Currency and Financial Crises of the 1990s and 2000s Assaf Razin Steven Rosefielde



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The 2008 Financial Crisis and Subsequent Great Recession

The origins of the 2008 financial crisis can be traced to various milestones in the construction of the post World War American economy. During the 1950s, Keynesianism became orthodox at the same time momentum built to rescind sundry New Deal and wartime restrictions on free enterprise including wage-price controls, and fair trade retail pricing (Miller-Tydings Act 1937; McGuire Act 1952, both rescinded in 1975 by the Consumer Goods Price Act). Deregulation in rail, truck and air transportation during the 1970s, ocean transport in the 1980s, natural gas and petroleum sectors 1970-2000, and telecommunications in the 1990s created opportunities for asset value speculation, soon facilitated by complementary deregulation initiatives in the financial sector. The Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA), and Garn-St. Germain Depository Institutions Act(1982) both increased the scope of permissible bank services, fostered mergers, facilitated collusive pricing, and relaxed accounting rules(Moody's for example is permitted to accept fees from insurers it rates). Beginning in the early nineties banks shifted from the direct loan business to packaging and marketing novel debt instruments like mortgage-backed securities(ultimately including subprime loans) to other financial institutions, and shortly thereafter President William Jefferson Clinton approved the Gramm-Leach-Bliley Act(1999) enhancing business flexibility. The Glass-Steagall Act 1933(Banking Act of 1933) had compartmentalized banks, prohibiting those engaged in stable businesses like mortgages and consumer loans from participating in riskier stock brokerage, insurance, commercial and industrial activities with the intention of building a firewall against speculative contagion. The repeal of provisions banning holding companies from owning other financial companies ushered in an era of financial merger mania across old divisional lines, allowing companies like Citicorp and Travelers Group to unite.

These developments, replicated across much of the globe, were all positive from the standpoint of neoclassical microeconomic theory because they enhanced competitive efficiency, with the proviso that moral hazards and speculative abuses were optimally contained by residual regulations ("liberalization"). However, if residual "laissez-faire"(do whatever you want) regulations were inadequate, then ensuing financial crisis costs could easily outweigh deregulatory efficiency gains.

Clearly, there are legitimate grounds for conjecturing deregulatory involvement in the 2008 global financial crisis, but deregulation isn't the only suspect. The financial environment also was placed in jeopardy by revisionist Keynesianism. John Maynard Keynes was an apostate monetarist who devised and spread the counter-depressionary gospel of deficit fiscal spending in his General Theory of Employment, Interest and Money. (Keynes, 1936)

He contended that the Great Depression had been caused by deficient aggregate effective demand brought about by negative income effects, prolonged by a liquidity trap and claimed that full employment could be easily restored by offsetting private hoarding (speculative idle cash balances) with government expenditure programs(deficit financed state procurements and programs). Other things equal, Keynes insisted competitive markets could and would achieve perpetual full employment, if it weren't for income (multiplier) effects, and this destabilizing force could be overcome without inflation through countercyclical government deficit spending and countervailing surpluses. There was no place in Keynes's universe for continuously mounting "structural deficits," sovereign debt and/or "managed" inflation that could feed speculation and cause financial crises.

Nonetheless, immediately after World War II, the U.S. government passed the Employment Act of 1946 prioritizing the attainment and maintenance of full employment (further codified and expanded in the Humphrey-Hawkins Full Employment Act, 1978). The law didn't fix quantitative targets, but marked the Truman administration's expansion of federal powers to include macroeconomic administration, management and regulation, without explicit constitutional sanction, and established the Council of Economic Advisors to aid presidential policymaking, as well as the Joint Economic Committee of Congressmen and Senators to review executive policies.

These actions enabled Washington to go beyond the perimeters of Keynesian orthodoxy, whenever full employment could not be sustained with trans-cyclically balanced federal budgets. The exclusion remained moot throughout much of the 1950s until William Phillips discovered, (Phillips, 1958) and Paul Samuelson popularized, the notion that full employment could only be maintained with "excess" monetary and/or fiscal stimulation accompanied by inflationary side-effects (Phillip's Curve). Keynes, many concluded was almost right. Deficit spending was essential, but it also should be applied no matter how much inflation it generates to secure the higher goal of full employment. Full employment zealots insist that governments are "morally" obliged to deficit spend forever, a position still widely maintained despite Milton Friedman and Edmund Phelps demonstrations that Phillips was wrong in the medium and long runs by omitting inflationary expectations. .

