A post in my ongoing series on the long-term aspects of the current economic crisis:
Our Crumbling Chinese Castle:
My previous post in this series posed the open question of whether and how financial chicanery on Wall Street –what I’m calling silly paper games–could lead to permanent wealth destruction in the US and a potentially prolonged slump and, if not, what exactly then is causing the ongoing economic crisis? It remains an open question whether this crisis is simply one of the financial sector, whereby the unraveling of some bad practices led everyone to panic, meaning there could be some fix to the banks that will pull us out of this; or whether something deeper happened, if there was some process of real wealth destruction that would lead us to a long period of pay-back. Paul Krugman’s latest column presents a clue in reviewing the Fed’s Survey of Consumer Finances, while Martin Wolf in the FT provides a whollistic narrative of the economic crisis, charting how a massive increase in the “leverage” (or “indebtedness”) of both the financial and household sectors was the underlying cause of the financial crisis.
Though I do hope to return to the issue of securitization in depth, the contributions from Krugman and Wolf have given me the ultimate answer to my question. The question was, how could financial sector mismanagement lead to actual wealth destruction. In other words, where did all the money go? Money is, in many ways, a putative thing–it exists in the mind (and on the balance sheets of corporations and households, to be sure, but these exist in a fluid continuum with banks and, thereby, ultimately with the Fed, and the Fed can create more money simply by increasing the size of the liability side of its balance sheet (through, e.g., buying government securities), a process governed ultimately by people sitting around and staring off into space while contemplating statistics (as someone who’s seen part of this process, I can vouch for the fact that it is largely the work of imagination)).
There are in the world, however, real things that make up our economy–food, construction materials, services like haircuts and car repairs, etc. etc.–and our primary concern in a recession is the inability of people to get enough of these things. The work of finance is to assign these activities relative values, either through the application of wisdom or the making of markets, and to determine ways to ensure they continue in an efficient way through proper resource allocation. This is done by funneling surplus wealth (savings) generated by certain activities to other, underfunded activities. The villagers join together and realize that a lot of the farmers have extra horses; the villagers agree that the extra horses will be loaned to till a new field on the outskirts of town so the younger farmers can have land of their own; the new farmers agree to give the old farmers sacks of grain in exchange for the loaned horses. Modern finance is a complex version of this. The financial sector (the villagers) essentially determines how many sacks of grain the horses are worth by establishing markets for such assets (the horses), and establishes formal processes for the old farmers to be paid back.
The question about our current economic crisis is then this: is it a matter of the villagers panicking and becoming doubtful about the horse deal, or are the new farmers actually fundamentally unprepared to farm?
Ok, that was confusing. Let’s try again: the real question is whether this is just a banking panic or something deeper, like the collapse of a major credit bubble. Evidence is beginning to mount (and, indeed, has been mounting for some time) that it is the latter.
What happened? Martin Wolf has it like this (for those of you without FT premium access): the economy as a whole began to steadily accumulate debt starting in the 1980s, with households in particular increasing their share of debt. In the past 8 years or so, this trend accelerated, with the financial sector in particular rapidly increasing their debt (or “leverage” as they liked to euphemistically call it). One of the first things you learn in economics classes is that, in closed economies, i.e. one’s that don’t trade, savings equals investment. If the financial sector went on investing, their needed to be commensurate amounts of savings. Where were the savings, though? If household debt was increasing as well, it definitely wasn’t coming from US households (indeed, the US savings rate plunged towards 0 as time wore on). Luckily, we’re an open economy. Thus, the second part of Martin Wolf’s story: China, or, more accurately, global imbalances. The financial deficit created by massive US and other developed-country borrowing and spending (we weren’t the only ones engaged in insanity) was financed mainly by poor countries sending their excess savings to us. (To finish off Martin Wolf’s story, the third factor in the crisis were the complex debt instruments such as securitized mortgages that allowed private and particularly household sector debt to increase so rapidly; this seems like a footnote at this point.)
So the question was, could financial sector mismanagement lead to actual wealth destruction? The answer is, wrong question: there was no wealth destruction really, just a lack of wealth creation, with the deficit being made up by borrowing wealth from developing countries. Or, the answer is, yes: we were destroying the wealth of Chinese workers through excessive spending facilitated by financial sector mismanagement.
This brings us to your Dark Comedy Hour take-home message: no amount of schooling will help you understand this crisis, it will simply confuse you. The real crisis goes like this: we spent money we didn’t have–Chinese money–and now we have to pay it back. This will take a long time. Our country’s magnificent growth over the past 30 years was, by and large, an illusion! We’re like the new farmers who, having borrowed the horses, realized we didn’t know how to farm and decided to play polo all day.
