The international trade axiom that holds that a current account deficit is identical to capital investment minus domestic savings is the means by which Ben Bernanke convinced the world that the U.S. Fed knew how, with cooperation, to prevent a then-looming crisis in September 2007. After Mr. Bernanke’s solution was bypassed and undermined for about a year (as the crisis built), it is by this axiom that the theory of financial stability, applied by the Fed and other monetary authorities, created a bridge to support new policies that have the ability to generate a worldwide recovery. There must be worldwide cooperation, however, to establish market policies that are consistent with this theory.

The implications of this equation explain not only the 2007–2009 crisis, but also each and every international financial bubble and bust that occurred since international trade began. As mercantilist exporters, every major nation in Europe (and Asia) has been surprised when excesses relating to investments made in the capital markets of importing nations (and real estate inflation at home) end up as banking or investment crises.

That is the price of all mercantilist folly, however. By refusing to spend imported currency (to maintain the mercantilist’s desire for a current account surplus), the money received for its exports must be invested to inflate something. When growth of consumption is precluded by policy, the money must either inflate domestic prices of capital goods or the capital markets of importing nations—and in each case, the capital markets most easily inflated are those for real estate.

Consider Japan in the 1970s and 1980s. Products were exported at prices below the cost of production in Japan. Major exporters made up their losses by selling Japanese real estate at prices inflated by bank lending that absorbed imported dollars while keeping the yen at exchange rates that were lower than normal.

One widely read reorganization disclosure document revealed that a major Japanese lender had kept absorbing losses on defaulting loans by the expedient of refinancing to absorb unpaid interest. Rather than disclosing nonperformance, the lender simply assumed an equal increase in the value of Japanese real estate. As a result, the law of compound interest expanded loan balances while contracting rents, which had the opposite effect on the saleable value of Japanese real estate held as collateral.

By the time that firm filed for reorganization, unpaid interest had compounded the loan balances to $20 billion while the value of sustained cash flows from its real estate holdings justified a total collateral value (for assets with any discernible value) of only $800 million. This reality was recognized when more than 95 percent of creditors accepted a plan of reorganization giving them only the fair value of their collateral (4 percent of their loan balances).

Meanwhile, money Japan imported in exchange for exports to the United States was invested in U.S. real estate and then lost as accelerating inflation, and later constraints on lending (caused by inflation fighting and unnecessary investments), burst as part of the U.S. S&L bubble. As a result, investments in such U.S. assets as the Pebble Beach golf course and Rockefeller Center produced still further losses for Japan.

The consequence of the international accounting identities referred to by Mr. Bernanke in 2007 is that a mercantilist nation’s desires to preserve exports by preventing currency adjustments (that otherwise translate into net export reductions) must be met by investing trade surpluses in the capital markets of importing nations. When productive uses for capital inflows do not exist (because manufacturing jobs are exported to the mercantilists), the balancing effect inherent in this axiom ends up creating a bubble in real estate. That was the ultimate driving force that generated the 2005–2006 housing bubble in the United States.

When a point was reached that good housing and mortgage investments were absorbed, some of the bankers who made money generating mortgages for sale overseas turned to lower and lower quality segments to keep their sell-side machines running. When poor quality led to nonperformance, however, and demands for recognition as debt of too-big-to-fail entities were denied, the accumulation of this excess liquidity burst and investors tried to reverse course.

To allow them to continue to avoid the need to change course (or to cushion the impact), mercantilist nations were then required to invest in U.S. obligations, at negative rates if necessary, to maintain their desired currency values. Thus, abiding by this trade axiom generated a liquidity trap wherein rates fell dramatically. It is also the reason rates are likely to stay low for an extended period of time.

Discontented mercantilist nations that continue to stay their course of supporting exports in the face of this folly will necessarily suffer by repression of return on investments (or other loss) for a correspondingly extended period. As the saying goes: it’s axiomatic.

In the case of Europe, corrections within the eurozone seem, finally, to be sorting out in a rather civilized manner because of the TARGET2¹ process for adjusting interbank transfers under the treaty creating the euro. The effect, for example, of a Greek banking crisis is that Greek deposits flow within the eurozone to the strongest economy, Germany. When Greek banks cannot fund deposit transfers by cash transfers to German banks (because they cannot collect loans), the TARGET2 process gives the receiving German bank an asset that corresponds to (and offsets) the deposit liability booked in Germany. The asset received is a Greek bank liability guaranteed by the Greek government.

Thus, for all the insistence by Germany that Greece must do this or that, to the extent Greece is financially harmed by Germany’s demands, the result is an increase in the exposure of German banks to Greek losses. Eventually, as is the case in the United States when one region engages in banking folly (e.g., Texas in the early 1980s), this TARGET2 process will generate a balance that preserves Greece.

Since Germany will not collect by force (i.e., through war, the prior remedy for mercantilist failures) because the advantages of a united Europe far outweigh the cost of unwinding Germany’s mercantilist folly, TARGET2 will, it appears, compel an EU resolution that does not destroy Greece and other financially impaired nations. The approach applied in the eurozone uses regional adjustments rather than federal funds to put responsibility back on the EU’s internal mercantilists.

Once the politics of this process had been worked out, it was easy to predict a financial stability solution for the euro crisis that will not result in hostilities. Recent data indicates positive economic trends in Greece, so it appears TARGET2 is working. It is more difficult to find solutions for situations in which there is no underlying treaty to uphold, but the logic of worldwide need will, we believe, lead others to find the means for correcting the $67 trillion of accumulated worldwide investment folly that created the 2007–2009 crisis.

Thus, fundamental principles of international trade confirm the theory of financial stability. Let’s hope, moreover, that we have now learned how to smooth the recovery process.