Anyone who pays attention to economic matters should be aware that the US is running very large trade deficits year after year for more than two decades. By 2006 the trade deficit had reached more than 6% of the US GDP. Studying the way money flows when a country is running trade deficits, we will see that trade deficits replace personal savings as the seed money to the financial market. The runaway US trade deficit thus allows US consumers to save less and consume more so that the US economy is boosted artificially to an elevated level. This is why the US economy has prospered in the past two decades while running escalated trade deficits in general. More detailed studies (see articles 2 and 2A) show that during the past two decades the US economy prospered most when the trade deficit expanded rapidly in the mid 1980's and in the late 1990's. However, the US trade deficit has become so large that even after allowing the personal saving to drop to near zero and funding the US economy to run in full throttle at the artificially elevated level, there are still extra seed money left in the financial market. This extra seed money then induces reckless expansion of lending to inflate a debt bubble beyond the needs of the US economy in recent years.
Apparently more lending leads to more profits for the financial markets and the Wall Street alike, so the incentive to lend more is always there. Such desire of more lending is usually balanced off by the fear of bad loans if lending standards are loosened too much in order to accommodate more lending. A new invention called CDO (Collateralized Debt Obligations) has changed the balance dramatically and helped to boost the debt bubble that is now deflating painfully. Let us consider the following example to see how this CDO strategy works. Suppose a bank initiates 1000 mortgage lending. In the old days before CDO, the bank will keep those 1000 mortgage lending on its own book. Since each lending carries some risks, the bank needs to set aside a certain amount of money from its own capital as the reserve to cover the risk of default related to that lending. Therefore, the total amount that the bank can lend out is constrained by the size of its capital. Under the CDO strategy, the bank will put those 1000 mortgage lending in a pool, asks some Wall Street professionals to turn the pool into securities collateralized by those 1000 mortgages, and then sell the synthesized securities to various investors. Since the bank does not retain those mortgages on its book, it does not assume any default risks of those mortgages so that the bank does not need to set aside any of its own capital against those lending as reserves. The bank profits from the fees of originating the mortgage lending and turning them into CDO, whereas investors assume the risks of defaults but collect interest payments of the mortgage borrowers; the rate the investors get after all those fees is usually still substantially higher than other old fashion debt instruments. In principle the bank can originate as much CDO based lending as it likes without the constraint of its capital size as long as there is markets for such CDO. CDO are not restricted to mortgage lending, but are applied to other lending like credit card loans, auto loans, debts related to merger and acquisition by private equity firms and other esoteric debts. Thus the lending and the overall amount of debts outstanding are boosted smartly by CDO.
Even with the help of CDO that are issued according to the prudent standard of risk assessments, it is still not enough to absorb all the extra seed money provided by the runaway US trade deficit. Some more brazen scheme is required to expand the debt bubble to the degree that all the extra seed money from the runaway US trade deficit can be used up and the maximum amount of profits generated for the participants of the financial market and the Wall Street. The result is now infamous CDO backed by subprime mortgages. A subprime mortgage requires no down payment, no verification of the income statement provided by the borrower ( in some cases no income statement at all), and carry a very low interest rate for the first few (up to five) years of the life of the mortgage. The low interest rate period of the mortgage is called the “teaser rate” period. After the teaser rate period expires, the borrower must either refinance into a lower rate mortgage or pay a substantially higher interest rate. Subprime mortgages are essentially the loans only based on the current market values of houses but without taking into account the ability of the borrowers to carry the loans. As has been pointed out in Comment 18, once mortgage lenders parcel out loans only based on the current market values of houses like subprime mortgages, it is very easy to push the housing prices up to the stratosphere. Thus as subprime mortgages take hold, US housing prices shoot up rapidly. This in turn gives subprime mortgage lenders and borrowers alike a false sense of security, thinking that before the teaser rate period expires the price of the house will go up sharply from the level when the mortgage is initiated so that the borrower will have no problem in obtaining a lower rate and affordable alternative mortgage or cash out with a handsome profit. The rapidly rising housing prices seem also to affect the rating agencies that rate those CDO. CDO backed by subprime mortgages were given AAA ratings so that conservative pension funds, investment trusts and endowments are allowed to buy them, though individual subprime mortgage probably must be rated as junk if considered alone. With all the pieces of subprime mortgage market fell into place, subprime mortgage lending took off like wildfire and exploded to a monstrous level, carrying the debt bubble to its pinnacle.
Unfortunate for all those drunken in the ecstasy of the debt bubble there still exist the invisible hand of the true free market. This invisible hand deems the reckless and wanton debt bubble powered by the runaway US trade deficit has already gone too far and needs to be reined in. The method to rein in is rather simple. It simply let US dollar fall against the currencies of trading partners with which the US runs substantial trade deficits (please see article 9 for the trade deficit weighted dollar index). As US dollar falls, the US trade deficit has started to stagnate by early 2006. This means that the US trade deficit after adjusted for inflation is actually falling since early 2006. Thus the extra seed money generated by the runaway US trade deficit disappears, and a liquidity squeeze has set in. The first to be hit is naturally the most explosive subprime mortgage lending. As subprime mortgage lending has stopped to grow, US housing prices have started to stagnate and then to turn south. Subprime mortgage borrowers discover suddenly that the values of their houses are now below the amount of mortgage loans they owe so that they cannot sell the houses and repay the loans without suffering from a heavy financial loss which they can ill afford. Many cannot afford the higher interest payments after the teaser rate period expires, and go into default. Quite a few, even before the expiration of the teaser rate period, simply walk away from the houses which now value less than the amount of loans. Those people can walk away from their houses without suffering any financial losses since they have not put down any money as the down payments; only thing that a walkaway suffers is his credit rating. As the foreclosure rate of subprime mortgages shoots up, the ratings of CDO backed by subprime mortgages tumble quickly from their fictitious AAA rating down to their true junk status.
Long term investors that ventured into those ill fated subprime mortgage backed CDO are also at fault since they have ignored the cardinal principle of investment, that is, higher return always comes with higher risk. They should have known that the AAA ratings of those ill fated CDO must be phony since those CDO pay substantially higher return than regular AAA rated securities. Those long term investors will suffer losses from those CDO for a long time but face no threat of imminent demise, since they have bought those CDO without any leverage. Many of them probably must sell those CDO once their ratings have proven not to be AAA, and thus will depress the market value of those CDO further. Most problematic are the speculative pools involved in the subprime mortgage backed CDO. Those pools are often sponsored by large financial institutions. They borrow heavily from the market by issuing commercial papers, and use the borrowed money to buy those CDO in order to profit from the interest rate gap between those CDO and commercial papers. When the news of subprime mortgage woes spread one day in August of 2007, the CDO backed commercial paper market collapsed in one stroke. As the result those speculative pools have faced the imminent danger of demise since they cannot roll over their CDO backed commercial paper anymore. From that time on until today, FED (The Federal Reserve Board) seems to be totally consummated by the efforts of avoiding large scale defaults of large financial institutions and Wall Street firms that have sponsored those speculative pools or have owned those CDO directly. The US Government and the US Congress are also scrambling around to save the endangered borrowers and lenders alike, but without a clear understanding of the cause of the crises and without any effective means to solve the problem. Readers interested in the unfolding of the crises and how the public sectors are scrambling to support the falling sky are referred to the series of comments posted on this website, titled “Tracing the liquidity squeeze”; those are Comments 46, 47, 48, 49, 50, 51, and 53.
