January 17, 2011
The Financial Crisis, Interpreted
Much of the popular, and scholarly, analysis of the crisis has focused on its financial aspects: the breakdown of financial markets, the malfunction of financial innovations, the failure of financial regulation. ...
... This attention is certainly warranted. The descent into panic that started in 2007 began in the American market for asset-backed securities and their derivatives, and was transmitted throughout the world largely through financial channels.
Yet this approach to the crisis misses its broader and deeper causes. This was, quite simply, a foreign debt crisis, the result of a classic capital flow cycle. It demonstrates remarkable similarities with previous instances of capital flow cycles, and of debt crises, from Latin America in the 1980s and Mexico in 1994 to East Asia in 1997-1998 to other occurrences in Turkey, Russia, Argentina -- not to mention Germany in the early 1930s or the United States many times in the nineteenth century.
Between 2001 and 2007 the United States borrowed from abroad between half a trillion and a trillion dollars every year. The aggregate amounts are hard to calculate, but probably come close to five trillion dollars and averaged about five percent of GDP per year – roughly similar to the percentages common in developing-country borrowing sprees. As capital flowed into the country, the American economy went down the well-worn path of other massive capital inflows. Large portions of the borrowed funds were spent on tradable goods, leading to a burgeoning of the country’s trade deficit, which roughly doubled. The remainder went to nontradable goods and services, leading to a substantial increase in their prices. Housing was only the most prominent nontradable that experienced this effect, but the phenomenon was much broader. Between 2002 and 2007, in fact, durable goods prices declined 13 percent in the United States, while services prices rose by 25 percent. Whatever may have been happening with the nominal exchange rate, this was the functional equivalent of a real appreciation, as relative prices shifted in favor of nontradables producers and against tradables producers.
Foreign borrowing allowed Americans to consume more than they produced, and to invest more than they saved. It allowed the U.S. government to spend more than it took in in taxes. It fueled a debt-financed expansion of consumption – of importables and of nontradables. The expansion became a boom, the boom became a bubble, and the bubble eventually burst.
These themes are more fully developed in our forthcoming book, Lost Decades: The Making of America's Debt Crisis and the Long Recovery (W.W. Norton), as well as this published chapter. In the article, Frieden, also notes the intellectual challenges posed by the crisis:
...I am sure that future scholarship will help us understand better the mix of opaque financial innovations, agency problems in financial institutions, regulatory laxity and capture, and other components of the dynamic that contributed to the depth and breadth of the crisis. But the macroeconomic sources themselves also suggest some major analytical questions of direct relevance to those interested in political economy -- none of which, to my knowledge, have been addressed convincingly by scholars. Herewith a simple catalogue:
1. What explains the division of the world into surplus and deficit countries? This was not a typical flow of capital from rich to poor nations: much of the capital flowed from poor to rich nations. Nor is it fully explained by demographic factors driving different savings rates, for in many instances the surplus savings of many surplus-saving countries are themselves the result of national policy. The same puzzles suggest themselves about the major borrowers: why did the United States and the United Kingdom shift so quickly from net creditors to net debtors?
2. What drove the striking macroeconomic and financial developments of the post-1995 period? To what mix of electoral, economic, technological, and special-interest constraints and opportunities were policymakers and financiers responding?
3. What was the relationship between purely financial developments and macroeconomic trends? Did finance drive macroeconomic policy, by enabling easy borrowing (and lending)? Did macroeconomic policies enable financial expansions? Or did some third set of factors drive both macroeconomics and finance?
4. Why was it so difficult for governments of the booming economies to begin adjustment before the crisis hit? From at least 2003, there was continual academic and policy discussion of the global imbalances, with a broad consensus that they were unsustainable and that they would cause serious problems. Yet virtually no government acted upon these warnings. General enjoyment of the good times is not a particularly convincing explanation, for there is ample evidence that politicians that preside over serious crises pay a major price. And yet a failure to adjust in time during a borrowing boom is the rule, not the exception.
Previous issues of The Political Economist are here.
Posted by Menzie Chinn at January 17, 2011 06:14 PMdigg this | reddit
Question #4 is an important question. I would be interested in the thoughts of those with great faith in gov't--there seem to be many on this blog--on this subject.
Why have gov'ts uniformly contributed to credit bubbles rather than being 'smart'?
Posted by: Bryce at January 17, 2011 09:25 PM
Jeffry Frieden writes, 'This was, quite simply, a foreign debt crisis, the result of a classic capital flow cycle.' While the movement of the relative prices of tradable and nontradable goods and services in the U.S. between 2002 and 2007 was consistent with the large capital inflows of the period, where were the subsequent 'sudden stop' and massive depreciation of the currency that are often symptomatic of a 'foreign debt crisis'? Was the post-Lehman collapse 'flight to quality' to U.S. Treasury debt reflective of a garden variety 'foreign debt crisis'?