The orthodox Keynesian straitjacket was loosened further by Walter Heller, Chairman of President John Kennedy's Council of Economic Advisors, 1961-64, who introduced across the board tax cuts as a counter-recessionary stimulus, even though this meant creating credit not just for investment, but for consumption as well. Keynes's employment and income multiplier theory required stimulating investment as the only legitimate method for combating deficient aggregate effective demand [Works Projects Administration 1932(WPA) providing 8 million jobs, and later investment tax credits]. He argued that new investment creates new jobs, wages, and derivatively increases consumption, whereas deficit consumption spending via diminished marginal propensities to consume merely transfers purchasing power from one recipient to another, without increasing employment. Heller's revisionism brushed Keynes's concerns aside, making it possible for politicians to claim that any deficit spending which benefited them and their constituents would stimulate aggregate economic activity and employment, including intertemporal income transfers from one consumer's pocket tomorrow to the next today.

This logic was extended by falsely contending that deficit spending and expansionary monetary policy accelerate long term economic growth. Although, there are no grounds for claiming that structural deficits and lax monetary policy accelerate scientific and technological progress (the ultimate source of sustainable economic growth), policymakers couldn't resist the temptation to assert that deficit spending and inflation are indispensable for maximizing current and future prosperity. The ploy has been successful as a political tactic, making deficits and inflation seem more palatable, but also has widened the door to compounding past abuses by upping the ante whenever the economy sours. Policymakers’ reflex isn't to retrench, but to do more of what caused problems in the first place.

Academic macroeconomists likewise succumbed to wishful thinking, brushing aside the speculative momentum embedded in postwar institutional liberalization and fiscal indiscipline. Influenced by Robert Lucas (1972), and Phil Kydland and Edward Prescott (1982), the conventional wisdom of 2000-2008 came to hold that business cycle oscillations were primarily caused by productivity shocks that lasted until price- and wage-setters disentangled real from nominal effects. These shocks sometimes generated inflation which it was believed was best addressed with monetary policy. Accordingly, central bankers were tasked with the mission of maintaining slow and stable, Phillips Curve compatible inflation. Although, central bankers were supposed to be less concerned with real economic activity, many came to believe that full employment and two percent inflation could be sustained indefinitely by "divine coincidence."22 This miracle was said to be made all the better by the discovery that real economic performance could be regulated with a single monetary instrument, the short term interest rate. Happily, arbitrage across time meant that central bankers could control all temporal interest rates, and arbitrage across asset classes implied that the U.S. Federal Reserve could similarly influence risk adjusted rates for diverse securities. Fiscal policy, which had ruled the roost under the influence of orthodox Keynesianism from 1950-80 in this way, was relegated to a subsidiary role aided by theorists' beliefs in the empirical validity of Ricardian equivalence arguments, and skepticism about lags and political priorities.23 The financial sector likewise was given short shift, but this still left room for other kinds of non-monetary intervention. The consensus view held that automatic stabilizers like unemployment insurance should be retained to share risks in case there were any unpredictable shocks. Commercial bank credit similarly continued to be regulated, and federal deposit insurance preserved to deter bank runs, but otherwise finance was lightly supervised; especially "shadow banks", hedge funds and derivatives.

A similar myopia blinded many to the destabilizing potential of Chinese state controlled foreign trading. As postwar free trade gained momentum, liberalizers not only grew increasingly confident that competitive commerce was globally beneficial, but that trade expansion of any kind increased planetary welfare. Consequently, few were perturbed after China's admission to the World Trade Organization (WTO) in 2001 either by the conspicuous undervaluation of the renminbi (RMB) fixed to support export-led development, or by Beijing's ever mounting dollar reserves. It was assumed that even if China over-exported (at the expense of foreign importables jobs), this would be offset by employment gains in the exportables sector as China increased its import purchases. "Overtrading" as theory teaches is suboptimal, but not seriously harmful to aggregate employment and has the compensatory virtue of expanding international commerce.

However, a fly spoiled the ointment. The Chinese (and some others like Brazil) chose to hold idle dollar reserve balances (hoard), instead of importing as much as they exported, compounding a "saving glut" caused by a broad preference for relatively safe American financial assets.24



Beijing's dollar reserves grew from 250 billion in 2001 to 2.6 trillion in 2010. In a perfectly competitive universe this wouldn't matter because others would borrow these unused funds, but not so in a Keynesian world where rigidities of diverse sorts transform idle cash balances into deficient aggregate effective demand, and simultaneously serve as a vehicle for financial hard asset speculation. For reasons that probably involve the Chinese Communist Party's desire to protect privileged producers in both its domestic importables and exportables sectors (implicit, stealth "beggar-thy-neighbor" tactics), Beijing became an immense source of global real and financial sector disequilibrium, contributing both to the 2008 financial crisis and its aftermath. Chinese leaders in its state controlled foreign trade system had, and have the power to reset the renminbi exchange rate, and increase import purchases, but they chose, and are still choosing to do neither.25

The cornerstones of 2008 financial crisis in summary are: 1) an evolving deregulatory consensus, 2) a mounting predilection for excess deficit spending, 3) a penchant for imposing political mandates on the private sector like subprime mortgage, student loan lending, and excess automobile industry health benefits which drove GM and Chrysler into bankruptcy in 2009, 4) waning concern for labor protection manifest in stagnant real wages and therefore flagging mass consumption demand,[shift towards promoting the security of other social elements] 5) a proclivity to prioritize full employment over inflation, 6) the erroneous belief that structural deficits promote accelerated economic growth, 7) the notion that government insurance guarantees, off budget unfunded obligations like social security, and mandated preferences to savings and loans banks were innocuous, despite the 160 billion dollar savings and loans debacle of the late 1980-1990s, 8) deregulatory myopia, and activists social policy, including the encouragement of subprime loans, adjustable rate mortgages(ARM), and tolerance of finance based credit expansion which flooded the globe with credit,26 9) lax regulation of post-Bretton Woods international capital flows(early 1970), 10) the "shareholder primacy" movement of the 1980s partnered Wall Street with CEOs to increase management's ability to enrich itself at shareholder expense, widening the gap between ownership and control first brought to light by Adolf Berle and Gardner Means in 1932,27 11) an indulgent attitude toward destructive financial innovation apparent in the 1987 "program trading," and 2000-02 "dot.com bubble" stock market crashes,28 as well as the 1998 Long-Term Capital Management hedge fund collapse,29 12) a permissive approach to financial auditing,30 including mark to face valuation for illiquid securities, 13) the creation of a one-way-street, too big to fail mentality that transformed prudent business activity into a venal speculative game on Wall Street, main street and in Washington, 14) the 2001 Wall Street stock crash which shifted speculative exuberance from stocks to hard assets(commodities, land, natural resources, precious metals, art, antiques, jewelry), and paved the way for the subordination of individual stock market investment to institutional speculation,31 15) credit easing in the wake of the dot.com bust, orchestrated by the Federal Reserve which started a consumer credit binge, reflected in high consumption and low savings rates, adding fuel to the inflationary fires, 16) 9/11 and the Iraq war which swelled America's federal budget deficit and triggered a petro bubble(and broad based commodity inflation), 17) an epochal surge in global economic growth led by Brazil, India, Russia and China(BRICs) wrought by technology transfer, outsourcing and foreign direct investment, which induced a wave of speculative euphoria, 18) Chinese stealth "beggar-thy-neighbor" renminbi undervaluation and dollar reserve hoarding, reflected in Chinese under importing, a burgeoning American current account deficit and an overseas "savings glut" which exacerbated inflationary pressures, raised prices for American treasuries and lowered interest rates,[widely mischaracterized as "financing imports"] 19) the 2006 American housing bust which toxified mortgage and derivative financial instruments,32 20) the emergence of "institutional" bank runs, where financial and nonfinancial companies flee repurchase (repo) agreements, 21) rapidly mounting sovereign debt in Iceland, several European Union states,33 as well as similarly onerous debt obligations in California and Illinois, 22) a naive faith in "divine coincidence," 23) a colossal regulatory blunder in imposing "mark to market" valuation (Fair Accounting Standard:FAS 157) of illiquid assets from November 15, 2007,34 24) increased separation of ownership from corporate control enabling top executives to excessively compensate themselves, including golden parachute perks. CEOs were institutionally encouraged to gamble with shareholders' money at negligible personal risk. (Bogle, 2011 p.488) The 2008 global financial crisis thus wasn't just a garden variety White Swan business cyclical event. It was a long time coming, and prospects for a repetition depend on whether underlying structural disequilibria, including political indiscipline are redressed.35

The Shock Wave

The defining event of the 2008 global financial crisis was a "hemorrhagic stroke;" a paralytic implosion of the loanable funds market that seemingly brought the global monetary and credit system to the brink of Armageddon. The September 2008 emergency was caused by the terrifying realization that major financial institutions, especially those connected with hedge funds couldn't cover their current obligations either with asset sales or short term bank credit because confidence had been lost in the value of their assets, and short term lending suddenly ceased. People everywhere were panicked at the prospect of cascading financial bankruptcies, where the securities of failed companies contaminated the value of other assets, triggering margin calls, shuttered credit access, lost savings, bank runs, stock market crashes, liquidity crises, universal insolvency, economic collapse and global ruination. All crises are ominous, but this one seemed as if it just might degenerate into a Black Swan debacle, equal to or greater than the Great Depression of 1929. After all, the U.S. Treasury and Federal Reserve Bank had reassured the public that the forced sale of the "risk management" investment banking firm Bear Stearns to JP Morgan Chase on March 24, 2008 for 5.8 percent of its prior high value had fully solved the subprime loan, mortgage and derivative securitization threat, but subsequent events revealed that Bear Stearns was just the tip of a potentially Titanic sinking iceberg, with American and European banking losses 2007-2010 forecast by the International Monetary Fund to reach 1 trillion, and 1.6 trillion dollars respectively.36 An additional 4 to 5 trillion dollars are expected to be lost through 2011, and although the Dow Jones Industrial Average fully recovered from the September 2008 highs by December 2010, 42 percent of its value was wiped out at the stock market crash's trough.37

The other shoe began dropping on September 7, 2008 when the Federal National Mortgage Association(Fannie Mae), and the Federal Home Loan Mortgage Corporation(Freddie Mac)[specializing in creating a secondary mortgage market] were placed into conservatorship by the Federal Housing Financing Agency after new mark to market accounting regulations(FAS 157) created havoc in the mortgage industry.38 At the time, Fannie Mae and Freddie Mac held 12 trillion dollars worth of mortgages.39 Three days later on September 10, 2008, the "risk management" investment bank Lehman Brothers declared bankruptcy after having failed to find a buyer, or acquire a Federal bailout to cover a 4 billion dollar loss. Merrill Lynch finding itself in similar dire straits was sold to the Bank of America on the same day. Six days later, the Federal Reserve announced an 85 billion dollar rescue loan to the insurance giant American International Group (AIG), also heavily involved in "risk management" securitization activities. The news ignited a wave of Wall Street short selling, prompting the SEC to suspend short selling immediately thereafter. Then on September 20 and 21, Secretary of the Treasury Henry Paulson and Federal Reserve Chairman Bernanke appealed directly to Congress for an endorsement of their 700 billion dollar emergency loan package designed to purchase massive amounts of sour mortgages from distressed institutions. Forty eight hours later, Warren Buffett bought 9 percent of Goldman Sachs, another "risk management" investment bank for 5 billion dollars to prop the company up. On September 24 Washington Mutual became America's largest bank failure ever, and was acquired by JP Morgan Chase for 1.9 billion.

These cumulating disasters, exacerbated by parallel developments in Europe and many other parts of the globe addicted to structural deficits, Phillips Curve justified inflation, financial deregulation, asset backed mortgages, derivatives, electronic trading, and hard asset speculation sent shock waves through the global financial system, including the withdrawal of hundreds of billions of dollars from money market mutual funds(an aspect of the shadow banking system), depriving corporations of an important source of short term borrowing. The London Interbank Offered Rate(LIBOR), the reference interest rate at which banks borrow unsecured funds from other banks in the London wholesale money market soared, as did TED spreads[T Bills versus Eurodollar future contracts], spiking to 4.65 percent on October 10, 2008, both indicating that liquidity was being rapidly withdrawn from the world financial system. In what seemed like the blink of an eye, the global financial crisis not only triggered a wave of worldwide bankruptcies, plunging production, curtailed international trade, and mass unemployment, but morphed into a sovereign debt crisis. Countries like Iceland, Ireland, Greece, Portugal, Italy and Spain found themselves mired in domestic and foreign debt that dampened aggregate effective demand, spawned double digit unemployment and even raised the specter of European Union dissolution. (Dallago and Guglielmetti, 2011)

