Guttmann Plihon Consumer[1]

8/2/2019 Guttmann Plihon Consumer[1]

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ConsumerDebtandFinancialFragility

RobertGuttmann(HofstraUniversity,NewYork)

&DominiquePlihon,(CEPN,UniversitParis13)

Duringthesummerof2007theUShousingcrisismorphedintoaglobalcreditcrunchdisrupting

theworldeconomy.Wearenow(April2009)facingtheworstfinancialcrisissincetheGreat

Depression,followedbypossiblyprolongedrecession.Thisdramaticturnhasputintoquestion

thelong-termviabilityofaglobalgrowthpatternwhichforthelastcoupleofdecadeshas

heavilyreliedonAmericaastheworldsbuyerofthelastresort.Inthispaperwewishto

explorethiscentralpillaroftheglobaleconomyandwhyithascavedtosuchhorribleeffect.(1)

1.Debt-FuelledGrowth

Debtaccumulationbytheeconomysprincipalactorsgovernments,corporations,

households,andthefinancialinstitutionsthemselves-hasnowforquitesometime

constitutedakeyelementinthegrowthdynamicofcapitalisteconomies.Thecompositionof

debthasevolvedcontinuouslyaseachofthesekeysourcesofaggregatedemanduseddebt

financingtoturnitselfintoauniqueengineofgrowth.

1.1.TheChangingCompositionofDebt:Propelledtoamuchgreaterroleintheeconomy

bytheGreatDepressionofthe1930sandWorldWarII,counter-cyclicalgovernment

spendinganchoreditselfatthecenterofoureconomicsystemastheWelfareStatecameto

maintainminimumincomelevelsacrossallleversoftheeconomy(unemploymentbenefits,

farmsubsidies,corporatetaxbreaks,lossguaranteesforbanks,etc.).Publicsectorspending

cameunderincreasedupwardpressureduringthestagflationcrisisofthe1970s,matchedby

inflation-inducedintensificationoftaxburdens.Thisconfluencesetthestageforthe

conservativecounter-revolutionunderReaganandThatcher,laterextendedtocontinental

Europe,whichaimedtolimittheroleofgovernmentandreduceitsdeficit-spending

proclivities.Whilepublicdebtrosefrom20.5%ofGDPin1980to42%in1995inthemajor

OECDcountries,itactuallyfellproportionatelyduringthesubsequentdecade(e.g.from50%

to38%ofGDPintheUSA).Overall,governmenthasactuallyendedupabsorbinga


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progressivelysmallershareofthetotalU.S.debt(i.e.from44%oftheaggregatein1958to

just17%in2008).

Thecorporateuseofdebtalsocametoplayanimportantroleinthepost-wargrowth

dynamic,firsttofundmass-productiontechnologyandinternationalexpansionamongmulti-

nationals,then(fromthemid-1980sonward)tolaunchaboominmergersandacquisitions.

Underthenewdictumofshareholdervaluemaximizationfirmsextendedthisgrowing

relianceonexternalgrowthtofinancialization,thegrowingaccumulationoffinancialassets

andliabilities.The1990ssawmassiveamountsof(debt-fuelled)capitaldirectedtowardthe

NewEconomybubbleuntilitsdemisein2000.AtthesametimeEuropeanandAmerican

firmsmanagedintheearly1990sandearly2000stocomeoutofrelativelyshortdownturns

byrestoringtheirprofitabilitytorespectablelevelswithoutboostinginvestmentspending

proportionately.Thisdisconnectionboostedtheirself-financingcapacityandmadethemless

dependentondebt-financingofproduction,withcorporateUSdebtdecliningfrom67%of

GDPin1991to55%in1995andfrom69%ofGDPin2001to64%in2004.

Followingderegulationofbankingactivities(EUsSecondBankingDirective1989,

FinancialServicesModernizationActof1999inUS),bankshadmuchgreaterscopefor

innovationandsotransformedthecreditsystemawayfromloansandtowardsecurities.This

alreadystartedintheUSwiththeemergenceofjunkbondsinthe1980s,butreachedawhole

newdimensionwhenbanksbegantopooltogetherloansandturnthoseintosecurities.Such

securitizationtransformedthetraditionalindirectfinancemodeloftakingdepositsand

makingloansintoanoriginate&distributemodel,whichenabledthebankstoearnhuge

flowsoffeesandcommissionswhiledramaticallyboostingtheirfundingvolumes.Centered

aroundanunregulatedandhighlyleveragedshadow-bankingnetwork,thebanksbuiltinthe

processamulti-layeredsystemtyingloans,short-termmoney-marketinstruments,long-term

securities,andvariousderivativestogether.Adollaroftraditionaldebtfundingproductive

spendingthuscametobecarriedafloatbyfour,five,six,perhapsevenmoredollarsofpurely

self-enclosedfinancialtransactions.Underlyingthisprofoundtransformationofourcredit

systemwasahugeexpansionofthefinancialsector,especiallyintheUnitedStateswhere

financialinstitutionsshareintotalU.S.profitsgrewfromastable16%shareinthe1973-85

periodtoarangeof21%to30%inthe1990sallthewaytoapeakshareof41%in2007.

Evenmoreimpressively,financialsectordebtintheUnitedStatesgrewfrom25%ofGDPin

1982to49%in1991andanastoundinglyhigh121%in2008.


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Muchofthefinancialsectorsextra-ordinaryexpansionoccurredfromthemid-1990sonward

whenbanksextendedtheirnewsecuritization-basedfundingmachinetoconsumerdebt,in

particularthefundingofhousingbymeansofmortgage-backedsecurities.Thisfuelledoneof

historysgreatboomperiods,butalsosetthestateforagreatcrisiswhenanexcessively

speculation-pronefinancialsectorgotrendereddangerouslyfragilebytheoverextended

Americanconsumer.Itisthisinteractionthatwewanttohighlightinourpapertogetabetter

understandingofthesystemiccrisiswefacetoday.

1.2.ConsumerDebtandWageStagnation:Anyeconomysincreaseinproduction

capacity,whichfirmscanfundbeyondearningsthroughbankloans,corporatebonds,and

newequityshares,hastobeaccompaniedbyproportionateincreasesindemandontheother

sideofthemarketequation.Whilethosecancomeaboutfrombusinessspendingitselforgovernmentspending,wearemorelikelyespeciallywhenlookingatthisintheaggregate

togetthesedemand-sideboostsfromhouseholdconsumption(whichinmosteconomies

marksbyfarthelargestcomponentofdemand,astaggering72%oftotalGDPintheUnited

States).Butduringthelastthreedecadeswehaveseenstubbornwagestagnationinthe

industrialnations.Thattrendfirstappearedinthe1970swhenindustrialwagescouldnot

keeppacewithacceleratinginflation,thenintensifiedduringtheextensivecorporate

restructuringofthe1980s,andfinallyextendedevenfurtherwiththesuddenentryof3

billionnewhumansintotheworldeconomyfollowingthecollapseofcommunismin1991.

AccordingtoIMF(2007),laborsincomeshareintheadvancedcapitalistcountriesfellfrom

68%in1980to61.5%in2005.Thiserosionwasfurthercompoundedbywideninginequality

betweenaminorityofglobalizationwinnersandmajorityofglobalizationlosers.Allthis

threatensdomesticeconomicstabilitybyfosteringthepossibilityofoverproduction

conditionsnecessitatingrecessionaryadjustments(torestorethebalancebetweensupplyand

demand).

Manycountries,especiallytheemerging-marketeconomiesandsuchtraditionalindustrial

power-housesasJapanorSouthKorea,havebeenabletoescapesuchanimbalanceby

launchingexport-ledgrowthstrategies,oftenfuelledbykeepingthedomesticcurrency

undervaluedthroughactiveexchange-ratemanagement.Obviouslynoteveryonecanrun

current-accountsurpluses.Somecountriesmustabsorballthoseproductsfromsurplus

countriesbyrunningdeficitsintheirtradebalance.Consumersinthosecountriescan,of


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course,contributetosuchabsorptioneveninthewakeofstagnantwageincomesbysaving

lessand/orworkingmore(ashashappenedwiththeUnitedStatesespeciallyand,toalesser

extent,alsoinEurope).Intheend,however,eitheroftheseresponseshasitsphysicallimits.

Inthatcontextthefacilitationofadequatehouseholdspendinginthefaceofstagnantincome

ismoreeffectivelyassuredbyaccesstoconsumerdebtwherebyhouseholdspendingcanbe

decoupledwithinlimitsfromconsumerincome.

Weseethistrendplayoutinallmajoradvancedcapitalisteconomies.Everywhereinthe

industrializedworldweobserveoverthelastcoupleofdecadeacorrelationbetween

stagnant,evenfallingwagesharesandrisinguseofconsumerdebt.Wesuspectthatthere

mayevenbeasymbioticrelationshipbetweenthetwointhesensethattherebydebt-boosted

consumptionlevelsstayedhighenoughandthushelpedboostgrowthofdomesticGDP

sufficientlytosustaininturnthegrowinguseofdebtbyhouseholdsoveralongperiodof

time.Table1showstheriseinconsumerdebtasapercentageofdisposableincomeinthe

UnitedStatesandFrancebetween1975and2006atrendconfirmedbyseveralrecent

studies(e.g.ECB,2007b).

Table1:Householddebtas%ofdisposableincome

1975 2006

UnitedStates 62 127

France 33 68Source:OECD

Theoveralltrendnotwithstanding,wehavetoaskourselveswhyAmericanfamilieshave

takenonsomuchmoredebtthantheirEuropeancounterparts. Aconstellationof

institutionalcomplementaritieshavetogethercreatedthatbiasinfavorofhigherlevelsof

indebtednessamongAmericans.Forone,thereisanationalconsensus,rapidlyadoptedeven

bythemostrecentimmigrantwishingtointegrate,ofpursuingtheAmericanDreamwhich,

forallpracticalpurposes,translatesintoenjoyinghomeownershipandarisingcapacityto

spend.Apowerfullyentrenchedget-rich-quickmentality,barelyrestrainedbyorganized

religionand/oranti-capitalisttraditionsfoundelsewhere,allowstherichtosetthesocial

normsofconsumptionfortherestofAmerica.Ideologicalpreferencesinfavorofsmall

governmenthavealsoledAmericanstoentrustcertainnecessities,whichintherestofthe

worldareprovidedaspublicgoodsbythegovernmentitself,tomarketregulationandhence


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enduppayingalotforthose-education,health,transportation,etcetera.Muchofthisis

financedbydebt,suchasstudentloansorcarloans.Thesewidelyavailablechannelsof

specializedloansareoneexpressionofahighlydevelopedsystemofconsumerdebt.This

popularsegmentoftheU.S.creditsystem,pushedaggressivelybycommercialbanksand

morespecializedlenders(e.g.creditunions,financecompanies)inaverycompetitive

environment,hasbeensupportedformanydecadesnowbytheU.S.governmentwitha

combinationoftaxbreaks,regulatoryrelief,andgovernment-sponsoredconcessionary

lendersassignedtopromotetheirsegmentofconsumerdebt(e.g.FannieMaeandFreddie

Macformortgages,SallyMaeforstudentloans).IntheendtheU.S.hasbuiltawhole

economyaroundconsumerdebt,includingcreditbureausevaluatingthecreditworthinessof

everyAmericanhousehold,debtcounselors,collectionagencies,andfinancialadvisors.

Americanshaveincreasinglymatchedtheirproclivityfordebtwithalowregardforsaving,

theexactoppositepreferenceprofilefromthatofmostEuropeansandEastAsians.

2.FinancialInnovationsandtheU.S.HousingBubble

Thetrendtowardshigherlevelsofdebtisfuelledbylendersfindingnewwaystoentice

moreborrowingandthefundingthereof.Financialinnovationisacrucialaspectof

finance-ledcapitalism.Anendogenousforcewithinanycreditsystem,itisinitiatedby

financialinstitutionsrespondingtospecificconstraintsforwhichtheyseeknewescapes

andsolutions.Alotofinnovationsareaimed,forinstance,atbypassingregulatory

restrictionsorothertypesofinstitutionalbarrierstothegrowthoffinancialtransactions.

Andmostofthisactivityendsupfacilitatingthebanksextensionofcredit.Wecansee

thistrendclearlywithregardtomortgages.

2.1.MortgageInnovation:Bankingderegulationintheearly1980s(Depository

InstitutionsDeregulationandMonetaryControlActof1980,DepositoryInstitutionsAct

of1982)enabledU.S.bankstomoveawayfromtheDepression-eramortgagestandard

(30-yearmaturity,fixedinterestratewithmaximumceiling,20%downpayment),which

forsolonghadservedU.S.home-ownerswell.Insteadthebanksbegantointroduce

adjustable-ratemortgageswherethepriceriskwouldbebornebytheborrowerrather

thanthelender.Tomakethesemoreappealing,bankswouldchargeartificiallylow

interestratesatthebeginningoftheloancontractthatwouldberesettohigherlevels


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later.Fromthereitwasonlyasmallsteptoballoonmortgages,whichpostponedmost

ofthedebt-servicingchargesuntilmuchlater,ornegative-amortizationloanswherea

portionoftheinterestpaymentswouldbeaddedontotheprincipalratherthanbepaid

concurrently.

Theincreasedpaceofmortgage-relatedinnovationledbanksinthemid-1990stomake

twocrucialchangesintheirhome-loanpractices.Withinterestratesfinallycomingdown

fromtheirhighlevelsofthe1980s,bankersmadeiteasierandcheaperto refinance.

MillionsofAmericanhome-ownersweregivenachancetoreplaceanoldmortgage

beforematuritywithonecarryinglowerinterestratesand,correspondingtotheincreased

valueofthehomeservingasunderlyingcollateral,alsoalargerprincipal.Theother

changeconcernedtheintroductionofhome-equityloans,akindofsecondmortgagethat

couldbeusedforanyspendingpurposewhilestillaffordingborrowerstheadvantageof

tax-deductibleinterestpayments.Bothoftheseinnovationsmadeitpossiblefor

Americanhome-ownerstocashinontheappreciationoftheirhomeequity.The

beginningofthehousingboominthemid-1990sprovidedanextrastimulusfor

householdconsumptionwhichpushedtheU.S.economyontoahighergrowthpathfor

yearstocome.(2)

2.2.Securitization:Therapidspreadofre-financingsandhome-equityloansresulted

fromamassiveshiftinthesuppliesoffundstowardsreal-estateinvestmentsasyet

anotherkeyfinancialinnovationcametorevolutionizethefundingofAmericanhome

ownershipintheearly1990s.Theinnovationwearereferringtohereisthe securitization

ofloans,inparticulartheissueofmortgage-backedsecurities.ThoseMBSarecreated

whensimilartypesofmortgagesarepooledtogetherandusedascollateralforthe

issuanceofsecurities.Investorsinthosesecuritiesreceivepaymentsofprincipaland

interestoftheunderlyingloansinthepool,whicharepassedthrough(minuspayment

ofservicingandguarantyfees).Suchrepackagingofmortgageloansintomarketable

securitiesallowedbankstorecuperateloaned-outfundsquicklyforadditionallending

ratherthanbestuckwithanilliquidloanassetformanyyears.Themuch-accelerated

turnovermadeitpossibleforbankstoincreasetheirlendingvolumegreatlywhile

transferringdefaultriskstoinvestorsandearnawholelotoffeesassociatedwith


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securitization.Initiallylaunchedalreadyintheearly1980sbygovernment-sponsored

entities(GSE)likeFreddieMac,FannieMaeandGinnieMae,ittookawhileforthisnew

financialproducttocatchon.Bythemid-1990s,however,MSBstartedtoattractamuch

largercommunityofinvestorsbecauseoftheirrelativelyhighyieldsinalow-interest

environment,especiallywhenconsideringawidespreadperceptionoftheirlowrisk

becauseoftheirimplicitgovernmentbacking. (3)WhiletotalannualMSBissuesaveraged

about$500billionduringthe1990s,thataveragetripledafter2002to$1500billiona

figureimplyingthesecuritizationofabout80%ofallnewU.S.mortgagesoverthelast

fiveyears.

2.3.HomeEquityWithdrawals:CombinedwiththeFedkeepinginterestratesverylow

intheearly2000s,amplefundingprovidedbymortgagesecuritizationsetoffamajor

housingboomintheUnitedStates.Astheboomtookholdafter2002,re-financingsand

home-equityloansenabledU.S.homeownerstoborrowagainstthesoaringvaluesoftheir

homesandsoboosttheirspendingcapacityconsiderably.Amountingto9%ofdisposable

incomeandaveraging$840billionp.a.atthepeak,suchhome-equitywithdrawals

increasedconsumptionby3%p.a.inthe2002-05period,equivalenttoanannual

spendingboostofabout$300bn.,comparedto1.1%p.a.duringthe1990s(Greenspan&

Kennedy,2005).

Eagertoexpandmarkets,lendersacceleratedtheboomafter2004bypushingnew

mortgageproducts,suchaspiggy-backscoveringdown-paymentrequirement(for

effective0%self-financing),Alt-Aloanscarryinghigherratesinreturnforrelaxing

incomeverificationandotherrequirementsforproofofcreditworthiness,andsubprimes

toborrowerswithtroubledcredithistories.Thesenon-traditionalloanswereattractive,

sincetheycarriedmuchhigherratesandearnedloanofficersalsohighercommissions.

Banks,nowmuchmoreheavilyinvolvedinloansecuritizationthemselvesandissuing

after2004morethanhalfofallnewMSB,bundledthesenon-traditionalmortgage

products(includingso-calledjumbomortgagestoobigforFHAinsurance)intohigh-

yieldingloan-poolcombinationswhosesecuritizationwouldstillearninvestment-grade

ratingsandsoproveirresistibletoinvestors.Suchhigh-yieldingnon-agencyMSB


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issuedbythebankswerealsogobbledupbyforeigninvestors,upto$500bn.in2005

alone.(4)

2.4.StructuredFinance:From2005onwardthesecuritizationmachineshiftedtoward

non-agencyMBSwithlaxerunderwritingstandardsandcomprisedarapidlygrowing

shareofsubprimesandAlt-As.Aroundthattimebanksdevelopedaningeniouswayto

maintaintriple-AAAratingsforthebondsbackedbypoolsofinherentlyriskierloans.

Rootedinthelogicofriskreductionbydiversification,theyfurthersecuritizedMBSinto

so-calledcollateralizeddebtobligations(CDOs)whichtheyslicedintotrancheswith

differentdefaultrisksbasedontheirspotinthelosspay-offhierarchy.

Thehigher-risktrancheswereplacedwithhedgefunds,structuredinvestmentvehicles

(SIVs),andotheroff-balance-sheetentitiestiedtobanksandfundedbythem.Muchof

thatfundingcamefromarapidlygrowingshort-termsecuritizationpillar,so-calledasset-

backedcommercialpaper(ABCP)backedbybundlesofshort-termdebts(e.g.student

loans,carloans,credit-carddebt),wheretheseintermediariescouldfundtheirpurchases

oflonger-termCDOs.

Thusemergedaself-enclosedfinancial-intermediationalternative.Thissystemofso-

calledstructuredfinancebundledloansintosecurities,slicedanddicedthoseinto

tranches,andsoldsaidtranchesofftoanewnetworkofopaque,highlyleveraged,and

risk-proneintermediaries.Thebankswerecentrallyinvolvedineverystepofthis

shadow-bankingcircuit.Theyissuedtheloans,earnedfeesfromtheirsecuritization,

andsetupthefundsmakingthemarketforthesesecurities.Sincemuchofthisactivity

occurredoutsidethebanksbalancesheets,theyneverprovidedadequatecapitalforit.

Insteadtheytriedtomanagetheriskbyinsuringthosesecuritizationinstrumentswith

credit-defaultswaps(CDS)whoseextensiveusegreatlyboostedtheissue-andtrading-

capacityofthisnewfundingsystem(seeIMF,2008).

3.ExcessU.S.ConsumptionandGlobalImbalances


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Bysecuritizingtheentirearrayofhouseholdloansintoaself-enclosedcircuit(ABCP->

CDOs+MBS=>consumerlending),theworldsleadingbankspropelledconsumerdebt

intothecenteroffinance-ledcapitalism.Whatweseehereunfoldisaconsumer-led

growthpatternintheUnitedStateswherehouseholdconsumptionhasrecentlymadeup

anastounding72%ofGDP,farhigherthanelsewhere.WithAmericasshareofwages

andsalarieshoveringinthe65%-68%rangethroughoutthe1990sand2000s,such

proportionatelyhighconsumptionlevelsnecessitatedsharpdeclinesinAmericas

personalsavingsrate(fromanaverage8%ofdisposableincomeatthebeginningofthis

periodtoanegative2%fifteenyearslater,in2006)aswellasincreasingrelianceon

consumerdebt.ThelatterexperiencedasignificantboostwhenAmericanhomeowners

wereallowedtoborrowmassivelyandcheaplyagainsttheirrapidlyrisinghousing

capital.Home-equitywithdrawalsprovidedmorethanhalfofAmericasnominalGDP

growthduringthepost-2001recovery.Theabilitytoboostdebt-financedconsumptionin

linewithrisinghousingpricesmakesitlessurgenttosave. Wecanobserveasteady

declineinhouseholdnetsavingintheUSsincetheearly1980s.Ourhypothesisisthatthere

isacloseconnectionbetweentheriseinUScurrentaccountdeficitandthefallindomestic

netsavingsinthehouseholdsector.Whilebothgovernmentandthecorporatesectorsmay

alsocontributetotheoveralldeclineindomesticsaving,theirroleseemstohavebeenless

predominantinthelongrun.Empiricalevidencesuggeststhatthelinkbetweenhouseholdnet

savingandcurrentaccountbalance,mostlikelymediatedthroughtheevolutionofassetprices(inparticularhousing),isinfactnotlimitedtotheUSandprevailsinseveralother

OECDcountries(ECB,2007a).

TheboostinUSconsumptionfromthehousingboomcarriedmajorspillovereffectsto

therestoftheworld.TheU.S.economy,findingitselfonceagainwithsignificantbudget

deficitsafter2001,hadtocompensateforagrowingimbalanceinprivatenetsavingwith

arelentlesslyrisingdeficitinnetexportswhichby2006hadgrowntoover$800bn.or

7%ofGDP.Inotherwords,theUnitedStatesspendscollectively7%morethanitearns

inanygivenperiodoftime,withthatgapbeinglargelyfinancedbyimportsofcapital

fromcountriesrunningchroniccurrent-accountsurpluses,notablytheoil-exporting

nationsofOPEC,Japan,andtheemerging-marketeconomies(EMEs)of,aboveall,Asia

(i.e.China,India).Therecyclingofthesesurpluseshasoccurredmoreorless

automaticallyoverthelastdecadetotheextentthatthosecountrieshavepeggedtheir


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undervaluedcurrenciestothedollar,whichobligesthemtobuyupdollar-denominated

assets(intheprocessofsellingtheirowncurrencies)whendefendingtheirpegsagainst

surplus-inducedcurrency-appreciationpressures.

3.1.TheUS-DollarasWorldMoney:Surpluscountriesacollectionofcommodity

producers,emerging-marketeconomies,andindustrialnations-havethusbeenableto

pursueexport-ledgrowthstrategies,rootedinconsciouslyundervaluedcurrencies,and

sustainthosebylendingtheirsurplusestotheonecountrywillingandabletoactasthe

worldsconsumerofthelastresort.TheUnitedStates,inturn,hasbeenabletolive

consistentlybeyonditsmeanswiththehelpofthesurplusnationssavings,thereby

endingupabsorbing75%oftheworldsaggregatetradeimbalances.Itshouldbenoted

thatthissymbioticrelationshipunderlyingtheglobalgrowthdynamicofthelastcouple

ofdecadeshasbeensupportedbyacrucialasymmetryintheworldeconomystemming

fromtheuseoftheleadingpowersnationalcurrencyasinternationalmoneyincross-

bordertransactions.Thatmoney,since1945theU.S.dollar,iscreatedwithintheleading

countrysbankingsystemandgetstransferredbycontinuousnetoutflowsfromthe

countryofissuetotherestoftheworld.Inotherwords,thecreationofinternational

liquidityrestsonchronicbalance-of-paymentsdeficitsoftheUnitedStateswhichother

countriesautomaticallyfinancetotheextentthattheyhold$-reservesorusedollarsin

internationalcirculation.TheUnitedStates,toputthatsameadvantageindifferentterms,

istheonlycountrycapableofborrowingfromabroadinitsowncurrencyandofdoingso

indefinitely.Itcanthereforeaccumulatelargerforeigndebtswithoutfeelingthesame

kindofdebt-servicingburdenandinthisfashionpursuemuchmorestimulativeeconomic

policiesforfarlongerthanothercountrieswouldbeableto.Thisrelaxationofitsexternal

constrainthasallowedtheUnitedStatestorunuphugecurrent-accountdeficits,have

thoseautomaticallyfinancedatlowcostbythesurpluscountries,andlivewithanegative

savingsrateeventhoughitistherichestcountryintheworld.

3.2.LookingattheOtherSideoftheCoin:Wehavebeenwitnessingaclearbias

amongAmericancommentatorsinfavorofexplainingthechronicimbalancesinthe

worldeconomynotasaresultoftheUnitedStatesabusingitsprivilegedpositionas

issuerofworldmoney,butinsteadasfosteredbypolicychoicesofsurpluscountries.One


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suchargument,pushedbycurrentFedChairBernanke(2005)andbyformerUSTreasury

SecretarySummers(2006),pointstoasavingsglutamongemerging-marketeconomies

intheaftermathoftheircrisisinthelate1990swhichcausedcapitalflows toreverse,

flowingnowfromdevelopingtoindustrializedcountries.TheEMEs,especiallythosein

Asia,havebuiltupexchangereservestosafeguardagainstpotentialfuturecapitaloutflows.

Indoingso,governmentofthesenationshaveendedupchannellingdomesticsavinginto

internationalcapitalmarkets.Thisexcesssavingexerteddownwardpressureonrealinterest

rates,stimulatingborrowingandconsequentlyasset-priceinflationindevelopedeconomies.

Arelatedview,putforwardbyM.Bordo&M.Flandreau(2001)orM.Dooley,D.

Folkerts-Landau&P.Garber(2003),characterizesthecurrentconfigurationasBretton

WoodsII.Thisargumentviewsthecurrentsituationnotunlikethepost-warfixed-rate

system,whichprevailedfromthelate1950stotheearly1970s.Theperipheryonceagain

seekstomaintainundervaluedcurrenciesatfixedratesforexport-ledgrowthandinthe

processendsupsupportingthecoresexternaldeficit.

Boththesavings-glutandBrettonWoodsIIargumentsignorethebasicasymmetryinthe

modusoperandiofthedollarstandard,theneedforchronicAmericanbalance-of-

paymentsdeficitswhichtodaytaketheformofU.S.current-accountdeficits

automaticallyfinancedbytherestoftheword.Thisseignioragebenefit,aspointedoutbyEichengreen(2007),putstheUnitedStatesattheactivecenteroftheworldeconomyand

rendersitfullyresponsibleforitsimbalances.Eichengreenstimelyanalysisendswith

thepertinentquestionwhetherthosesymbioticimbalancescanpersistindefinitelyand,if

not,whichwouldbethemostlikelyadjustmentscenarios. (5)

3.3.AdjustmentOptions:Anyeventualadjustmentprocessintherebalancingofthe

worldeconomywouldrequireasteady,significantimprovementinU.S.netexportsover

thenextfiveyears.SinceNixonssuspensionofBrettonWoodsin1971successiveU.S.

governmentshaveprovenwillingtolettheUS-dollardepreciateinordertoboostitsnet

exports(byrenderingUSexportscheaperabroadandimportsintotheUnitedStatesmore

expensiveforAmericans)andtore-valueUSassetsabroadin$-terms.Theproblemwith

thistypeofadjustmentisthat,withpricemovementsfasterthanvolumechanges,any


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depreciationraisesinitiallytheimportbillandsomakesthetradedeficitworsebeforeit

getsbetter(theso-calledJ-curve).Apartfromthedelayedreaction,thereisalsothe

problem,alreadyviolentlymanifestonceinOctober1979,ofanexcessivelylargedollar

depreciationbecomingself-feedingtothepointofacutelyendangeringtheworld-money

statusoftheUS-dollarespeciallynowthatithassince2002forthefirsttimeaserious

rivalintheeuro.SuchacrisismaymakeitimpossiblefortheUnitedStatestocoverits

twindeficitsoratleastrequiremuchhigherU.S.interestratestokeepforeigninvestors

attracted.

Anotheradjustmentoptionwouldinvolvecorrespondingchangesintheeconomicpolicy

posturesoftheUnitedStatesandthesurpluscountries.Americaspoliciestocutits

excessconsumption,throughtaxincreasesorincreasedforcedsavings,wouldhavetobe

matchedbyexactlyoppositepoliciesamongsurpluscountriestoboostdomestic

consumptionviacurrencyappreciation,taxcuts,and/oralaxmonetarypolicy.Whilethis

kindofsymmetricpolicy-drivenadjustmentmightultimatelybethesmoothest,itisalso

mostdifficulttoimplementintheabsenceofinternationalmechanismsforeconomic-

policycoordination.

Ultimately,despitesomepersistentdollardepreciationafter2006renderingitsproducts

moreprice-competitiveinglobalmarkets,theUnitedStatesfailedtousethisopportunity

toputitshouseinorder.Necessarymacro-economicpolicychangesprovedpolitically

toodifficulttocarryoutbothdomesticallyaswellasintherestoftheworld.U.S.policy-

makersmademattersworsebyinvadingIraqandlettingtherestoftheworldpayforthe

rapidlygrowingcostsofthismilitaryadventure.Theirlackofconcernfororderly

adjustmentswasrootedinoptimisticassessmentsdrawnfromAmericasevidentstrength

intradeinservicesanditscomparativelyhighforeign-investmentreturnswhichhave

keptitsnetinvestmentincomepositionbalanceddespiteitsverylargeforeigndebtin

excessof$3000bn.(6)Theproblemhereisthat,intheabsenceofanypolicy-driven

adjustments,globalimbalancesbecomeuntenableandtriggeracutecrisisasawayof

enforcingthenecessaryrebalancingbetweendeficitandsurpluscountries.Thisis

preciselywhathastranspiredsinceearly2007.


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4.TheMakingsofaSystemicCrisis

Theprevailingglobalgrowthpatterncouldnotbere-balancedintime,becauseithadserved

bothsidesoftheequationsowellforsolong.TheUnitedStates,obligedbytheworld-money

statusofitscurrencytorunlargeexternaldeficitsautomaticallyfinancedbytherestofthe

world,usedthisprivilegetofundexcesslevelsofconsumptionthatkeptAmericanshappy

despitelargelystagnantincomesamongamajorityofthem.Andtherestoftheworld,

especiallytheemerging-marketeconomieswhose3billioncitizenshadjustbeenallowedto

joincapitalismafterthecollapseoftheSovietUnion,enjoyedthebenefitsofexport-led

growthandtransformationintocreditornationswithlargecurrencyreserves.Thatmutually

beneficialarrangementfuelledaglobalengineofamplecreditsuppliesatlowinterestrates.

Atthecenterofthatenginewasafinancialinnovation,namelysecuritization,whichenabled

Americanstoborrowever-growingquantitiesagainsttheirrapidlyappreciatinghomesfrom

thesaversoftheworld.

Suchagrowthpatternhashadtheadvantageofallowingspendingandsavingspatternstobe

separatedfromincome.Americansspentfarmorethanwarrantedbytheirincomelevels

whiletheemergingmiddleclassesinthenewlyindustrializingcountriesaccumulatedsavings

evenfasterthantheiralreadyimpressiveincomegrowth.Thisseparationofincomeand

spending,attheheartoffinance-ledcapitalismsglobalization,maintainedaggregatedemand

atsufficientlyhighlevelstoforestallrecessionaryadjustments.Sincethelastmajordownturn

intheearly1980stheworldeconomy,notablytheU.S.economyasitslargestcomponent,

hadexperiencedonlytworelativelyshallowandshort-liveddownturns(1990/91,2000/01).

Bothofthesewereovercomerelativelyswiftlybyaggressivemonetarypolicyactionpushing

interestrateslower,sharplyrisingbudgetdeficitsboostingspending,andcontinuedcredit

suppliesmaintainingprivatesectorspendingdespitestagnantorevendecliningincomes.

4.1.FinancialFragility:Butsuchlongperiodsofstabilitycarrytheirownseedsofself-

destructionbyengendering,asH.Minsky(1964)arguedsoconvincingly,increasinglyfragile

financialstructures,whicheventuallywillleadtomajorcrisis.Asdeficit-spendingunits(i.e.

businesses,households)experiencesuccesswiththeirpreviousactions,theybecomemore

inclinedtotakeongreaterriskintheirsubsequentengagements.Thesamebiasalsotakes

holdamongtheirlenders.Intheabsenceofanymajorrecessionaryadjustmenteconomic


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actorslosesightofthepossibilityoffailure.Theybecometoooptimistic,inclinedto

downplayrisksinthechaseforhigherreturns.Sucheuphoriaissociallyconstructed,hence

widelyshared.Overtime,usuallyasamatterofacoupleofdecadesoraquarterofcentury

withoutmajordownturns,financingpositionsofdebtorsandcreditorsalikewillthushave

becomeprogressivelymoreprecariousasaresultofincreasedrisk-taking.

InthiscontextMinskydistinguishedbetweenthreefinancingpositionshedgefinance

wherethenetcash-flowpositionofdebtorsissufficientlypositivenotevertoendangerthe

servicingofdebts;speculativefinancewherenetcash-flowpositionscanbeattimes

inadequatetomeetpaymentcommitmentsastheyaccrue,andPonzifinancewhereadditional

debtisnecessarytomeetexistingdebt-servicingcharges.Intheabsenceofanyrecessionary

adjustmentswipingoutthemostvulnerabledebtorsandsoremindingeveryoneelseofthe

dangersofexcessiverisk-taking,thefinancialstructurebecomesprogressivelymorefragile

bycontainingagrowingproportionofspeculative-andPonzi-financeunitsinthelatephases

ofalongboom.Itisatthispointthatan(otherwiserelativelyminor)eventcanexposethe

degreeofoverextensionprevalentinthefinancialstructureoftheeconomyandtriggera

panicreactionthatbreaksopenachainreactionofdefaults,forcedassetsales,financial-

marketcollapses,andgeneralizedshortageofaffordablecreditthemakingsofafinancial

crisis.

WehavegoodreasontoaskourselvestowhatextentMinskysvisionofincreasedfinancial

fragilitybuildingupduringalongboomoverseveralcyclesdoesnotapplyalsotothe

averageAmericanfamilyanditshugebuild-upofconsumerdebtoverthelast25years,with

theburstingofthehousingbubbleservingasthecatalystforamajorfinancialcrisisona

globalscale.Ifthatisindeedthecase,thenwehavejustenteredacrisis-drivenadjustment

processthatgoesinbothlengthanddepthbeyondamererecessionaryadjustment.

4.2.TheBurstingoftheBubble:Followingatwo-yearperiodofpersistenttighteningby

theFed(i.e.seventeenconsecutiveinterest-hikes)in2004-06,theU.S.housingbubbleburst

duringthesecondhalfof2006whenhomesales,construction,andevenpricesallstartedto

tumble.Atthatpointnon-traditionalmortgages,especiallysubprimes,begantoseetheir

initiallylowteaserrates(of1.5%to3%)resettomuchhigherlevels(usuallybetween10%

and15%,butinsomecasesrisingto18%)whichimmediatelycausedmanyofthosehigher-


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riskborrowerstofaceseriousdebt-servicingproblems.Inthespringof2007itbecameclear

thatuptoathirdofallsubprimemortgagesmightendupindefaultoncemostscheduled

interest-rateresetswouldhaveruntheircoursebymid-2009,triggeringintheprocess

perhapsasmuchas5millionforeclosuresandtherebyassuringacontinuouslydeepening

real-estatedownturnboundtolastovertwoyears.Thisstarkrealizationputintoquestionthe

investment-graderatingsofmanyMSBcontainingsubprimesintheirpools.Asaresult

ratingsagencies,underpressuretoacknowledgetheirmistake,begantodowngradealotof

MSBbelowinvestment-gradelevelwhichdisqualifiedthemfrombeingboughtorheldby

mutualfundsorpensionfunds.

