The Hankyoreh (South Korea), May 5, 2008
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There can be little doubt that U.S. economy is now in a recession. It has lost jobs for three consecutive months, which has never happened except in periods associated with recessions. Consumer spending, which accounts for 70 percent of GDP, has been essentially flat for 3 months, while the housing sector continues to contract. Non-residential investment is also lagging. The National Bureau of Economic Research, the official recession dating body, will likely date the recession as beginning last December or January, although this announcement will not be made until the summer at soonest.
Like the 2001 recession, this recession is the result of the collapse of an asset bubble; in this case the bubble is in the housing market rather than the stock market. As was the case in the last financial collapse, many of the biggest losers appear to be foreign investors. In the late 90s, foreign investors rushed to buy into the U.S. stock market hoping to take advantage of double-digit returns. Instead, most of them got the opportunity to enjoy plunging stock values as the market lost almost 50 percent of its value from March of 2000 to July of 2002.
This time around foreign investors are again taking large losses, largely as the result of the collapse in value of various derivative instruments that were tied in some way to mortgage debt. These losses are even harder to understand than the losses associated with the collapse of the stock bubble.
At least investing in U.S. stocks in the late 90s offered the promise of high returns, the returns on mortgage backed securities and their derivatives would have been only a couple percentage points higher than the return on U.S. treasury bonds. It is difficult to understand why investors would take such large risks for such small returns.
In fact, the willingness of foreign investors to throw money away on U.S. investments continues to this day. Foreign investors continue to hold trillions of dollars in dollar denominated treasury notes and short-term bonds or certificates of deposit. These investors have been willing to hold these bonds at very low interest rates, even though the dollar has been plunging in value against the euro and other major currencies.
These dollar holdings are hard to understand, since the dollar is so obviously an over-valued currency whose value is likely to continue to fall against other currencies. In addition, the interest rate on these holdings is extremely low.
As far as the value of the dollar against other currencies, the euro used to be worth just 82 back in 2002. Today the euro is worth nearly twice as much, at just under $1.60. If an investor had held euros under her mattress for the last six years, she would have almost doubled her money measured in dollars.
The other part of the story that is difficult to understand is the willingness of foreign investors to hold long-term bonds in a weak currency, at a low interest rate. The interest rate on U.S treasury bonds has been hovering near 3.5 percent in a context where inflation is 4.0 percent. Usually, investors expect to get a premium for holding long-term bonds. In this case, they are getting a negative real rate of interest.
While many U.S. investors also are holding bonds at this interest rate, we have an excuse. The federal government makes it difficult for middle income investors to hold foreign currencies. It prohibits banks in the United States from offering saving accounts, checking accounts, or certificates of deposits in foreign currencies. In other words, to some extent investors in the United States are forced to accept low returns in dollar denominated assets, by contrast foreign investors throw their money away by choice.
There has been a long history of foreign investors taking big losses on investments in the United States. The first big losses were associated with the collapse of canal building boom in 1837. Twenty years later foreign investors took another big hit with the collapse of a railroad boom in 1857.
Apparently, the taste for losses in dollar denominated assets never fades for foreigners. No matter how much money foreigners lose in the United States, they happily ignore history and pretend that they are buying completely safe assets. This willingness to take large losses is hard for economists to explain, since we usually think that investors try to maximize their returns.
Of course the willingness of foreigners to take large losses on U.S. investments is good news for those of who get to rely on people in foreign countries subsidizing our living standards. The news is not as good for the people in countries taking the losses, especially when they live in poor developing countries. But no one said that life is fair.
Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR).