The Dollar vs. Yen exchange rate that was artificially stimulated by Japan's near zero interest rate policy, had started to cave in from the summer of 1998 as the fallout of Asian Financial Crises spread to Russia. With the usual 2 to 3 year lagging time, U. S. runaway trade deficit tapered around the end of 2000, heralding the burst of the mighty Dot-com Bubble.
The recovery from the recession caused by the burst of the Dot-com Bubble was slow and uneven. However, masked by the slow recovery, dramatic changes had occurred in the front of U. S. trade balance, paving the way for a perfect storm of exploding runaway trade deficit. It was this explosive runaway trade deficit that eventually brought on a huge mortgage based bubble. When this mortgage bubble burst, the crash and the self-destruction of the globalization scheme of yesterday followed. In the after math of the self-destruction of the globalization scheme of yesterday, a new phase of U. S. and the global economy that can be properly called the era of "Quantitative Easing" has dawned. This new phase of economy will be discussed in the next section.
The Dot-com Bubble had started to unravel in the second half of 2000. The sudden terrorists attack at 911 shocked the whole country, and sent the consumer spending fell off a cliff. As the public recovered from the panic, consumer spending bounced back up rapidly. Such a sharp reversal in consumer spending led various kinds of definition of business cycle to call the fourth quarter of 2001 as the end of the recession1. If there had not been the 911 terrorist attack, the economy probably would have continued its smooth but rapid fall through 2002. The artificial rapid bounce after 911 naturally could not have maintained its pace. Indeed the economic recovery had slowed down markedly in 2002. Then the talk of the Iraq War and the SARS scare further delayed the recovery. It was well into 2004 that the recovery picked up speed as the trade deficit exploded.
The burst of the Dot-com bubble affected people that held a lot of stocks, but not lower income folks that do not hold a lot of stocks. Thus the consumption of lower level consumer goods mostly imported from China was not affected. With artificially set very low exchange rate between Yuan and Dollar, China's trade surplus against U. S. has overtaken that of Japan in 2000, and has kept growing even through the recession and slow recovery years from 2001 to 2003. Since 2004 U. S. trade deficit against China has grown further. Another factor in the trade front was the newly launched Euro. Euro is another kind of currency manipulation2 that helps German exporters at the expense of weak countries like Greece. Since Greece is not a trade competitor of U. S. but Germany is, U. S. trade deficit vs. Euro region also expanded rapidly. On the other hand Japan's currency manipulation based on the near-zero interest rate policy waned as U. S. interest rate dropped rapidly, too. The trend of overall U. S. trade deficit of goods, and individual trade deficits against China, Japan and EU are plotted in logarithmic scale in the following figure through the period of interest.
In the graph at the right, the curves are drawn with the scale of log-10 (billion dollars), so that by comparing the slopes of the curves we can immediately compare the growth rate of each curve. The black curve is U. S. goods trade deficit against the whole world, the red one is against China, the purple one is against EU and the blue one is against Japan. Since the country wise data is not adjusted for seasonal variation, 12 month running averages are used in the graph. For example, if we look at a point at June, 2005, it is the average value between July 2004 to June, 2005 so it represents the condition around December, 2004 to January, 2005, not the condition of June, 2005.
It is worth to pay attention to the blue curve in the graph, U. S. trade deficit with Japan. This blue curve started to decline when the recession has started in 2001 and had not recovered to the pre-recession height until the middle of 2005. This sorry behavior of U. S. trade deficit with Japan was a stark contrast to the trade deficits with China and EU. As discussed in the previous section the high flying U. S. Dollar (vs. Japanese Yen) plunged in 1998 when the shock wave of Asian financial crises reached Russia. About 2 years later, U. S. trade deficit started to wane and triggered the burst of the Dot-com bubble. By that time Dollar had tumbled to about 110 Yen per Dollar, from the height of 170 Yen per Dollar. In order to fight the recession The Federal Reserve lowered interest rate steadily until 2004. The lowering of U. S. interest rate eroded the value of Dollar vs. Japanese Yen further, causing U. S. trade deficit against Japan to stagnate. Since during that period, Japan's export capacity was idled but not scrapped, when U. S. interest rate started to rebound alongside with the value of Dollar vs. Japanese Yen, Japan's trade surplus with U. S. expanded quickly, without the usual 2 to 3 years of delay.
After U. S. trade deficit vs. Japan also recovered in 2005, the overall U. S. trade deficit, the black curve in the graph, entered the period of explosive expansion to induce the gigantic bubble the burst of that triggered the "Crash". With those backgrounds we are now ready to look into the characteristics of this gigantic bubble itself.
