Month: April 2013

The Distorted Nature of Global Trade Imbalances

Drawing from the theories of Ludwig von Mises and Friedrich August Hayek, from the Austrian school of Economics, many market economists have viewed the US and Spanish trade deficits as healthy reflections of the comparative advantages enjoyed by different economies.

A deeper look at the economic structures of surplus and deficit trading countries alike however highlights how external imbalances are often a reflection of internal imbalances and/or distortions. Policy makers therefore should not overlook trade imbalances and assume that they are reflections of optimum market performance and global comparative advantages.

The ECB famously noted in 2004 that “A widening of the household sector deficit was a pattern not seen in earlier episodes of current account deficit widening”. The implication here was that the rising deficit on the current accounts of periphery Euro zone countries and the US was accompanied directly by foreign borrowings from the household sector to fund consumption rather than investment.

This should not however lead to the simplistic belief that American and Spanish households are directly responsible for their indebtedness, and should stop consuming to ease the imbalances. The true causes of excessive trade imbalances are more complicated, and much of the fault lies with the financially crippled and regulated surplus nations such as China and Germany.

With the ascent of globalisation and financial innovation it suddenly became much easier for nations such as the US, Spain and Greece to run persistent deficits with access to easy credit. The US was able more than ever to attract international credit flows due to its reputation as a secure investment market, coupled with a large financial sector able to create collateralised debt obligations (CDOs) which spread individually crippling risks across multiple investors.

Other nations such as Spain and Greece found easy access to credit streams from the European Central Bank, lending on distorted Value at Risk (VAR) calculations, which were supported by the easy transfer of savings across Euro Zone borders. With the artificial access to German savings, Spanish and periphery markets proved to be much more lucrative sources of consumption than their German counterparts.

This is largely due to the history of the German export-led development model. Under government direction of resources away from household consumption and towards export-oriented firms, domestic sources of consumption had historically been handicapped. This was due to distorted interest rates, high levels of government protection, and a crippled financial sector unable to adequately evaluate investment opportunities. The financial sector, unable to efficiently apportion savings towards local investment, instead relied upon established ‘crony’ relationships with exporting firms and government bureaucracies to allocate funding across the economy. The German economy grew at two speeds under this export-led growth strategy, with a super efficient manufacturing sector and an inefficient services sector unable to attract domestic demand.

With no attractive outlet for their savings appropriated by high-end exports, German households instead poured their savings into the Euro Zone’s financial sector- injecting billions of dollars into economies where domestic demand was healthier and more competitive. This influx of easy credit flows kept periphery interest rates low, and household consumption boomed in housing and similar activities that had experienced widespread deregulation. This was most famously seen in the Spanish President Aznar’s “Ley de Suelo” and similar reforms, which deregulated financial transactions and encouraged housing construction.

China’s domestic imbalances had a similar financial structure to that of Germany, but were also compounded by government industrial policy. With the Yuan undervalued by the Jintao administration, exports yielded higher returns relative to domestically geared production, and the structural trade surpluses similar to Germany were deliberately exacerbated by government policy.

As a result of this trade surplus the Jintao and Jinping administrations built up enormous reserves of US dollars. If these dollars were to be converted back to Yuan however, it would create a large demand influx for the Yuan, thereby revaluing the currency at its natural value. Instead, the Chinese government opted to return their foreign currency reserves (FCRs) back into the US economy- buying government bonds and providing the financial sector with high liquidity. With the competitive nature of American finance and household consumption, these funds again led to an influx of demand (and therefore supply) for housing projects and similar household investments and consumer items.

The obvious correlation between trade deficits and economic busts should provide enough empirical support to refute the notion that trade deficits are healthy reflections of global competition, but it isn’t. Market fundamentalism is intoxicatingly simple to cite, but the assumptions that underlie its arguments are baseless.

The build-up of household debt and consumption seen in domestically geared economies was not a healthy manifestation of global comparative advantages. Instead, it symbolised a sinister allocation of resources in surplus nations, which fuelled household debt accumulation in deficit nations.

