Monday, November 5, 2007

Financial Crisis: Burst Bubble, Frayed Model

In a web post entitled “The Financial Crisis” Burst Bubble, Frayed Model,” Robert Wade succinctly points out the interdependencies in the world economy.
1. Exporters in countries running trade surpluses such as China and Japan sell the dollars they earn to their banks in return for domestic currency (to pay their workers, etc.).
2. These countries’ central banks buy the dollars from exporters to dampen their currency appreciation and domestic wages which impairs their economy’s competitiveness. This increases the supply of domestic currency which increases domestic demand and creates inflationary pressure.
3. Central banks use their stock of dollars to invest in US assets such as property and Treasury bonds. (China recently made a large purchase of the stock of the US hedge fund, Blackstone Group.) One result is higher bond prices, lower yields, lower interest rates, increased US domestic debt and imports that cause the US deficit to grow even more.
4. All of this puts downward pressure on the dollar.
5. “This mechanism has generated impressive economic growth in both deficit and surplus countries. Large trade imbalances generate larger increases in financial transactions and rising financial fragility.
6. In 2004, “Foreign banks, with still fast-rising dollar reserves meeting a smaller supply of US government and quasi-government bonds, therefore switched to … asset-backed securities.” In this context, private banks and other financial organizations developed “sub-prime” mortgages and packaged them. These were given AAA ratings by rating agencies who obtained the business by optimistic ratings.
7. All was well as long as housing prices increased and mortgagees believed that rising prices allowed them to extract equity and thus meet the higher repayment terms that developed.
8. “The bursting of the property bubble in the US in 2006 triggered a sequence in which, slowly, banking and financial operators became aware that the foundation of the debt pyramid was quicksand.” The large international banks and firms like Merrill-Lynch are now acknowledging the problem and writing off billions.
9. Wade suggests that the figure to watch is the ratio of total US Debt to GDP. It has been rising rapidly and in 2006 was 340%. “If US debt/GDP suddenly flattens, the US will experience a recession. If US debt/GDP falls, the world will experience a recession.

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