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Reflections on the causes and consequences of the debt crisis of 2008

Reflections on the causes and consequences of the debt crisis of 2008

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Policy Report 
Robert M. La Follette School of Public Affairs, University of Wisconsin–MadisonVolume 19, Number 1, Fall 2009
La Follette
In This Issue
Reflections on the Causesand Consequences of theDebt Crisis of 2008...............................1What the Stimulus Package Saysabout President Obama’s Plansfor Health Care Reform.......................6Putting Community Colleges First.....8The Impact of the EconomicCrisis on State Governments...........12
Director’s Perspective
Restoring Confidence,Economic Growth
With many Americans feeling as though theeconomic foundations of our society havebeen deeply shaken, careful policy analysisand management of public resources inresponding to the economic recession areof the highest priority. To restore public con-fidence, our public and private sector lead-ersmust balance the need to develop short-term policies to stimulate economic growthwith longer term investments in the eco-nomic and social infrastructure of our nationthat will reduce the likelihood of anothersevere recession.President Obama has identified, in part,health care and education as key prioritiesfor investment and reform, with the expec-tation that increased spending and greateraccountability will enhance the effective-ness and efficiency of these sectors andlong-run economic growth. In this context,this issue of the
La Follette Policy Report 
offers perspective on the causes of theeconomic crisis that began in 2007, itsramifications, and on solutions offered toaddress it.
Reflections on theCauses and Consequencesofthe Debt Crisis of2008
By Menzie Chinn and Jeffry Frieden
I
n late 2008,the world’s financial system seized up.Billions ofdollars worthoffinancial assets were frozen in place,the value ofsecurities uncertain,andhence the solvency ofseemingly rock solid financial institutions in question.By theend ofthe year,growth rates in the industrial world had gone negative,and evendeveloping country growth had declined sharply. This economic crisis has forced a re-evaluation ofdeeply held convictions re-garding the proper method ofmanaging economies,including the role ofregula-tion and the ideal degree ofopenness to foreign trade and capital.It has also forceda re-assessment ofeconomic orthodoxy that touts the self-regulating nature offreemarket economies. The precise origin ofthis breathtaking series ofevents is difficult to identify.Because the crisis is such an all-encompassing and wide-ranging phenomenon,andobservers tend to focus on what they know,most accounts center on one or twofactors.Some reductionist arguments identify “greedas the cause,while othersobsess about the 1990s era amendments to the 1977 U.S.Community Reinvest-ment Act that was designed to encourage banks and other financial institutions tomeet the needs ofthe entire market,including those ofpeople living in poorneighborhoods.They also point to the political power ofgovernment-sponsoredentities such as Fannie Mae and Freddie Mac,agencies designed to smooth the flow ofcredit to housing markets.In our view,such simple,ifnot simplistic,arguments are wrong.Rather,we viethe current episode as a replay ofpast debt crises,driven by profligate fiscal policies,but made much more virulent by a combination ofhigh leverage,financial innova-tion,and regulatory disarmament.In this environment,speculation and outrightcriminal activities thrived;but those are exacerbating,rather than causal,factors.
Histor
 
y Repeats, Again
 The United States has borrowed and spent itselfinto a foreign debt crisis.Between2001 and 2007,Americans borrowed trillions ofdollars from abroad.The federalgovernment borrowed to finance its budget deficit;private individuals and compa-nies borrowed so they could consume and invest beyond their means.While somespending went for physical commodities,including imports,much ofthe spending  was for local goods and services,especially financial services and real estate.Theresult was a broad-based,but ultimately unsustainable,economic expansion that
Director
 