As the liquidity squeeze continues with the US trade deficit showing no sign of rebound, the credit woes has started to spread beyond the subprime mortgage sector. Problems are appearing in the sectors of prime mortgages, credit card loans, auto loans, debts related to merger and acquisitions, esoteric debt instruments and so on. Eventually we should expect that the whole CDO market and the markets of unusual debt instruments will be all wiped out and the losses will extend to trillions of dollars. If such an out sized loss is forced to be shouldered by the private sectors, large scale failures of financial institutions including banks, investment bankers and brokerage houses are unavoidable. As the consequence the whole global financial system will face the danger of collapse. Some naively think that the US Government should come in to shoulder the loss in order to save the US economy from being pulled down by the collapse of the financial system. However, neither the US Government nor the US tax payers has the money to cover such losses. If forced to do so, the US Government can only ask FED to monetize the losses, meaning just printing money to cover those losses. Such a monetization will surely ignite a hyper inflation down the road. Another solution is to ask dollar rich foreign governments, like Japan and China, to come in to buy up and nationalize (by foreign governments) all those troubled financial institutions. Such a solution, even if is possible, will certainly carry heavy political prices and will triger a political firestorm that may very well burn down the current globalization scheme.
At the beginning of the liquidity squeeze only the most speculative lending is restrained, but the economy itself does not experience adverse effects. As the liquidity squeeze advances, more vital sectors of the economy will start to feel the pinch. With CDO booted out of the financial market, banks are forced to go back to the old fashion way of lending. On top of that they must deal with huge losses incurred by the collapse of CDO. It is natural that banks will be reluctant to make new loans. At the extreme when banks are caught with lending phobia, no matter how low FED reduces short-term interest rates, the desire of lending will not pick up. Most of the liquidity that FED injects into the financial market will simply be parked in the treasury markets, causing the yields of treasuries to plummet. This is exactly the situation that Japan has encountered when it has lowered interest rates to near zero and then literary to zero since the middle of 1990's. We thus dub this situation as the “Japan syndrome”. Once Japan syndrome gets hold, the economy will grind to a halt for many years. In the case of Japan it is essentially still in the grip of the syndrome as its stagnated consumer spending attests. Without any doubt it is an urgent job to monitor the possible approach of the Japan syndrome in the US economy. This is why we are refocusing our attention in this article on a long forgotten monetary measure, the monetary base, for this purpose.
The monetary base is composed of the total reserve held by the banking system plus the amount of currency in circulation. When lending is robust and the economy is chugging along fine, the growth rate of the monetary base will usually be high, but with many exceptions. On the other hand the growth rate of the monetary base will slacken as lending withers and the economic expansion slows down; this dire case only has one explainable exception during the time span covered by this article. FED has certain, but not unlimited power to influence the monetary base. The extreme case of the Japan syndrome is one example that FED will lose control of the monetary base completely. There are also numerous occasions when the FED's influence on the monetary base will diminish or disappear as we will see in later discussions in this article. A diligent monitoring of the behavior of the monetary base is thus an effective way to assess the conditions of the economy.
In order to use the monetary base as an effective monitor, we need to understand the characteristics of monetary base from a historic perspective. In the next section the correlation between the monetary base and the real economy is analyzed using data from 1959 to the present. Section 3 is devoted to the detailed analysis of the movements of the monetary base with FED's interest rate move and the inflation as two inportant inputs. The last section is reserved for concluding discussions.
The monthly average value of the monetary base is tabulated by FED, reaching back to January of 1959. At each new publication of the value of the most recent monetary base number, earlier tabulations are always slightly modified; the modifications can reach back for many decades. For our purpose of extracting general characteristics of monetary base, such slight modifications have no noticeable effect. Our compilation in this article is based on the version published on Jan. 24, 2008, the most up-to-date version when we have started this analysis.
The year to year % changes of the monthly values of real (means inflation adjusted) monetary base are plotted as blue dots in the graphs at the right. The years covered are written at the bottom of each graph. The inflation adjustment is based on the year to year % changes of the monthly values of price index of PCE (Personal Consumption Expenditure). The year to year % changes of the quarterly values of real GDP are plotted as the brown curves in those graphs.
From the top graph we observe that any time when the blue monetary base curve dips to a bottom, like in 1960, 1970 and 1974, the brown real GDP curve always come down to meet it. This implies that a near zero or negative yearly growth of the real monetary base foretells the coming recession. This characteristic also persists through the middle and the bottom graphs. Only exception is the case of 1996 where the blue curve dives to a slightly negative value in 1996, but the brown real GDP curve bottoms out at +2% level in 1995 and then rises through 1996 and beyond. This exception was the result of the massive waves of yen carry trades so that many speculative pools borrowed money in Japan instead of from domestic US banks to undertake their speculative activities. It is worthwhile to point out that the most recent dive of the blue monetary base curve indicates a coming recession.
Let us return to the top graph of the figure at the right. When the blue monetary base curve thrusts up strongly, the brown real GDP curve responds and also forms a peak, but the peaks of the brown curve always lie above the peaks of the blue monetary base curve. Since both curves use the same scale, this means a small yearly growth rate of the real monetary base can support a much stronger yearly growth rate of the real GDP. In the middle graph the above mentioned characteristic between the peaks of the blue monetary curve and the peaks of the brown real GDP curve still holds until 1983. However, from 1985 and later, the relative positions of the peaks are reversed, that is, the peaks of the blue monetary base curve now lie above the peaks of the brown real GDP curve. This reversal persists through the bottom graph, too. Also the positions of peaks in the blue and the brown curves are not well aligned after 1981. We should note that years 1981 to 84 can be considered as the transition years from the preglobalization era to the globalization era, so there are considerable differences in the characteristics of those curves in those two eras.
The reversal of peaks of two curves mentioned in the previous paragraph carries interesting messages. Comparing the peaks of the brown real GDP curves in the preglobalization era and the peaks in the globalization era, we observe that the peaks in the preglobalization era are much higher than those of the globalization era. This indicates that the maximum growth potential of the US economy has diminished substantially in the globalization era compared to the preglobalization era. On the other hand the peaks of the blue real monetary base curves become substantially higher in the globalization era than in the preglobalization era. This is due to the runaway US trade deficit dominating the financial market and causing the monetary base to gyrate more violently in the globalization era. Those two reversals of the heights of peaks of the brown and the blue curves then explain the reversal pattern as discussed in the previous paragraph.
