How Asia bails out America

The surprise three-quarter point cut in interest rates by the Federal Reserve, America’s central bank, on Tuesday was generally understood as a straightforward move. Shares were plummeting, the economy was falling into recession, so action had to be taken to boost economic activity.

But closer examination shows the story is not so simple. Wall Street investment banks have argued for weeks that America is either already in or about to enter a recession (1). And despite the recent panic over shares, much of the concern is focused on the bond (IOU) markets.

Tuesday’s surprise rate cut is best seen as a single episode in a much longer drawn-out drama. Two key factors are at work: the relatively sluggish character of growth in the developed world and the dynamism of many Asian economies (these are discussed in more detail in Phil Mullan’s recent spiked essay, The truth about the ‘credit crunch’). These two factors are interrelated rather than autonomous. The interaction between them in recent years is key to explaining the current market volatility.

America’s economy has in effect been subsidised by Asian countries and oil-producing economies in recent years. Huge flows of capital from the developing world have financed America’s massive trade deficit. Asia has helped pay for American consumption.

But over a period of years such subsidies have distorted the American economy. Capital flows from Asia have enabled America to keep interest rates lower than they would otherwise be. Such easy credit helped create a housing bubble in America as loans were easily available. This was the root of the misleadingly named ‘subprime crisis’ in America. The underlying problem was not irresponsible lenders or feckless borrowers but the lack of dynamism of the American economy and its dependence on Asian credit.

The subprime problem was compounded when the excess debt in the American financial system was securitised. Rather than hold on to the loans, the mortgage lenders sold them on to other financial institutions which wrapped them up into complex financial instruments. So someone might borrow money from a local bank in, say, Arkansas, but that bank would then sell on the debt to another institution. Once the debts started going bad, confidence in the financial system was undermined.

By last week it looked like the credit crunch was easing. Inter-bank rates – the rates at which banks lend to each other – were returning to more normal levels. But the downgrading by a credit rating agency of Ambac, one of the world’s largest bond insurers, on Friday helped prompt a new panic. Such bond insurers are active in many markets including that for mortgage-backed securities. To make matters worse, Ambac’s downgrading triggered a downgrading of the debt that it insured. Hundreds of billions of dollars worth of bonds were affected. It was a painful reminder that the credit crisis was far from over.

Watching the television or reading the newspapers it is easy to get caught up in the bewildering detail of the financial markets. But the bigger picture is one of a sluggish American economy which has come to depend heavily on credit from the dynamic countries of Asia.

Daniel Ben-Ami is a financial and economic journalist. Visit his personal website here.

(1) See for example Recession coming, Global Economic Forum Morgan Stanley 10 December 2007 and ‘Recession a reality’, Morning Call Notes Merrill Lynch 7 January 2008.