These awesome events, together with collapsing global equity, bond and commodity markets unleashed a frenzy of advice and emergency policy intervention aimed at stemming the hemorrhaging, bolstering aggregate effective demand, and repairing regulatory lapses to restore business confidence. FAS 157-d (suspension of mark to mark financial asset pricing) broke the free fall of illiquid, mortgage backed asset valuations, offering some eventual support in resale markets. The Emergency Stabilization Relief Act bailed out system threatening bankruptcy candidates through emergency loans, and toxic asset purchases. FDIC savings deposits insurance was increased from 100,000 to 250,000 dollars per account to forestall bank runs. The SEC temporarily suspended short selling on Wall Street. The government pressured banks to postpone foreclosures invoking a voluntary foreclosure moratorium enacted in July 2008. The Federal Reserve and Treasury resorted to quantitative easing(essentially printing money) to bolster liquidity and drive short term government interest rates toward zero, effectively subsidizing financial institutions at depositors' expense. The federal government quadrupled its budgetary deficit in accordance with Heller's neo-Keynesian aggregate demand management tactic, concentrating on unemployment and other social transfers, instead of the direct investment stimulation advocated by Keynes.40 Committees were formed to devise bank capital "stress tests," coordinate global banking reform, ( Levinson, 2010) improve auditing and oversight, prosecute criminal wrong doing including Ponzi schemes (Bernard Madoff),41 and investigate regulatory reform of derivatives and electronic trading(Dodd-Frank Wall Street Reform and Consumer Protection Act, July 2010).42 In Europe many imperiled banks were temporarily nationalized, and a series of intra-EU austerity and rescue programs launched. In the larger global arena, the International Monetary Fund, World Bank and others provided emergency assistance, and the deep problem of Chinese state controlled trading was peckishly broached.

With the advantage of hindsight, it is evident the American government's Troubled Asset Relief Program(TARP), including the "cash for clunkers" program, other deficit spending and quantitative easing, passive acceptance of Chinese under-importing(dollar reserve hoarding), continued indulgence of destructive speculative practices(program trading, hedge funds, and derivatives), together with regulatory reforms and confidence building initiatives didn't cause a Black Swan meltdown and the subsequent hyper-depression many justifiably feared.43 Some of these same policies may deserve credit for fostering a recovery, tepid as it is, but also can be blamed for persistent, near double digit unemployment, a resurgence of commodity, stock and foreign currency speculation, and the creation of conditions for a sovereign debt crisis of biblical proportions in the years ahead when the globe is eventually confronted with tens of trillions of dollars of unfunded, and un-repayable obligations.44

At the end of the day, it shouldn't be surprising that the institutionalized excess demand disequilibrium of the American and European macroeconomic management systems would produce some relief, even though their policies were inefficient and unjust. Financial stability is being gradually restored, and output is increasing, but the adjustment burden has been borne disproportionately by the unemployed, would be job entrants, small businesses, savers, pensioners and a myriad of random victims, while malefactors including politicians and policymakers were bailed out.45 Moreover, the mentality and institutions which created the crisis in the first place remain firmly in command. Incredibly, the Obama administration under cover of the Frank-Dodd Act already has begun mandating a massive expansion of the very same subprime loans largely responsible for the 2006 housing crisis and the 2008 financial debacle that swiftly ensued.46 This action and others like it will continue putting the global economy squarely at Black Swan risk until academics and policymakers prioritize financial stability over parochial, partisan, ideological and venal advantage. (Wedel, 2009)

The 2008 financial crisis also has placed macroeconomic theory in a quandary. The "divine coincidence" is now seen for the pipedream that it was, but there is no new consensus to replace it other than the pious hope that structural deficits, loose monetary policy and better financial regulation (aggregate demand management) will foster prosperity no matter how irresponsibly politicians, policymakers, businessmen, financial institutions, special interests and speculators behave. (White, 2010) Worse still, there seems to be little prospect that a constructive consensus soon will emerge capable of disciplining contemporary societies for the greater good by promoting optimal efficiency, growth and economic stability. The global economy is flying blind, propelled by a disequilibrium mentality (some say herd mentality) that spells trouble ahead with scant hope for learning by doing. Most players seem to believe that contemporary monetary and fiscal management, combined with better financial regulation will work well enough, but they appear to be conflating wishful thinking with economic science.


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