The 2008 crisis and the role of exchange rates and trade flows

The 2008 crash wasn't simply a financial crisis. We must also look at the wider economics imbalances which had built up and which directly contributed to the unstable state of the world's finances.

John Mills
20 January 2015

Most people believe that the economic crisis which peaked in 2008 was caused by deficiencies in the banking and financial system and that reforms to stop another similar crisis occurring should therefore concentrate on changing the ways in which banks and the financial sector operate. There is no doubt that there was an unsustainable boom in the 2000s across most of the western world, feeding on very loose credit conditions and asset inflation, and that huge increases in bank lending, some of it involving very dubious financial engineering, contributed very substantially to the financial disaster which subsequently materialised. The issue raised in this Bulletin, however, is whether it was faults in the financial system which were the fundamental cause of what went wrong or whether there were deeper reasons for the debacle which meant that the financial system was the conduit rather than the causa causans for the huge loss of output and the social distress which the crisis brought in train.  

The starting point for an alternative view about the events which peaked in 2008 is to look at trading patterns over the preceding two or three decades. Here is what happened:

In the 1970s the Keynesian approach to economic management broke down, to be replaced by monetarism. The result was a huge increase in interest rates and tightening of the money supply across most of the West, which generated very large increases in exchange rates. In the UK, for example, the real effective parity of sterling rose by more than 60% between 1977 and 1981.

At the beginning of the 1980s, by contrast, China began to engineer an enormous reduction in the external value of its currency, the renmimbi. According to IMF figures, between 1980 and 1985, the renmimbi was devalued by 37%. This, however, was only the start. Between 1985 and 1993, a further devaluation of over 60% in its real effective exchange rate took place, leaving the cost base for manufacturing in China massively lower than in the West.

As a result of the Asian crisis in 1997, many other Pacific Rim countries also devalued their currencies by very large amounts, the Korean won, for example, by about 50% and the Malaysian ringgit by 35%.  

The result for the West was that large swathes of manufacturing became uneconomical as production migrated on a huge scale to the Pacific Rim. In the UK, for example manufacturing as a percentage of GDP fell from 32% in 1970 to barely 10% now.

As a high proportion of foreign trade is in manufactures rather than in services or raw materials – typically about 50% - the inevitable result was that the East began to pile up enormous balance of payments surpluses while the West went into deficit. The UK has not had a balance of payments surplus in manufactures since 1982 or an overall surplus since 1983.

It took a few years for the scale of China’s increase in manufacturing output to develop its full impact, but by 2008 China’s trade surplus in manufactured goods peaked at $421bn, with its average surplus across all of its current account transactions in the mid-2000s averaging about $250bn per annum. These huge sums had to be mirrored by capital exports, much of which took the form of China buying western government bonds, particularly US Treasuries as well as a range of other assets.

In the West, the effect of their massive balance of payments deficits with the East was to suck demand out of western economies, which the authorities somehow or other had to replace. This was done in two main ways, these being:

A Governments ran deficits to keep up demand, partly because they had little alternative but to do so. This is because government and balance of payments deficits are to a large extent mirror images of each other.

Increasingly lax monetary policies were introduced, encouraging asset inflation, particularly in housing and stocks and shares, which encouraged consumers to keep spending. At the same time, credit conditions were relaxed, encouraging consumers to spend more than they were earning, thus enabling them to maintain or increase their living standards, supported by increasing debt.

Given that, at the time, as now, no western government had an explicit exchange rate policy which might have tackled the root cause of trade imbalances which was the fundamental reason for the problems they faced, there was little policy alternative to what was done.

At the same time the enormous influx of funds from the East, which was used to buy up assets in the West, kept western exchange rate far too high while the export of capital funds from the East kept their exchange rates far too low for most western manufacturers to be able to compete against their industries.

The result was that conditions were created where a major boom, driven by excessive credit creation was virtually inevitable. It is the continuation of the same imbalances which has been largely responsible for the slow recovery which we have seen in the West from the crisis which materialised at the end of the 2000s.

If this analysis is correct it has a substantial bearing on both what now needs to be done to get western economies growing again at reasonable speed on a sustainable basis and what is required to avoid an extremely damaging repetition of what occurred between 2007 and 2009. In particular we should consider:

If the root cause of the 2008 crisis and the West’s slow growth especially recently is trade imbalances caused by exchange rates which leave some economies with far lower cost bases than others, then the most important objective should be to tackle this problem. If the fundamental reason for the 2008 crash was excessive trade surpluses and deficits rather than serious defects in the world’s financial structure, then it is the trade problems which need to receive the main focus of attention rather than financial reform.

Broadly speaking, the target should be to achieve exchange rate adjustments which would enable all the world’s diversified economies to have a sufficient share of manufacturing – whose exports still make up such a high percentage of world trade -  to be able to pay their way in the world, to avoid excessive and highly destabilising surpluses building up.

It would be rational for all countries to participate in the parity adjustments which would be required, to produce a much more stable world economy capable of reasonably fast and sustainable growth. It is in fact no more in the interest of surplus countries to curtail their living standards so that they can lend vast sums to deficit countries which are never going to get repaid, than it is for deficit countries to maintain exchange rates which ensure that they are permanently constrained by balance of payments problems.

If much more balanced trade conditions were in place it would make it much easier for the financial system to be operated and controlled so that it ran on a stable basis. Deficit countries would no longer be forced into creating excessive both public and private debt to sustain demand. Governments could easily run deficits – if they needed to do so at all – which were small enough to be easily sustainable. The financial conditions leading to boom and bust would be much easier to avoid.

In particular, the two main thrusts of current financial reform would become much less pressing. These essentially fall into two categories. One is to insist on banks having much larger capital reserves in relation to their lending. The second is to increase very substantially the extent to which banks and other financial institutions are regulated.

The problem with both these approaches is that each of them adds significantly to the cost of finance while at the same time discouraging lending, making funding harder to obtain particularly by the sectors of the economy – manufacturing, exporting and import saving – which it is most in the interest of western economies to encourage. It is not possible for banks both to deleverage and to increase lending at the same time without massive increases in the capital they have available to absorb losses. This is not an argument for doing nothing to reform the financial sector but it does make a strong case for not trying to put all the weight of economic reform on finance rather than trading, if the result is to make the financial system significantly less responsive to the more pressing needs of the rest of the economy.

Getting exchange rates aligned in the way which needs to happen to spread prosperity much more evenly across the world would also enable a better balance to be achieved between the interests of borrowers and lenders. Ultra-low interest rates are unfair to savers, encourage asset inflation, and lead to misallocation of resources. The world’s economies would be better served by interest rates moving to low positive rates net of inflation.

None of these comments indicate that steps should not be taken to improve regulation and control of the financial sector where this can be done economically and efficiently. It does, however, strongly point towards much more effort being put behind world financial reforms which would make the conditions which precipitate financial crises much less likely to occur. The time when western economies can be run with all control of the economy being achieved by fiscal and monetary policies while the exchange rate, as a policy instrument, is ignored, must surely pass. Floating exchange rates, left entirely to market forces, are not the answer. Every country’s exchange rate provides a crucial relationship with every other country in the world and getting this in the right place is just as important as the adoption of sensible and realistic fiscal and monetary policies.  


This article is part of the There is an Alternative series. An economist and entrepreneur, John Mills is Chairman of JML. He recently established The Pound Campaign to raise awareness of the uncompetitive exchange rate and the effect it is having on UK manufacturing and the wider economy.

John Mills is a donor to openDemocracy.

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