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The Bureau o International Inormation Programs o theU.S. Department o State publishes a monthly electronicjournal under the eJournal USAlogo. These journalsexamine major issues acing the United States and theinternational community, as well as U.S. society, values,thought, and institutions.

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Editor, eJournal USAIIP/PUBJU.S. Department o State301 4th St. S.W.Washington, DC 20547United States o America

E-mail: [email protected]

U.S. DEPARTMENT OF STATE / MAy 2009

VOLUME 14 / NUMBER 5

http://www.america.gov/publications/ejournalusa.html


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eJournaluSa 1

In hindsight, the bubble in the U.S.

housing market, the irst indication

o what would become a global

inancial crisis in the all o 2008, should

have been obvious. The prices o houses

had risen beyond the salaries o many

ordinary Americans, but the availability

o new, riskier mortgage products ueled

the rush to home ownership. Whats

more, the inlation in their real estatevalues had many homeowners eeling

wealthy. Historically in the United States,

housing prices had always gone up. So

what went wrong?

And how did the ailure o one sector

o the U.S. economy help trigger what

many have seen as the greatest worldwide economic crisis since the Great Depression o the 1930s? For this issue o

eJournal USA, we asked six inancial experts to oer their opinions on how the global crisis came about and some o the

ways the world will react to this shared problem.

Political scientist Mark Blyth begins by listing six events that had a role in causing the crisis. John Judis, a senioreditor with the New Republic, then clariies international currency by examining agreements rom the Bretton Woods

conerence in 1944 to the present-day negotiations among nations.

Charles Geisst, a inancial historian, writes that improved computing, 24/7 trading around the globe, and the ease

o trading contributed to the problem. Customers were able to obtain executions or their stock trades with a speed

unimaginable in the mid-1990s. The volumes and the appetite or transactions appeared endless. Once asset values

began to collapse, the banking and insurance crises occurred within months.

Famed investor George Soros contends that regulation is necessary to limit the growth o asset bubbles. But Soros

also warns against going too ar: Regulations should be kept to the minimum necessary to maintain stability. Law

proessor Joel Trachtman seconds the call or more regulation as well as improved corporate governance. In conclusion,

economics proessor Richard Vedder describes the history o various international trade agreements and organizationsand their role today.

There is no shortage in the world o experts with opinions about the causes o the current crisis and prescriptions

or getting out o it, and its true that a dierent group o experts might well oer a dierent set o views rom those

presented here. What is surprising, perhaps, is how oten certain common ideas emerge in these articles: that the nature

o markets is cyclical, that global trade relationships are interdependent, and that a modicum o market regulation is a

good thing.

The Editors

About This Issue

At a meeting in the White House with his economic adviser s, President Barack Obama speaks

to the press on April 10, 2009.

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eJournaluSa 2

U.S. DEPARTMENT OF STATE / MAy 2009/ VOLUME 14 / NUMBER 5

http://www.america.gov/publications/ejournalusa.html

The Global Financial System:Six Experts Look at the Crisis

Overview

The End of American Capitalism?Mark Twain, Lake Wobegon, andthe Current CrisisMarkBlyth, Professorof InternatIonal

PolItIcal econoMy, Brown UnIversIty

While the type o inancial crisis we ace today isunprecedented, crises o capitalism are not. Theyare commonplace.

International Issues

Debt Man WalkingJohn B. JUdIs, senIoredItor, Thenew

republic

Economists know the atal law in ourinternational monetary system but they cant

agree on how to ix it.

Globalization and the U.S. FinancialSystemcharles r. GeIsst, Professorof fInance,

Manhattan colleGe

Globalization helped uel the current inancialcrisis, and it will undoubtedly be employed tohelp resolve it.

Sidebar: Moving Forward on theEconomyU.S. leaders look ahead.

Timeline of Financial Asset Bubbles

The Role of Regulation

Revise Regulation: The Theory ofMarket Equilibrium Is WrongGeorGe soros, chaIrMan, soros fUnd

ManaGeMent

While international regulation must bestrengthened or the global inancial system tosurvive, we must also beware o going too ar.Markets are imperect, but regulations are evenmore so.

Global Financial Trouble: Causes,Cures, ResponsesJoel P. trachtMan, Professorof

InternatIonal law, tUfts UnIversIty

No doubt, economic historians will argue oryears to come about the causes o the globalinancial crisis. The primary causal actor wasmacroeconomic, but appropriate regulation mighthave averted or ameliorated the crisis.

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eJournaluSa 3

A Historic Look at InternationalTrade

The Evolving Global Financial SystemrIchard vedder, dIstInGUIshed Professorof

econoMIcs, ohIo UnIversIty

During the late 19th and early 20th centuries, therewas little coordination o international inances. Thatchanged substantially ater World War II, and thechange is continuing today.

Additional Resources

Glossary

Books, Articles, Reports, Web Sites, andVideos Related to the Global Economy

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eJournaluSa 4

While the tpe o inancial crisis we ace toda isunprecedented, crises o capitalism are not. The arecommonplace.

Mark Blth is proessor o international political

econom at Brown Universit. He is the author oGreatTransormations: Economic Ideas and Political Change inthe Twentieth Century.

