Posted by: Dirk | June 17, 2009

How to save the world (economy)


In the last years, we have seen an economic crisis develop. It started in the sub-prime segment of mortgage-backed securities, the spread to other financial markets, finally affecting the real economy. Falling world trade, GDP and unemployment have resulted. In order to fight off the economic crisis, its causes must be understood. This article is therefore divided into two parts. Part one explains what the reasons behind the financial crisis are, and part two explains a possible way out.

Part one – How we got into the mess

The story starts with the burst of the twin bubble in Japan in 1990 [1]. After the collapse of both Nikkei and real estate market, investors were eager to transfer their capital somewhere else. One of the destinations was Scandinavia, where a financial crisis resulted in the early 1990s [2]. The money went to the Asian tigers then, creating another bubble. Again, when the bubble burst, a financial crisis resulted – the Asian crisis of 1997. The IMF gave the countries that were in trouble very bitter medicine, leading those countries to rethink their development strategies. High foreign exchange reserves were perceived as a buffer against financial crisis, like Hong Kong showed [3].

In the middle of the 1990s, another bubble developed in a developed nation – the IT bubble in the US. While Bill Clinton reduced the government debt, savers were driven into the markets for private assets. Also, capital inflows from abroad helped to create an abundance of capital for firms in the IT sector. The subsequent increase in IT productivity in the US is mainly a result of higher levels of capital per worker [4]. Finally, the bubble did burst and recession followed.

In the 2000s, the defining fact is that of the economic imbalances between the US and China. The Chinese government sought to develop their country by fixing the exchange rate at a low level and then export itself into economic nirvana – more jobs, and savings from the US for the times when the demographic catastrophe would hit. The one-child policy has led to a huge problem of how to deal with the elderly when there few young workers that will support them. So, it was thought, buying US treasury bonds would save the situation and provide goods and services at a time when China would be grey.

Therefore, the current account was driving the capital account in China. The country wanted to export, and export more than it imports. To make that possible, it has to accept dollar-denominated assets when the US runs out of Yuan to pay with. The Chinese government chose treasury bonds because the risk seemed to be zero. Although the US government was expanding the supply of t-bonds, the demand increase was driving up the prices of those bonds, which implies that yields are sinking. They were sinking to the point where they were below US inflation (see graph: red-inflation, blue-yield from t-bonds). This would have consequences.

A household that wants to save needs an asset which pays an interest rate that is higher than inflation. If otherwise, the purchasing power of the savings would decrease over time. The compound effect would make long-term saving quite unattractive. Therefore, in 2003 at latest US households recognized that saving in t-bonds would not do them any good. The yield was close or even below the rate of inflation. Therefore, the financial sector searched for other investment opportunities. The world economy in 2002/03 looked weak, countries like Japan and Germany were in a bad situation economically. On top of this, the negative trade account of the US vis-a-vis other countries like Germany or Japan meant that there was even more external demand for US financial assets than before. So, both the domestic demand and external demand for US assets of the private sector had increased.

Finally, some of the capital was invested into US corporate stocks and bonds, while mortgage-backed assets were sold off to the rest of the world. Some of these, however, were also kept in the US financial system. Since the securitization of assets has nothing to do with the US interest rate set by the Federal Reserve, lose monetary policy cannot be blamed for it. Most lenders offered teaser rates, which led to a disconnect from the US interest rate. Also, buyers expected to gain from buying a house as long as the increase in price overcompensated the interest rates on the loan. This led to a deterioration of lending standards and a warning in 2004 from the FBI [5].

The lose monetary policy, which was based on the New Neo-classical Synthesis (NNS), created a different problem [6]. The increase in the supply of credit led to an increase of corporate debt [7]. This was something that the NNS did not care about, since money is assumed to be neutral. However, increasing the money supply means that it gets easier for some to go into debt and then buy some other firms. Firms had to protect themselves by loading up with debt themselves in order to keep control. This caused a deterioration of financial health in the corporate sector, and the rise of speculative and Ponzi finance [8]. The financial instability that resulted led to a debt-deflation process in 2008, following the model developed by Irving Fisher in 1933 and confirming the predictions of Hyman Minsky [9].