In the next section we will investigate in detail how the monetary base curve and the real GDP curve interacts under the influences of FED actions, inflation and the runaway US trade deficits (for the globalization era only).
In the previous section we have pointed out that the growth rate of the real monetary base persistently serves as a foretelling tool of the coming recessions and economic booms throughout the preglobalization and the globalization eras alike. However, we have also observed the sudden reversal of the pattern with regard to the peak positions of the blue monetary base curve and the brown real GDP curve as the transition into the globalization era from the preglobalization era takes place. Those observations argue strongly against the notion that in the digital age the importance of cash has diminished so that the monetary base should become meaningless, since the currency in circulation is the dominant component of the monetary base. We should note that the digital age did not dawn suddenly in the early part of 1980 so the sudden reversal of the pattern as discussed above cannot be explained by this digital age argument at all. Also what we are observing from the actual data is a persistent tight correlation between the monetary base and GDP whether before or in the digital age, especially when the onset of recession is concerned.
Before we plunge into the detailed discussion of the behavior of the monetary base, we need to consider the role of personal savings more carefully. In the preglobalization era, personal savings was the major source of the seed money for the financial market. As various parties, including governments and private entities, borrow against this pool of seed money, the wheel of financial market starts to rotate and the money grows as lending generates more lending. Through 1960's personal savings averaged about 8.5% of the disposable personal income. In the high inflation period of 1970's the average personal saving rate edged up to 10%, reflecting the uncertainty of the public about the future. The actual saving rate oscillated around this broad average trend, but deviations from the average were rather small, like plus minus 1%. The actual peaks and troughs of the personal saving rate shows no systematic correlation with the ups and downs of the real economy. Thus in the preglobalization era personal savings provided a rather stable pool of seed money for the financial market. The ups and downs of the monetary base rather depended on how dynamically the financial market turn around the seed money but not influenced very much by the ups and downs of the personal saving rate. In the globalization era personal saving rate of the US has declined steadily as the US trade deficits run wild, and the saving rate has finally dropped to only 0.5% of the disposable personal income in 2006 and 2007. The trade deficits, though also serve as the seed money to the financial market, have a very strong influence on the monetary base and the economy. Though the detailed workings of the trade deficts will be discussed later, it is worth to point out that FED's control over the monetary base is steadily eroding as the trade deficit increases. Brain washed by the experiences in the preglobalization era, many stock market players still naively believe that FED is almighty, and call FED to lower interest rates anytime when stock prices fall big with a maddening voice. However, after the recent unprecedented aggressive moves to lower the short term interest rate by FED in January of 2008, how have the stock prices reacted? Stock market has simply sunk into a bear market with the bottom still not in sight. With those points in mind, now let us turn to discuss the detailed ups and downs of the real monetary base and see how they are related to the real economy through the interactions with inflation rate, FED action, and the runaway trade deficit.
(A) 1960 to 1983: the preglobalization era
We added the year to year % changes of the monthly values of PCE price index as red dots, and the inflation adjusted monthly averages of the federal funds rate as green dots in the previous three graphs. The scale of the federal funds rate is up side down, that is, a higher real federal funds rate corresponds to a lower green dot in the grap. The first portions of the expanded graph covering the years from 1960 to 1985 is posted at the right.
Though not shown in the graph at the right, through the 1950's inflation rate gyrated with the ups and downs of real GDP. In the middle of 1958 when the real GDP had been struggling to get out of the negative growth rate and the inflation rate was still falling, FED decided to lift the federal funds rate from its ultra low level of below 1% . That ultra low federal funds rate had pushed the yearly growth rate of real GDP above 9% by the second quarter of 1959. That tightening from the middle of 1958 to November of 1959 was intended to prevent the 1958 to 1959 rapid expansion of real GDP turned into an inflation surge. However, the 1958 to 1959 FED tightening did force the growth rate of monetary base to soften, and the growth of real GDP to slow. As 1960 dawned, the year to year growth rate of real monetary base had already dipped into the negative territory, foretelling the coming recession when the year to year change of real GDP fell into the negative territory in the first quarter of 1961 as shown in the graph. FED's easing move started from the end of 1959 had lifted the growth rate of real monetary base from its nadir, paving the way for the real GDP to recover from the early part of 1961. Seeing the bottoming out of the growth rate of real monetary base, FED had turned into tightening again from early 1961 and continued this slow tightening until 1964. This move of gentle tightening by FED have moderated the growth rate of real monetary base and prevented the economy to overheat. As the result the inflation rate stayed below 2% level until 1965. This achievement of FED was a typical text book example how FED had targeted inflation only and succeeded both in controlling inflation and promoted a steady economic growth in the preglobalization era.
In the early part of 1964 the Johnson administration enacted the tax cut proposed by the Kennedy administration and then pushed through many “Great Society” legislations, increasing the social spending substantially at the time when the Vietnam War was heating up. This provided substantial physical stimulus for the US economy. FED's prolonged gentle tightening had stagnated the yearly growth rate of real monetary base so the tightening move had come to a hold by the early 1965. Here we observe an interesting phenomena, that is, with a very strong physical stimulus, the real GDP can spur ahead without the support of a surging real monetary base. That was exactly what happened in the 1965 to 1966 surge of the yearly growth rate of real GDP; the growth rate of real GDP shot up to annualized 8.5% but without a noticeable surge in the blue real monetary base curve. Such a strong growth spurred a rapid expansion of hiring, and the yearly growth rate of nonfarm payrolls zoomed up to above the 5.0% level, generating strong demand for goods and services. This kind of sudden surge of nonfarm payroll numbers implied the hiring of many low skilled workers and thus lowered the productivity. The production of goods and services was not able to catch up with demand, and an inflation surge of 1966 followed. The inflation rate that was held below 2.0% for many years broke above 2.0% and topped 3.0% by the end of 1966 as the red curve attests. Such an inflation surge turned a stagnating growth rate of real monetary base into a slumping one and that in turn pulled down the growth rate of real GDP to the level of 2.5% in 1967. As the growth rate of real GDP came down, the inflation rate spontaneously dropped by a moderate amount. However, such a self-adjustment of inflation rate only gives a false sense of security since in the following bout of moderate economic surge, the inflation rate will jump to an even higher level as we will see below. What had FED done in that period? It not