Posted by: Phil Rothman at January 17, 2011 09:27 PM
This seems a deeply unconvincing argument if you look at the dollar. Classic foreign debt crises show up first and most as currency crises. Yet one strong effect of the crisis was to send the dollar trade weighted index up b about 20%.
The dollar means the the US is not like other countries. So much of the international financial system relied on dollar financing that we saw a desperate rush for funding. The Fed made swap agreements with central banks so that they could provide dollar liquidity.
Compare this with, say, Mexico in the 19909's. the one thing we most certainly did NOT see was the Mexican Central Bank making emergency supplies of liquidity to the Fed and others.
Because so many warned about the danger of the US current account deficit it is tempting to try to fit the crisis which actually happened into the pattern people foresaw. But it won't do.
Posted by: David Blake at January 17, 2011 10:01 PM
"Once upon a time,the world was a global village, where all accounts were a zero sum"
Looking into the ECB statiscal wharehouse,and then looking in Fred data for the same, may convince any reluctant reader.There was an homogeneous consumption function,a unidimensional thinking of the economies.
Statistical Data Warehouse
Federal Reserve Economic Data
The charts are foretelling from consumers,debts and current accounts and banks debts.Labor productivity was not improved and the unemployment median did not improve to the same extent as the debts, private and public were during this time frame.
Euro area 16 (fixed composition) - Standardised unemployment, Level, Total (all ages), Total (male & female), Eurostat, Seasonally adjusted, not working day adjusted
The exit strategies were and still are murky:
Government debt (as a % of GDP) Europe
Fernand Braudel "grammar of civilization" A civilization is not one economy but several economies,is a well accepted principle.
A question remains outstanding,is it decades for nothing or a civilization for nothing?
Posted by: ppcm at January 17, 2011 11:31 PM
Here's my theory for #4:
In the broadest sense, the imbalances had worked to the advantage of exporters in certain countries since the 1950s, and for bankers in the US and Britain since the 1980s. In each case, these had become the politically dominant interest groups and the source for most of the vitality in each respective economy. These institutions were, however, still children of the imbalances that had raised them to power, and so they effectively insisted that the imbalanced be maintained, despite any related damage to their economies.
Meaning, of course, Goldman Sachs could have bankrolled John Kerry's campaign if George Bush had pissed them off by actually doing anything about the imbalances. So he didn't do anything. And the situation is worse if you're an export-led country, because any deliberate attempt to unwind the imbalances will lead to rioting, unemployed workers in your cities as well as PO'd industrialists.
What would you do?
Posted by: Hugh at January 18, 2011 05:29 AM
There is no exclusion for "trade flows" in the FED's calculation of inflation (just one bad definition). Apparently the FED was unconcerned about capital inflows as the reserve requirements against the old measure of Euro-dollar borrowings had been eliminated years before.
Posted by: flow5 at January 18, 2011 06:47 AM
The "broad consensus" was not shared by Alan Greenspan, the only policymaker who truly mattered:
"I conclude that spreading globalization has fostered a degree of international flexibility that has raised the probability of a benign resolution to the U.S. current account imbalance. Such a resolution has been the general experience of developed countries over the past two decades. Moreover, history suggests that greater flexibility allows economies to adjust more smoothly to changing economic circumstances and with less risk of destabilizing outcomes.Indeed, the example of the fifty states of the United States suggests that, with full flexibility in the movement of labor and capital, adjustments to cross-border imbalances can occur even without an exchange rate adjustment. In closing, I raise the necessity of containing the forces of protectionism to ensure the flexibility needed for a benign outcome of our international imbalances."
Remarks by Chairman Alan Greenspan
November 20, 2003
His remarks on November 19, 2004:
2005 testimony http://www.federalreserve.gov/boarddocs/testimony/2005/20050623/default.htm
Posted by: dd at January 18, 2011 07:20 AM
#3 - Macroeconomic policymakers had little or no sense that financial developments (if that's being used to refer to the rapid growth of credit) mattered for the macroeconomy. That could have been because of an excessive faith in "inflation targeting", an excessive compartmentalization of policy institutions (with most central banks having de facto or de jure separate "monetary" and "financial stability" wings), or simply an excess of faith in financial innovation as always and everywhere efficiency- (and growth-) enhancing.
#4 - The experience in emerging economies has been that policymakers aren't aware of the cost of crises unless and until they've been through them. The same goes double or triple for advanced economies. Policymakers were well aware of the imbalances, but in most cases simply assumed they would get resolved somehow - after all, they hadn't had any crises in the past. Cue hubris about the brilliance of central bankers etc.
Posted by: Basilisc at January 18, 2011 07:34 AM
"From at least 2003, there was continual academic and policy discussion of the global imbalances, with a broad consensus that they were unsustainable and that they would cause serious problems."
Not sure this lesson has yet been learned. Asian currency mercantilism continues apace, with no effective actions being taken to stop it.