’s Perspecti
 
vecontinued on page 16
 
drove up the relative price ofgoods not involved in foreigntrade—things like haircuts,taxi rides,and,most important,housing.The key “nontradablegood was housing;thatboom eventually became a bubble.And,when that bubbleburst,assessments ofassets and liabilities across the boardbecame unbalanced. This disaster is,in our view,merely the most recent ex-ample ofa “capital flow cycle,”in which foreign capitalfloods a country,stimulates an economic boom,encouragesfinancial leveraging and risk taking,and eventually culmi-nates in a crash.In broad outlines,the cycle describes thedeveloping-country debt crisis ofthe early 1980s,the Mex-ican crisis of1994,the East Asian crisis of1997-1998,theRussian and Brazilian and Turkish and Argentine crises of the late 1990s and into 2000-2001—not to speak oftheGerman crisis ofthe early 1930s or the American crisis of the early 1890s.There are,to be sure,unique features of contemporary events,for the United States is not Ar-gentina,but the broad outlines ofthe crisis is ofa piece with hundreds ofsimilar episodes in the modern interna-tional economy.
The United States
 Ten years ago,few observers voiced concern about an im-pending debt crisis.In fact,the federal government regis-tered substantial budget surpluses in 1999 and 2000,and sur-pluses were projected for the indefinite future.The recessionof2001,combined with the Bush administration’s tax cuts,quickly erased those surpluses and threw the federal budgetinto a substantial deficit of1.5 percent ofgross domesticproduct (GDP) by fiscal year 2002.National security spend-ing after the September 11,2001,attacks further increasedthe deficit.By 2004,the federal budget deficit was more than $400billion,the largest in history.As shown in Figure 1,thisdeficit rivaled those ofthe Reagan deficits ofthe early andmiddle 1980s.The government ran these deficits with ease,for it could borrow just about as much as it wanted interna-tionally.This ready access to capital funds was the new real-ity ofglobally integrated financial markets. The result was a continual rise in America’s foreign debt,expressed as a share ofGDP.This is most clearly seen in thesize ofthe country’s current account deficit,the amount thecountry needs to borrow from the rest ofthe world to pay 
2La Follette Policy Report Fall 2009
Figure 1. Actual and C
 
yclically Adjusted Budget Deficits
The cyclically adjusted budget deficit is the deficit that would be incurred if the economy was at full employment.
   B  u   d  g  e   t   D  e   f   i  c   i   t  a  s  a   P  e  r  c  e  n   t  a  g  e  o   f   G   D   P
121086420-2-41962196619701974197819821986199019941998200220062010
Fiscal Year
Source: Congressional Budget Office,
Measuring the Effects of the Business Cycle on the Federal Budget 
(June 2009). Note: 2009-11 are projections.
CyclicallyAdjustedActual
 
Fall 2009La Follette Policy Report3
for the excess ofits imports over its exports.In other words,a current account deficit means that the country is not cov-ering its current expenses out ofcurrent earnings,so that itmust borrow the difference from abroad.Between 2001 and2007,the American current account deficit averaged be-tween $500 billion and $1 trillion every year,resulting in acurrent account deficit equal to an unprecedented 6 percentofGDP in 2006,as Figure 2 shows.For a while,this borrow-ing failed to manifest itselfin a corresponding degree ofin-debtedness to the rest ofthe world—largely because the dol-lar’s value fell over this period (and most ofAmerica’s assetsabroad are denominated in foreign currency).However,thatstring ofgood luck ended in 2008,when America’s net in-debtedness to the rest ofthe world deteriorated substantially (about $1.3 trillion).This episode demonstrates that,in fact,there is no such thing as a free lunch,no matter how muchthings appear to change.
Facilitators of American Excess
 Two other plausible causes have been forwarded for the cur-rent crisis.The first is the “saving glut”on the part ofEast Asia and the oil exporting countries.The other is an overly loose monetary policy.The first is,we believe,a red herring;the second bears more blame,but is more ofa contributorthan a primary instigator. The saving glut,a term coined by then Federal ReserveBoard governor Ben Bernanke in a 2005 speech,argues thatthe U.S.current account deficit is better viewed as an East Asian capital surplus.Hence,one can think ofincipient ex-cess capital being pushed in the direction ofAmerica.Morerecently,several observers,including even the Bush adminis-tration in its
2009 Economic Report ofthe President 
,have pro-moted the view that this capital flow to America is the rootcause ofthe financial crisis of2008,by inducing risk-taking behavior and the subsequent housing boom.China is a central character in this drama.In the firstdecade ofthe 21st century,China’s saving rate surged evenmore than its incredibly high rate ofinvestment,so that ittoo started running large current account surpluses,up to 10percent ofGDP in 2008,according to the InternationalMonetary Fund.The oil exporting countries are also taggedas part ofthe capital flows to the United States.They wereminor players until the oil prices began rising in 2004 andpeaking spectacularly in 2008 (before dropping just as pre-cipitously thereafter).
One point highlighted by the development ofthese
Figure 2.Current Account Balance, Net International Investment Positionas Ratios of Gross Domestic Product
   R  a   t   i  o  o   f   C  u  r  r  e  n   t   A  c  c  o  u  n   t   B  a   l  a  n  c  e   t  o   G   D   P
Ratio of Current AccountBalance to GDP.02.010-.01-.02-.03-.04-.05-.06-.07
 a t i   o oN e t I  n t  en a t i   on al  I  nv e s t m en t  o si   t i   on t  o GD
.20.15.10.050-.05-.10-.15-.20-.25
197619801984198819921996200020042008
Calendar Year
International investment position data is for year-end.Source: Bureau of Economic Analysis, 2008 International Investment Position release, and 2009 first quarter final GDP release; and authors’ calculations
Ratio of Net InternationalInvestment Position to GDP

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