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U.S. DEPARTMENT OF STATE / MAy 2009
VOLUME 14 / NUMBER 5
http://www.america.gov/publications/ejournalusa.html
eJournal uSa 1
In hindsight, the bubble in the U.S. housing market, the first indication of what would become a global
financial crisis in the fall of 2008, should
have been obvious. The prices of houses
had risen beyond the salaries of many
ordinary Americans, but the availability
of new, riskier mortgage products fueled
the rush to home ownership. What’s
more, the inflation in their real estate
values had many homeowners feeling
wealthy. Historically in the United States,
housing prices had always gone up. So
what went wrong?
And how did the failure of one sector
of the U.S. economy help trigger what
many have seen as the greatest worldwide economic crisis since the Great Depression of the 1930s? For this issue of
eJournal USA, we asked six financial experts to offer their opinions on how the global crisis came about and some of the
ways the world will react to this shared problem.
Political scientist Mark Blyth begins by listing six events that had a role in causing the crisis. John Judis, a senior
editor with the New Republic, then clarifies international currency by examining agreements from the Bretton Woods
conference in 1944 to the present-day negotiations among nations.
Charles Geisst, a financial historian, writes that improved computing, 24/7 trading around the globe, and the ease
of trading contributed to the problem. “Customers were able to obtain executions for their stock trades with a speed
unimaginable in the mid-1990s. The volumes and the appetite for transactions appeared endless.” Once asset values
began to collapse, the banking and insurance crises occurred within months.
Famed investor George Soros contends that regulation is necessary to limit the growth of asset bubbles. But Soros
also warns against going too far: “Regulations should be kept to the minimum necessary to maintain stability.” Law
professor Joel Trachtman seconds the call for more regulation as well as improved corporate governance. In conclusion,
economics professor Richard Vedder describes the history of various international trade agreements and organizations
and their role today.
There is no shortage in the world of experts with opinions about the causes of the current crisis and prescriptions
for getting out of it, and it’s true that a different group of experts might well offer a different set of views from those
presented here. What is surprising, perhaps, is how often certain common ideas emerge in these articles: that the nature
of markets is cyclical, that global trade relationships are interdependent, and that a modicum of market regulation is a
good thing.
— The Editors
About This Issue
At a meeting in the White House with his economic advisers, President Barack Obama speaks
to the press on April 10, 2009.
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U.S. DEPARTMENT OF STATE / MAy 2009/ VOLUME 14 / NUMBER 5
http://www.america.gov/publications/ejournalusa.html
The Global Financial System:
Six Experts Look at the Crisis
Overview
The End of American Capitalism?
Mark Twain, Lake Wobegon, and
the Current Crisis
Mark Blyth, Professor of InternatIonal
PolItIcal econoMy, Brown UnIversIty
While the type of financial crisis we face today is
unprecedented, crises of capitalism are not. They
are commonplace.
International Issues
Debt Man Walking
John B. JUdIs, senIor edItor, The new
republic
Economists know the fatal flaw in our
international monetary system — but they can’t
agree on how to fix it.
Globalization and the U.S. Financial
System
charles r. GeIsst, Professor of fInance,
Manhattan colleGe
Globalization helped fuel the current financial
crisis, and it will undoubtedly be employed to
help resolve it.
Sidebar: Moving Forward on the
Economy
U.S. leaders look ahead.
Timeline of Financial Asset Bubbles
The Role of Regulation
Revise Regulation: The Theory of
Market Equilibrium Is Wrong
GeorGe soros, chaIrMan, soros fUnd
ManaGeMent
While international regulation must be
strengthened for the global financial system to
survive, we must also beware of going too far.
Markets are imperfect, but regulations are even
more so.
Global Financial Trouble: Causes,
Cures, Responses
Joel P. trachtMan, Professor of
InternatIonal law, tUfts UnIversIty
No doubt, economic historians will argue for
years to come about the causes of the global
financial crisis. The primary causal factor was
macroeconomic, but appropriate regulation might
have averted or ameliorated the crisis.
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eJournal uSa 3
A Historic Look at International
Trade
The Evolving Global Financial System
rIchard vedder, dIstInGUIshed Professor of
econoMIcs, ohIo UnIversIty
During the late 19th and early 20th centuries, there
was little coordination of international finances. That
changed substantially after World War II, and the
change is continuing today.
Additional Resources
Glossary
Books, Articles, Reports, Web Sites, and
Videos Related to the Global Economy
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eJournal uSa 4
While the type of financial crisis we face today is
unprecedented, crises of capitalism are not. They are
commonplace.
Mark Blyth is professor of international political
economy at Brown University. He is the author of Great
Transformations: Economic Ideas and Political Change in
the Twentieth Century.
