The Finacial Crisis: Burst Bubble, Frayed Model

At the same time, the central banks use their increasing stocks of dollars to invest [3] in US assets in order to earn a return. The return flow pushes up the value of the dollar (just the wrong direction for reducing [4] the US trade deficit) and also pushes up asset values in the US, including property and Treasury bonds. Higher bond prices go with lower yields, and therefore lower interest rates. Lower interest rates push up consumption, domestic debt and imports in the US, and cause the country's deficit to grow even bigger. Robert Wade is professor of political economy at the London School of Economics. He worked as a World Bank economist in the 1980s. He is the author of Governing the Market: Economic Theory and the Role of Government in East Asia's Industrialization [5] (Princeton University Press, 1990) and of "Is globalization reducing poverty and inequality?", in John Ravenhill, ed., Global Political Economy [6] (Oxford University Press, 2005). Also by Robert Wade in openDemocracy: "Inequality of world incomes: what should be done? [6]" (14 November 2001) "The invisible hand of the American empire [6]" (13 March 2003) "Globalisation: emancipating or reinforcing? [6]" (29 January 2007) "The world's World Bank problem [6]" (10 July 2007) The banks' choice This mechanism has generated impressive economic growth in both deficit and surplus countries; but it is inherently unstable. Large trade imbalances [7] generate larger increases in financial transactions and rising financial fragility, as rapidly increasing central-bank reserves (due to the US current-account deficit) provide the fuel for inflationary pressures and for mushrooming growth of the financial sector relative to other sectors. Banking crises, foreign-exchange crises, housing crises and the like become more likely (see Richard Duncan's book, The Dollar Crisis [8] [Wiley, 2005], and his "Blame the dollar standard", FinanceAsia, September 2007 [9]) [subscription only]). More specifically, central banks, faced with rising reserves denominated mostly in dollars, have a choice of three types of dollar assets: (a) the bonds of the US government, in the form of Treasury bonds (b) the bonds of "quasi-government" agencies, or government-sponsored enterprises [10] (GSEs), like the mortgage lenders Fannie Mae and Freddie Mac (c) asset-backed securities issued by the private sector. The banks' preference is for government bonds, the safest. But the supply and therefore the price of Treasury bonds depend on the state of the US budget deficit. When it is in or near surplus the supply is low and the price relatively high - therefore the returns are relatively low; and so the central banks switch their purchases to (b) or (c). The turbo-charger effect In the late 1990s, with both the US current-account deficit and foreign central-bank reserves continuing to increase, the US budget went into surplus thanks to the internet bubble and fast overall growth. The supply of government (Treasury) bonds therefore fell. Foreign central banks switched their demand to the next safest US asset, quasi-government bonds, in particular those of the mortgage lenders. So Fannie Mae and Freddie Mac [11] enormously expanded their bond-issuance and mortgage-lending in the next several years, initiating the housing-market bubble. But then the US budget went into deficit after the collapse of the stock-market bubble and the George W Bush administration's tax cuts [12], and the Treasury needed to sell more bonds. To cut a long story short, it engineered a halt to the issue of any more quasi-government bonds (to curb competition with government bonds), and foreign central-banks' demand switched back to government bonds. By 2004 the property boom initiated earlier was generating rapid and broad-based economic growth in the US (enough [13] to get Bush re-elected). So tax revenues increased and the US budget again went into surplus. The supply of new Treasury bonds fell. Foreign central banks, with still fast-rising dollar reserves meeting a smaller supply of US government and quasi-government bonds, therefore switched to the third category of US assets, so-called asset-backed securities [14] (ABSs). Between 2003 and 2004 the issuance of ABSs in the US more than doubled, and then almost doubled again in 2005. A large part of these ABSs was backed by mortgages - mortgages issued not so much by the quasi-government mortgage lenders as by private banks and other financial organisations. To generate new demand, the latter developed new kinds of mortgages [15] aimed at people previously not able to obtain mortgages on conventional terms: the so-called "sub-prime" mortgages, or "liar" loans, or Ninja loans (no income, no job). The mortgagees were told that continuously rising house prices would allow them to "extract equity" from the rising value of the house and in this way meet the higher repayments when the repayment terms toughened in a year or two. The private banks developed techniques [16] of "securitising" the mortgages, techniques known by the impressive-sounding term "structured finance", by which combinations of highly risky mortgages could be packaged and sold - and given AAA ratings by the rating agencies on the pretext that the risk was widely dispersed (hence the ironic appellation, Ninja AAA loans). This mechanism constituted a turbo-charger [17] on the US house market. House prices escalated, the bubble intensified. It was not only foreign central banks which accumulated dollars and sought to buy US dollar assets; so too did commercial banks, insurance companies, pension funds and the like. And they were not only non-US investors; US investors were also seeking to buy the same "risk-free" assets. Meanwhile, US consumption soared, spurred on by equity extraction from rising house values, and so therefore did the US trade deficit. The jump in US imports helped to fuel a global economic boom in 2004-06; to which China's fast growth [18], itself fuelled by exports to the US, contributed via improved terms of trade for commodity producers in developing countries. The world economy grew at its fastest rate in decades in 2004-06. Globalisation was cheered [19] to the rooftops; the views of "anti-globalisation" activists were being confounded (so the argument went), as free-market capitalism was evidently working to bring widely disbursed economic growth and associated benefits, even in parts of Africa. Much more at: http://www.opendemocracy.net/article/the_end_of_neo_liberalism?1

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