THE F INANCIAL CRISIS RECONSIDERED The Mercantilist Origin of Secular Stagnation and Boom-Bust Cycles Daniel Aronoff The Financial Crisis Reconsidered The Financial Crisis Reconsidered The Mercantilist Origin of Secular Stagnation and Boom-Bust Cycles Daniel Aronoff THE FINANCIAL CRISIS RECONSIDERED Copyright © Daniel Aronoff 2016 Softcover reprint of the hardcover 1st edition 2016 978-1-137-55368-3 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No portion of this publication may be reproduced, copied or transmitted save with written permission. In accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6–10 Kirby Street, London EC1N 8TS. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. First published 2016 by PALGRAVE MACMILLAN The author has asserted their right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire, RG21 6XS. Palgrave Macmillan in the US is a division of Nature America, Inc., One New York Plaza, Suite 4500, New York, NY 10004-1562. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. E-PUB ISBN: 978-1-349-57547-3 E-PDF ISBN: 978-1-137-54789-7 DOI: 10.1057/9781137547897 Distribution in the UK, Europe and the rest of the world is by Palgrave Macmillan®, a division of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS. Library of Congress Cataloging-in-Publication Data Aronoff, Daniel, 1961– author. The fi nancial crisis reconsidered : the mercantilist origin of secular stagnation and boom-bust cycles / Daniel Aronoff. pages cm Includes bibliographical references and index. 1. Global Financial Crisis, 2008–2009. 2. Financial crises. 3. Business cycles. 4. Mercantile system. I. Title. HB37172008 .A76 2015 330.9(cid:2)0511—dc23 2015027275 A catalogue record for the book is available from the British Library. Contents List of Figures and Tables vii Preface xi Acknowledgments xvii Part I The Current Account Deficit and the US Housing Boom: Establishing the Connections 1 1 The Metamorphosis of China’s Trade Policy 3 2 The Current Account Deficit and the Housing Boom 15 3 Mercantilism and the Current Account Deficit 39 4 The Current Account Deficit: A Necessary Condition for the Housing Boom 55 Part II The Capital Flow Bonanza, the Credit Explosion, and the US Housing Boom: Channels of Transmission 67 5 A Review of Explanations for the Housing Boom 69 6 Decision-Making during the Housing Boom 81 7 The Capital Flow Bonanza and the Housing Boom 99 8 The Role of Policy during the Housing Boom 127 Part III Accumulation and Secular Stagnation: Identifying the Underlying Malady 131 9 Accumulation and Secular Stagnation: Part I, Theory 133 10 Accumulation and Secular Stagnation: Part II, Application 147 vi ● Contents Part IV The Financial Crisis, I: The Meltdown and the Successful Initial Policy Response 165 11 Descent into the Abyss 167 12 The Initial Policy Response 181 Part V The Financial Crisis, II: The Limits of Conventional Policy in a Balance Sheet Recession 201 13 The Dilemma of Policy in a Balance Sheet Recession 203 Part VI Policy Options: How to Exit the Balance Sheet Recession and End Secular Stagnation 219 14 Policy Options 221 Notes 239 Index 279 Figures and Tables Figures 1.1 Total current account balance for China, 1998–2008 9 1.2 China/US foreign exchange rate, 1990–2008 10 1.3 Saving and investment in China, 1992–2008 11 1.4 US China bilateral trade in goods, 1999–2014 13 2.1 Home mortgage liability levels, 2000–2008 16 2.2 Home price and CPI growth, 2000–2008 16 2.3 Mean leverage of broker-dealers, 1996–2009 17 2.4 BAA corporate bond yield relative to yield on ten-year treasury, 2000–2008 19 2.5 Household leverage versus household price change, 1997–2007 22 2.6 Total current account balance for the United States, 1960–2014 23 2.7 Capital mobility and the incidence of banking crises, 1800–2008 28 2.8 Real estate appreciation and change in current account, 2000–2006 30 2.9 (a) Southeast Asian and other flows into US government bonds, 1984–2005 (b) Southeast Asian and other flows on ten-year treasury yield, 1984–2005 32 2.10 US corporate business: profits before tax, 1996–2008 35 3.1 10-/30-year treasury constant maturity rate, 1996–2008 40 3.2 US productivity growth, 1996–2008 41 3.3 Balance on current account and Federal government budget, 1990–2008 42 3.4 Foreign holdings of US securities, 2007 45 3.5 Crude oil prices, 2000–2008 47 3.6 Global imbalances (in percent of world GDP), 1997–2009 48 3.7 China’s stocks of bank reserves, forex reserves, and PBOC bills, 2002–2008 51 3.8 China’s monetary base and international reserves, 1998–2007 52 3.9 Real trade weighted US dollar index: major currencies, 2000–2008 53 4.1 Residential construction and mortgages as percent of GDP, 2000–2008 56 viii ● Figures and Tables 4.2 US unemployment, natural rate, 2003–2008 57 4.3 Expenditure growth, 2003–2008 57 4.4 Gross capital flows and current accounts, 1995–2010 