If you draw what statisticians call a time series of the returns to the U.S. banking sector from 1947 to 2008, it is possible to talk with some confidence about
the average rate of profitability of the sector over time,
the peaks (1990s to mid-2000s), the troughs (1947 to
1967), and the sharp growth of the sector’s profitability
over the past 10 years. If you then add in the data for the
period between August 2008 and April 2009, the entire
series, like the banking system it describes, simply blows
up. Averages, means, variances, and the like dissolve,
so extreme have been recent events. Indeed, when the
former chairman of the U.S. Federal Reserve Bank, Alan
Greenspan, admits that his understanding of market
processes was deeply flawed, and when the current
chairman, Ben Bernanke, says that we face the greatest
The End of American Capitalism? Mark
Twain, Lake Wobegon, and the Current Crisis
Mark Blyth
President Barack Obama speaks at the G-20 Summit in London, April 2, 2009.
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crisis since the Great Depression, we should probably take
it seriously.
And serious it is. With a grossly diminished $1.3
trillion in assets and as much as $3.6 trillion in liabilities,
coupled with a halving of the stock market, the U.S.
financial system is either severely stressed, insolvent, or,
worse still according to some, at the end of its tether. The
end of capitalism has been declared many times before.
And yet, to paraphrase American writer and humorist
Mark Twain, reports of its death have been greatly
exaggerated.
The U.S. capitalism that will emerge from this
crisis will be different from the highly financialized
consumption-driven and trade-imbalanced version that
we developed over the past two decades. It already has
changed insofar as Wall Street proper no longer exists.
But what people tend to forget is that we have been
here before. While the type of crisis we face today is
unprecedented, crises of capitalism are not: They are
commonplace. It’s just that this one has hit the United
States rather than another region of the world. But we
have been here before and have survived, mainly because
the present is not a copy of the past. Remembering this
tempers the expectation that U.S. capitalism has run its
course.
The Lake Wobegon ProbLem
(Where everyone is above average)
While there are surely many plausible candidates
— ranging from the bonus culture of banks to Chinese
savings and German parsimony — to blame for the crisis,
focusing on the immediate present may mask a deeper set
of causes. Putting this crisis in proper perspective requires
that we begin almost 30 years ago with the unexpected
marriage of unlimited liquidity and limited asset classes.
Six processes came together to get us where we are today.
First, beginning in the 1980s, the world’s major
financial centers deregulated their domestic credit
markets and opened up their financial accounts. This
“globalization of finance” resulted in a spectacular growth
in available liquidity as previously isolated markets became
intertwined. Second, this liquidity was given a huge boost
with the growth of new financial instruments, particularly
techniques of securitization and the increasing use of
credit derivatives. Third, given this growth of global
liquidity, long- and short-term interest rates began to fall
precipitously. In 1991 the U.S. prime and federal funds
rates (and thus global interest rates) began their long
decline out of double figures to historic lows.
Fourth, given these changes, the commercial
banking sectors of these now finance-driven economies
became increasingly concentrated. Available bank credit
skyrocketed at the same time as the privatization of former
state responsibilities, especially in pensions, encouraged
the growth of large non-bank institutional investors, all
seeking “above-average” returns since their jobs depended
upon beating some benchmark average, usually the annual
return of the Standard & Poor’s 500 or an index of their
sector’s performance.
Fifth, the U.S. current account deficit climbed
to historically unprecedented proportions of the gross
domestic product. The United States was effectively
borrowing between 3 and 6 percent of GDP each year for
more than 20 years, and borrowing at such low interest
rates seemed to make money free given the growth rates
that we grew accustomed to.
Sixth, and perhaps what facilitated all of the above,
was a deep seated ideological change that took place
in the United States between 1970 and 2000. Namely,
markets came to be seen by politicians, pundits, and
the public as self-regulating wonders that could produce
ever higher risk-free returns if only the state’s blundering
and inefficient regulations could be swept away, which
they were by obliging politicians of both parties. Add all
this together and you have a financial sector that is both
dependent on continually finding above-average returns
at the same time as it becomes an increasingly large and
important part of U.S. gross domestic product.
Federal Reserve Chairman Ben Bernanke testifies before the U.S. Congress.
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The LimiTs of Lake Wobegon
The problem with chasing a moving average is that it
continually gets bid upwards. Here we run into a problem
of asset classes: the limited number of categories of assets
from which investors can seek above-average returns.
There are only a few such classes around: equities (stock),
cash (money market), and fixed income (bonds), to which
one can add real estate and commodities. If equities,
bonds, and money market instruments are regarded as
reciprocal investments within a class, then stock markets,
relatively underpriced in the early 1990s, became the
obvious place to go for such returns. The massive volume
of liquidity in its search for above-average returns first
flooded U.S. equity markets and quickly thereafter hit
global stock markets during the middle to late 1990s.
