Subprime disease a traded infection

By Thomas Palley

In recent months, the US subprime mortgage crisis has been rippling outward affecting other countries. British banks have made large loan-loss provisions and there has been a run on the Northern Rock bank. German lenders have incurred similar losses and Germany has suffered two large bank failures. European banks have also become leery about lending to each other, forcing the European Central Bank to infuse emergency liquidity. Now, Japan’s banks are feeling the heat.

These global spillovers have their origin in the huge US trade deficits of the past several years. Those deficits played a critical role generating the distorted interest rate environment that created the subprime bubble, and they also explain how subprime loans have wound up in Tokyo portfolios. For policymakers everywhere there are lessons about the dangers of large trade deficits.

Over the last several years, the US trade deficit has persistently drained spending from the US economy. As a result, much of manufacturing failed to recover after the recession of 2001, making for a weaker than usual recovery. This weakness prompted the Federal Reserve to push interest rates to historic lows in 2003, keep them there for an extended period, and then only raise rates gradually for fear of undermining the economy.

The Fed’s ''easy money'' policy succeeded in avoiding a relapse into recession, but it came at the price of a housing bubble and a twisted expansion. The hallmarks of this twisted expansion were house price inflation, a construction boom, explosive growth of non-traditional subprime mortgages, a debt-financed consumer spending binge, and yet larger trade deficits.

The counterpart of these deficits was trade surpluses in the rest of the world, which provided the conduit for distributing subprime holdings globally. Moreover, these trade surpluses persisted because many countries actively pursue export-led growth, and they therefore blocked appreciation of their currencies against the dollar to maintain competitiveness in US markets.

These large surpluses in turn sought an investment home, which helps explain why long-term interest rates did not rise as predicted when the Fed eventually raised short-term interest rates after 2004. More importantly, artificially low short-term interest rates promoted a ''chase for yield'' among investors, who started lending at diminished risk premiums.

This chase affected both American and foreign lenders. In Japan, interest rates have been close to zero for a decade, while European interest rates have been below US rates since the end of 2004. Japanese and European investors therefore willingly bought subprime mortgage loans, which spread holdings around the world and also elicited additional supply.

Ironically, owing to bureaucratic inertia, China is the one country that did not get caught up in the frenzy. Instead, it has invested in Treasuries, while capital controls have limited individual Chinese investor access and exposure to US financial markets.

The vast scale of foreign accumulation of dollar assets means that other countries are now vulnerable to US credit market losses. Paradoxically, that may support the dollar. However, other countries are better placed in terms of economic fundamentals. Though they will bear financial losses, their households are in better financial shape - except in countries that have also had house price bubbles. Contrastingly, US households are burdened with debt, and there is a massive overhang of house supply that promises to drive down house prices, further erode financial wealth, and further undermine economic activity.

The sting in the tail is that a troubled US economy will likely come back to haunt other economies because of their reliance on export-led growth and investments aimed at supplying US consumers. And that sting may hurt China most owing to its heavy reliance on export-led growth and foreign direct investment.

From a policy perspective there are several big lessons. First, failure to address problems in one area (trade deficits) can trigger policy responses elsewhere (monetary policy) that ultimately create even bigger problems. Second, large trade deficits cause real distortions, the consequences of which are costly, albeit slow to emerge.

The consequences of the distortions caused by the US trade deficit will be worst for the US, but they will also affect surplus countries that have accepted dollar-denominated financial assets in payment. Moreover, many countries are vulnerable to the extent that they depend on the US market. That points to the urgency of global policy mechanisms preventing repeats of such trade imbalances, and for countries to shift from export-led growth to domestic demand-led growth.

Thomas Palley is founder of the Economics for Democratic and Open Societies Project.