Following the slow recovery from the ash of burst dot-com bubble, two new bubbles had arisen, they were another stock market bubble and a giant mortgage bubble. Though the newly arisen stock market bubble was comparable in size to the dot-com bubble, its burst did not have the power to cause the self-destruction of the globalization scheme of yesterday. It was the burst of the giant mortgage bubble that induced the "Crash", or called "The Great Recession" that we classify as the end of the globalization scheme of yesterday; the globalization scheme of yesterday was set into motion in early 1980s.
The first issue we need to look into is what had caused the formation of the giant mortgage bubble the burst of that did such a damage to the U. S. economy. Many economists have pointed their fingers to the very low short-term interest rates around 2003 undertaken by The Federal Reserve under the leadership of Alan Greenspan. However, an explicit rigorous inspection of the actual monetary data shows the blame of the rise of the mortgage bubble should not be placed on the monetary policy, but squarely on the giant leap of the U. S. trade deficit as will be discussed below.
The way home mortgage grows is as follows: First is to lend money to home buyers to initiate many home mortgages. e. g. supposes the total sum of those home mortgages is $100 million. This pool of mortgages is used as the base to issue $100 million worth mortgage backed securities to be sold to investors and speculators. The original lenders recoup the money and lend out another $100 million worth of mortgages and so on. Assuming the turnover time is kept more or less constant, the speed the amount of home mortgages will accumulate depends on the size of initial amount available to be lent to home buyers, and the amount of money in the hands of investors and speculators available for buying the mortgage backed securities.
The amount of money involved in the expansion of home mortgages mainly come from two possible sources, the money created by Federal Reserve, and the runaway trade deficit. "Reserve Bank Credit" published regularly measures the amount of money created by The Federal Reserve. In Fig. 9-2 at the right "Reserve Bank Credit" is plotted as the black curve at the bottom of the graph. The accumulated U. S. trade deficit is plotted as the blue curve in the middle of the graph, and the total amount of home mortgage outstanding is plotted as the red curve in the top of the graph. The curves in Fig. 9-2 are all plotted in vertical scale of log-10 (billion dollars) in quarterly intervals. The slope of a curve at certain point measures the growth rate of the curve at that point.
Reserve Bank Credit, the black curve, grows with a more or less steady rate except a one quarter surge at the fourth quarter of 1999. The 1999 4-th quarter peak was due to the emergency to save Latin American countries from default as the shock wave of Asian financial crises propagated cross the Pacific Ocean. From 1994 up to 2007 when the "crash" hit, the growth rate of Reserve Bank Credit had rather moderated gradually. There is no sign that Federal Reserve was printing extra amount of money in the period when the mortgage bubble was formed. On the other hand, the growth rate of the red curve, the rate of increase of total amount of outstanding home mortgage had accelerated steadily from 2000 up to 2005, turned into a steady growth rate through 2006, and then decelerated into 2007. The divergent behavior of Reserve Bank Credit and the total amount of outstanding home mortgage disaaproves the claim that the mortgage bubble was due to Federal Reserve's overly loose monetary policy.
The runaway trade deficit does not increase the amount of money created by The Federal Reserve, but it changes the way money flows through the society. As the consequence Wall Street speculators are able to borrow huge amount of money that they could not get hands on before the launch of this runaway trade deficit based "globalization scheme of yesterday" as has been pointed out in Section 3 of this review article3. The money borrowed by Wall Street speculators is mainly used to buy stocks to create stock market bubbles or used as the seed money to initiate home mortgages to create the mortgage and housing price bubble. In Fig. 9-2, the accumulated U. S. trade deficit is plotted as the blue curve.
In the period from the beginning of 1997 to the end of 2000 the blue accumulated trade deficit curve has grown much faster than the amount of outstanding home mortgage curve, that is, the red one. This difference in the growth rate indicates that during this period Wall Street speculators threw the borrowed money mainly into the stock market to generate the dot-com bubble. It is after the burst of the dot-com bubble and the earnest recovery from the recession generated by the burst, that is, from 2004 the growth rate of the amount of outstanding home mortgage, the red curve, caught up with the expansion rate of accumulated trade deficit, indicating the borrowed money by Wall Street speculators went into both the stock market and the mortgage market. By this way an explosive mortgage bubble was formed alongside with another stock market bubble.
