In late 2008, the world’s financial system seized up. Billions of dollars worth of financial assets were frozen in place, the value of securities uncertain, and hence the solvency of seemingly rock solid financial institutions in question. By the
end of the year, growth rates in the industrial world had gone negative, and even developing country growth had declined sharply.
This economic crisis has forced a re-evaluation of deeply held convictions regarding
the proper method of managing economies, including the role of regulation
and the ideal degree of openness to foreign trade and capital. It has also forced
a re-assessment of economic orthodoxy that touts the self-regulating nature of free
The precise origin of this breathtaking series of events is difficult to identify.
Because the crisis is such an all-encompassing and wide-ranging phenomenon, and
observers tend to focus on what they know, most accounts center on one or two
factors. Some reductionist arguments identify “greed” as the cause, while others
obsess about the 1990s era amendments to the 1977 U.S. Community Reinvestment
Act that was designed to encourage banks and other financial institutions to
meet the needs of the entire market, including those of people living in poor
neighborhoods. They also point to the political power of government-sponsored
entities such as Fannie Mae and Freddie Mac, agencies designed to smooth the flow
of credit to housing markets.
In our view, such simple, if not simplistic, arguments are wrong. Rather, we view
the current episode as a replay of past debt crises, driven by profligate fiscal policies,
but made much more virulent by a combination of high leverage, financial innovation,
and regulatory disarmament. In this environment, speculation and outright
criminal activities thrived; but those are exacerbating, rather than causal, factors.
Figure 2: Current account to GDP ratio (blue, left axis) and end-year net international investment position to GDP ratio (red, right axis). Source: BEA June 2009 release, 2008 NIIP release, author’s calculations.
The subsequent sections are: (1) History Repeats, Again; (2) The United States; (3) Facilitators of American Excess; (4) Consequences, and; (5) Long Term Prospects. From Long Term Prospects:
We are now witnessing the unwinding of this process of
debt accumulation. Households and firms are busily trying to
reduce their debt loads, in the face of dimmer prospects for
income and profits. For households, savings rates are rising,
but at the cost of stagnant consumption. For firms, the reduction
of debt load is consistent with a reduced rate of investment
in plant and equipment.
In some sense, this process of retrenchment is necessary.
For many years, the United States consumed more than it
produced. We borrowed and for a while thought that the old
rules had been suspended. But now it turns out that we do
have to pay back what we have borrowed. The attendant
higher saving rate and lower investment rate will lead to a
substantial improvement in the current account balance, or
in other words, the paying off of our debt.
More broadly, though, this also means that the United
States cannot rely upon the driver of growth that has sustained
it over the past three decades– namely consumption.
But the consequences extend beyond the nation’s border.
The world can no longer rely upon the American
consumer. Who will take up this role remains to the next
The entire article, which draws on a book the authors are writing, can be read here.