Once that particular bubble burst, most spectacularly
in East Asia, neither bonds nor fixed income alone would
provide the above-average returns that the markets —
and all of us who depended on them — now expected.
The next stop for investors was therefore the ill-fated
dot-com bubble, and thereafter the next most obvious
asset class, real estate — hence, the global housing boom,
which began just as the dot-com bubble popped in the
late 1990s. By 2008 this housing bubble had run out
of (good) borrowers, in part owing to Federal Reserve
Chairman Greenspan’s raising of interest rates in the
mid-2000s. The result of looking for a new return was
that the remaining class of assets, commodities, became
the next bubble, with oil quadrupling in price and basic
foodstuffs rising between 40 and 70 percent in a little over
a year. However, with the exception of oil, these were small
markets, too small to sustain such volumes of liquidity,
and these bubbles burst quickly. The commodity market
collapse combined with losses in the subprime sector of the
mortgage derivatives market triggered the current crisis.
Although it is referred to as the “subprime crisis,”
it is perhaps better described as a subprime trigger for a
systemic crisis caused when all these factors came together
through financial actors’ risk management practices. While
Container ships with imports from Asian countries are unloaded at New Jersey docks.
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banks and other financial firms have sophisticated models
for managing their various risks (credit, liquidity, and the
like), those same technologies can create instabilities in
markets by either blinding their users to tail risks, which
causes a channeling of risk into common portfolios across
asset classes as everyone hedges the same way, or by linking
assets together in a search for liquidity as positions are
unwound as banks de-leverage. So what is rational for one
bank can create systemic risk for all banks as asset positions
become serially correlated on the upside and the downside
of the bubble.
Once the entire banking system had loaded up on
mortgage derivatives and credit default swaps, the crisis
was just waiting to happen. It came when losses at several
major U.S. banks triggered the fall of Lehman Brothers,
which in turn caused massive losses in systemically linked
markets, particularly the massive credit default swaps
market. Liquidity dried up, and the crisis had begun. How
it unfolds from here is really anyone’s guess, but does this
mark the end of American capitalism? There are several
reasons to think that this is not the case, and that Mark
Twain’s injunction still stands.
mark TWain and Three
reasons To be hoPefuL
It is worth noting that while
Federal Reserve Chairman Bernanke
said that we faced the greatest crisis
since the Great Depression, he did
not say that we face a crisis as big
as the Great Depression. Twenty
to 40 percent unemployment, a
collapse of world trade, ruinous
competitive currency devaluations,
absurd tariff levels, and the collapse
of democracy were the reality of the
Great Depression across the world.
We face challenging times in the
current crisis, and there is always
the possibility that things could
get much worse, but things are
nowhere near this severe. This gives
me reason for optimism regarding
Twain’s observation, mainly because
there is a huge difference between
the world of the 1930s and the world that we live in today.
Time’s arrow means that we always “live it forward,” such
that the conditions of the present are never the same as
the conditions of the past. Three of those conditions that
pertain today and that are different from those of the 1930s
give us the opportunity to avoid the mistakes of the past.
The first lesson learned is that lessons can be learned.
We are not doomed to repeat the 1930s precisely because
we can reflect upon how bad the 1930s were and how
actions taken to protect ourselves individually in this
period made us all worse off collectively. Those lessons
learned made states across the world build automatic
stabilizers into their economies in order to stave off
collapses in consumption that would lead to protectionist
and nationalist demands in the event of an external crisis,
and to rely on multilateral cooperation to forestall obvious
policy errors. One can legitimately argue that different
countries learn different lessons. Hence, the Germans
are worried about the inflationary consequences of the
spending the Americans want the Europeans to undertake
to avoid the unemployment that the Americans fear.
But the point of meetings such as the G-20 is to air
those differences and find room for policy agreements.
The question is one of balance between stimulus and
regulation, and both sides of the Atlantic know that they
On Black Friday in 1929, investors watch the chalkboard as stock values plummet.
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need to find common ground to move forward.
My second reason for optimism derives from the
new MAD. During the Cold War, we spoke of “mutually
assured destruction,” in which the United States and the
Soviet Union had so many nuclear weapons that one side
could not destroy the other without destroying itself. Swap
“mutually” for “monetarily” and you get the new MAD —
“monetarily assured destruction” — which exists between
China and the United States. One consequence of the
financialization of the U.S. economy was that we managed
to get China to swap real goods for paper, and a terrible
rate of return on holding the paper, for more than 20
years, in the course of which the Chinese (and other East
Asian economies) built up astonishingly large trade and
current account surpluses. Essentially, without anyone ever
making such a wager formally, the United States made a
one-way bet that we could run our economy on finance in
a global division of labor in which China made the goods
in return for dollars that would be lent back to us so we
could consume their products. That system has also come
to an end. China need