In order to understand how the runaway trade deficit will inevitably lead to the self destruction
of the globalization scheme of yesterday, we must first grasp what are the sufficient and
the necessary conditions to generate the runaway trade deficit. In "LOGIC", for an event to occure
with certainty, both sufficient conditions and necessary conditions must be satisfied. Three
conditions are specified in
the Introductory Section4 and Section 25 of this article, they are,
(1) substantially reduced tariffs to allow freer flow of goods and services across the national boundaries,
(2) reduced restrictions on the free flow of capital,
(3) wholesale allowance of currency manipulations.
Those three conditions are necessary conditions but not the sufficient condition to generate runaway U. S. trade deficit, that means, even if all those three conditions are satisfied, runaway U. S. trade deficit still may not occur since there lacks a necessary condition. The lacking sufficient condition is that U. S. consumers must have enough money to buy imported goods, raw materials and services produced in foreign countries. With the sufficient and necessary conditions of generating the runaway U. S. trade deficit identified, we can proceed to see how the globalization scheme of yesterday had destroyed itself.
Wall Street is enriched enormously from the runaway U. S. trade deficit as has been pointed out in Section 33 of this review article. It is natural that Wall Street wants to see the runaway trade deficit to expand more and more. However, three necessary conditions and the sufficient condition required to create the runaway trade deficit contain an implicit contradiction that will limit the size of U. S. trade deficit. As U. S. trade deficit increases, more and more manufacturing jobs are shipped to overseas, causing U. S. domestic jobs shift toward lower paid service jobs. This means consumers' income will not grow sufficiently to buy more and more foreign made goods and services to let U. S. runaway trade deficit to reach the degree of satisfying Wall Street. The way to resolve this dilemma requires Wall Street to take the lead to recycle the money borrowed through the process of runaway trade deficit back to consumers so that consumers will have enough money to buy more and more foreign made goods and Wall Street can be enriched more and more.
From Fig. 9-1 we can see that the deficit with EU for luxury goods and the deficit with Japan for high quality but also high price consumer goods can only carry the burden of expanding the runaway trade deficit to certain degree. Eventually the import of inexpensive low level consumer goods from China must be expanded enormously to satisfy the desire of Wall Street to become ever richer and richer. This means the money borrowed from foreign trade surplus nations must mainly goes into the hands of the middle and lower income class consumers.
The traditional Wall Street tactic to recycle the borrowed money to consumers alongside of enriching themselves is to blow stock bubbles. Since higher income consumers own disproportional amount of stocks than the middle and lower income consumers, this method has a limit how high the runaway trade deficit can be pushed. Here the blowing of the mortgage bubble becomes an ideal method to recycle borrowed money into the hands of middle and lower income groups so that the runaway trade deficit can be pushed to its maximum and allow Wall Street to be enriched to the limit. To generate a mortgage bubble is not difficult. The down payment requirement is steadily lowered, even to zero (so called "subprime mortgages"). Borrowers are directed to short term mortgages with teaser rate that is substantially below the market rate. A large number of middle to lower income people become eligible to borrow and buy houses, generating a housing price bubble. Riding on the exploding houseing price, those new buyers of house can refinance their mortgage in a very short time to the amount exceeds their original purchase price; thus they get extra cash to buy foreign imports and help to push the runaway trade deficit to go higher further, Wall Street can borrow more to blow the bubble larger and become richer, and so on. Unfortunately the trade deficit cannot expand forever. When the runaway trade deficit peaks, the trade deficit based mortgage and housing price bubble will burst, many low income home buyers will default, and Wall Street served as the lender to low income home buyers will be wiped out. That was the phenomena called the "Great Recession" or the "Crash". We will discuss in detail the onset of the unravelling of the giant bubble next.
As has been discussed in the previous section6, armed with Yuan pegged to Dollar at more than 8 Yuan / Dollar, U. S. trade deficit with China had expanded steadily. By year 2000 U. S. trade deficit with China has surpassed U. S. trade deficit with Japan already. Coming into the 21st century, China's admission into WTO with strong support from Clinton Administration but without being required to abandon the more than 8 Yuan/Dollar peg, U. S. trade deficit with China expanded further in a rapid pace. By 2005 U. S. trade deficit against China had surpassed 200 billion dollars a year. Alarmed by this rapid escalation of the trade deficit with China, U. S. Congress put a strong pressure on China to let Yuan appreciate or suffer the fate to have a substantial tariff imposed on all imports from China. Chinese Government relented and let Yuan appreciate gradually against Dollar starting from July of 2005. With the usual delay factor from a major exchange rate change to the change of trade balance, the runaway U. S. trade deficit with China had waned in a few years, bringing the total U. S. trade deficit to follow the trend. Thus a recession in 2008 is predicted to start in 20087 as the giant mortgage bubble and the accompanying stock market bubble both burst. U. S. runaway trade deficit did stop to grow by the end of 2006, prompting us to watch more closely other economic indicators to detect the oncoming recession in 2008. Before the regular annual revision at the end of July, 2007, both GDP and consumer spending were portrayed to have sustained a steady growth rate, showing no sign of the approach of a recession. However, the end of July, 2007 annual revision changed the whole picture, showing the growth rate of GDP and consumer spending had decelerated alarmingly for quite a while already. The changed picture had led us to issue a recession watch at the end of July, 20078.