64 4.5 Gross capital flows by region, 1995–2010 65 5.1 Mortgage origination by type, 2001–2007 70 5.2 MA LTV DTI subprime, 1999–2006 71 5.3 House price index rate of change, 1975–2009 77 5.4 HPI and subprime lending MA, 1988–2007 78 6.1 Broker-dealer leverage and VaR, 2001–2012 89 6.2 Shadow bank, commercial bank liabilities, 1990–2011 91 6.3 Market-based, bank-based holdings of home mortgages, 1980–2010 92 7.1 Not enough banks to source safety for cash pools 103 7.2 Asset-backed securities issuance, 2000–2008 105 7.3 Institutional cash pools, 1997–2013 106 7.4 Shadow banking diagram 110 7.5 Ten-year treasury constant maturity rate, 2000–2008 112 7.6 Actuarial ratio for public pensions, 1992–2013 113 7.7 Annual return for state and local pensions, 1992–2013 114 7.8 Net interest margin for large US banks, 2002–2008 115 7.9 Households and nonprofit organizations—net worth level, 2000–2008 119 7.10 MA foreclosures versus defaults, 1990–2008 123 7.11 MA foreclosures versus home price, 1990–2008 124 7.12 Home vacancy rates and home prices, 2000–2010 125 7.13 Margins offered (down payments required) and housing prices, 2000–2009 125 9.1 Fed funds rate, ten-year treasury yield, 2004–2007 135 10.1 (a) Top 1 percent and 0.1 percent income share, including capital gains, 1980–2013 (b) Average, top 1 percent and 0.1 percent income, including capital gains, 1980–2013 153 10.2 Real median household income, labor force participation rate, 1984–2013 157 10.3 Regression tests ten-year treasury yields on Fed funds rate, 1985–2006 164 11.1 Subprime ABX indices by vintage, 2006–2009 168 11.2 Output gap, 2007–2015 169 11.3 Household, corporate net worth, 2003–2010 170 11.4 Leverage Venn diagram 173 11.5 Home equity example 174 11.6 MPC based on housing leverage ratio 175 11.7 Spending in small versus large net worth decline countries 176 11.8 Bank balance sheet example 1 178 11.9 Broker-dealer balance sheet example 179 12.1 Thirty-day commercial paper and treasury rates, 2007–2009 182 12.2 Fed assets, 2007–2009 183 12.3 Fed liabilities, 2007–2009 184 Figures and Tables ● ix 12.4 Bank balance sheet example 2 184 12.5 Bank C&I loans, 2008–2011 188 12.6 Bank loan losses, 2005–2011 189 12.7 Loan rate spread versus loan volume example 190 12.8 (a) Bank loan financing—cost, 1998–2010 (b) Bank loan financing—total amount, 1998–2011 192 12.9 Nonfinancial corporation bond issuance, 2005–2011 193 13.1 Civilian labor force participation rate, 1990–2014 204 13.2 Bank and household credit, 1990–2014 205 13.3 CBO 2014 budget outlook 214 Tables 5.1 Merril Lynch 2007 AR—residential mortgage 73 5.2 Mortgage related losses to financial institutions from the subprime crisis—June 18, 2008 74 7.1 Subprime mortgage exposures, 2008 112 Preface This book attempts to explain the broad features of the US housing boom of the 2000s, the subsequent financial crisis and the slow recovery that followed. Every acre of this territory has been surveyed by the most eminent contemporary economists, historians, and journalists. The reader must be provided a good reason to spend her time and attention (and money) on yet another tome on the subject. In this preface I shall attempt to pique her interest. Disagreement with the “Conventional Wisdom” I n this book I present and substantiate a hypothesis that the mercantilist policies of China and other Southeast Asian countries created a capital flow bonanza 1 in the United States that set off an unsustainable housing boom, which was fol- lowed by a catastrophic financial crisis from which the United States has still not fully recovered, seven years after the event. Many of the conclusions I reach in this book differ from commonly held views on the housing boom, the financial crisis and its aftermath (relevant sections are in parenthesis). ● Most people believe the housing boom was primarily caused by a reckless increase in financial sector and household leverage and a decline in loan underwriting standards—I disagree (part I). ● Most people believe reckless lending during the housing boom was perpe- trated by unscrupulous bankers—I disagree (part II). ● Most people believe that housing investors, lenders, and borrowers were motivated by irrational beliefs during the boom—I disagree (part II). ● Most people believe policymakers should have acted to slow the credit expansion during the housing boom—I harbor some doubts (part II). ● Few people (if any) see the current account deficit and income concen- tration as essentially similar phenomena in terms of impact on the US economy—I propose a theory that explains why they are similar and why they cause secular stagnation and boom-bust cycles (part III). ● M any people (particularly policymakers) believe it was prudent for the government to shield bank bondholders from loss and banks from bank- ruptcy during the financial crisis—I disagree (part IV).