Whose Problem? Global Imbalances, Part 2: Subprime to Tea Party to Tipping Point
Book: Financial Cold War: A View of Sino-US Relations from the Financial Markets
Author: James A. Fok
ISBN: 9781119862765
Previous: Whose Problem? Global Imbalances, Part 1
The weakest link broke in 2008. It happened to be US subprime mortgages. But Fok’s point is the chain was long. Housing policy, securitization, Basel loopholes, Asian savings, oil money, deregulation, politics. Any link could have snapped. Subprime just went first.
This second half of Chapter 3 traces how dollar-system imbalances turned into a global crash, then into populist politics, then into a possible tipping point under Trump and Covid.
The weakest link
Fannie Mae bought conforming mortgages to give banks liquidity. Nixon privatized it in 1968 while keeping implicit government backing. Securitization spread through Fannie, Freddie, and Salomon’s Lewis Ranieri. Tranching created AAA slices from risky pools.
By the late 1990s most US mortgages sat in securities held worldwide. Borrower and risk-bearer grew distant. Credit default swaps let banks shed risk and cut capital charges. Money market funds and repo markets funded the machine.
Low rates made housing look like a one-way bet. In 2003, 70 percent of mortgages met GSE standards. By 2006, 70 percent were subprime or non-standard. Asian reserves and oil money crowded AAA demand. Structurers manufactured fake AAA from subprime. The US absorbed nearly 80 percent of cross-border savings. Chuck Prince said keep dancing until the music stops.
The music stops
Bear Stearns fell in spring 2008. Lehman collapsed in September, triggering nearly $10 trillion in losses. AIG needed $85 billion after selling CDS protection it could not honor. Fannie and Freddie, backing $5 trillion in home loans, were nationalized.
Panic sold everything except Treasuries and the dollar. Emerging market crises usually trigger flight from the troubled country. The US crisis sucked money in. That is the privilege in action.
Paulson, Bernanke, and Geithner argued they could not legally save Lehman like Bear. Maybe. We will never know the counterfactual.
Bernanke, a Depression scholar, knew panics feed themselves. The Fed slashed rates, widened collateral rules, and pushed TARP through Congress. Nine big banks got coerced capital injections. Citigroup’s total bailout topped $476 billion.
The rescue was global. European banks’ balance sheets dwarfed their home economies. Ireland’s bank liabilities hit 700 percent of GDP. Reserve Primary Fund broke the buck on September 16. Wholesale dollar funding froze. Fed swap lines eventually lent $10 trillion, mostly to the ECB.
No other central bank could play that role. Dodd-Frank and Basel III followed, but the big lesson was clear: the Fed backstops global dollar liquidity.
China’s exports fell from +25 percent year-on-year in July 2008 to -18 percent six months later. Beijing’s stimulus propped up global growth and deepened domestic imbalances. Bankers got rescued. Workers did not.
Anyone for tea?
AIG bonuses enraged the public. Rick Santelli’s CNBC rant on homeowner bailouts launched the Tea Party. Gridlock left the Fed alone with low rates. Asset prices boomed while wages lagged.
Europe’s debt crisis exposed the euro’s design flaw. America’s 2011 debt ceiling fight got the US downgraded. Occupy Wall Street followed. Brexit and Trump channeled the anger into nationalist politics.
A tipping point?
Trump told Clinton that China used America as a piggy bank. Fok flips it. China held over $1 trillion in Treasuries at end of 2020, second only to Japan. Roughly a third of China’s reserves sit in US government bonds.
The dollar anchors economies representing 70 percent of world GDP. Trade is about 60 percent of global output. Cross-border financial claims exceed 400 percent. Capital markets matter more than cargo ships.
Trump’s 2017 tax cuts sent most benefits to the top 1 percent. His trade war raised real issues about Chinese practices. But no bilateral deal could fix America’s global deficit. The root cause is the dollar’s reserve role.
Dollar demand stops the US currency from falling enough to reflect productivity shifts elsewhere. That hurts US manufacturing workers. At the same time, the world needs dollar liquidity, which pushes America toward current account and fiscal deficits. Japan and Switzerland run surpluses with reserve currencies, but those currencies are minnows next to the dollar.
Covid broke something new. In March 2020, Treasuries sold off when they should have rallied. Liquidity vanished in the $18 trillion “risk-free” market. The Fed pledged unlimited bond buying. Its balance sheet hit $7.4 trillion by end of 2020. US debt reached 129 percent of GDP. Foreign official holdings of Treasuries stalled after 2013. The Fed backfilled.
Michael Howell calls this a fourth phase: the Federal Reserve guarantee, after gold, petrodollars, and emerging market reserve accumulation. Investors assume the Fed always saves the day. Exiting that support is brutally hard.
Fok asks if we are reaching a tipping point. Easy borrowing funded wars, tax cuts, and bailouts. Politics fractured. Yellen pushed a global minimum corporate tax in 2021, but pandemic debt may overwhelm that fix. Trading partners hunt alternatives.
Reform means either a productivity miracle or a managed monetary transition nobody wants to attempt. Chapter 4 turns to China.
My take
The GFC was the bill for decades of dollar-system imbalances. Emerging markets get IMF lectures. America borrows without limit. When crisis hits home, capital still flees into the dollar.
Covid’s Treasury seizure in March 2020 is the warning. Connally’s line may be reversing. The dollar is still everyone’s problem. America is starting to feel it too.