The policy reaction by the Fed and central banks worldwide was to drive down interest rates to (close to) zero. This did not help. Saving-investment balances were coming up, with savings that are still kept inside the banking system. Apparently, there are no investment opportunities. This situation was described by John Maynard Keynes in 1936 [10].

So, we got to where we are because of global imbalances, causing over-investment in the US. The US has been an attractive place for investment, and many countries rich and poor invested their capital there (see above, quarterly net capital inflow). That left economists wondering why capital flows uphill [11]. However, while capital inflows increased, the return to capital in the US decreased. That is what simple economic theory would predicts. Given demand, increase the supply of a factor and the return to that factor will decrease.

Part two – How do we get out of the mess

The big question now is how we get out of the economics crisis. There are three intertwined problems that need to be fixed:

  1. the international economic order
  2. the demand failure
  3. the over-indebtedness

All issues are intertwined. It would interesting to see how these issues played out during the Great Depression, which was very similar to our economic crisis [12]. However, in the following a recipe based on Keynes will be applied to the economic crisis of today.

The current international economic order has caused the financial crisis [13]. The integration of China, which runs an export-led growth strategy, has caused capital flows to the US, where the money was absorbed by the government. There would have been no problem with this if the money had been invested into something which delivers a return. It was not. The expansion of government spending under George Bush did not go into investments for the long-run, like infrastructure, innovation, education, but into the Iraq war and other mostly unproductive activities. So, the US government does not have a liquidity problem (it could pay, but only in the future) but a solvency problem (it doesn’t have the money now nor later). Of course, the solvency problem is not very large. All debts are denominated in dollars, so both possibilities – default and inflating – to reduce this debt remain. Although there is a problem with the international economic order, there is no need to act now. Other countries sustain higher levels of government debt.

A bigger problem is the demand failure. Worldwide demand has fallen, and protection is looming. To increase global demand, someone has to spend some serious money. That would, I will argue in the following, be China and all the other countries accumulating dollar reserves. These countries have to inflate. By increasing the supply of money, they will see their respective price levels increase. This leads to a shift in demand from foreign sources to local sources. China, for instance, would export less and import more since, even though the fixed exchange rate will be kept, US products become cheaper in yuan terms. China has money to buy them, having piled up close to $2,000 bn in dollar-denominated assets. Spending these reserves would increase global demand. The alternative is to keep the dollars since they are meant to be savings. Then the US would have no other possibility to regain control over its economy than by default or inflation.

This is a potential win-win situation. China would over time reduce her dollar-denominated reserves while the US is not inflating its debt away, and the US economy gets a demand boost that is needed badly, while honoring its commitments and repaying part of its debt, thereby being able to keep the status of the US dollar as reserve currency. If unemployment results in China while moving from an export-led growth model to that of a more inward-looking domestic economy the government would have enough assets to fund a social system that keeps workers happy in times of transition. The rest of the world – including Europe – will benefit from the increase in global demand and be pulled out of the depression as well. Countries with low indebtedness and possibilities to increase government spending should do so. This combination should ensure that the Keynesian multiplier is as large as possible.


The on-going economic depression has been caused by economic imbalances. The rest of the world invested in the US, allowing the US to increase its debt and import more than it exports. This has fueled another giant bubble in the financial market, a near copy of the dot-com bubble. As long as global economic imbalances exist, the occurrence of financial crisis will not stop. However, the financial industry has benefited handsomely during the who process. There will be huge pressure to keep the financial system as it is, since a few stand to gain a lot and the bill would be shared by billions of savers worldwide [14].