only watched idly the inflation surge of 1966, but started to ease the monetary condition by lowering the real federal funds rate from the middle of 1966 to the middle of 1967 in order to fight the slow down of economic growth. That easing move of FED in couple with the spontaneous temporary drop of the inflation rate under its own weight helped to boost the yearly growth rate of real monetary base in 1967 and 1968, and thus stimulating the growth of real GDP in 1968. With that moderate economic growth the unchecked inflation surged again, and reached 4.5% level by the end of 1968. The 1968 inflation surge did not slow down the growth rate of real monetary base, and the real GDP continued to grow near 5% a year. FED finally tightened the monetary condition in late 1968 to fight the inflation. That tightening pushed down the growth rate of real monetary base toward zero, and ushered in the recession of 1970. FED's belated tightening of late 1968 only lasted for about 6 months, and then turned into an aggressive easing in order to prevent the economy to sink into a recession. Unfortunately many years of the attempt to target economic growth instead of inflation had damaged the effectiveness of FED and the economy, so the inflation were moving according to its own momentum, disregarding the actions of FED. As FED was easing aggressively from the middle of 1969 to early 1971, the inflation rate actually started to level off and headed south due to its own weight. The easing of the inflation then lifted the growth rate of real monetary base and that in turn lifted the real GDP into a positive growth in 1971. At the end of 1972 the growth rate of real monetary base had a sharp spike, corresponding to an strong upward surge of the real GDP accompanied by strong gains in the nonfarm payrolls. FED only reacted to that surge of activity belatedly and timidly so that a strong inflation surge took hold in 1973 and continued into 1974. The sharp spike of the late 1972 coincided with the disengagement of US military from South Vietnam. We should note that the first energy crisis took place in late 1973. Considering that the red inflation curve is the year to year comparison so that it lags the real events by a few months, the first energy crisis should have affected the red curve in early 1974. By that time the inflation rate had already surged up to around 9%, and the first energy crisis only pushed the inflation rate up further to 10.5%. It is clearly a mistake to attribute the powerful inflation surge of 1973 to the first energy crisis. The inflation surge was the cumulative result of years of misguided FED focus on the economic growth instead of inflation. As the inflation rate surged in 1973, it naturally pushed down the growth rate of real monetary base and finally led it into the deep negative territory, and thus triggered the 1974 to 1975 recession. As the recession took hold, inflation rate peaked and started to fall under its own weight in 1974. This falling inflation rate then revived the growth of real monetary base, carrying with it the real GDP. The FED actions during that inflation surge of 1973 can only be described by one word, “disarray”. In the middle of 1973 FED had in effect started an aggressive easing operation as the green real federal funds rate curve fell sharply toward the negative territory at the time when the inflation rate was surging. FED actually raised the nominal federal funds rate in 1973, but the rate of increase fell far behind the rising inflation rate so that the inflation adjusted federal funds rate ended up fell along with the rising inflation. The real driving force in the period of 1973 to 1976 was the inflation and FED was merely driven around by the inflation.
As the 1973 inflation surge ran its course and started to turn south spontaneously in 1975, both the real monetary base and the real GDP started to recover and the real federal funds rate had also started to rise. However, as the inflation rate dropped spontaneously to the level of 5% and the real GDP growth rate reached 6% in the middle of 1876, FED let the real federal funds rate to fall back again. If FED had the courage to hold on to the actual tightening of the monetary condition and let the real federal funds rate to continue to rise through 1976 and into 1977, probably the inflation rate would have fallen below 5% and the back of the entrenched inflation force would have been broken. Unfortunately the temporary lull in the tightening of the monetary condition from the middle of 1976 to the spring of 1977 had allowed the real GDP to continue to chug along 5% growth rate and reignited the inflation surge of 1977 and 1978. The renewed tightening from the spring of 1977 was too late to put the inflation genie back into the bottle. Thus the inflation surged through 1978 along with a strong growth of the real GDP. Now we need to turn our attention to the lower insert of the graph at the right that covers the years from 1978 to 1985. The inflation surge that started in 1977 continued into 1979 and the inflation rate had reached 7.5% by the beginning of 1979 as the red curve attests. The Shah of Iran was deposed in early 1979 and the second energy crisis had started. This pushed up the inflation surge further and the rate reached 11.5% by early 1980. As the inflation surged, the growth rate of real monetary base fell into the negative territory by the spring of 1979 and the growth rate of real GDP had also started to plunge. Near the end of 1979 FED decided to break the back of the inflation force at any cost. FED had started to target monetary measures like the monetary base, and let the real federal funds rate gyrate to whatever level necessary to held the real monetary base steady. As the result the growth rate of real monetary base was held at the negative territory through 1980 and 1981. This iron fist policy of FED brought in two back to back recessions, one in 1980 and the other in 1982, but finally broke the back of the inflation force. As the inflation surge ran its course and started to retreat, the shape of the falling red curve in 1981 was convex, implying a more violent fall compared to the case of 1975. Thus the inflation rate fell below the 5% line by the end of 1982. Around that time span the US economy has entered the era of globalization.
From the lengthy and detailed tracing of the behavior of the monetary base, the real GDP, the inflation and the federal funds rate through the preglobalization era, we may conclude that FED must target the inflation if it wants to retain its influence over the whole economy. If FED tries to target the economic growth, it will end up having both the strong inflation surges and violent ups and downs of the real economy.(B) 1983 to 1992: The first phase of the runaway trade deficit, the junk bond bubble and its aftermath
Since taking office in 1981, the Reagan administration had pushed strongly to liberate the cross national boundary flows of goods and capitals and thus launched the so called “globalization” in the world economic scene. This globalization scheme contains two basic flaws. The first is that each nation in participation is allowed to set its own monetary and physical policies without coordination with other economic powers in the world, and the second is that each government is allowed to intervene in and manipulate the currency market as it likes. With those two basic flaws the current globalization scheme naturally produces runaway trade imbalances that is now endangering the scheme itself. When we analyze the movements of the US economy and the monetary base, we always need to keep in mind about the existence of the runaway US trade deficit in the globalization era. Though we repeatedly say that trade deficits also play the role of the seed money to the financial market in place of personal savings, we do not mean that one dollar of trade deficit will have the same effect on the economy and the monetary base as one dollar of personal savings. Actually one dollar of trade deficit has far more violent influence than one dollar of personal savings. We will discuss in detail why it is so in the next paragraph.
