Foreign Trade and Investment Imbalances Were a Major Cause of the U.S. and Global Financial Crisis. They Remain a Huge Unaddressed Risk, Because It was Easier Politically to Just Blame the Bankers.
“The YouTube video below is a simple and pretty good explanation of how the economy works and how credit cycles can affect it. I read that former U.S. Treasury Secretary Henry Paulson has been sending this video to friends, so I thought I would make it available for viewing on my site. I am not an economist, so I could be wrong, but while the video is good, I believe it is missing an important cause of credit cycles. Let me try to explain it simply with a theoretical example: If the U.S. economy had no foreign trade or investment and the Fed did not print any new money (except a relatively minor amount, to stay at the same percent of U.S. GDP, as GDP grows), I believe that the funds available to lend to borrowers (credit), would be limited to those domestic funds that had been saved by investors (e.g. cash in circulation, bank deposits and money market accounts). In other words, in a “closed”, domestic-only economy, credit lent to some Americans could not exceed the savings of other Americans. This would place a strong check not only on private sector borrowing, but on U.S. government borrowing to fund annual deficit spending. If the government borrowed too much, as they have in recent years, they would crowd out private sector borrowing and vice versa. But in recent times in the U.S. this has not been the case; pre-crisis we had record borrowing by consumers, businesses, and governments, all at the same time. How did this happen?
Credit discipline breaks down and major credit cycles occur, as a result of many factors, but two that I believe are at or near the top of the list are as follows: 1) Excessive foreign investment in U.S. debt caused by U.S. trade deficits and also possibly by the U.S. dollar being “the world’s trading/reserve currency”. (While being “the world’s reserve currency” probably reduces slightly U.S. borrowing costs and materially increases Fed profits, I think it may be a negative for U.S. credit discipline, as it tends to increase foreign investment in U.S. debt obligations.), and 2) The Federal Reserve growing the money supply at too rapid a rate.
The Fed has long ignored Nobel Laureate and monetary economist Milton Friedman’s admonition against trying to peg prices or unemployment using monetary policy. Friedman believed that the Fed could only prudently control the money supply, but I believe that has become very difficult for the Fed, given the massive levels of foreign trade and investment in the U.S.. When Mr. Friedman, gave his acclaimed 1967 speech on monetary policy, U.S. foreign trade wasn’t even 5% of GDP and we were running a trade surplus (so he largely ignored foreign trade). Forty years later though, in 2007, U.S. foreign imports of goods and services were over 20% of GDP and the U.S. was running an annual trade deficit of about $600 billion (over 4% of GDP).
This posting briefly discusses the first factor (foreign trade and investment-caused credit cycles) cited above. I believe both Greenspan and Bernanke have spoken of this same issue, as a major cause of the global financial crisis (and I agree), but they have referred to it as “A Global Savings Glut”. I think this is a poor descriptor and makes it hard to understand. I believe that much of the foreign investment in the U.S. has occurred because these “trade-surplus” countries have had little choice; they must invest the net U.S. dollars they receive for their goods and services in U.S. assets, because of the U.S.’s long-running, massive trade deficits and because the U.S. is the world’s reserve currency. To the extent of the U.S.’s annual trade deficit, we have been selling U.S. assets to foreigners to fuel our consumption (of more of their goods and services than they consume of ours) and they have been investing these dollar-denominated assets largely in highly-rated U.S. debt.
Up until 1983, the U.S. exported more goods and services than it imported; it ran a trade surplus with the rest of the world. That meant that the U.S. received net foreign funds (currencies) in excess of the dollars it spent to import goods and services. Any country who is a material, long-term net exporter must invest the net foreign currencies they receive, in exchange for their goods and services, in foreign assets. Typically, most countries that run long-term trade surpluses invest in the “trade deficit” countries’ safest assets; government/sovereign debt, bank debt, or other highly-rated securities. Since 1983, the U.S. has run a trade-deficit with the world; it has imported more goods and services than it has exported. As a result, those countries where we have significant, long-term trade deficits (e.g. China, Germany, OPEC countries) have had little choice but to reinvest those dollars back into the U.S. in highly-rated, primarily debt securities. These foreign investment dollars flooded back into the U.S. and other developed countries (with trade deficits) in the mid-2000’s and caused a major credit boom and asset bubbles (throughout the developed world), and when they busted, they caused banking crises (throughout the developed world).
