Trade Deficits and Global Capital Flows: The Mercantilist Bubble Machine

Book: Financial Stability: Fraud, Confidence and the Wealth of Nations by Frederick L. Feldkamp and R. Christopher Whalen
ISBN: 978-1-118-93579-8

Chapter 18 zooms out from balance sheets to the global economy. Feldkamp and Whalen use an international trade identity to explain not just the 2007 crisis, but centuries of mercantilist boom and bust.

Current account deficit equals capital investment minus domestic savings.

Ben Bernanke used this axiom in September 2007 to argue the Fed knew how to prevent a looming crisis with international cooperation. When that solution was bypassed for about a year, the crisis built anyway. The same identity later helped the Fed and other central banks build a bridge toward recovery.

The Mercantilist Trap

Every major exporting nation in Europe and Asia has been surprised when excess investment in importing nations’ capital markets, combined with real estate inflation at home, ended in banking crises.

That is the price of mercantilist policy. By refusing to spend imported currency and maintaining current account surpluses, export nations must invest their trade proceeds somewhere. When consumption growth is blocked by policy, the money inflates either domestic capital goods prices or the capital markets of importing nations. Real estate is always the easiest target.

Japan’s Lost Decades

Japan in the 1970s and 1980s exported products below production cost. Exporters made up losses by selling inflated Japanese real estate funded by bank lending that absorbed imported dollars while keeping the yen artificially weak.

One major Japanese lender hid defaulting loans by refinancing to capitalize unpaid interest into principal. Loan balances compounded upward while rents fell, crushing collateral values. When the firm filed for reorganization, unpaid interest had grown balances to $20 billion while cash flows from real estate justified only $800 million in collateral value. Creditors accepted 4 cents on the dollar.

Meanwhile, Japanese capital flowed into U.S. real estate. Pebble Beach and Rockefeller Center became famous losses.

The U.S. Housing Bubble

The accounting identity Bernanke cited explains the 2005 and 2006 U.S. housing bubble directly. Mercantilist nations preserving exports by blocking currency adjustment must invest trade surpluses in importing nations’ capital markets. When manufacturing jobs leave for mercantilist exporters, productive uses for capital inflows shrink. Real estate absorbs the excess.

When quality housing investments were exhausted, bankers moved down the credit spectrum to keep mortgage securitization machines running. Poor quality led to nonperformance. When too-big-to-fail entities could not keep hiding obligations off balance sheet, the liquidity burst.

Mercantilist nations then had to invest in U.S. obligations, even at negative rates, to maintain desired exchange values. Rates fell dramatically. The liquidity trap that followed is why low rates may persist for an extended period.

Europe and TARGET2

The eurozone gets a more optimistic treatment. The TARGET2 system for adjusting interbank transfers within the euro treaty creates a civilized correction mechanism. When Greek deposits flee to German banks, Greek banks cannot fund the transfers. TARGET2 gives German banks an asset matching the deposit liability, backed by Greek government guarantees.

Germany’s demands on Greece increase German bank exposure to Greek losses. Eventually, as with Texas banking folly in the 1980s, the process generates a balance that preserves weaker members. War is off the table. A united Europe is worth more than unwinding mercantilist folly by force.

Recent data showing positive trends in Greece suggests TARGET2 is working. Solutions without an underlying treaty are harder, but the authors believe worldwide need will push other nations toward correcting the $67 trillion of accumulated investment folly behind the 2007 crisis.

What I Think About This

Global trade felt like a separate conversation from subprime mortgages when I lived through 2008. Feldkamp and Whalen connect them with an equation, not a metaphor.

If you run persistent surpluses and refuse to let your currency appreciate, you are going to inflate something. If the importer’s productive sector is hollowed out, that something is real estate. If bankers need product to sell overseas, credit quality deteriorates. If hidden debt surfaces, spreads blow out.

It is axiomatic, as the authors say. Not in a preachy way. In a balance-sheet identity way.

The Bernanke angle is interesting too. The Fed had a theoretical framework for cooperation in 2007. Politics and delay burned a year. Understanding the identity did not prevent the crisis. Applying it consistently afterward helped build the bridge.

International trade confirms the theory of financial stability. The hard part is getting mercantilist nations to accept that surpluses have consequences they cannot export away forever.

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