We first trace the money from personal savings. When individuals save, money are mostly deposited into banks. Suppose $100 flows into the banking system. Banks will lend out this $100 deposit to businesses or individuals as auto loans, credit card loans, mortgages and so on. Here the rule of reserve comes into play. FED has the authority to set the reserve requirement, say at 10% level. This means that when banks try to lend out this $100, they must keep $10 as reserve and are allowed to lend out only $90. This $90 new lending will flow back to the banking system as new deposits so that the banks can now lend out this $90. At this second round of lending, banks are again required to reserve 10% of $90, that is, $9, and are allowed to lend out only $81, and so on. How much total lending this repeated deposit-lending cycle will generate eventually from the original deposit of $100 can be calculated by a precise mathematical formula called the sum of geometric series. In the case of 10% reserve requirement, the total amount of lending generated from the initial $100 deposit will be $1000. If the reserve requirement is reduced to zero, then the $100 deposit can eventually generate infinite amount of loans. In the case of trade deficits, the route that money flows is very different from the case of personal savings. When US consumers buy imported goods and services, US dollars flow into the hands of foreign manufacturers. Those foreign manufacturers must sell those US dollars for the currencies of their homeland so that they can pay their workers and buy new supplies to continue their operations. Those trade deficit related dollars will eventually end up in the hands of large foreign institutions, including foreign governments when they buy up those dollars in order to prevent the upward revaluation of their currencies vs. US dollar. It is those large foreign institutions that bring the trade deficit generated dollars back to the US financial market. However, when the foreign institutions bring the dollars back into the US, they are unlikely to deposit them into banks, but rather directly invest in various financial instruments. For example, a foreign institution brings back $100 million, and buy commercial papers issued by a pool buying subprime mortgage backed CDO. This is equivalent to lend this $100 million to the pool. When the pool buys $100 million worth of CDO, it is equivalent for the pool to lend $100 million to the mortgage banker that initiated the subprime mortgages so that the banker can initiate another $100 million of subprime mortgages with this newly borrowed $100 million. In this cycle of lending, there is no reserve requirement, or it is equivalent to zero percent reserve requirement. Thus the original $100 million of the trade deficit generated dollar can balloon into whatever amount of subprime mortgages as long as there is the appetite for the market to buy up those CDO. This example shows vividly why the trade deficits have a much more explosive effect on the economy and the monetary base alike when serve as the seed money to the financial market than the personal savings. This also explains why the periods of rapidly expanding trade deficits always generate speculative bubbles like the recent CDO bubble.
Now let us account for the details of the behavior of the real monetary base and the real economy as we did for the preglobalization era, starting from year 1982 to year 1992. The graph that covers from year 1978 to 1996 is posted at the right. Seeing the success of the iron fist policy to break the back of the entrenched inflation force, FED had relaxed the tightening policy and had allowed the nominal federal funds rate to fall from above 18% level in the middle of 1981 to about 13% level by the end of 1981 (real federal funds rate fell from 10% to 5% as show in the green curve). After another short tightening in the spring of 1982, FED relaxed again and allowed the nominal federal funds rate to fall to 8.5% by early 1983 (real federal funds rate from 10% to 4%). This series of easing moves by FED had lifted the growth rate of real monetary base out of the negative territory and up to +6% by the middle of 1983. The rapid growth of real monetary base than invigorated the real economy, sending the yearly growth rate of real GDP to about 8.5% by the first quarter of 1984. Fearing the powerful movement of the monetary base will rekindle inflation, FED had turned to tightening mode in the spring of 1983 and had brought the real federal funds rate from the level of 4% to 8% by the fall of 1984 as shown in the green curve in the graph. That tightening move slowed the growth rate of real monetary base, and subsequently pulled down the growth rate of real GDP to below 5%. The preventive move of FED thus kept the inflation in check, and no inflation surge had occurred from the robust economic expansion of 1983 to 1984 that had generated 4 to 5% yearly growth rate for nonfarm payrolls. Seeing the drop of the growth rate of real monetary base from its 1983 to 1984 tightening, FED reversed course and eased the real federal funds rate from the fall of 1984. This easing lifted the growth rate of real monetary base to above 7% by the spring of 1986. However, the growth of real GDP diverged from the movement of the real monetary base and weakened somewhat in the time span of 1986 to 1987. That slow growth of the real economy prompted FED to ease more in the spring of 1986, and eventually led the real federal funds rate to 2.5% level by early 1987. FED then held the real federal funds rate at that level until early 1988.
During the period of 1983 to 1986 the growth rate of real monetary base oscillated around 5% level. That average level was much higher than in the preglobalization era, and was the result of the rapidly increasing trade deficit. The trade deficit was only 0.6% of the disposable personal income in 1981, but had risen steadily to 4% of the disposable personal income by 1986. As discussed before, seed money provided by the trade deficit have much more violent influence on the growth of the monetary base than the seed money provided by the personal savings, so the floor of the growth rate of the real monetary base was elevated substantially compared to the preglobalization era due to the rapidly expanding trade deficit. The slow yearly growth of real GDP in the stretch of 1986 to 1987 was also the result of the expanding trade deficit. In 1980's manufacturing was still an important part of the US economy. As foreign manufactured goods flooded in, US manufacturers felt the pressure. As the result fixed asset investment by businesses slowed down and had caused the slow down in the growth rate of real GDP. The excessive growth of the real monetary base at that time span went into the generation of the junk bond bubble. The junk bond bubble supported rampant corporate raiding and leveraged buyouts that pushed up stock prices. The rapid expansion of the trade deficit had created winners and losers. The biggest winner of the rapid expansion of the trade deficit was the Wall Street that profited mightily from the junk bond bubble and the resulting corporate raiding and leveraged buyouts. The greater New York area also bathed in the halo of the Wall Street and the housing prices bubbled. Another big winner was the housing prices of California and Hawaii. The majority of the US trade deficit at that time was due to the trade with Japan, followed by the trades with Asian tigers like Taiwan, Hong Kong and Singapore. A substantial amount of trade related dollars in the hands of Japanese flowed into Hawaii and bid up the prices of houses there, whereas money from Asian tigers bid up housing prices in California. The biggest loser of the first phase of the runaway trade deficit was the industrial heartland of America. Under the pressure of the surging import, factories closed and many workers were laid off. It was under the political pressure from the industrial heartland, the Reagan administration negotiated with Japan in early 1985 to bring down the dollar vs. Japanese Yen. As the result US Dollar tumbled from the level of 250 Yen/Dollar to around 125 Yen/Dollar within a few years. Major changes in currency exchange rates usually take two to three years to be reflected in the trade status. It was in 1987 that the first phase of the runaway US trade deficit was under control. The US trade deficit first stagnated and then started its long slide; the trade deficit decreased to near zero by 1991. With the stagnation and then the decline of the US trade deficit, the direct support of the junk bond bubble started to wane. The withering of the junk bond bubble stopped all the leveraged buyouts, and the stock market crashed in late 1987 both from the creeping liquidity squeeze as will be discussed below and from the disappearence of the support from the leveraged buyouts. The personal saving rate had declined from 11.2% in 1982 to 7.0% by 1987. However, as the trade deficit decreased, the personal saving rate just stayed at the 7% level. That meant a substantial reduction of the seed money for the financial market, and thus a liquidity squeeze had started. The housing bubble in the greater New York area had burst as the stock market crashed, and the liquidity squeeze triggered the savings and loans crisis. Savings and loans were not financially strong institutions to begin with and they shared the fate of all mortgage lenders of “borrowing short and lending long”. At the heydays of the trade deficit borrowing short was not difficult. Quite a few sickened saving and loans used the tactic of borrowing through brokered deposits to speculate and to get by. When the liquidity squeeze due to the declining trade deficit set in, savings and loans were shut out of the short term financial market and fell like autumn leaves. That kind of busts naturally burdened large commercial banks, and top US commercial banks eventually required capital infusion from Asia to survive. In addition to those financial troubles, bad news also came from the inflation front. When trade deficit was running wild, inexpensive imports suppressed domestic prices and calmed inflation. However, as the trade deficit started to decline inflation naturally revived. By late 1987 the yearly inflation rate had already reached 4%. All those bad news clobbered the growth rate of real monetary base; the growth rate dropped to 3.5% by early 1988. At the beginning of 1988, not long after the big stock market crash, from the fear of the creeping inflation FED started to tighten by sending the inflation adjusted federal funds rate, the green curve, to rise from 3% to over 5% by early 1989. With that FED tightening, the growth rate of real monetary base slumped further and reached a slightly negative level by November of 1989 as the blue curve attests.