The Zeitgeist has moved us towards markets so far that almost nobody believes that government can do good. I do not call for a repeal of market-led capitalism. I do not believe that radical change will do us good. The solution outlined above builds on current institutions. It will depend on us whether we can regain our control over an economic system and ensure that it provides peace and prosperity for all of us. I hope that I have provided a first stepping stone on our way, if only to start a much-needed discussion.


[1] Charles P. Kindleberger and Robert Z. Aliber. 2005. Manias, Panics, and Crashes: A History of Financial Crises. John Wiley & Sons, 5th edition

[2] Lars Jonung. 2008. Lessons from Financial Liberalisation in Scandinavia. Comparative Economic Studies 50, 564–598

[3] Asia Week. 1998. Hong Kong Fights Back. vol. 51, link

[4] Bart van Ark, Mary O’Mahoney and Marcel P. Timmer. 2008. The Productivity Gap between Europe and the United States: Trends and Causes. Journal of Economic Perspectives, vol. 22(1), 25-44

[5] CNN. 2004. FBI warns of mortgage fraud ‘epidemic’. link

[6] Marvin Goodfriend. 2002. Monetary Policy in the New Neoclassical Synthesis: A Primer. International Finance, vol. 5(2)5, 165-191

[7] Hernando de Soto. 2000. The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else. B&T

[8] Hyman P. Minsky. 1986. Stablizing an Unstable Economy. Yale University Press

[9] Irving Fisher.  1933. The Debt-Deflation Theory of Great Depressions. Econometrica 1(3), 337-57.

[10] John Maynard Keynes. 1936. The General Theory of Employment, Interest and Money. link

[11] Eswar Prasad, Raghuram Rajan and Arvind Subramanian. 2007. The Paradox of Capital. Finance and Development vol. 44(1), link

[12] Barry Eichengreen and Kevin H. O’Rourke. 2009. A Tale of Two Depressions. Vox Eu

[13] W. Arthur Lewis. 1978. The International Economic Order.

[14] Mancur Olson. 1965. The Logic of Collective Action: Public Goods and the Theory of Groups. Harvard University Press

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  1. [...] was saved, jobs were not. And during this whole decade, the Fed failed to recognize the problems in the international picture,  despite warnings from the BIS, the central bank’s best friend. And all this was not caused [...]

  2. [...] explain what has happened and give hints as to how we can get out of this mess. In June 2009 I have described the idea of making China spend its dollar reserves, and by now I would suggest that Germany and Japan as well as all the other [...]

  3. “Since the securitization of assets has nothing to do with the US interest rate set by the Federal Reserve, lose monetary policy cannot be blamed for it. Most lenders offered teaser rates, which led to a disconnect from the US interest rate.”

    Satz 1 folgt dem Greenspan-Mythos “Wir konnten nichts dafür, wir konnten nur die kurzfristigen Zinsen beeinflussen”.
    Der scheint mir zunächst schon mal in einem gewissen ökonomischen Widerspruch zu Satz 2 zu stehen: hätten die Banken ohne niedrige kurzfristige Zinsen derartige Lockvogelangebote (für die Anfangszeit) machen können?

    Tatsächlich hat aber das Finanzsystem ganz allgemein bei der Hypothekenfinanzierung noch stärker als sonst mit der Fristentransformation (aus kurz mach lang) gearbeitet. Auf diesem Wege müssen zwangsläufig niedrige Leitzinsen der Fed eben doch auch auf den Hypothekenmarkt durchschlagen.
    (Zur Funktionsweise im Einzelnen vgl. z. B. das Kapitel “Shortening the Maturity Structure to Tap into Demand from Money Market Funds” in dem Papier “Deciphering the Liquidity and Credit Crunch 2007–2008″ von Markus K. Brunnermeier –

    Dass ein solcher Sachverhalt einem hochintelligenten Mann wie Alan Greenspan auch schon während seiner Amtszeit entgangen ist, das mag glauben, wer’s glauben mag!

  4. [...] imbalances must be reversed in order to get out of the crisis (I have published analysis in June 2009 – almost three years ago – that pointed that way. Others did so, too.). Getting out of [...]

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