By Andy Xie, guest economist of Caijing and board member of Rosetta Stone Advisors Limited
From Caijing Online
Several prominent newspapers have featured articles that blame the current financial crisis on China’s buying U.S. treasuries. As the theory goes, the deficit countries –Australia, Ireland, Spain, the United States, the UK, etc. – are Peking ducks, the surplus countries – China, Japan, Russia, Saudi Arabia, etc. – are duck farmers. The later force-feed the former into bloated debt junkies that eventually blow up.
Of course, both willing lenders and borrowers must exist for a debt bubble to exist. But who do you blame? The borrower, the lender or the middleman? I am sure that stories and theories on all three are plentiful. But accusations against China and other lending nations appears politically convenient, allowing politicians in the crisis countries to blame someone else and avoid making hard choices. However, this theory has the causality wrong.
Finger pointing in the blame game so far is mostly at Wall Street, i.e., the middleman. It is easy to do. Just look at the CEOs of these institutions. They have paid themselves hundreds of millions of dollars on supposed accounting profits that have become today’s write-offs. Their institutions are either already bankrupt or close to it. And on top of that, there was Bernie Madoff’s US$ 50 billion scam to crystallize the problem.
It is easy for common people to see that this crisis has happened because these greedy people have taken advantage of the system and ruined it for their personal gains. I am sure Hollywood will have a feast with the stories that are coming out of Wall Street. Great movies could be made just by faithfully recording what happened.
I have been writing about Greenspan’s guilt for this crisis. In 1999, I focused on how his rate reductions in response to the Asian Financial Crisis led to the IT bubble. In 2000, I wrote that his rate reductions in response to the tech burst would lead to a property bubble or bond bubble or both. And in 2003, I added that a new bubble was emerging with Greenspan pulling the strings. When he took over the Fed in 1987, the U.S. financial sector had US$ 1.9 trillion in debt, or 29 percent of GDP. When he departed in 2005, it had risen to US$ 13 trillion, or 104 percent of GDP.
During a congressional hearing last year, Greenspan professed that he was shocked financial institutions that had borrowed so much didn’t take good care of their money. This was like saying he didn’t know what was going on. But in 1998, when Long Term Capital Management blew up, it nearly brought down the financial system. The problem was excessive leverage as reflected in financial-sector debt. If one fund could bring the system down, imagine how much risk the massive growth of the hedge fund industry and the proliferation of proprietary activities at investment banks could pose to the system. Indeed, the consensus among regulators and analysts after the debacle was that such unbalanced sheet activities should be regulated. But opposition from Greenspan and top officials in Clinton’s administration kept such activities unregulated and laid the foundation for the current crisis.
In a credit bubble, monetary policy plays a dominant role and must be held responsible. A bubble happens somewhere everyday. All that’s needed it for everyone to bids up the price of an asset solely on the expectation someone else will pay more latter. Hello Kitty dolls, pu’er tea, or modern paintings all could become bubbles. As long as supplies cannot increase quickly in response to rising price and something captures the attention of enough people, a bubble can happen. But, such bubbles are small relative to total money supply and can form without the support of monetary policy.
A credit bubble, however, is large relative to total money supply. Without an accommodating monetary authority, a credit bubble cannot possibly occur. For leveraging to increase from 29 percent to 104 percent of GDP couldn’t have happened without the Fed accommodating. If one person could and should have stopped the bubble, it was Greenspan.
But instead of being alarmed, Greenspan repeatedly claimed that the proliferation of derivative products was good for efficiency and failed to acknowledge that it was mostly for speculation. Thus, he is the individual most responsible for the crisis.
In his inaugural speech President Obama spoke about a collective failure to make hard choices. It was a euphemism for reckless borrowing by U.S. households. Should the borrowers who are not paying their debts be blamed?
Some prominent analysts think it was all the fault of crafty bankers who cooked up complex products and fooled the masses into taking on debts they wouldn’t be able to repay. I don’t think so. U.S. households who took on triple zero mortgages – zero down payment, zero interest and no principal payments for two or three years – knew they were offered only an upside proposal. If property price rises, they could benefit from the appreciation. If the price falls, they could walk away. They were offered a free option plus a nice house they could stay in for the time being for free. It was rational for them to take the deal. But was it right? I think it would be quite naïve to portray the borrowers as the ultimate Peking ducks.
Of course, if the surplus countries were not willing to lend, what happened in the United States or other deficit countries couldn’t have occurred. Greenspan’s loose monetary policy would have led to dollar weakness and inflation, which would have forced him to raise interest rates. To what extent the surplus countries should be assigned some of the blame?
Initially, the desire to accumulate foreign exchange reserves in dollars was a response the emerging market crises of 1997 and ’98. The crises were triggered by a dollar shortage. When Bernanke was at the Fed under Greenspan, he coined the famous term ‘savings glut’ to explain the large and lasting U.S. current account deficit. In his mind, the U.S. was doing the world a favor by spending the money that other countries wouldn’t. Bernanke’s explanation portrayed the U.S. as a passive receiver of savings surpluses. But if Greenspan had refused to loosen up the money supply, if the regulators had stopped the sales of dubious derivative products, if American households had refused to borrow money they couldn’t pay back, surplus foreign savings couldn’t have flowed into the U.S. economy, and the dollar would have risen to keep out the money.
A more cogent explanation is the U.S. system evolved to take advantage of this source of cheap money. Self-interest prompted Wall Street to embrace a new business model that centered on pumping the cheap foreign money into the U.S. housing sector. By 2004 it was obvious that surplus countries couldn’t get off accumulating dollars without their economies crashing. Their economies restructured for selling to the deficit countries and financing the sales with their surpluses. Private demand for dollars in these countries collapsed. Their central banks had to buy all the surplus dollars. Even though they knew it would crash one day, they didn’t have the courage to let it go and bear the economic consequences. They waited for the U.S. to implode.
A bubble can be an honest mistake. The herd mentality is a human weakness that underpins bubble phenomenon. However, in some bubbles, there are people who try to incite and take advantage of the herd mentality for their personal gains. These are the people who deserve to be prosecuted. We don’t have to look far to see such people. Who pocketed millions on false profits? Who gave worthless derivatives triple-A ratings? Who changed the rules for dubious financial products to be sold?
The blame game is not just a rhetorical game. If deficit countries blame surplus countries for the crisis, they may just wait for the later to fix the problem. Apart from fiscal and monetary stimulus and bailing out their banks, they may not undertake structural reforms to balance their economies. The inaction could prolong the downturn and lay the foundation for another crisis. It is better to fix the problem now. The U.S. shouldn’t rely on stimulus alone to prop up the economy.
President Obama spoke eloquently about responsibility. This is what solving the problem all is about. Instead of blaming someone else and asking for assistance, everyone must cut back to help the economy to live within its means. Spending too much got the U.S. into trouble. Spending more won’t get it out of its problem.