It would be nice if the cause of the credit crisis could easily be pinned on poor government regulation, greedy lenders, or careless borrowers. Unfortunately, no one actor is to blame and the causes of the crisis extend back in time. This makes developing an understanding of the crisis a bit of a history lesson.
In 1973 (unfortunately, the story goes back at least that far), the Bretton Woods Monetary System came to an end. The Bretton Woods System was a global mechanism for maintaining fixed exchange rates and encouraging international economic interconnections. At the heart of the system was the U.S. dollar. Under this system, the U.S. government maintained (at least initially) a promise of backing every $35 issued with 1 ounce of gold. This promise constrained U.S. ability to expand the money supply and provide liquidity to markets. Unfortunately, this promise proved unsustainable due to global and domestic need for more liquidity than was possible under the gold constraint. This led the Nixon Administration to move the dollar to an international “float” by 1973. By moving the dollar to a float, any inherent limit on the number of dollars in circulation was removed. Rather, the volume of money in the economy became constrained only by the good faith of the monetary authority – the Fed. Fortunately, the Fed maintained this faith well for 25 years. Unfortunately, it is clear that this restraint waned in recent years.
Adding to the complexity of events, by the 1980s the Japanese economy had attained economic maturity. With this economic maturity came high levels of savings. During the 1980s, a significant portion of these savings found outlet in the global economy. Given the dominant position of the U.S. economy, a large share flowed into the U.S. economy. This flow into the U.S. was greeted with some domestic alarm (a very visible instance centered on the Japanese purchase of Rockefeller Center in 1989), yet the inward flows continued.
The savings flow from Japan did slow somewhat with the downturn of the Japanese economy during the early 1990s. However, waiting to take up the slack were the South Korean and Chinese economies. The significant trade surpluses these countries ran with the U.S. kept a large flow of foreign savings coming into the U.S. These foreign financial inflows kept the cost of borrowing low in the U.S. and helped fund the strong economic performance of the U.S. economy during the 1990s.
Unfortunately, much of the world did not mirror the strong growth of the U.S. economy. Growth in the European economies was slowed by the costs of adopting the euro. Worse, the East Asian economies fell into a serious economic contraction in 1997 and the Russian economy was hit by a separate crisis in 1998. With the U.S. the dominant global economic actor, the world looked to us to provide stability. Further, these crises had direct ramifications for the U.S. economy. The Dow Industrial Average saw a 10 percent fall in 1997, and an additional fall of 17 percent in 1998 (though there was a recovery in value between the two downturns). Beyond declines in the broader market, U.S. officials saw evidence of risk of a serious financial collapse with the failure of Long- Term Capital Management hedge fund. Fortunately (or unfortunately, as it may turn out), the Fed responded to these risks by utilizing the increased discretionary ability it gained following the collapse of the Bretton Woods agreement. It increased the money supply to stabilize the economy (this is seen by the ¾ point lowering of the Federal Funds Rate in 1998-99). It is noteworthy that the Fed acted to stimulate the economy through an expansion of the money supply in the midst of the longest peacetime expansion in the history of the United States. For our story, the import lies with the Fed reinforcing the expansion in liquidity already underway due to the inflows of foreign savings.
Beginning in late 1999, the Fed did try to rein in liquidity by raising interest rates (to a high of 6.5 percent). Unfortunately, the economic downturn of 2001-02 forced the Fed to reverse this tightening, and by 2004 the Federal Funds Rate had fallen to 1 percent. The Fed was more aggressively pushing liquidity into the economy than at any time in history. And the policy was successful – the recession of 2001-02 was very shallow and short lived. But all that money needed an outlet; one turned out to be the market for housing.
It would be easy to make too much – or too little – of this part of the story. The high levels of liquidity generated by inflows of foreign savings and loose domestic monetary policy were not the cause of the current credit crisis. However, without this liquidity the run up in the housing market would have been unlikely to occur. As such, high levels of liquidity provided one important contributor to the ongoing credit crisis. The change in financial oversight provides another.
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