November,14, 2008
Americans’ fascination for imported goods and China’s currency policy also stand to blame
Americans’ fascination for imported goods and China’s currency policy also stand to blame
Americans’ fascination for imported goods and China’s currency policy also stand to blame
MUMBAI: “I hate Alan Greenspan,” she said.
“Your ex-boyfriend?” I asked.
“No, Dumbo, The ex-chairman of the US Federal Reserve, the central bank of the United States.” “OK. And why do you hate him?”
“The more I read, the more convinced I am that he is the only one responsible for the current financial crisis.”
“What makes you so sure?”
“Oh, a lot of financial market experts have been saying that.”
“And you agree with what they say?”
“Well, I have my own logic, too. You know, in the aftermath of the dotcom bubble going bust, Greenspan as the chairman of the Federal Reserve started to cut interest rates in a bid to ensure the economy did not go into a recession because of the stock market collapsing. His idea was to get people to consume more. By mid-2003, the benchmark interest rate had fallen to as low as 1%, and that is where it stayed for the next 12 months or so.”
“So?”
“With the interest rates at such low levels, people started to borrow to buy homes. Low interest rates combined with the belief that house prices will continue to go up fuelled another bubble. Banks and other financial institutions that gave out home loans decided it was a good opportunity to expand the market.
So they decided to give home loans even to those who were not creditworthy enough and would not get a loan in the normal scheme of things. But they were smart enough to get out of these loans very quickly by securitising them.
Securitising meant pooling similar kinds of loans together, dividing them into financial securities and selling them to financial investors. It freed up the money and they could lend again.
A major part of the equated monthly installment (EMI) paid by the borrower was passed on to the financial institution that bought these securities. The borrowers had taken loans primarily because the loans were structured to have a low EMI initially.
Since the housing prices were on their way up, the borrowers planned to sell out before the higher EMIs set in. When they tried to sell out, there were not enough buyers because the prices had run just too far.
At this point of time, borrowers started to default. And banks and financial institutions who had bought these securities were in trouble. And since banks across the world had bought these securities, the crisis gradually spread.”
She would have gone on. But I cut in: “it’s not as simple as you make it out to be.”
“How is it then?” she asked.
“There are other reasons for the mess as well. During Clinton’s term as the President of the US, the American government used to run a budget surplus, meaning the government earned more than it spent.
However, after George Bush took over, taxes were cut, giving more money in the hands of the people, so they could spend. At the same time, the government spending also went up.
When the government spends more money, it obviously ends up as added income in the hands of somebody, and he or she has the option of spending that extra income. And what did the Americans spend on? Imported goods - they imported goods from countries like China, Japan and other Southeast Asian countries, paying the exporters from these countries in US dollars.
The exporters repatriated the dollars to their home countries, to be exchanged for the local currency. As a result, the central banks of these countries ended up with huge foreign exchange reserves, and all those dollars eventually came back to America.”
“And how did the dollars come back to America?” she asked.
“Oh. The central banks of countries like China ended up investing in securities issued by the US government to finance its budget deficit. You see, the US government was spending more than it was earning.
And where did all the extra dollars needed to manage the deficit come from? They came from borrowing — borrowing through issue of financial securities that the central banks of China and other countries bought. Since there was great demand for these securities, the interest rates offered on these securities continued to be low.
MUMBAI: “I hate Alan Greenspan,” she said.
“Your ex-boyfriend?” I asked.
“No, Dumbo, The ex-chairman of the US Federal Reserve, the central bank of the United States.” “OK. And why do you hate him?”
“The more I read, the more convinced I am that he is the only one responsible for the current financial crisis.”
“What makes you so sure?”
“Oh, a lot of financial market experts have been saying that.”
“And you agree with what they say?”
“Well, I have my own logic, too. You know, in the aftermath of the dotcom bubble going bust, Greenspan as the chairman of the Federal Reserve started to cut interest rates in a bid to ensure the economy did not go into a recession because of the stock market collapsing. His idea was to get people to consume more. By mid-2003, the benchmark interest rate had fallen to as low as 1%, and that is where it stayed for the next 12 months or so.”
“So?”
“With the interest rates at such low levels, people started to borrow to buy homes. Low interest rates combined with the belief that house prices will continue to go up fuelled another bubble. Banks and other financial institutions that gave out home loans decided it was a good opportunity to expand the market.
So they decided to give home loans even to those who were not creditworthy enough and would not get a loan in the normal scheme of things. But they were smart enough to get out of these loans very quickly by securitising them.
Securitising meant pooling similar kinds of loans together, dividing them into financial securities and selling them to financial investors. It freed up the money and they could lend again.
A major part of the equated monthly installment (EMI) paid by the borrower was passed on to the financial institution that bought these securities. The borrowers had taken loans primarily because the loans were structured to have a low EMI initially.
Since the housing prices were on their way up, the borrowers planned to sell out before the higher EMIs set in. When they tried to sell out, there were not enough buyers because the prices had run just too far.
At this point of time, borrowers started to default. And banks and financial institutions who had bought these securities were in trouble. And since banks across the world had bought these securities, the crisis gradually spread.”
She would have gone on. But I cut in: “it’s not as simple as you make it out to be.”
“How is it then?” she asked.
