25 years and counting
CREDIT BUBBLE BULLETIN


by Doug Noland
Asia Times
Jan 20, 2010


The US ran small current account surpluses in 1980 and 1981. By 1984, the current account had turned to a (at the time massive) negative US$94 billion. The deficit ballooned further to $118 billion in 1985, $147 billion in 1986 and $160 billion in 1987. Prior to 1983, the largest current account deficit had been the $15 billion posted in the inflationary year 1978

Fears of mounting "twin deficits" were at the time viewed as a factor behind the dollar weakness and the jump in yields that precipitated the 1987 stock market crash. The simultaneous rapid escalation in current account deficits and stock prices in the 1980s was no coincidence. Credit was expanding rapidly. Total (consumer and mortgage) household debt growth jumped from 1982's 5.6% to 1983's 11.1%, 1984's 12.6%, 1985's 16.1%, 1986's 11.5% and 1987's 10.4%. On the business side, borrowings expanded 9.9% in 1982, 9.1% in 1983, 16.2% in 1984, 11.0% in 1985, 11.4% in 1986%, and 7.7% in 1987. Things really heated up after the Alan Greenspan Federal Reserve's post-crash reflation: junk bonds, leveraged buy-outs, Michael Milken, Ivan Boesky, and the "decade of greed".

By decade, the US posted cumulative deficits of $3 billion in the seventies, $778 billion in the eighties, and $1.230 trillion during the nineties. And while the 2009 deficit will have shrunk significantly on a year-over-year basis, the year's more than $400 billion shortfall will put the past decade's cumulative current account deficit at a staggering $5.83 trillion. Taking a different perspective on the issue, the Fed's Z1 "Flow of Funds" report has the rest of world (ROW) holding $943 billion of US financial assets at the end of 1985. ROW holdings ended last September at $15.052 trillion.

I have referred to this massive worldwide agglomeration of (largely US) financial claims as the "global pool of speculative finance". It is the primary fuel for what has become pervasive and unrelenting global boom and bust dynamics.

An op-ed piece by David Backus and Thomas Cooley in Monday's Wall Street Journal caught my attention:
In the 1920s, capital began flowing from Massachusetts to North Carolina, a process that continued until after World War II as textile mills migrated to the South from New England. Beginning in the 1950s, capital moved again as textile manufacturing moved to Mexico, India and Malaysia. Capital has long moved to where it can be used most productively, and by and large, that has been a good thing. Whether capital moves within a country or between countries, its flow addresses imbalances between available local capital and uses for capital (otherwise known as investments).

Through much of history, the major capital flows have been from rich countries to poorer ones. England financed canals in this country and railroads in Australia and India. That's no longer the case. The most notable importer of capital in recent times has been the United States ... Germany, Japan, China and Switzerland have been significant exporters of capital. Over the past 10 years, oil-exporting countries have been exporters of capital. These facts are collectively referred to as "global imbalances".

The standard view in policy circles is that they represent a serious threat to economic stability rather than a sensible market reallocation of capital. In the standard view, such imbalances are "unsustainable" and the longer they last, the more drastic and painful will be the ultimate "adjustment". After 25 years of such threats, you might think positions would change. Instead, the same people are now arguing that these capital flows were one of the root causes of the financial crisis.
I strongly believe years of massive US current account deficits created a global financial backdrop that foments historic booms and busts. Our system's credit excesses were indeed the root cause of the imbalances that ensured financial crisis. And I have to admit that I have difficulty these days grasping how analysts could see it any other way. A big stock market recovery and resurgent optimism have emboldened views that should have been thoroughly discredited.

For years, I've been amazed at the prevalence given to the view that our current account deficits were the result of global "capital" clamoring to own our assets. Messrs Backus and Cooley even refer to the current account deficit as "the net amount of capital flowing into the country". It has been painful to see like-minded analysis in the past from both Greenspan and his successor at the Fed, Ben Bernanke - who surely must know better. Bernanke persists in blaming our asset bubble problem on the surfeit of international "capital" that pushed global yields down.

Traditionally, large and persistent current account deficits were recognized as important evidence of excessively loose monetary conditions. During periods of stable global monetary regimes (under gold standards or even Bretton Woods after 1944), policymakers understood that balanced trade flows were a critical facet of overall financial stability. Trade imbalances nurtured pernicious financial dynamics. Only in the last 25 years has creative thinking concocted a hypothesis that such deficits are not only not dangerous - but they are indicative of a healthy allocation of "capital" and the superiority of the US markets and economy. And the bigger our deficits, the more vocal the apologists became in rationalizing our lack of financial discipline.

I have argued over the years that there is no "chicken or the egg" issue. It is our credit system that creates new financial obligations (credit) that then leave the country in enormous quantities to finance purchases of oil, manufactured goods and other imports, commodities, and foreign securities and direct investment. These dollar-denominated global financial flows (US IOUs), by their nature, must find their way back to the US credit system - predominantly through the acquisition of our debt securities and other financial assets.

It is not a case of the Chinese exporting their "capital" to the US - they instead send us goods in exchange for our debt. They reinvest dollar financial claims received both from exporting goods and being on the receiving end of massive "hot money" and direct investment inflows. I refuse to refer to the recycling of US financial obligations back into our securities markets as an injection of "capital". These are electronic journal entries and have little to do with "capital" in the traditional meaning of the word.

The inflationists focus almost exclusively on deflation risk. They use this recurring argument that (fiscal and monetary) stimulus is necessary to stabilize prices and avoid a downward debt spiral. They are inherently current account deficit apologists. Despite rapidly rising mortgage debt growth and 2001's $400 billion current account deficit, the inflationists argued for massive monetary stimulus back then to combat deflationary forces.

Not surprisingly, considering the monetary backdrop, current account deficits expanded even more rapidly - $459 billion in 2002, $522 billion in 2003, $631 billion in 2004, $749 billion in 2005, and $804 billion in 2006. Fed funds began 2006 at 4.25% and mortgage credit expanded almost $1.4 trillion during the year.

In hindsight, it should be apparent that unrestrained global credit and consequent asset inflation, bubbles, and boom and bust dynamics were the pressing systemic risk - not deflation. Fighting the burst tech bubble and "deflation" through the massive inflation of mortgage credit was an unmitigated disaster. Problems were "papered over" and a much greater bubble emerged. While the apologists were trumpeting the wonders of "Bretton Woods II," massive US current account deficits were exporting US credit bubble dynamics to the rest of the world.

Trillions of combined federal government debt issuance and Federal Reserve monetization have become this cycle's ammo for battling "deflation". I have stated my belief that this unprecedented inflation of government credit is both delaying necessary economic adjustment and creating a very dangerous bubble backdrop. I have argued that reducing our economy's dependence on massive credit expansion is fundamental to creating a more stable financial and economic environment. Comprehensive economic restructuring is essential for reducing credit dependency and dramatically shrinking our current account deficits. But with the markets up and the economy rebounding, focus on structural problems and imbalances has been relegated to the "permabears" - who have apparently learned little during the past 25 years.

http://www.atimes.com/atimes/Global_Eco ... 0Dj03.html