As the U. S. trade deficit stopped to grow, the mortgage bubble started to collapse, and the price of mortgage backed securities began to sink. In June of 2007 two Bear Stearns sponsored funds that speculated on risky subprime mortgage based Structured Debt Obligation failed, a prelude to the trouble ahead. Shortly after the issuance of the warning8 about the coming recession, the first financial firestorm arrived. Several Citibank sponsored "Structured Investment Vehicle (SIV)" were frozen out of commercial paper market; if they could not refinance their maturing commercial papers, they would default. Eventually Citibank was forced to take those SIVs into its own balance sheet to bail them out. Similar fate was befallen on other SIVs. By the end of 2007, the money market condition had become so tight, The Federal Reserve had created "Term Borrowing facility" to pump liquidity into the market in an unconventional way.
During the early stage of financial firestorms up to November, 2007, Wall Street kept bullish view and urged investors to buy stocks, and pushed the market to move up further. Wall Street even unleashed strange opinions like "China will come to rescue the world even if U. S. and other markets outside China stumble" just to prevent investors to sell stock holdings. Wall Street people advocating such views were called "decoupling theorists" later on.
In early March of 2008, we issued another stern warning of the inevitability of a recession since The Federal Reserve had yielded the control of the economy to the runaway trade deficit9. Shortly after, Bear Stearns, the 7th largest financial entity on Wall Street, failed10. Next were the turn of Fannie Mae and Freddie Mac, the government sponsored but privately owned entities created to boost home mortgage lending. Eventually those two entities must be taken over by U. S. Government to prevent outright default on their debts11. The climax, of course, was the failure of Lehman Brothers12, Merrill Lynch13 and AIG14. Thus came the financial crash and the self-destruction of the globalization scheme of yesterday.
As the mortgage bubble reached the peak and then burst, we have started to hear the mutter about various financial innovations that were hidden from public view since the financial media rarely reported on them. After the burst, many blamed those financial innovations as the cause of the mortgage bubble. Let us study those financial innovations in detail here. We will see that those innovations just played a secondary role in the fiasco. The main reason that the giant mortgage bubble had formed and then burst is the globalization scheme of yesterday that tried to use the runaway trade deficit to superficially boost U. S. economic growth and at the same time enrich Wall Street traders.
Banks that initiate home mortgages often want to sell the mortgages to third parties. By selling the mortgages, banks can recoup the capital and initiate new mortgages, just to gain fees repeatedly. By selling the mortgages, banks' capital will not be depleted by reserves required if the mortgages are not sold and stayed on their balance sheets. However, for investors and speculators alike to hold individual mortgages is not only tedious but risky and costly. Thus arise the entities, often called "vehicles" in financial parlance, to buy the mortgages and sell bonds to investors and speculators with the pool of the mortgages as collaterals. Such "vehicles" are often sponsored by the mortgage initiators themselves. The "vehicles" manage the mortgages in the pool, and pass through the interests and the principles paid by the mortgage borrowers to the bond investors, of course, after subtracting the fees charged by the "vehicles".
By transforming home mortgages into such mortgage backed securities, debt rating agencies can now rate the mortgage backed securities using statistical models to estimate the default risks based on their assumption and the understanding about the macroscopic economic environments. With the mortgage backed securities rated, investors and speculators can place a price on them so that the market to trade those securities emerges.
The above discussions may prompt a misunderstanding that by the securitization, new mortgages can be created without limit, and thus ignite a bubble. Actually total amount of mortgages is constrained by the amount of money buyers of mortgage securities can throw in to buy those securities. As we have already stated that the ability of investors and speculators to buy mortgage backed securities is boosted by the runaway trade deficit, but The Federal Reserve did not create a lot of money during the period of the formation of the mortgage bubble. Thus it is not the mortgage backed securities but the trade deficit that has created the mortgage bubble and caused its burst when the trade deficit started to wane.