“There are other reasons for the mess as well. During Clinton’s term as the President of the US, the American government used to run a budget surplus, meaning the government earned more than it spent.
However, after George Bush took over, taxes were cut, giving more money in the hands of the people, so they could spend. At the same time, the government spending also went up.
When the government spends more money, it obviously ends up as added income in the hands of somebody, and he or she has the option of spending that extra income. And what did the Americans spend on? Imported goods - they imported goods from countries like China, Japan and other Southeast Asian countries, paying the exporters from these countries in US dollars.
The exporters repatriated the dollars to their home countries, to be exchanged for the local currency. As a result, the central banks of these countries ended up with huge foreign exchange reserves, and all those dollars eventually came back to America.”
“And how did the dollars come back to America?” she asked.
“Oh. The central banks of countries like China ended up investing in securities issued by the US government to finance its budget deficit. You see, the US government was spending more than it was earning.
And where did all the extra dollars needed to manage the deficit come from? They came from borrowing — borrowing through issue of financial securities that the central banks of China and other countries bought. Since there was great demand for these securities, the interest rates offered on these securities continued to be low.
And this is something Greenspan must have inherently understood. He could continue to cut interest rates and even maintain them at a level as low as 1% because he knew that central banks of China will continue to invest in financial securities issued by the US government. Thus, the willingness of countries flush with dollars earned through exports to the US to invest in US government securities at low interest rates ensured the prevalence of a low interest rate environment in the US. As the Economist newspaper aptly put it: “America buys China’s goods; China buys America’s debt.”
“That is a very interesting way of looking at it,” she said with a smile.
“I am not done yet. And what did this low interest rate regime do? It fuelled the housing bubble, whose implications I have already explained. It also encouraged the US government to continue to live beyond its means. I don’t know if you realise this, but the US is one of the few countries that can borrow internationally in their own currencies. In contrast, if India has to borrow from abroad, it has to do so in dollars.
This would mean it has to repay in dollars, too. And to repay in dollars, it would need to earn those dollars through exports or hope that Indians abroad keep sending a huge number of dollars home. The US does not have to bother about all that. It borrows in its own currency. So, worse come worse, it can always print more dollars and repay the loans. That’s how they could afford to run a larger deficit. But look how it has come to haunt them now…”
“But there is something I still don’t understand. When China exports to the US, it earns in dollars, but when Chinese exporters repatriate that money back to China, they need to convert dollars into yuan or the renminbi as their currency is called.
That would mean the demand for yuan would go up and it would appreciate against the dollar. And yuan appreciating would mean that for every dollar that Chinese exporters sell, they would get a lesser number of yuans. Wouldn’t this over a period make Chinese imports uncompetitive?”
“Your question is logical. But the reality is different. The Chinese central bank does not allow the yuan to appreciate very fast. It keeps buying dollars and thus releasing yuan into the market. This ensures that there is no scarcity of yuan in the market and so the currency does not appreciate at a fast pace. At a much broader level, this helps keeps the Chinese exports competitive.”
“So are you saying that the US and China have an arrangement of ‘you scratch-my back and I’ll scratch yours’?”
“Exactly.”
“But what about all these experts who have been criticising Greenspan?”
“That my dear is the benefit of hindsight. Six months back, how many people were criticising Greenspan? Very few. Moral of the story — human beings like to create heroes, only to destroy them.”
“That is a very interesting way of looking at it,” she said with a smile.
“I am not done yet. And what did this low interest rate regime do? It fuelled the housing bubble, whose implications I have already explained. It also encouraged the US government to continue to live beyond its means. I don’t know if you realise this, but the US is one of the few countries that can borrow internationally in their own currencies. In contrast, if India has to borrow from abroad, it has to do so in dollars.
This would mean it has to repay in dollars, too. And to repay in dollars, it would need to earn those dollars through exports or hope that Indians abroad keep sending a huge number of dollars home. The US does not have to bother about all that. It borrows in its own currency. So, worse come worse, it can always print more dollars and repay the loans. That’s how they could afford to run a larger deficit. But look how it has come to haunt them now…”
“But there is something I still don’t understand. When China exports to the US, it earns in dollars, but when Chinese exporters repatriate that money back to China, they need to convert dollars into yuan or the renminbi as their currency is called.
That would mean the demand for yuan would go up and it would appreciate against the dollar. And yuan appreciating would mean that for every dollar that Chinese exporters sell, they would get a lesser number of yuans. Wouldn’t this over a period make Chinese imports uncompetitive?”
“Your question is logical. But the reality is different. The Chinese central bank does not allow the yuan to appreciate very fast. It keeps buying dollars and thus releasing yuan into the market. This ensures that there is no scarcity of yuan in the market and so the currency does not appreciate at a fast pace. At a much broader level, this helps keeps the Chinese exports competitive.”
“So are you saying that the US and China have an arrangement of ‘you scratch-my back and I’ll scratch yours’?”
“Exactly.”
“But what about all these experts who have been criticising Greenspan?”
“That my dear is the benefit of hindsight. Six months back, how many people were criticising Greenspan? Very few. Moral of the story — human beings like to create heroes, only to destroy them.”
(The example is hypothetical)
http://www.dnaindia.com/money/report-think-greenspan-alone-got-you-into-this-mess-1206237
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