"What explains the division of the world into surplus and deficit countries? This was not a typical flow of capital from rich to poor nations: much of the capital flowed from poor to rich nations. Nor is it fully explained by demographic factors driving different savings rates, for in many instances the surplus savings of many surplus-saving countries are themselves the result of national policy."
An important part of the answer is given in the paragraph itself, here: "for in many instances the surplus savings of many surplus-saving countries are themselves the result of national policy." It is the well-worn strategy of export-led growth, facilitated by an undervalued currency. Japan and China have together more than $4 trillion in reserves, the bulk of which was gained after 2000.
"While the movement of the relative prices of tradable and nontradable goods and services in the U.S. between 2002 and 2007 was consistent with the large capital inflows of the period, where were the subsequent 'sudden stop' and massive depreciation of the currency that are often symptomatic of a 'foreign debt crisis'? Was the post-Lehman collapse 'flight to quality' to U.S. Treasury debt reflective of a garden variety 'foreign debt crisis'?"
Quite correct. The private sector 'financial panic' intervened to at least forestall a public sector dollar crisis, the likes of which would make the current malaise seem merely like a small lull in the ongoing affluence of modern times. But, of course, we are not taking the opportunity to address the underlying imblances - the U.S. trade balance is back on its unsustainable path. I must admit this surprises me, as I thought a good bout of unemployment would bring the needed political pressure to put a stop to currency interventions abroad.
Posted by: don at January 18, 2011 10:45 AM
Yes, these are exactly the pressure points (or fault lines, as Prof. Rajan calls them) that helped drive the crisis.
I agree with Basilisc above, that the conventional wisdom at the time was that the account imbalances were mostly harmless - remember the "savings glut" explanation? Only a few economists were really pounding the table about it (I can only recall Stephen Roach - who likely got fired from Morgan Stanley for his out of consensus views, and the folks at the Levy Institute).
I think Prof Rajan's political economy views about stagnating incomes goes an awful long way to explaining the switch from creditor to borrower, though I think that's an area ripe for cross-national research.
Posted by: Kevin at January 18, 2011 01:08 PM
So many questions... How about: The prospect of nuclear war pushes agents in the USA but not China to heavily discount the future.
Or... some enormous religious calamity that will end the earth is coming soon and the wise, chosen people have decided live it up a little?
Perhaps the American protestant work ethic is finished and Mancur Olson-type rent-seeking has become the new norm? More likely, information technologies are having highly unequal effects on groups of Americans and cooperation is more difficult than usual.
The prospect of the USA becoming China's 'bitch' is amusing to say the least. You would think that mature, dignified and well-paid Americans would get embarrassed with all the fingerpointing of China and simply proceed to fix their own house.
Congratulations for the book Menzie!
Posted by: westslope at January 18, 2011 03:33 PM
1. Why the US and UK?
From Krugman, this week's NYT Magazine:
"You still hear people talking about the global economic crisis of 2008 as if it were something made in America. But Europe deserves equal billing. This was, if you like, a North Atlantic crisis, with not much to choose between the messes of the Old World and the New. We had our subprime borrowers, who either chose to take on or were misled into taking on mortgages too big for their incomes; they had their peripheral economies, which similarly borrowed much more than they could really afford to pay back. In both cases, real estate bubbles temporarily masked the underlying unsustainability of the borrowing: as long as housing prices kept rising, borrowers could always pay back previous loans with more money borrowed against their properties. Sooner or later, however, the music would stop. Both sides of the Atlantic were accidents waiting to happen."
Krugman seems to be arguing a broader systemic case, ie, individual regulatory regimes or fiscal policies were not as much to blame as global liquidity. Which in turn Blames it on Beijing: It's the steam pressure, not the strength of the pipe. I would note, however, that both the US and UK are key financial intermediation centers. That's where the Chinese money was re-cycled, and perhaps it leaked into domestic economies.
2. Policy drivers post-1995: Fall of communism. Liberals (fiscal conservatives) shift to the left of the median voter boundary; social conservatives come to the boundary on the right. Fosters Clinton's deregulatory tendencies, ie, we return to a pre-1929 regulatory mindset.
3. Macro policies. The Fed's mandate is to maintain full employment and price stability. And it did. There was really no inflation to speak of, because the liquidity was real--not printed by the Fed, but minted by the factories of China. The Fed had to slam on the breaks in the absence of material inflation. No paradigm for that, so they didn't.
4. No one acted despite warnings. "From at least 2003, there was continual academic and policy discussion of the global imbalances, with a broad consensus that they were unsustainable and that they would cause serious problems." In the case of the US, the same could be said of 2009, 2010, or 2011.
Posted by: Steven Kopits at January 18, 2011 04:19 PM
Hugh asked what I would do, given that central banks have uniformly contributed to bubbles rather than countering them.
I would repeal the laws that SUPPRESS free market provision of money.
Posted by: Bryce at January 20, 2011 11:40 AM