What went wrong?

I have started to write a series of articles about the causes and consequences of the great financial crisis of 2007-08. The crisis of the eurozone forms just one part of this much larger crisis. If and when I complete the different bits of analysis of this complex crisis I will be posting them as a series of short articles which will be listed on this page.

I have completed the first two articles, which are linked below, in which I try explain starting with absolute basics how unbalanced economies develop and how that relates to unbalanced trade. I am starting with the issue of trade imbalances because I believe that such imbalances lay at the root of the financial crisis and that, although it is important to understand what specifically went so drastically and catastrophically wrong in the financial system, without understand how the deeper trade and global imbalances drove the damaging financial system mutations it is not possible to understand the crisis as a whole.

Part 1: Understanding the basics – How an economy becomes unbalanced

Part 2: How economic imbalances lead to imbalances in trade

A brief summary of crisis and its causes

The Crises Erupts

Following a long period of economic growth and relative stability a major crises erupted in the global financial system between August 2007 and October 2008. This crises took the form of a massive credit crunch. Capital and credit flows were severely disrupted and in some cases credit flows stopped all together. Major financial institutions were revealed to be holding vast amounts of bad debt and as a consequence many major financial institutions, including numerous banks large and small, became insolvent. In order to prevent a collapse of the financial system, an event that would have caused the largest and most catastrophic depression in history, the governments of the developed economies of the world pumped a huge amount of public funding into the financial system. In some cases this involved nationalising major banks and financial companies.

It has been estimated that by late 2009 the financial support offered to the financial system by various governments and state institutions represented 18% of the Eurozone GDP, 73% of USA GDP, 74% of UK GDP, and taken together that amounts to a staggering 25% of global GDP. Interest rates were reduced to unprecedented low levels, with inflation taken into account some interest rates became negative.

The impact of the crises was severe. World output fell as fast in the first year after it’s April 2008 peak as during the Great Depression, and the volume of world trade and equity markets fell even faster than during the Great Depression. World trade fell by close to 20% in the twelve months from April 2008 (compared to 10% after June 1929) and equity markets fell by around 50% (compared to 20% after June 1929). Fortunately a bout of rediscovered emergency Keynesianism was applied by the authorities in the US and the UK and prevented a major slide into a prolonged depression.

Nevertheless the 2007-8 crises was the biggest recessionary crises in the history of global capitalism since the Great Depression and it’s effects are still being felt in profound way through out the global economy.

The impact of the crises was uneven. The most severe effects were felt in the developed economies, in particular in the Eurozone bloc where the crises exposed structural weaknesses in the Eurozone system, while most emerging economies weathered the crises well and continued to grow although at reduced rates. The pattern since the crises has been one of modest recovery in the USA, event more modest recovery in the UK, a prolonged recession with little recovery in the Eurozone (the world’s largest economy) and continuing but slowing growth in the emerging economies. Overall global growth has slowed since 2008.

It is still not clear if the crises is over and it is possible that a second stage of the crises could yet unfold and might involve the break up of the Eurozone or a financial and economic crises in China.

A brief summary of the causes of the crisis

During the decade before the 2007-08 financial crises very big imbalances in global trade developed. Some countries went heavily into deficit on their current account and some countries developed matching very large surpluses.

This development grew out of the patterns and organisation of international trade that had preceded it but the imbalances in trade in the decade prior to the crises were much larger than anything seen before. The most significant imbalance was the huge trade deficit that the USA developed prior to 2007 but large trade deficits also developed in the weaker Eurozone countries. These defects were matched by the development of huge surpluses by China, Japan and Germany, and significant surpluses in the oil exporting countries.

None of these imbalances were corrected by currency shifts. The dollar did not fall in value because countries like China and Japan were deliberately keeping their currencies cheap and the dollar strong to ensure they continued to generate current account surpluses. The status of the dollar as the world’s reserve currency also helped keep it strong. Germany’s surplus was not corrected by a strengthening currency because it was now inside the Eurozone and the Euro was undervalued in terms of Germany’s trade performance (although over valued for the weaker Eurozone countries).

As result of these growing and uncorrected imbalances vast capital flows were generated as mountains of dollars flowed out of the USA, and Euros flowed out of Germany, and into the surplus countries where they were recycled via the major financial global centres, in particular New York and London. This capital inflow was not given but lent so the inflow built up a very large debt levels in the deficit countries such as the US and the eurozone periphery. The capital inflows from the surplus countries were partially used to buy USA government debt (Treasury Bills) thus fuelling a ballooning US government deficit and incidentally paying for the costly post 9/11 wars. Other governments, such as the Greek government, also found it easy to finance large government deficits.

These recycled dollars also poured into the global financial system looking for investment opportunities and in the process driving down interest rates (because there was now a surplus of capital available for lending). The trade imbalances that had generated the capital flows were generated by the inability of businesses in the surplus countries to compete with foreign business so by definition it was hard to find productive profitable investment opportunities in deficit countries such as the USA or eurozone periphery for the inflowing capital generated in the surplus countries. As a consequence big flows of capital began to flow into property markets in a number of countries, particularly the USA, Ireland and Spain, and a property bubble began to develop and prices were pushed up, and also into personal debt so lots more people became personally more indebted. The asset bubbles generated attractive investment opportunities which in turn attracted even more capital and the various property bubbles became very inflated.

The financial system was poorly prepared to handle these huge flows of capital because, for a complex raft of reasons, it had become systemically incapable of managing risk and had become ever more relaxed about taking risks. At the same time ludicrously complex new financial instruments and mechanism were being invented and widely adopted. These were seen as spreading the risk around the finance system, and thus reducing risk. In fact these new new financial instruments were actually spreading high risk poison around the system whilst also camouflaging it and confusing the financial sector corporate managers. The prevailing theoretical and policy consensus which underlay the management of the economy, and of the finance system, was heavily focussed on ensuring inflation did not rise, and did not have the theoretical framework which allowed those responsible to understand that the financial system was growing increasingly unstable. Eventually the major centres of the global financial system became deeply unstable and in 2007 imploded. The pyramid of debt collapsed and almost overnight the world became saturated with bad debt.