Tuesday, May 12, 2009

Crisis for Dummies: Global Imbalances.

Trade in commerce assumes we are exchanging things of equal economic value. What happens when a country consumes more than it produces?

Global imbalances
When americans consume at 103% or their own production for a sustained period of time, they need to borrow the extra 3%. Americans have pretty much eaten their savings so that extra 3% must be funded by savings from elsewhere. This is where the global kicks in. Enter China, saving countries of Europe and petro-dollars all too happy to buy treasuries to re-invest their dollar denominated debts.

The US govt has such a low cost of financing, even in this crisis, that this has worked for a long-long time. See also the entry on Securitization on how the machine kept producing debt backed products to sell to foreigners. When real products are going extinct and there is only debt, no worries! repackage that debt and sell it as a product.

Impact on economy, crisis
What it creates is a trickle of principal and interest payments that drag on the real economy. They impact cash flow, and now instead of having 100 available for consumption you may have only 97. To keep up with 103 you need to borrow 6 now. And so on and so forth until you cannot borrow the next layer. Then "naked consumption" appears and it has been chewed up by debt repayments. By the time you are done, you may be at 90% available for consumption and it starts to look like a serious recession (-13% GDP fall).

The way out
Default. All of the sudden defaulting on debt becomes fashionable through QE (see inflation/deflation entry). Foreigners are facing a potential fall in GDP combined with an increase in monetary volume.

Equilibrium: imbalances cannot exist long term
But imbalances need to resolve themselves. The RMB needs to appreciate (making goods from China more expensive) or dollar denominated debt will need to default through inflation and equivalent dollar depreciation. The point being that at the end of the day, equilibrium says that over a period of time on average what was consumed is what was produced. There is no free lunch is the principle sustaining equilibrium in global exchange. You don't mock about with that principle. The last time large imbalances appeared was WW1 when old Europe was in debt up to its eyeballs, not producing but rather over consuming. America was too happy to oblige.

Sustainable imbalances can be politic
But, what if, in the globalized version of Cheney's "deficits don't matter", imbalances do not matter? Afterall the Chinese are happy growing at a brisk pace, they probably consider buying treasuries a Keynesian action of some sort whereby they sustain their own growth by financing the american consumer. They know they are going to take a cut. Each time they take a cut, they can write it off as as a 'stimulus package' subsidizing the US to subsidize themselves.

The death of the US super-consumer
A readjustment of global imbalances is already under way. Consumption is down and driven by the US. The US has been consuming at 103 for a sustained period of time. I, for one, believe that the financial flash we just witnessed woke up the american public in a cold sweat. Already savings are shooting through the roof and your average citizen is adjusting his standard of living faster than you can say "nationalize the banks". And this is a good thing (c).

Blame the saviors
It really baffles me when officialdom blames the saviors for saving money. It is almost as if there was a moral flaw in doing so. I really cannot connect to that argument. So they don't consume enough? is that it? True, america has pulled the world out of misery by consuming until they got obese. You know it is hard being a super-consumer. But maybe I am missing something...

A dollar run?
Armageddon in finance goes something like this: unfriendly central banks coordinate a run on the dollar. Europe would stick with the US, it would become Occident vs the rest of the world, finance edition. I do not believe it will come to that.


Bill Burke said...

This seems like a Mexican Standoff or MAD. Hopefully nobody goes nuclear. I do worry that once China builds up its own consumer base, they'll have less and less need to subsidize the American consumer. There already seemed to be some rumblings of that in earlier public comments from Chinese officials.

Another thing that scares me is that just as we're going to need to ramp-down our deficit spending, Pakistan will fall and we'll get into a messy, uber-expensive war.

Marcf said...

Maybe you refer to the calls for a new currency so that the debt accumulated by the Chinese does not depreciate at the will of the US government (a.k.a QE).