The structural reasons behind the Sub Prime Crisis

(Ref Financial Times dt August 22)
In a recent article in the Financial Times, Martin Wolf, the well known columnist has dug deeper into the sub prime crisis. Many of the articles written on the subject have focused on the linkages between different markets. But this one looks at broad macro economic factors contributing to the crisis. We all know the US has been running a major current account deficit in the recent past. A current account deficit essentially means the country is spending more that it is saving. According to Wolf, there is an excess of savings over investment (and consumer spending) in much of the world. This has been offset by an excess of investment (and consumer spending) over savings in a smaller part of the world. In 2006, the countries with surplus savings generated a current account surplus of about $1300 billion. The US current account deficit absorbed about two thirds of this surplus.

In simple terms, foreigners have been buying US assets on a vast scale. The funds provided by foreigners have been absorbed by the US government and households since the stock market bubble burst in 2000. Between the first quarter of 2000 and the third quarter of 2003, there was a negative swing in the US budget balance of 7% of GDP. Household spending has also been on the rise since the 1990s. By 2006, households had accumulated a financial deficit of close to 4% of GDP. This household deficit has absorbed the financial surpluses of the business sector. This rise in household indebtedness has worked through asset backed borrowing. Or more precisely mortgages. This had to happen because with the US absorbing so much of capital, the government already having piled up a huge fiscal deficit and businesses showing surpluses, somebody had to spend to prevent the economy from going into recession. That is also why the Fed is likely to cut interest rates and sort of prolong the party. The other alternative which the Fed has, cutting the current account deficit or increasing the budget deficit, are not that practically feasible.

Wolf concludes on a poignant note: “Today’s credit crisis, then, is far more than a symptom of a defective financial system. It is also a symptom of an unbalanced global economy. The world economy may no longer be able to depend on the willingness of US households to spend more than they earn. Who will take their place?”