Unnecesary Blunders in the GFC- Revising the Role of Government

The collapse of Lehman Bros. on September, 15, 2008 precipitated a global collapse in confidence among creditors and depositors alike; but whilst the heavily indebted economies of Europe and the United States were structurally unsound (with production geared against export-led growth), extreme economic slowdown was not a necessary condition for the subsequent structural adjustment. The behaviour of the US treasury during the crisis epitomized the ineffectual and indecisive policymaking deemed largely responsible for the exacerbated nature of an otherwise mild cyclical downturn.

It is now common knowledge that nearly all developed economies had become highly indebted before the winding up of Bear Stearns in March 2008. One commonly overlooked aspect however, was that this debt was largely illusory, and was a result of complex financial swaps and hedges that expanded credit, leverage, and the broader money supply. Much of the debt counted in the US economy was a result of inter-bank lending, where banks created complex chains of borrowing. For example, J.P Morgan would lend $1 to a hedge fund, which lends $1 to an investment bank, which lends $1 to a broker, which lends $1 to a mortgage bank, which lends $1 to the homeowner. The total financial leverage therefore becomes $5, but the actual indebtedness of the household (real economy) is only $1. The virtue with this structure, known as Fractional Reserve Banking, is that as long as all the links are safely capitalised and secure, debt can be quickly deleveraged without serious repercussions on the non-financial economy. The longer the chains are however, the more pronounced the effects are if one link breaks. In the US, the chains were extremely long (in some cases chains reached leverage ratios of 30:1) and the situation quickly became an untenable deleveraging nightmare.

This is exactly what happened with the bankruptcy of Lehman Bros, and the US treasury’s decision to not guarantee creditors and lenders. The chain was allowed to break, and otherwise modest losses in the financial sector matured into system-wide threats to the world financial system. But why were the banks so poorly capitalised in the first place? Was it because they expected government aid in conditions of system wide failure? Or was there some other fault line in the system? Many commentators do indeed simplistically blame “crony capitalist” relationships between congress, the Federal Reserve, and Wall Street; where an implicit promise from congress to socialise losses if they are systemic encourages the mass accumulation of tail-risk (financial jargon for risks that are rare, but catastrophic, and systemic if realised). But a more technical approach towards the problem of poorly capitalised institutions points the finger towards accounting standards stipulating transparency.

The new accounting standards (Known as “Mark to Market” accounting standards) took discretionary power away from regulators and banking officials, and handed it over to the forces of the market. Institutions were required to report their solvency as a function of the market value of their assets. During a boom period, with rapidly rising asset values, these institutions witnessed enormous profits and were able to reward large bonuses to their employers and run down their capital reserves. But when values began to fall, losses built up, and to maintain “official” solvency they were required to liquidate their assets en masse with virtually non-existent capital reserves and anxious depositors. This drove down the value of their previously profitable assets, and a positive feedback loop spiralling downwards compounded the problems yet again, and financial balance sheets did not recover until the suspension of the new accounting standards in March 15, 2009.

The relevance for both of these points is that financial sector losses were compounded by the government’s reluctance to intervene in Wall Street, and instead rely upon the efficiency of the market to allocate resources. The Federal Reserve was even forced to increase interest rates early 2008 during the deleveraging process, and winding up of Bear Stearns due to an unsubstantiated attack on commodity prices (and specifically oil) leading to an increase in cost-pushed inflation. With the monetarist paradigm stressing inflation control over demand-management the Federal Reserve hiked up interest rates, despite the contraction in the money supply as a result of deleveraging. The effects were again ruinous, as the money supply contracted rapidly as a result of monetary policy plus the necessary structural adjustment. If the treasury had instead intervened in commodity speculation directly, and regulated oil hoarding in the typical post-war Keynesian approach, the money supply could have expanded and supplementarily supported the deleveraging process, which would otherwise have been deflationary.

Yet even despite the difficulties imposed on the deleveraging process by accounting madness and artificially high interest rates, the non-financial economy was acting with typical flexibility moving employment away from the bloated domestic-demand sectors towards exporting sectors throughout the credit crunch. The trade deficit from 2006-2009 almost halved for example, whilst the current account deficit narrowed from $974 billion in 2006 to a mere $189 billion in 2009. This path had already begun before the collapse of Lehman- and the excessive output gaps experienced alongside stagnant growth could have been avoided if the US Treasury was more willing to consider its full role in the management of economic affairs.

This argument leads on to the topic of financial life-support by government which I will analyse in another piece, citing the Third World mass defaults on debt from 1982-1989, the Swedish crisis of 1992 and Japan’s lost decade.

Outline of Australian economic trends

*The following outline of Australia’s economic trends is an addition to Systemdestroyer’s analysis of Australian economic performance. Hopefully the data/analysis provided will be useful to readers*

Systemdestroyer’s article can be found here-

Australia’s annually adjusted growth in Gross Domestic product (GDP) since 1990 has been relatively stable. Despite negative growth in 1991, the economy has been growing steadily reaching a climax of 5% in 1999. This robust growth expedited by the Freemarketeer reforms implemented by the Hawke-Keating government has been accompanied by rising income inequalities however.

The value of the gini coeficient (a common measurement of income inequality) has risen from 0.28 in 1990 to 0.33 as of 2013. Many Keynesian and progressive economists have blamed Free market ideology for such income differentials, but the general consensus is that the rise is a natural result of globalisation, which introduces more Labour market competition and labour replacing capital, undermining the wealth share of the lower classes.

Services and commodities have accounted for an increasingly large share of GDP and employment in the domestic economy since the sweeping economic rationalist reforms of the Hawke-Keating era eliminated the protection previously given to manufacturing. Although the initial devaluation of the Australian dollar following its float in 1983 initially helped exporting manufacturing sectors grow more quickly than their tertiary industry counterparts, their market share has fallen at an accelerating rate, reflecting more efficient use of organisational capital relative to wages in Asia (specifically China), and an appreciated currency. The effect on GDP of the declining manufacturing sector however has been minimal, since Asia’s shift towards manufacturing has precipitated an increase in Australian commodity exports, where there is a strong comparative advantage. As a result, the shift away from manufacturing represents a major structural adjustment in Australia’s economy in favour of sectors where our comparative advantage in human capital and natural resources is more apparent. This structural adjustment has become one of the factors contributing to Australia’s stable growth rates despite fluctuating global trade conditions.

Australia’s current account deficit since these structural reforms has been in a healthy condition. After the credit dry up of 2007, and subsequent bust after 15, September 2008 with the collapse of Lehman bros, Australia fared well relative to other OECD countries, with the lowest public debt rates and sturdy economic growth despite a single quarter of contraction in 2009. The maintenance of employment and healthy terms of trade is largely attributed to the ascent of bilateral and multilateral trade agreements alongside the reforms mentioned with the Asia-Pacific region which has experienced sturdy growth using the export subsidy growth strategy, and through protectionism, shifted production away from commodities and low-demand-elasticity industries towards manufacturing. Trade with China for example has grown from $113 million dollars in 1973 to over $85 billion dollars in 2009 (despite sluggish growth conditions), reflecting an enormous increase in trade with the region facilitated by trade agreements and structural reform. This represents an ongoing long-term geopolitical-economic shift towards the region, and away from debt laden developed markets.

An interesting anomaly in Australian economic trends is a reversal of the prediction of Wagner’s law. This economic law states that government spending as a percentage of GDP is inclined to rise as a result of increasingly dangerous technological monopoly, and public demands. Following the ascent of Milton Friedman’s monetarism and Reaganist ideology, both the Liberal and Labor parties have extensively privatised existing public enterprises such as QANTAS and TELSTRA, and any R & D investment is usually open to usage by private enterprise (as seen by the implementation of the National Broadband Network). This privatisation under third-way ideology has consequently led to a lot less government regulation of sectors deemed important, and competition has flourished under the laissez-faire growth model. Cuts in subsidisation have also strengthened the government’s revenue base despite remnants of protectionist subsidisation aimed at low skill manufacturing under pressure from an appreciated currency.

All of these trends have been driven by the general economic and philosophical structure of the world since the 1970s. Such “Megatrends” (as referred to by the UK political commentator Anatole Kaletsky), have encompassed economic thinking and been practiced widely. Multilateral trade agreements, domestic and foreign structure, open market policies, and income equities have all been changed in the Australian economy since 1990 within the paradigm of the free market fundamentalists. Whether these changes will finish in flourishing growth and competition, or disaster is still to be seen.