The Blog

Now What?

How we got into today's mess and where we go from here.

9:00 AM, Jul 24, 2009 • By DAVID M. SMICK
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When people asked what fundamentally caused the financial crisis, my answer is not what they expect. I respond with one phrase--the fall of the Berlin Wall. By the early 1990s, after the collapse of the socialist model, emerging market economies such as China, India, Eastern Europe, and the commodity producers wanted to be like the West--capitalists. And they became pretty good at making their economies more productive. This had the effect of lowering real wage costs globally while setting up these economies as powerful exporters.

Soon a global ocean of capital--of excess savings--was beginning to swirl around a liberalized worldwide financial system. Partly as a consequence of the Asian crisis of the late 1990s, most of these emerging market economies by the late 1990s adopted a new export-oriented model for success. They tied their currencies to the U.S. dollar and refashioned their economies as large export platforms. The target: The U.S. consumer who fairly quickly became the world's consumer of last resort.

As large parts of the world set up shop as a giant, low-cost, export engine, the low saving U.S. consumer became almost addicted to consumption. As we kept consuming, many of the world economies began stockpiling record amounts of excess savings. This reliance on exports, in lieu of developing consumer-based economies, created enormous global savings imbalances. In China alone, excess savings in the form of central bank reserves quickly approached $2 trillion. The problem was that there were too few investment opportunities for so much capital. A lot of this excess saving was recycled back into the U.S. financial system, usually in the form of fixed income purchases, with U.S. Treasury securities a favorite target.

This dangerous ocean of capital, which again reduced global wage demands, allowed American policymakers to think they had defied the financial laws of gravity. That was the period when Alan Greenspan was called "the Maestro" and attempted to tame the business cycle. At one point, the Federal Reserve launched a series of hikes in short-term interest rates. Long-term rates not only failed to rise but dropped. That's not supposed to happen. In the process, financial risk became severely underpriced as long-term interest rates dropped to unrealistic lows. Wall Street thought it had discovered riskless risk.

Because the global economy was out of balance, Americans went on a credit binge. U.S. household debt soared from 75 percent of annual disposable income in 1990 to 130 percent just before the crisis. At the height of this period, gluttonous Americans were spending far more than a dollar for every dollar they earned as they propped up the global economy.

During the administration of George W. Bush, the U.S. economy would have grown at an annual rate of less than 1 percent without a steady stream of private equity loans, according to economist Niall Ferguson. And why were private equity loans so attractive? Because this dangerous global ocean of capital in our interlinked world financial system had unrealistically reduced long-term interest rates to unheard of low levels. This was an unsustainable situation. Asset prices, including the price of housing, shot through the roof with little response from the regulators, including the Federal Reserve. At the same time, U.S. monetary policy remained extraordinarily accommodative. With the regulators asleep at the switch, here was a giant bubble certain to burst. Why? Because sooner or later financial bubbles always burst.


Perhaps the greatest mystery of this Great Credit Crisis is how some mortgage defaults in a relatively small subprime market (initially of only $200-$300 billion) could topple a world financial system worth several hundred trillion dollars. How could some collapsing mortgages bring about the worst financial crisis since the 1930s? It doesn't make sense.

The answer is the credit crisis reflected something larger and more fundamental than a mere problem of mortgage defaults. The crisis erupted to such magnitude in large part because global markets declared a buyers' strike against our less than transparent financial architecture--the sophisticated paper assets including securitization financial institutions use to measure risk and deploy capital. The housing crisis was a mere trigger for a collapse in trust of paper, followed by a deleveraging of the entire bloated-with-credit global financial system.