The real economy was out of sync with the real monetary base at that time. As been pointed out before that the real GDP went through a slow growth period when the manufacturers were clobbered by the massive invasion of imports and businesses were hesitant to invest in the fixed assets in the heydays of trade deficit and the junk bond bubble of 1986. When the tide turned in 1987 and the trade deficit had started to peak and then retreated, US manufacturers bounced back. The globalization and the trade imbalance was still at their infancy at that time. US manufacturers were down in the preceding wave of trade deficit, but not out. Skilled workers were laid off but had not disappeared from the scene. As manufacturers bounced back, the desire of fixed asset investment returned and carried the growth of the real GDP for two years into 1989 while the growth of real monetary base had been dropping fast. That mini boom of manufacturers also stirred a moderate bounce in the nonfarm payrolls and lifted the inflation rate toward 5%. On the other hand one may wonder what had happened to the businesses that listened to the weird economic theory and the voices of the Wall Street speculators, that is, the claim that by loading up junk bond debts the businesses would become more profitable. Those businesses met the reality check of common sense, and were pushed to the brink of bankruptcy by their debt loads as the liquidity squeeze advanced. They started to lay off a large number of experienced workers under the name of corporate restructuring, and the growth rate of nonfarm payroll numbers gradually turned into negative. The growth rate of real GDP had followed the downward path of the nonfarm payroll numbers and had started to slide toward a negative territory, too. What was FED doing at that time? When FED had realized what was happening, it undertook a massive easing operation starting from the middle of 1989 by pushing the real federal funds rate to literally zero by the middle of 1992. Due to the weakened hold of the declining trade deficit on the monetary base, FED regained the control over the monetary base and the growth rate of real monetary base rose steadily with the giant FED easing. However, the belated help from FED with all the stimulus packed in the surging monetary base came at the middle of the collapsing financial system and the falling debt laden corporations, and was not able to prevent the US economy from sliding into the recession of 1990 and 1991.(C) 1992 to 2002: The second phase of the runaway trade deficit, the dot-com bubble and its aftermath
By 1992 US government had taken over many failed savings and loans and had paid off all the depositors of those failed savings and loans through deposit insurance and the Resolution Trust Corporation created in 1989. The bail out of those savings and loans cost the US Treasury about $150 billion. The US Treasury simply issued enough amount of US treasury debt instruments to cover the cost. During a recession the demand for loans were low, and the issuance of those treasury debts not only were absorbed by markets easily but served as a stimulus for the economy. Also by 1992 troubled US bank giants had obtained enough new capital infusion from their Asian partners. The painful corporate restructuring of the debt laden businesses had run its course by that time, too. Thus the wheel of the financial system was ready to turn again.
The long slide of US dollar, especially vs. Japanese yen, since early 1985 reached a turning point in early 1989 when the retreat of US trade deficit became apparent. The rebound of dollar continued until 1990 when the US economy finally fell into the recession. That rebound of US dollar induced the rebirth of the US trade deficit, rising from its nadir of 1991. However, the return of the US trade deficit did not mean a runaway trade deficit yet. The ratio of trade deficit to the disposable personal income was 0.6% in 1991, 0.7% in 1992, 1.3% in 1993, 1.8% in 1994, and 1.7% in 1995, 1996 and 1997. Thus the influence of the trade deficit was limited and FED still controlled the monetary base during that period. FED had turned from the giant easing mode to a gradual tightening in the latter half of 1992 as the green curve in the following graph at the right attests. As the gradual FED tightening gathered intensity in 1994, the growth rate of real monetary base (the blue curve) slumped quickly and dived into the negative territory by the middle of 1996. However, the lavish monetary base provided by the four year long FED easing and the reborn financial system finally pulled the real economy out of the negative growth as the brown curve in the graph shows. Though the growth rate of real GDP had ups and downs, it averaged out around 3.0% during the time span of 1992 to 1996. The growth rate of nonfarm payrolls was confined in the band of +1.5% to +3.5% in that period. The modest performance of the US economy thus had kept the inflation rate at check as the red curve in the graph shows. It is interesting to observe that the excessive growth rate of real monetary base over the growth rate of real GDP during that period had not induced another bubble. Probably without the runaway trade deficit bubble is difficult to form. Also it may be due to the fact that with the memory of the junk bond bubble and the pain from its burst still so vivid, there were few brave souls on the Wall Street dare to do any brazen moves.
The situation changed rapidly in the middle of 1995 when Japan dropped its short-term interest rates to near zero and thus triggered the massive waves of yen carry trades. Yen carry trades are the strategy of speculative money pools, aided by multinational banks, to borrow yens at near zero interest rate, sell those borrowed yen for dollars, and then use those dollars to buy higher yielding dollar denominated debt instruments or engage in other speculative activities. The unleash of yen carry trades pushed up the exchange rate of dollar vs. yen quickly. Right before the middle of 1995, the monthly average of the value of dollar was like 85 yen/dollar. By the middle of 1998 the value of dollar had climbed to 145 yen/dollar. With that kind of upward revaluation of dollar, the US trade deficit exploded anew, ushering in the second phase of the runaway trade deficit. By 2000 the trade deficit had reached 5.3% of the disposable personal income. That wave of the exploding trade deficit had lifted the growth rate of real monetary base sharply toward the level of 7.5% by the middle of 1999, and that rapid growth of the real monetary base in turn pushed up the yearly growth rate of real GDP to 4.5% level in 1997 and sustained it at that level until the second quarter of 2000 as the brown curve in the graph shows. FED tightened in early 1997 and then eased in the middle of 1998 in reaction to the debacle of Long Capital (will be discussed later). That series of moves by FED did influence the red inflation curve as expected, but not the monetary base very much. The growth rate of the nominal (before the inflation adjustment) monetary base, that was not shown in the graph, shot up in straight line from the nadir of 1996 until the middle of 1999. The break of the blue real monetary base curve at the turn from 1997 to 1998 was only a small nuance added by the dipping and then the rising behavior of the red inflation curve. Apparently FED, though still controlled inflation, had lost the control of the monetary base to another force, that was, the second phase of the runaway trade deficit. The sharp spike in the blue curve at the end of 1999 and the sharp downward spike at the end of 2000 were due to the Y2K effect and the reaction against the first upward spike (they will be discussed later).
