Explaining US Financial Instability and Its Global Implications
japanfocus.org
As everyone now knows, the current financial market turmoil spreading across the Atlantic economy and beyond started with rising defaults in the United States mortgage market. How did the US come to experience a gigantic house-price bubble?
The explanation starts with US trade deficits and their financing. The US has been running an increasing trade (or more accurately, current-account) deficit since the early 1980s, with only one short interruption. The excess of imports over exports is paid for by newly printed dollars or Treasury bonds.
In countries running trade surpluses (like China and Japan), exporters to the US sell their dollars to their banks in return for domestic currency. This increases the demand for domestic currency, which - if the central bank does not intervene - tends to appreciate in value. As the currency appreciates, so too does the wage level, which impairs the economy's competitiveness. So to maintain export competitiveness and to boost employment, the central banks buy the dollars from exporters in return for newly created domestic currency; this functions as high-powered money - increasing domestic demand, raising the ratio of "financial" to "real" transactions, and encouraging speculation in domestic and foreign assets.
At the same time, the central banks use their increasing stocks of dollars to invest in US assets in order to earn a return. The return flow pushes up the value of the dollar (just the wrong direction for reducing the US trade deficit) and also pushes up asset values in the US, including property and Treasury bonds. Higher bond prices go with lower yields, and therefore lower interest rates. Lower interest rates push up consumption, domestic debt and imports in the US, and cause the country's deficit to grow even bigger.
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