InAugust2007thisdeterioratingsituationexplodedsuddenlyintoafull-blownglobalcredit

crunch.OncethespikeofsubprimedefaultsbegantospilloverintothemarketforMSB,it

spreadpanickyfeartoseveralothersecuritizationlayers.Thenextmarkettocollapsewas

thatofcollateralizeddebtobligations(CDOs)whichbundledifferentkindsofdebttogether,

includingcorporatebonds,mortgage-backedsecurities,andcredit-carddebt.Anumberof

investorsheavilyengagedinthenow-paralyzedCDOmarket,notablyhedgefunds,private-

equityfunds,structuredinvestmentvehicles,andotherbank-runspecial-purposeentitiesthat

hadbeenkeptoffthebooks,suddenlyfoundthattheynolongerhadrecoursetoshort-term

fundsmobilizedviaissueofasset-backedcommercialpaper(ABCP),thethirdsecuritization

layertocollapseinthefallof2007.(7)Thisforcedthemtodrawmassivelyonemergency

bankloansputasideforpreciselysucheventualities.Thesuddenhikeindemandforsuch

fundsputalotofpressureontheinter-bankmarketwhichbanks,nowsuddenlyfearfulof

whatlosseslaidahead,werenotwillingandabletorespondtomeaningfully.Aseventhe

shortest-term(overnight)inter-bankratesshotfarabovecentralbanktargetsoncedemand

forfundsstartedtooutpacesupplyoffundsconsistently,theworldsleadingcentralbanks

hadtostepinrepeatedlywithhugeliquidityinjectionstopreventtheinter-bankmarket,the

nervecenteroftheglobaleconomy,frombecomingparalyzed.

4.3.GlobalCreditCrunch:Wearenowinthemidstofanunprecedentedglobalcredit

crunch.Thecoordinatedandunprecedentedlender-of-last-resortinterventionsoftheECB,

theFed,theBankofEnglandandothermonetaryauthoritiesboughthebankssometimeto

copewiththehugetrillion-dollarlossfromthecollapseoftheshadow-bankingsystemin

August2007.Beingforcedbynew(mark-to-market)accountingrulestodeclarelosses

rapidly,thebankswereluckythatthemarketsnolongerfunctionedtogivethemanyreliable


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signalsaboutcurrentfair-marketprices.Theythuscouldestimatetheirlossesastheysaw

fitbasedontheircomputermodels(mark-to-modelaccounting).Mostbankschosetodeclare

theirlossesgraduallyonaquarterlybasiswhileatthesametimemobilizingrecurrentcapital

injectionswithwhichtocoverthosewrite-downlosses.

Theproblemwiththatgradualiststrategywasthatbankswouldeventuallyrunoutoftime.At

somepointthemercilesscombinationofinvestorlossesanddecliningsharepriceswould

makeitincreasinglydifficulttoattractnewcapitalatatimewhenmuchmorewasneeded.

Firsttohitthiswall,inMarch2008,washighlyleveragedinvestmentbankBearStearns

whoseFed-assistedmergerwithJPMorganChasewipedoutthefirmsshareholders.The

panicfromthiscollapseonceagainsentshuddersthroughthecreditmarkets,promptingthe

Fedtowidendramaticallytherangeofpermissiblecollateralagainstwhichbankscould

borrow(throughthenewTermSecuritiesLendingFacility)andtoextendthatliquidity

protectionbeyondcommercialbankstoinvestmentbanks(thePrimaryDealersCredit

Facility).

Eventhoughthesemeasurescalmedthingsdownforafewmonths,thepsychological

damagewasdone.Shareholderfearsofgettingwipedoutwhenafailedbankhadtobe

rescuedbythegovernmentledinvestorstofleebanks,therebyreducingtheircapitalbase

whilemakingrecapitalizationmoredifficult.Banksrumoredtobeintroublesawtheircredit-

defaultswappremiashootupwhich,inturn,wouldsparksell-offsthatwerefurtherfuelled

byshortsellers.InSeptember2008thedeepeningU.S.housingcrisisfinallyknockedoutthe

hugegovernment-sponsoredmortgagelendersFannieMaeandFreddieMac,attheexpense

ofa$200bn.bail-outbytheUSgovernment.Fearingthemoral-hazardimplicationsofits

toobigtofaildoctrine,theUSgovernmentdecidedtoletfailingLehmanBrothersgo

bankruptbarelyaweeklater.Thatcollapsetriggeredadevastatingchainreactionofextreme

stressconditionsamongcredit-defaultswaps,corporatebondmarkets,moneymarketfunds,

commercialpaper,andthentheinter-bankmarket.Morethansixmonthsofimpairedbank

lendingandseverelydepressedcapitalmarketshavebynow(lateApril2009)prompted

multi-trilliondollarbail-outsintheUnitedStatesandEuropeanUnionwhileatthesametime

triggeringagloballysynchronizedrecession.Withgovernmentsobligedtorecapitalizebanks,

guaranteetheirliabilities,andbuyouttheirtoxicassets,theywillbeinclinedtousetheir

dramaticallyextendedpowersoverbankstoimposeanewregulatoryregimeonfinance.

5.ExitStrategies


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Lookingatthiscrisis,oneistemptedtocompareitsunfoldingtoanine-inningbaseballgame.

Usingthatmetaphor,weareprobablysomewhereinthemiddleofthefifthinning.The

gamestartedwhenthesub-primebulletwentoffamidstaburstingU.S.housingbubblein

early2007.Asthebulletricochetedthroughthecreditsystem,ittookdownthethree

principalsecuritizationpillarsaroundwhichbankshadconstructedaglobalshadow-banking

system.Thatcollapse(inAugust2007)leftmanyoftheworldsleadingbankswith

enormouslossesforwhichtheydidnothaveenoughcapitalonhand.Thebanksthendecided

todeclaretheirlossesgradually,moreorlessinproportiontothemobilizationofnewcapital

sourceswithwhichtowriteofftheselosses.ThisstrategywascutshortinMarch2008when

therescueofBearStearnswipedoutitsshareholdersandsoleftpotentialsourcesofprivate

bankcapitaldissuaded.Thefourthinningsawanewtypeofbankrun,asrumorsofabanks

imminentdemisesentitscredit-defaultswappremiumshootthroughtheroofwhichinturn

triggeredmassiveshortsellingofthebanksbondsandequityshares.Inthefaceofrapidly

mountingattacksonthesolvencyofkeyfinancialinstitutionstheU.S.governmentlet

LehmanBrothers,WallStreetsfourth-largestinvestmentbank,collapseon15September

2008.Theexplosivefall-outfromthatbankruptcy,triggeringseverepanicconditionsin

severalcrucialfinancialmarkets,morphedveryrapidlyintoaglobalcreditcrunchthat

grippedtheentireworldeconomywithparalyzingforce.Sincethenwehaveexperienceda

freefallineconomicactivityacrosstheentireglobe,fuelledbycollapsingassetvalues,steep

productioncutbacks,andenormousdestructionofjobs.Aconfluenceofbankingcrisis,

collapsingreal-estatemarkets,andstockmarketcrashsincethenmayleadtoadeflationary

spiralintheJapanesestyle(seeBoyer,Dehove&Plihon,2004).

