still working on financial regulation legislation, but it is not likely that it will go as far as is necessary to get rid of that sort of betting.
The moral hazard created by naked short-side bets was a major factor in the recent financial upheaval. I find it sadly ironic, then, that the solution to the problem – TARP – is so often criticized for creating moral hazard.To create a total collapse of our financial system, the taxpayer had to bail out failing banks and insurance companies, and, to the consternation of the torch and pitchfork crowd, their politically unworthy counterparties. The payments to the counterparties were somehow taken by demagogues as proof that the bail-outs were unnecessary or, at least, unnecessarily generous. But the bail-outs could only have succeeded as bailouts if they stopped all the dominoes from falling.
As Rahm Emanuel is said to have said, a crisis is a terrible thing to waste. The amount of money going abroad has declined by reason of the recession, but the US is still running a large trade deficit, and money is still coming here looking for a home. But now, with the ratings agencies credibility gone and the “AAA-rated” brand destroyed, the only AAA-credit that anyone trusts is Uncle Sam’s. Thus, despite a spiraling Federal deficit, foreign banks and American savers are lending money to the Federal government at historically low interest rates.
This change in financial appetites should not be wasted. The government should seize the opportunity to undertake massive infrastructure projects, putting people to work using funds borrowed now (and not later, when the permits are granted and environmental impact statements are done, and interest rates have risen in anticipation of the work starting). This opportunity to upgrade our infrastructure may not come again. Of course, I don’t for a minute believe that such projects can be sold on the rational basis that exists for doing them. But I have infinite faith in our politicians’ ability to find some other reason to do what material conditions demand be done. By the middle of 2011, it will be clear to President Obama that the jobs lost to cheap labor are not coming back. Something more will have to be done to create jobs, and the infrastructure and cheap foreign money will be sitting there...
Lowering taxes will not help restore the private economy even when infrastructure projects have primed the pump. Tax cuts are a supply-side solution, and the only problem with supply is that we cannot effectively compete with China to supply it. Reducing business taxes would make us less uncompetitive, and that might be part of a strategy we could use, but the real problem is that globalization has put the comparative advantage in labor-intensive goods across the shrunken oceans, and nothing we can do in the way of domestic incentives can fix that. Meanwhile, our politicians tie themselves in knots over illegal immigration, when the real problem is "virtual" immigration. When a Chinese farmer moves to Shanghai to make cell phones for Americans, he becomes part of "our" labor force and keeps wages in it down. He takes a job from an American as surely as someone who sneaks across our borders. We used to have a competitive moat around us called the ocean. We need to replace that moat with tariff walls. Let China grow its domestic markets to where its employees live as well as ours. Then we can get rid of the tariffs and compete on quality.
Disclosure: No stocks mentioned. I hold shares in several small Chinese companies that sell almost exclusively to the Chinese market.