How we got into this mess: a political primer

International Economy, The, Wntr, 2009 by David M. Smick

The April 2 G20 meeting in London of the major world economic leaders could have been the most important global economic gathering since 1944, when the Bretton Woods conference reshaped the old order near the end of World War II.

But it wasn't.

Another Bretton Woods is not in the cards because U.S. and European officials, like ships passing in the night, couldn't agree on their response to the financial crisis. This is a tragedy because the world's policymakers are failing to deal with many fundamental issues, including the question of how we got into this mess. Lack of a widespread policy consensus adds confusion to global political constituencies dangerously unaware of the global nature of the financial crisis.

Someday, historical archeologists will sift through the rubble of this ugly financial period. They will conclude not only that our regulators were asleep at the switch, the big global banks deployed reckless amounts of leverage while losing any understanding of their own balance sheets, and gluttonous American consumers spent a lot more than they earned.

Historians will also discover the flip side to this morass. The entire world was out of balance. While Americans became dependent on massive leverage and over-consumption, large parts of the world, primarily the emerging markets, became dangerously dependent on exports--either goods and services or high-priced oil.

Today, with the industrialized economies in trouble, the emerging market economies based on this export model are crash landing. Why is that important for the rest of the world? The collapse of emerging markets from Hungary to South Korea, of course, could have consequences far beyond their borders. The World Trade Organization, moreover, forecasts overall global trade to decline by 9 percent this year. From 1929 to 1932, the beginning years of the Great Depression, foreign trade among developed economies plummeted in volume terms by about the same yearly amount.

The political community has an oversimplified view of the cause of the financial crisis. Somehow the bursting of a mere $300 billion U.S. subprime bubble in August 2007 brought a global financial system worth hundreds of trillions of dollars to its knees. Actually, the seeds of financial turmoil were planted much earlier--as odd as it sounds, with the 1989 fall of the Berlin Wall. Today's financial crisis all began as an unintended consequence of the collapse of the state-run economic model.

Within several years of that momentous event, emerging economies including China, India, Eastern Europe, and commodity producers like Russia burst onto the scene. They wanted to be like the industrialized world--capitalists. As they liberated their economies and financial systems, making them more efficient, the resulting new productive capacity led to a global ocean of capital. There suddenly was more money globally than there were investment opportunities.

A lot of this new capital poured into the United States, particularly into the U.S. Treasury market. In the process, most emerging market economies adopted a new model for growth. Fixing their currencies in one form or another to the dollar, they revamped their economies as export platforms and spent little time enhancing the consumption bases of their own economies.

The goal: to export consumer and capital goods to the industrialized world. And the target of choice: the gluttonous, debt-ridden American consumer. At one point in the process, Americans became the .world's consumer of last resort, spending an incredible $1.10 for every dollar they earned.

For a while, the new system worked beautifully. As emerging markets exported goods and services, and oil, to the industrialized West, they built up mountains of excess savings. At one point China alone had compiled a mountain of foreign exchange reserves, mostly in U.S. dollars, approaching $2 trillion. After the Asian and Russian financial breakdowns in the late 1990s, these mountains of excess savings were seen as an effective insurance policy against global speculators questioning currency valuations.

As emerging markets recycled that capital back into the debt-ridden United States, Americans took a financial magic carpet fide. This Niagara Falls of foreign capital inflows caused real U.S. interest rates to drop drastically. This abrupt financial distortion is how today's financial crisis began. With such an abundance of capital, the price of financial risk plummeted. Families, woefully under-qualified financially, were allowed to purchase homes far beyond their means. To manage the distribution of so much capital, and to assess the risk entailed in its distribution, the big commercial and investment banks ramped up and abused the securitization process and then concocted another paper financial instrument to insure the securitized instruments.

Thinking they had discovered riskless risk, our large global financial institutions added insult to injury. Through reckless borrowing from that ocean of capital, the global financiers leveraged their own capital to dangerous heights. Failed Wall Street firm Bear Steams, for instance, deployed irresponsible amounts of leverage at a ratio of 34 to one. But the prize goes to the German bank Hypo Real Estate which, at 112 to one, deployed the leverage of a lunatic.