The historical foreign trade and investment data from the U.S. Department of Commerce Bureau of Economic Analysis supports this thesis. The U.S. trade deficit was just $52.3 billion or 0.87% of GDP in 1990. By 2007, it was $598.5 billion or 4.13% of GDP. A nearly five-fold increase (as a percent of GDP) in the trade deficit in just 17 years. Essentially, by 2007, we were selling about $600 billion a year of U.S. assets to foreigners to purchase more of their goods and services than they bought from us.
And these foreigners had no choice but to reinvest these dollars back in the U.S., because the world was flooded with U.S. trade-deficit dollars, year after year since 1983. In 1990, foreigners invested about $139.4 billion in the U.S. ($48.5 billion in direct investments, $27 billion in U.S. Treasuries, and just $1.8 billion in U.S., non-U.S. Treasury securities and U.S. bank/brokerage debt). By 2007, foreign investment in the U.S. increased to a whopping $2.1 trillion; a nearly 15-fold increase in just 17 years (foreign investment in the U.S. was 14.5% of GDP in 2007)!!! And while foreign direct investments and U.S. Treasuries were $221.2 billion and $165.3 billion, respectively in 2007, foreigners bought a whopping $1.12 trillion of U.S., non-U.S Treasury securities (lots of Fannie, Freddie, Ginnie, and private-label MBS) and U.S. bank and brokerage debt. In other words, pre-crisis, foreigners were inundating the U.S. financial system with cheap debt. Post-crisis, in 2012 for example, foreign investment in the U.S. had materially declined and foreigners were primarily sticking to riskless U.S. Treasury Securities. In 2012, foreign investment in the U.S. was down to just $544 billion (down 74% from 2007 pre-crisis levels); not much more than the 2012 trade deficit of $311 billion. Also, in 2012, foreigners invested $166.4 billion in direct U.S. investments, but they didn’t invest a dime in riskier U.S., non-U.S. Treasury securities and U.S. bank and brokerage debt (in fact, it was a negative $190.5 billion!); instead, they invested almost exclusively in U.S. Treasury Securities; a whopping $589.5 billion. I guess these foreigners, who had lost tens of billions chasing yields on U.S, non-U.S. Treasury securities and U.S. bank/brokerage debts pre-crisis, now just want their money back some day, even if it meant earning little to no yield?
Throughout economic history, whenever you have had these types of massive foreign investments into a country’s sovereign debt and banking/financial system, they have always caused major credit cycles; asset bubbles and busts and banking crises. Historically, it happened when rich, developed countries (like the U.S.) had invested in developing countries (through sovereign debt and foreign banking systems). This time, as a result of foreign trade and investment imbalances, the U.S. and most other developed countries were the ones to experience the credit bubble and bust, and banking crises. I am not sure why our top U.S. economic experts, at The Fed and elsewhere in government, ignored the historical warning signs provided by these massive foreign investment inflows? It was not part of my responsibilities, as a mid-sized bank CEO, to monitor these massive foreign flows of capital and their effect on our financial system and economy. As the manager of an individual bank (a microeconomic role), I thought our government’s economic experts ‘had our backs’, but they didn’t. Could it have been hubris? That these economic experts just couldn’t believe that the U.S. financial system and economy would react the same way that developing countries had for decades, when they experienced similar massive foreign investment inflows? Whatever the reason, I do believe, even though the government has chosen to ‘blame the bankers’, that they now understand how important foreign trade and investment imbalances are and the damage they can cause. I believe this is why the U.S. recently formally and publicly cajoled Germany to reduce its ‘unsustainable’ and ‘damaging’ trade surpluses.” Michael Perry, former Chairman and CEO, IndyMac Bank
The YouTube video ‘How the Economic Machine Works’ by Ray Dalio can be viewed here:
Ray Dalio, founded the investment firm Bridgewater Associates in 1975. He studied finance at Long Island University, went to work in the commodities division of Merrill Lynch in 1972, and earned his Harvard M.B.A. in 1973. His investment firm, which claims 13% annual returns with $165 billion under management, shuns public markets and utilizes a global macro investing style based on economic trends, such as inflation, currency exchange rates, and U.S. gross domestic product.