When issuing mortgage backed securities with a pool of mortgages as collateral, a twist can be applied. Instead of issuing one kind of securities covering all the mortgages in the pool, multiple trenches of different kinds of securities can be issued. For example, four trenches A, B, C, and D are issued. Trench A receives the lowest pay back and D the highest pay back. However, when some mortgages in the pool default, the pay back to D trench will be reduced. When the defaults wipe out the D trench, further defaults will then eat into the trench C and so on. Obviously trench A is the safest and D the most risky. By this way the issuer hopes to attract investors and speculators with different aims and increase the sales of the securities. However, the underlying cash flow for all trenches does not change from the plain vanilla mortgage backed securities and so is the total amount of mortgages available that will not change by issuing those structured mortgage backed securities. It is wrong to claim such structured mortgage backed securities aided the mortgage bubble.
"Debt" quoted here are mortgages. This product uses a pool of trenches from structured mortgage backed securities as the collateral and issue trenches of different kinds of securities. The collateral are usually junior trenches of structured mortgage backed securities. The collateralized debt obligations are somewhat safer for its senior trench than the junior trenches of the underlying structured mortgage backed securities used in the collateral. On the other hand the junior trenches of the collateralized debt obligations become more risky but higher yielding instruments than the trenches used in the collateral. The junior trenches of such collaterized debt obligations became the darling of speculators and adventurers who never dreamed the coming collapse of the mortgage bubble. The senior trenches of collateralized debt obligations were often difficult to sale, and the issuers were forced to retain them in the inventory. Such instruments to fan speculation do not increase the amount of available mortgages so cannot create the mortgage bubble nor to cause its burst.
Credit default swap is an over-the-counter derivative instrument. Over-the-counter means that there are no official trading markets and regulations for such derivatives. The party and the counter party involved in such a derivative must negotiate between themselves to decide the conditions. Instead of abstract descriptions about this financial innovation, let us consider an explicit example here.
Suppose an investor purchased a corporate bond. From the fear that the bond may default, he wants to buy a five year insurance on the bond. The investor may buy a credit default swap customized for the bond as the insurance in case of default. If the bond defaults, the investor can sell back the bond at the original purchase price to the seller of the credit default swap. In the meanwhile the investor must pay insurance premium regularly to the seller of the credit default swap. Credit default swap is not only used in this kind of straightforward insurance purpose, but can also be used as a tool to speculate on the bond. For example, if the speculator bets that the bond will default within five years, he may purchase a credit default swap of the bond for five years. If the bond really defaults within five years, the speculator will win big without the need to explicitly shorting the bond. On the other hand the seller of credit default swap is always betting that the bond will not default so can pocket all the premium payments made by the buyer. The seller of credit default swap must post collateral to show that he can pay the buyer in case of actual default.
Synthetic collateralized debt obligation is to create a portfolio of structured mortgage backed securities, using credit default swap, without actually owning those securities. To create such a synthetic collateralized debt obligation needs substantially less money to create a portfolio equivalent to a honest collateralized debt obligation. This means with a smaller movement in price of the underlying structured debt obligation, the portfolio can suffer a huge loss or win big, so it is a leveraged speculative device. Before the crash the majority of credit default swap was for speculation, not for actual insurance on debts. Speculations do not increase available mortgage, so they did not create the mortgage bubble. Some may say that such speculations had induced the sudden collapse of the mortgage bubble. However, as have been pointed out already, the start of the collapse to the climax of the crash took more than a year. It is the ignorant speculators who lost big by not realizing the step by step advance of the collapse, not the imaginary sudden collapse triggered by the speculations. The reason of the big losses was due to the default of underlying home mortgages that was triggered by the less available mortgage money caused by the wane of the runaway trade deficit, but not by the speculations themselves.
Comment 71: What is a "recession"? Are there any mechanical forewarning signals about incoming recessions?
by Chih Kwan Chen (Aug. 27, 2009)
2. Comment 83: The Cause of European Crisis is Euro, the “Currency Manipulation Plot of the Third Kind” by Chih Kwan Chen (October 1, 2011)
3. Section 3 of this review article
4. Section 1 of this review article
5. Section 2 of this review article
6. Section 8 of this review article
7. Comment 25, by Chih Kwan Chen (Oct. 18, 2005)
8. USA Outlook Update (July 28, 2007) by Chih Kwan Chen
9. Anatomy of Bubbles, by Chih Kwan Chen (March 6, 2008)
10. Wikipedia article about Bear Stearns
11. Wikipedia article about Federal Government takeover of Fannie Mae and Freddie Mac
12. Wikipedia article about Lehman Brothers
13. Wikipedia article about the trouble of Merrill Lynch
14. Wikipedia article about the financial crises of AIG