Earlier we gave an example how dollars generated by trade deficits inflated the bubble by pouring into CDO. Actually those dollars may be deployed in more mundane instruments like US treasuries, whereas the capital previously in those mundane instruments may be displaced into CDO to inflate the bubble. Though runaway trade deficits provide fuel for a bubble, there still needs a spark to ignite the bubble. In the example given earlier it is CDO that serves the role of the spark. In the Reagan bubble it was junk bonds that ignited the bubble. In the Clinton era from 1997 to 2000, it was the “Internet” that played the role of the spark. Personal computers were around for a long time, but by late 1990's their price had dropped so much that an average middle class family could easily afford to have a powerful enough PC at home. However, the usefulness of a personal computer was quite limited for an ordinary family except for youngsters to play video games. On the other hand Internet had also evolved steadily and was ready for the big time by the latter half of 1990's. Those two, when fused, has proven to be a dynamite. People can send e-mails among family members, friends, colleagues and business partners without the constraint of the postal service. People can chat on instant messengers with friends or strangers. Small businesses can post ads on the Internet without the prohibitive price tags as in TV and radio ads. People flogged to buy personal computers to get on the Internet. Makers of computer hardwares, softwares, and Internet service providers naturally profited handsomely. The Wall Street jumped on this Internet band wagon and steered large sums of money toward anything smelled like an Internet play. Not only the prices of stocks of new startups adopted a name ends with “.com” was bid up to stratosphere, all other stocks also rode on the band wagon and flied high. For example, the SP500 stock index that includes 500 largest companies soared many times during the period. That Clinton bubble is properly nicknamed as the “dot-com” bubble. It was during that dot-com bubble FED lost the control of monetary base to the runaway trade deficit.
The dot-com bubble encountered the same fate as its predecessor, the junk bond bubble of the Reagan era. When the runaway trade deficit started to peak and then declined in 2000, a liquidity squeeze started and the bubble burst. The end of the runaway trade deficit was again due to the falling dollar in earlier years. To explain that fall of dollar it is necessary to go back to the middle of 1995 when Japan unleashed the wave of yen-carry trades by its near zero interest rate policy. By that time Japanese manufacturers had outsourced lower end manufacturing to other developing countries due to the exhaustion of inexpensive labor source within Japan and from the steadily rising Japanese yen. Their first target destination was Taiwan. As Taiwan used that chance to climb up the economic ladder, its relatively small labor pool was also exhausted and the production cost rose substantially by early 1990's. Thus Japanese manufacturers had diversified into other Asian countries like Philippine, Thailand, Malaysia, Indonesia and so on. The products of those countries were exported to the US, so they pegged their currencies to US dollar. As yen-carry trades carried dollar higher and higher vs. yen, the currencies of those countries also flew higher and higher against yen. In principle those countries could have abandoned the peg to dollar, but they believed in the prevailing economic wisdom of that time claiming that the developing countries should have maintained the currency peg with dollar. Pretty soon the high flying local currencies made the manufacturing of low end products not cost effective in those countries. Thus those countries sunk into trade deficit status just like the US but with far less wealth to withstand such deficit spendings. Soon those countries went bankrupt in one domino style reaction when speculative hedge funds suddenly discovered the folly to listen to those foolish economic rhetoric saying that the peg to dollar is gold, and dumped the high yielding but now worthless securities issued by those countries. That was the Asian financial crisis, and in the aftermath Asian countries affected all abandoned the peg and let their currencies to fall big against dollar. The shock wave started from Asia spread. In the summer of 1998, Russian was forced to abandon the peg to dollar, and in the summer of 1999 that was the turns of Latin American countries. The US government was forced to change the so called “strong dollar” policy and jointly intervened with Japanese government to force dollar to fall vs. yen in the summer of 1998. That l80 degree turn-around of the policy of the US government panicked the yen-carry traders, and they unwound the trades by selling dollars to buy back the borrowed yens. Thus dollar fell hard against yen with a lightening speed. It was that fall of dollar in 1998 that forced the runaway trade deficit to peak and than retreat in 2000 after the usual two to three years of delay for major changes in the exchange rates to be reflected on the trade status.
As already mentioned before the sharp upward spike in the blue monetary base curve at the end of 1999 was caused by the Y2K effect. In the early days of computer programming programmers represented the year by only the last two digits, like 1999 as 99 and 2000 as 00, to save the precious memory space in the primitive computers. Those programs were inherited generation to generation of newer and newer computers without much modification. However, the way of treating year causes big trouble as the turn of the century approached. The year 2000 supposedly is represented as “00”, but also are the year 1900. If someone deposited money into his account on January of 2000, the computer of the bank would be confused without knowing whether that was January of 2000 or January of 1900 and thus would have crashed. Businesses were furiously trying before the turn of the century to remedy that Y2K problem by installing new computer systems and updating their softwares. Still many doubted the effectiveness of those remedies and withdrew large sums of cash from their bank accounts at the eve of the new century, and thus caused the sharp rise of the growth rate of the monetary base at the end of 1999. When the remedy for the Y2K problem turned out to be effective as the new century arrived, people than returned the cash to the banks and caused that sharp upward spike in the blue curve to disappear. The sharp downward spike at the end of 2000 was simply the technical reaction to the 1999 spike since the blue curve is the percentage change of the year to year comparison of monetary base. However, the broad peak of the blue curve at the end of 1999 was genuine and the sharp fall of the growth rate of the real monetary base in 2000 was due to the sensitivity of monetary base to the slight change in the direction of the runaway trade deficit . That sharp fall of the blue curve correctly foretold the coming burst of the dot-com bubble and the resulting recession of 2001. FED started to ease rapidly from early 2001 when it finally sensed the burst of the dot-com bubble and the rapidly approaching recession. We should note that the economy was falling into the recession even before the 911 disaster. The spike in the blue curve at September of 2001 was due to the frantic effort of FED to pump in liquidity to prevent ill effects from 911. That massive liquidity injection continued into the spring of 2002, causing the blue curve to rose to a broad peak. That massive liquidity injection had prevented the real economy to sink further from the shock of 911, and the real GDP had started to rebound in 2002.
