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Was This a Financial Crisis or a Trade Deficit Crisis?

I have nothing much to add to this analysis by Kevin Drum, but it definitely tracks with my understanding, and I'd sure love to hear some answers:

[B]etter regulation would have reduced the size of the credit bubble and the ensuing crash, but in the end, all the cheap money generated by our persistent trade deficit had to go somewhere. You can't hold back the tide forever, after all.

I guess I've been haunted for months by John Hempton's simple formulation: banks intermediate the trade deficit. If China is sending us huge bales of cash every month, it's going to end up in the banking system and the banking system is going to end up lending it out. Sure, Alan Greenspan made things worse, George Bush made things worse, and the giddy free market ideology of the Republican Party made things worse. Bill Clinton, Robert Rubin, and the Wall Street wing of the Democratic Party made things worse too. But the underlying cause is, and always has been, our persistent trade imbalances. That was as much a weapon of financial mass destruction as the rocket science derivatives that Warren Buffett so famously criticized.

Things have improved on this score recently. Our trade deficit is half what it was at its peak. The problem is that this isn't nearly enough: eventually, we need to pay down all these loans. That means we need to start running a trade surplus, not merely a smaller deficit. And we have to do this even though oil prices are almost certain to rise in the long term and our dependence on foreign oil is going to continue to grow. I still haven't figured out how this is going to happen, and as near as I can tell, neither has anyone else.

By Ezra Klein  |  June 11, 2009; 8:20 AM ET
Categories:  Financial Crisis , Solutions  
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But of course the credit bubble FED the trade deficit. The reason we could run big trade deficits for so long was that we could buy on credit, thinking that we were still growing wealthier because the value of our homes seemed to be rising so much.

So you & Drum are right to point out the centrality of the trade deficit, but the credit bubble is still the primary culprit. And i think you let the banks off too easily when you kind of shrug your shoulders and say, well of COURSE they'll find a way to lend it out. Ultimately nobody's responsible for their lending & underwriting policies but them, and the policies they chose were reckless. You can say they were driven by an agency problem, where the rules of game rewarded them for making loans rather than taking sound risks. But again, the banks themselves write most of those rules. Don't give them a pass!

Posted by: tomwoods | June 11, 2009 8:49 AM | Report abuse

"I still haven't figured out how this is going to happen, and as near as I can tell, neither has anyone else."

the dollar is going to fall, that's how it's going to happen. We are about half as rich as we think we are, and when the dollar falls to where it should be, our standard of living will fall 50% and we won't be able to afford to buy anything. No more oil, no more Chinese toys and electronics, no more Japanese cars. That's when the trade imbalance will correct itself.

Posted by: Bloix | June 11, 2009 9:24 AM | Report abuse

It is not clear if it is that easy – trade deficit as the root cause. By that argument, countries which run trade surplus will be in better shape and should not have problems we are facing. So are countries like Japan, China, Germany and S. Korea in better place? It at least does not seem so.

What about countries like Canada, Australia and Brazil who on the other hand have trade surplus or balanced trade but could escape fate like the first group?

Ask Paul Krugman, he is the ‘go to guy’ for International Trade.

In absence of clear evidence and analysis, I think it will be more fruitful to settle on ‘regulation failure and Greenspan failure’ as prime reasons. For almost 2 decades, America had been in thrall of that ‘old babbler’ who confused obfuscated press releases as the economic regulatory competence. We are paying dearly for that. Why are we shy of pointing glaring sins of that guy:
- Oh, let people go and get ARM loans
- No, there is no housing bubble
- And Bush’s irresponsible Tax cuts were no problems (Harry Reid in disgust publicly said that Alan Greenspan was the republican hack!)
So did he not allow this credit run to go amok?

Only other day we were singing praises for our Northern neighbors for the way they do banking. So are not regulations and prudent management something to do to avoid credit bubbles?

Posted by: umesh409 | June 11, 2009 9:37 AM | Report abuse

"all the cheap money generated by our persistent trade deficit"

This misunderstands cause and effect, which is much more circular but which ultimately traces back to China. The Chinese have been flooding the US with money and causing the credit bubble precisely because doing so keeps their currency artificially cheap, which helps their exports, which boosts our trade deficit, which enables the Chinese to flood our country with money, etc.

If China's currency had been allowed to float, there would have been no credit bubble.

Posted by: tomtildrum | June 11, 2009 9:39 AM | Report abuse

Note that banks didn't need to lend (or otherwise invest) that money in the US, necessarily. To that extent, a lack of globalisation, or a parochial world view amongst financiers helped stoke the bubble.

Posted by: albamus | June 11, 2009 10:05 AM | Report abuse

On the second thought, this whole idea of ‘cause and effect’ is absurd in Economics. Unlike physical sciences, such an approach does not lead us to any practically usable knowledge. As others have commented, it is too much circular thing here in Economics.

I suppose ideas like ‘emergent properties’ or ‘stability of system in general’ may be more relevant approaches here. Obviously Economics already has such established ways of investigation (system dynamics) away from ‘cause and effect’ and that may be more useful. At least it will avoid all these needless media out pourings and theatricals where Larry Kudlow says something as a cause (to blame Democrats) and Dr. Doom Roubini castigates someone else. Just too much blame game (including my own rant against dead horse Greenspan) without any concrete, useful output.