Thisdeclineisdrivenbytwonegativefeedbackloopsofsystemic-crisisproportions.One,

especiallypronouncedwithintheUnitedStates,combinesadepressioninrealestatewitha

broadeconomicdownturntoundermineanalreadymuch-weakenedbankingsector.Hence

renderedunwillingandunabletolend,thebanksareparalyzed.Cutofffromcredit,heavily

indebtedactorsareobligedtoreducetheirdebtservicingburdensbycuttingbackspending

andsellingoffassets.Thesecondloop,internationalinnature,concernsthefrightfullyrapid

andextensiveunravelingoftheworldeconomy.Theglobalfinancialcrisishasreinforced

massivecutbacksinshort-termcapitalflows,whichhavehelpeddepresslonger-termdirect

investmentactivityand,bycreatingamassiveshortfallincrucialtradefinance,hampered

trade.Hopefully,theforthcomingG-20summitswilldealwiththereformoftheinternational


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monetarysystemandthequestionofthefutureinternationalcurrencyinthecontextofa

multipolarglobalizationprocess.

Wehavetostoptheseinter-connectedspiralsofde-leveragingandde-globalizationlestwe

wanttofindourselvesdrivenintoaglobaldepression,whichitwillbemostdifficultto

emergefrom.Policy-makersallovertheworldunderstandthisimperative,butitremainsto

beseenwhethertheycanactaccordingly.Wehaveseenarapidandunifiedpolicyresponse

inmostindustrialandemerging-marketeconomies,consistingoffiscalstimulus,monetary-

policyeasing,andassistancefortheirbattereddomesticbankingsystems.Andanewglobal-

governancestructurehasemergedtoaddresstheinternationaldimensionsofthiscrisis,the

G-20.ButitsLondonsummitinApril2009hasrevealedthelimitsofcollectivecrisis

management.WhileusefullyboostingtheresourcesoftheInternationalMonetaryFund,the

G-20leadersfoundthemselvesdividedoverfurtherglobalstimulation.Atleasttheyare

beginningtomapoutthebroadoutlinesofaconsensusconcerningfinancialre-regulation,

helpedbysignificantoverlapsbetweentheObama-Geithnerplan,theEUsDeLarosire

Report,andtheUKsTurnerReport.TherewillbemanymoreG-20summits,eachofwhich

havingitsagendashapedbytherespectivephaseofthecrisisprevailingatthetime.

InthemeantimeweneedtopayspecialattentiontotheactionsoftheFederalReserve.Led

byaspecialistondebt-deflationcrises,BenBernanke,theFedhasprobablybeenthemost

innovativeofthecrisis-fightingpolicy-makers.Anditalsooccupiesamoststrategicposition

attheapexofbothde-leveragingandde-globalizationspiralswhichhasenabledittoattack

bothaggressively.Ithastriedtotackletheformerwithanarrayofnewliquidity-injectionand

asset-swappingschemestounclogtraditionalfundingchannelsandrebuildabrokencredit

system.Andithasbeguntoinsertitselfmoreaggressivelyinmanagingthedollar-based

internationalmonetarysystem,usingintheprocessacombinationofdirectmonetizationof

U.S.debt(throughitsnewbondpurchases),currencyswapswithothercentralbanks,

prudentialregulationofbanks,andglobal-governancereforms(IMF,FinancialStability

Forum,etc.).Inthatsenseitiswellpositionedtoplayacrucialroleintheunfoldingofthe

crisisanditseventualresolution,dedicatingthemiddleinningsofthegametotherecovery

ofthefinancialsystemandhelpingtomanagetheendgamestransitiontoamoremulti-polar

systemthatmaywellrequireagooddealofglobalcoordination.


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Notes

1)Seeinthiscontextamoreextensiveversionofthispaper(Guttmann&Plihon,2008).2)SeeM.McConnell,R.Peach&A.Al-Hashimi(2003)formoredetailsontheeffectsof

refinancingandhome-equityloansonboostingconsumerspendinganddepressingthepersonalsavingsrate.3)Three-quartersofthenearly$5000billioninMSBoutstandingin2006hadbeenissuedbygovernment-sponsoredlendersFreddieMacorFannieMae,withalotofthemcarryingGinnieMaeguaranteesorFHAinsurance.ThosekindsofMSBcarriedatthatpointayield1.5%to2%abovethe4.5%returnearnedona5-yearTreasurynotewhereastheriskiestMSB,composedofsubprimesandentirelyunsecured,couldfetchasmuchas15%atthe2006peak.4)SeeR.Simon,J.Haggerty&J.Areddy(2005)formoredetails.

5)Thatquestionhasalsocometopre-occupypost-KeynesianeconomistsgroupedaroundWynneGodleyattheLevyInstitute(www.levy.org)andC.FredBergstenatthePetersonInstituteforInternationalEconomics(www.iie.com).SeealsotheinterestingreportbyEuropeanCentralBank(2007a)onthatquestion.6)Thisinvestment-returndifferential,whichgoesevidentlyfarbeyondobviousdifferencesinthecompositionofclaimsandliabilitiesintheUnitedStatescapitalaccount(e.g.proportionatelylargerforeignpurchasesoflow-yieldingTreasurysecurities,moreforeigndirectinvestmentbyUSmultinationalsabroad),hasbeenthesubjectofmuchdiscussioninrecentyears.See,forinstance,BankforInternationalSettlements(2007)orS.Curcuru,T.Dvorak&F.Warnock(2007).7)FormoreonthecollapseofthevarioussecuritizationlayersseeR.Guttmann(2007).

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Documents

Guttmann Plihon Consumer[1]