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US Economy: The Subprime Market, Depreciation and the Exchange Rate

Economics / US Economy Oct 29, 2007 - 01:18 AM GMT

By: Gerard_Jackson

Economics Best Financial Markets Analysis ArticleCurrent economic commentary is misleading a great number of people. The problem is — as always — bad economics. We can all recall that it was not long ago when we were told by a horde of financial and economic advisers that the subprime market would sink the American economy. What this lot overlooked was the important fact that only about 14 per cent of mortgages are subprime. Moreover, less than 2 per cent of these are in trouble.

The ace in the hole of our commentators and advisers is the sheer magnitude of the monetary figures. For example, the first quarter of this year experienced something like a $7 billion increase in foreclosures. This is a massive sum that was bound to boggle the public's mind — and so it did. But when we look at it in terms of a $13 trillion plus economy a different picture emerges: we find that it is less than 0.07 per cent of GDP. Let's look at this another way. This $7 billion is 3.5 per cent of Google's current market value, 2.5 per cent of Microsoft's market value and 12.5 per cent of Bill Gates' net worth. The idea that $7 billion could sink the American economy is ridiculous.

Critics will, of course, assert that because consumption is about 72 per cent of GDP then the cost of foreclosures has to have a damaging effect on consumer spending. There are two problems with this line of thinking: Firstly, these mortgages only amount to about 0.07 per cent of spending. Secondly, and more importantly, GDP is not gross. Total spending is about $28 trillion dollars of which about 30 per cent is consumer spending. The problem is that the conventional approach deliberately ignores spending between businesses, counting only spending on fixed capital.

The Bureau of Economic Analysis has tried to remedy this flaw by including spending on intermediate goods. It calls the resulting statistic gross output. So what we find is that “...income produced or net product is roughly only about one-third of gross income”. (Sumner Slichter, Towards Stability , New York: Henry Holt & Co., 1934, p. 7, cited in C. A. Phillips, T. F. McManus and R. W. Nelson, Banking and the Business Cycle , Macmillan Company, 1937, p. 71). Another fact that is overlooked is that if the $7 billion was based on real bank deposits then the money is being spent. The only ones who suffer are the lenders and borrowers. The builders and landowners to whom the money was paid are spending it. Problems start when loans are based on bank-created deposits. This is another important fact that is generally ignored.

Any economic or financial advice that is based on the fallacy that consumption dominates and drives the economy is bound to be faulty. On top of the consumer-spending fallacy we are also being fed the fallacy that a depreciating currency causes inflation and raises interest rates. The reasoning is as follows: a falling dollar raises the prices of imports which is inflationary; to curb the resulting inflation the Fed must raise interest rates which then send the economy into recession. This argument is just another version of the fallacy that an adverse balance of payments causes inflation by driving down the exchange rate. But what causes an adverse balance of payments? When we ask this question we immediately realise that the argument is circular. It assumes what it is supposed to explain. So what is the real cause of depreciation? Inflation is the cause.

In a free economy the principle cause of a cumulative deficit in a country's international payments is to be found in inflation. . . In a country whose currency is not convertible into gold, inflation leads to its continuous devaluation in terms of foreign currencies. (Michael A. Heilperin, International Monetary Economics , Longman's, Green & Co., 1939, p. 123)

What is truly awful is that this subject had been thoroughly hammered out about 200 years in what we now call “bullion controversy”. Yet our media oracles are completely unaware of this fact. So much for expert opinion.

Trade takes place between countries because the prices of their products differ. This is a self-evident fact that would not require repeating except that many of our economic commentators have not grasped its full significance. I have argued for sometime that if a country's currency has been over-valued for a lengthy period it is likely that it will become more oriented to domestic production while its imports of manufactures will increase as its deficit worsens, and it might even find some of its manufacturers moving offshore. In turn, the exporting countries will find themselves in the reverse situation.

The following excerpt explains that when a large foreign loan causes a shift in buying power consequent on a payment of reparation or an international loan affects both directly and indirectly the demand for international goods. Its direct effect in increasing the borrowers' demand for foreign goods and reducing the lenders' may not be important. But it has an indirect effect: It increases the demand for home market goods in the borrowing country. That increased demand for home markets goods “ will lead to an increased output of these goods. In a progressive country this means that labour and capital, that would otherwise have passed to export industries and industries producing goods which compete directly with import goods, now go to the home market industries instead.

Output of these import-competing goods and of export goods increases less than it would otherwise have done. Thus, there is a relative decline in exports and an increase of imports and an excess of imports is created”. A corresponding adjustment takes place in the lending country and an excess of its exports is created. (Chi-Yuan Wu, An Outline of International Price Series , George Routledge & Sons LTD pp. 291-92)

The above was from a debate on what was called the “transfer problem”. But it is clear that the same reasoning applies to credit expansion. (See Jacob Viner's Studies in the Theory of International Trade , Harper & Brothers, 1937). Anyone who cares to study the literature will find that I am not saying anything original. Unfortunately our commentariat does not recognise the importance of economic history and the history of economic thought. The result is that none of them seem able to see that there exists a powerful link between monetary policy, the current account deficit and the depreciating dollar.


By Gerard Jackson

Gerard Jackson is Brookes' economics editor.

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