Unlike the retreat of the first phase of the runaway trade deficit in the late 1980's to early 1990's that brought down the trade deficit almost to zero, the retreat of the second phase of the runaway trade deficit was very mild. In 2000 the US trade deficit of goods and services accounted for 5.3% of the disposable personal income. The ratio was 4.9% in 2001, and 5.4% in 2002. The question arises how such a mild retreat of the trade deficit creates such a large effect like bursting the dot-com bubble. That is due to the heavily leveraged nature of a stock market bubble. First we consider the following example to illuminate the leverage in a mundane stock trading. Suppose a company XYZ has one billion shares of common stocks outstanding, and its common stock is trading at the price of $50 per share with bid at $50.00 and ask at $50.01. Suppose an order to buy 10,000 shares comes in and is filled at the ask price; the trade costs $500,100. Before the trade the total capitalization of XYZ is $50 billion. After the trade the capitalization becomes $50.01 billion, an increase of $10 million. Thus a new cash input of $500,100 has pushed up the capitalization of XYZ by $10 million, a leverage of 20. If XYZ is a member of SP500 index, the index will go up accordingly to reflect the increase of the total capitalization of the 500 stocks in the index by $10 million. Another feature of a stock market bubble is speculation. Speculative pools are formed to borrow money from the financial market that is flushed with the seed money from the runaway trade deficit, for example, by issuing commercial papers. Those speculative pools then use the borrowed money to buy stocks. When the trade deficit is expanding, those pools can borrow more and more money from the the financial market and boost stock market higher and higher. Once the trade deficit starts to retreat, even by a small amount, the influx of money to the market will slow whereas those bought in lower prices want to cash out. If the market retreats just by only a modest amount, those speculative pools bought near the top cannot hold on for long and must dump their holdings since they are continuously paying interests on their borrowings. According to the built-in leverage in stock trading as mentioned before, stock prices will come down as quick as its rise. The drop of stock prices in turn will force more speculative pools to dump stocks and so on. Thus stock prices will come down like an avalanche. In essence a stock market bubble at its speculative peak is an unstable animal, and a small disturbance will cause the bubble to collapse under its own weight. The biggest loser of the burst of the dot-com bubble was individual investors since they were slow to get out compared to the professional speculators. Many saw their life savings severely damaged, and were forced to cut back spending. As business sales slowed, businesses lost the incentive to invest in fixed assets. They laid off many workers, froze new hirings, and outsourced jobs to developing countries whenever it was possible. Thus the whole economy slided into a recession. Especially hard hit was the high tech industry that has not recovered after more than seven years. Even today many new graduates from engineering and computer science schools have difficulty of finding jobs with reasonable salaries, though the industry and politicians always pretend that jobs in the high tech industry are begging for workers and want the government to train more and more such talents just to fill the unemployment office.(D) 2002 to 2007 and beyond: The third phase of runaway trade deficit and the CDO bubble
The burst of the dot-com bubble had loosened the control of the runaway trade deficit on the monetary base. When FED had started to ease aggressively since the beginning of 2001, the growth rate of real monetary base shot up with the easing as the blue curve in the graph at the right shows. 911 had prompted FED to ease more and thus boosted the blue curve to its phenomenal peak around 2002. However, that heroic effort of FED only met with a modest rise in the growth rate of real GDP, and that prompted FED to ease more, bringing the federal funds rate down to 1% level in 2003. Despite the second leg of FED easing the growth rate of real monetary base came down steadily from the middle of 2002 until the middle of 2004. The drop of the growth rate of real monetary base in the latter half of 2002 probably was due to the calming down from the 911 disaster. However, the steady decline of the blue real monetary base curve from early 2003 to the middle of 2004 when FED was still easing and the real economy was growing strongly as the brown curve in the graph shows, needs an explanation. Prompted by the rise of US dollar near the end of 2000 when the retreat of US trade deficit became apparent, US trade deficit had started to rise from its rather high nadir in 2002. Let us see the ratio of trade deficit to disposable personal income during that period. As stated before, the ratio was 5.3% in 2000, 4.9% in 2001 (a high nadir), and 5.4% in 2002. The ratio rose rapidly to 6.1% in 2003, 7.1% in 2004, and 7.9% in 2005. This phase of the runaway trade deficit induced the CDO bubble and pushed up the growth rate of real GDP toward 4% by 2004. Since CDO boom has allowed banks to increase lending without increasing the requirement to put aside reserves, banks naturally flocked to CDO lending in place of the old fashion type lending, and thus diminished the growth rate of real monetary base. It is also interesting to observe that from the middle of 2004 to the end of 2006 as FED was tightening aggressively, the pace of the drop of the blue monetary base curve had not changed from prior years when FED was easing. During 2006 when FED was still tightening as the green curve shows, the blue monetary base curve actually had a bounce. Those phenomena imply that FED had lost the control over the monetary base again during the CDO bubble.
The demise or the deflation of the CDO bubble has started in 2006 when the US trade deficit has changed its direction to south again due to the weakness of US dollar in prior years. The detailed process how the demise of CDO bubble has come around is discussed in the introductory section already so will not be repeated here. It is worth to observe that as CDO bubble has started to deflate, the blue monetary base curve had a bounce in 2006 as expected. It is also worth to be noted that a CDO bubble is more durable than a stock market bubble in its process of demise so the troubles in the most prevalent CDO backed by subprime mortgages was noticed by very smart observers only near the end of 2006. Average players in the financial market was awakened to the risk even later, in one day of August of 2007 that caused the collapse of the CDO backed commercial paper market. Only then FED has realized the seriousness of the matter and has started the frantic easing that is still continuing today.
The sharp fall of the blue growth rate curve of real monetary base deep into the negative territory since August of 2007 is a strong warning of troubles ahead. After the collapse of CDO backed commercial paper market in August of 2007, certainly no more new CDO are dare to be issued. Banks are forced to go back to old fashion lending that requires to put aside reserves. In theory the monetary base should rise but not. The steep decline of the monetary base curve then indicates the onset of the lending phobia accompanied by the increased danger of a Japan syndrome. A recession in not far away future is inevitable. If FED cannot regain the control of the monetary base and make the blue curve turn up sharply, any recovery from the recession cannot be expected to take place in any foreseeable future. The plan of US government to distribute money directly to consumers is also not likely to wipe out the lending phobia. As for the trade deficit, the steadily weakening dollar means that the deficit is not going to turn up in coming two years. Thus the liquidity squeeze will continue at least until 2010. At the time when personal savings rate is still flirting around zero with no sign of any significant upturn, FED becomes the only force to create liquidity from the thin air to counter the drain of liquidity due to the gradually falling trade deficit. It is worth to watch closely the behavior of monetary base to monitor the unsettled condition of the US economy.
The analysis of this article shows how runaway trade deficit always creates a bubble. For those who stubbornly refuse to consider the runaway trade deficit as a force to be reckoned with in their analysis of the US economy, the booms accompanied with bubbles and the busts when the bubbles burst are all look like random events. By this way those analysts will surrender the power of seeing into the future course of the economy completely. If the flaws in the current globalization scheme that creates the runaway trade imbalance are not corrected, the waves of runaway US trade deficits will increase their intensity. The scale of bubbles accompanying the waves of runaway trade deficits will also escalate in the process. Some day the bubble will reach to such a scale so that the burst of the bubble will topple the whole US economy with no chance of recovery for many decades. Thus an economic super power will be reduced into a banana republic by its own design.