So we’re entering a prolonged depression comparable in size and scope to the Great Depression and that will require a fairly permanent shift in spending habits. Why permanent? It is highly doubtful that a situation in which we do nothing and China gives us money to spend on their goods is sustainable. It is an instance of poor countries giving their money to rich countries for free.
That, in turn, raises another question: why would the poor countries do this? Fortunately, the answer to this is a simple cocktail of 1) export competition, 2) cultural backwardness, and 3) political corruption.
On export competition, the main reason the developing countries were willing to send us their surplus savings is that China had what I would term a predatory export policy: China’s dollar peg, whereby their currency is kept artifically low in order to make their exports cheaper than that of other countries, is maintained by forcing companies that sell to the US to exchange their dollars for renmenbi (the Chinese currency); the Chinese then reinvest this money in US Treasury securities. This decreases Chinese spending power and increases US spending power. (Again the real money/fake money dichotomy is useful here from several angles: the Chinese make real things–trinkets, widgets, etc.–and make profits. They then steal this money and issue fake money, sending the real money back to us and, since we don’t make anything with it, it becomes fake again.) This recycling process has the effect of lower Chinese spending power: if the money were kept in-country, their currency would have to rise, leading to average Chinese being able to buy more from abroad (and from us). We, in turn, have our spending power artificially inflated: the increased buying of US Treasury securities decreases the interest rates that they can fetch, lowering US interest rates in general, making borrowing cheaper and spending thus easier. Why would the Chinese stay poor on purpose, besides trying to put all of their (mainly Asian) competitors out of business?
This brings us to 2) cultural backwardness. The following may make me seem like a haughty westerner, but I say So What?: as the Olympics showed, the Chinese have a lot of pride in themselves and are not as wary as they should be of authority. It’s the type of place where the leaders would force a girl to inadvertently lip-synch a song so they could match the prettiest girl with the best voice. Give them many years of double-digit GDP growth and they’re liable to not only start getting comfortable with one-party rule, they might actually join those who are depriving them of political freedom in a national pride-off. All this despite the fact that, unlike in Western countries, average Chinese enjoy no social safety net (i.e. health care, social security, medicaid, etc.) and instead must save to cover these costs, thus all the savings they send to us. Which leads to…
3) Political corruption. As protests across China showed, a lot of Chinese who haven’t shared in the boon emanating from export growth have felt disenfranchised of late. The protests, along with more recent signs of a broad slowdown in exports, showed cracks in the Chinese facade. Nevertheless, the Chinese really have been slowly attempting reforms to bring market forces to China and introduce political freedoms. Thus, a potentially frigthening strategy on the part of the Chinese Communist Party has become apparent: use currency manipulation to sustain growth, build political legitimacy, and to destroy the export sectors of competitor countries. Increase the number of stakeholders in export growth as a means to stifle domestic protests from rural elements–i.e. build a middle class. Once these stakeholders have been established, allow the currency to slowly appreciate while gradually introducing political freedoms. Lastly, take credit for all this to maintain power and influence over the new middle class.
Despite being effectively a war against the poor, it’s not a bad plan in the grand scheme of things. It’s a lot better than a bloody revolution as a means to political freedom. The plan is frightening, however, when you begin to wonder what happens if the export growth slows. This is what is happening now. For as our Chinese castles, with their home theaters, three car garages and two SUVs, flat screen televisions and wet rooms, crumble to the ground, the Chinese export-sector workers are returning home permanently in droves, suddenly unable to find work and make the remittances that were supporting their families.
China took steps to release it’s currency peg last year, but has abruptly reversed course as the US slump has worsened. This is understandable. What is less understandable is how, with spending habits headed for a permanent shift in the US, the Chinese Communist Party can maintain control of their country. Rural protests were already growing in frequency.
No one’s perfect though: just as the Chinese leadership faces pressures from the bottom to somehow reignite export growth, the US leadership feels pressure from the very top to get money back into the American wealth destruction machine. Light Touch Tim Geithner and his ilk are now bending over backwards to ensure the banks are not nationalized, wasting hours of taxpayer time and money trying to come up with ever more elaborate schemes to avoid nationalization and the inevitable firing of all their friends and cronies on Wall Street, and preventing the badly needed write-downs of toxic assets in the process. Somehow, the bankers still think they can go back to work “levering up” their institutions debt to 30 and 40 times assets, and make the attendant imaginary bonuses to lead their kingly lifestyles. Eventually, everyone is going to have to wake up: the Chinese will have to start allowing their people to enjoy their own wealth, and we will have to spend much less; our bankers will have to realize that they are not kings and that, even back when there were kings, there were only a few of them.
It’s just a little worrying that the last time the world woke up from something like this, they called it a world war.