Posted by: umesh409 | June 11, 2009 10:11 AM | Report abuse

Trade imbalance will persist as long as there is a cheaper labor else where. Either we restrict trade based on labor advantage or wait until the world catches up to our standard of living. Of course, countries must allow their currency to float or this delays the balancing.

Posted by: sailor0245 | June 11, 2009 10:31 AM | Report abuse

I have figured out how it is going to happen -- naturally. :-)

Lithium-ion battery packs needed to power even a small car now cost about $10,000.

A few years ago, I came up with the equation that: if 100mpg vehicles allowed America needed to import only half as much oil (meaning 5 million bbl/day -- at that time) and if we needed to pay only half the price ($30/bbl) due to lowered demand, then, we could save $165 billion a year (5,000,000 bbl/day X 365 days X $30 instead of 10,000,000 bbl/day X 365 days X $60 = a saving of $164,250,000,000/year)...

...or, exactly enough to subsidize building the 16.5 million cars and trucks we manufacture every year as LITHIUM, PLUG-IN hybrids -- at $10,000 per vehicle!

With oil potentially approaching the $150/bbl range, we could be shipping $500 billion more a year overseas to pay for it, potentially justifying any form of subsidy for the manufacture of lithium plug-in hybrids.

Much more powerful lithium (as well as other design) batteries are in our near future, potentially wiping out most of our trade deficit, depending (so far this year running at $360 billion, about half of last year).
10X power lithium ion battery in 5 years?
For 30 years it has been known that building lithium ion batteries with silicon wires (instead of carbon wires) could yield ten times the power holding ability but, because silicon wires expanded and contracted so much as they cycled that they quickly crumbled. The development of silicon nano wires *– about a thousandth of the width of a sheet of paper -- has solved that drawback -- while potentially making lithium ion batteries more stable (safer) at the same time!

Near term (five years), only the anode side of the batteries will be manufactured with nano wires, yielding the quadruple jump (up powering GM’s Volt to go 160 miles on one charge instead of 40?). Long term, manufacturing the cathode side with silicon nano wires is expected to reach the ten multiple target (introducing hybrid, long distant trucks?).

Posted by: DenisDrew | June 11, 2009 10:34 AM | Report abuse

To break the circular arguments simply start
with taking responsibility for our own
(American) situation.

Posted by: George20 | June 11, 2009 10:38 AM | Report abuse

the trade balance is a problem because it is a sign of the shift of manufacturing out of the united states and the unplanned for consequences of this national policy

china invested the money earned from our purchases in our bonds

this investment money could have been used in many ways, good, bad and mixed good/bad

it could have been used to fuel improvements for the common good, it could also have been used to fuel the greed of market speculation

turns out the financial industry and the leaders who determined financial policy
went with greed

subprime mortgages and business loans, and the credit default swap scam are the result of decisions made by those in economic leadership positions, individually and collectively

the trade imbalance does not excuse them

Posted by: jamesoneill | June 11, 2009 1:09 PM | Report abuse

This analysis is a pretty good one. One could try to look more deeply at the different trends that have generated our trade deficit. But that deficit does seem to be the clearest indication of our long term problem. President Obama's economic agenda is the most realistic attempt to deal with the real problems that one could reasonably expect. Given political realities, he will be doing well if he succeeds even with a part of it. Currently, opinon seems to be divided into two groups. The larger one wants to deny that there is anything more than a trasitory problem and believes that a return to normalcy is already on the way. The other sees a more lengthy process of adjustment to the evolving economic new realities with some substantial long term financial dislocations. Even assuming the latter case is the real one, there are big limits on what government can do to control even our own econcomy let alone the rest of the worlds. We can try to put a regulatory framework in place that contains the next crisis within a more manageable range. We can try to keep our own economy and the rest of the world's from lurching into a totally uncontrollable crash. We can recognize the need to provide some public assistance to those who are the more severe victims of the economic crisis. We can look for ways that the government can stimulate real investment that actually expands the productive capability of our economy and reduces our reliance on foreigners. This effort is particulary needed in the case of energy. But, in the end, reaching some kind of better economic equilibrium depends on a very large number of individual decisions many of which involve choosing between undesired alternatives. Those choices will only get made when there is no other alternative and they will be reacting to many other choices that are inevitably spread out over a long time. Unless you are one of those who have decided that the sun is already shining again, the best you can expect is keeping the resolution of this particlar crisis under some level of control and taking steps that will make the next one less bad.

Posted by: dnjake | June 11, 2009 1:21 PM | Report abuse

Invest abroad.

Posted by: jwogdn | June 11, 2009 1:21 PM | Report abuse

This post really concerns an empirical question rather than an analytical question. Specifically, does the capital account drive the current account, or vice versa? I have not studied this issue since 2001. In 2001, the prevailing academic research suggested that the capital account surplus drove the current account deficit. If still true, this empirical fact would negate Mr. Klein and Mr. Drum's posts.

Posted by: Dellis2 | June 11, 2009 1:42 PM | Report abuse

BTW is was the Chinese demand for dollar investments that caused the problem but in how rapidly it came on (so you could blame it on Mao). Even if there is all this invested money we should in the long run move toward some equilibrium.

Posted by: jwogdn | June 11, 2009 2:43 PM | Report abuse

You're saying we had to borrow so much money to do so way.

The primary way in which we are going to be able to beat the trade deficit sucks- our wages and benefits are going to have to meet the lower paid countries somewhere in the middle. Massive inflation in the dollar v. yuan is part of that story.

Posted by: staticvars | June 11, 2009 2:55 PM | Report abuse

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