I you draw what statisticians call a time series o thereturns to the U.S. banking sector rom 1947 to 2008,it is possible to talk with some conidence about

the average rate o proitability o the sector over time,the peaks (1990s to mid-2000s), the troughs (1947 to

1967), and the sharp growth o the sectors proitabilityover the past 10 years. I you then add in the data or theperiod between August 2008 and April 2009, the entireseries, like the banking system it describes, simply blowsup. Averages, means, variances, and the like dissolve,so extreme have been recent events. Indeed, when theormer chairman o the U.S. Federal Reserve Bank, AlanGreenspan, admits that his understanding o marketprocesses was deeply lawed, and when the currentchairman, Ben Bernanke, says that we ace the greatest

The End of American Capitalism? Mark

Twain, Lake Wobegon, and the Current CrisisMark Blyth

President Barack Obama speaks at the G-20 Summit in London, April 2, 2009.

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eJournaluSa 5

crisis since the Great Depression, we should probably takeit seriously.

And serious it is. With a grossly diminished $1.3trillion in assets and as much as $3.6 trillion in liabilities,coupled with a halving o the stock market, the U.S.inancial system is either severely stressed, insolvent, or,worse still according to some, at the end o its tether. Theend o capitalism has been declared many times beore.And yet, to paraphrase American writer and humoristMark Twain, reports o its death have been greatlyexaggerated.

The U.S. capitalism that will emerge rom thiscrisis will be dierent rom the highly inancializedconsumption-driven and trade-imbalanced version thatwe developed over the past two decades. It already haschanged insoar as Wall Street proper no longer exists.But what people tend to orget is that we have beenhere beore. While the type o crisis we ace today isunprecedented, crises o capitalism are not: They arecommonplace. Its just that this one has hit the UnitedStates rather than another region o the world. But wehave been here beore and have survived, mainly becausethe present is not a copy o the past. Remembering this

tempers the expectation that U.S. capitalism has run itscourse.

The Lake Wobegon ProbLem(Whereeveryoneisaboveaverage)

While there are surely many plausible candidates ranging rom the bonus culture o banks to Chinesesavings and German parsimony to blame or the crisis,ocusing on the immediate present may mask a deeper set

o causes. Putting this crisis in proper perspective requiresthat we begin almost 30 years ago with the unexpectedmarriage o unlimited liquidity and limited asset classes.

Six processes came together to get us where we are today.First, beginning in the 1980s, the worlds major

inancial centers deregulated their domestic creditmarkets and opened up their inancial accounts. Thisglobalization o inance resulted in a spectacular growthin available liquidity as previously isolated markets becameintertwined. Second, this liquidity was given a huge boostwith the growth o new inancial instruments, particularlytechniques o securitization and the increasing use ocredit derivatives. Third, given this growth o globalliquidity, long- and short-term interest rates began to allprecipitously. In 1991 the U.S. prime and ederal unds

rates (and thus global interest rates) began their longdecline out o double igures to historic lows.

Fourth, given these changes, the commercialbanking sectors o these now inance-driven economiesbecame increasingly concentrated. Available bank creditskyrocketed at the same time as the privatization o ormerstate responsibilities, especially in pensions, encouragedthe growth o large non-bank institutional investors, allseeking above-average returns since their jobs dependedupon beating some benchmark average, usually the annualreturn o the Standard & Poors 500 or an index o theirsectors perormance.

Fith, the U.S. current account deicit climbedto historically unprecedented proportions o the grossdomestic product. The United States was eectivelyborrowing between 3 and 6 percent o GDP each year ormore than 20 years, and borrowing at such low interestrates seemed to make money ree given the growth ratesthat we grew accustomed to.

Sixth, and perhaps what acilitated all o the above,was a deep seated ideological change that took placein the United States between 1970 and 2000. Namely,markets came to be seen by politicians, pundits, and

the public as sel-regulating wonders that could produceever higher risk-ree returns i only the states blunderingand ineicient regulations could be swept away, whichthey were by obliging politicians o both parties. Add allthis together and you have a inancial sector that is bothdependent on continually inding above-average returnsat the same time as it becomes an increasingly large andimportant part o U.S. gross domestic product.

Federal Reserve Chairman Ben Bernanke testifes beore the U.S. Congress.APImages


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eJournaluSa 6

The LimiTsof Lake Wobegon

The problem with chasing a moving average is that itcontinually gets bid upwards. Here we run into a problemo asset classes: the limited number o categories o assetsrom which investors can seek above-average returns.There are only a ew such classes around: equities (stock),cash (money market), and ixed income (bonds), to whichone can add real estate and commodities. I equities,bonds, and money market instruments are regarded as

reciprocal investments within a class, then stock markets,relatively underpriced in the early 1990s, became theobvious place to go or such returns. The massive volumeo liquidity in its search or above-average returns irstlooded U.S. equity markets and quickly thereater hitglobal stock markets during the middle to late 1990s.

Once that particular bubble burst, most spectacularlyin East Asia, neither bonds nor ixed income alone wouldprovide the above-average returns that the markets and all o us who depended on them now expected.

The next stop or investors was thereore the ill-ateddot-com bubble, and thereater the next most obviousasset class, real estate hence, the global housing boom,which began just as the dot-com bubble popped in thelate 1990s. By 2008 this housing bubble had run outo (good) borrowers, in part owing to Federal ReserveChairman Greenspans raising o interest rates in themid-2000s. The result o looking or a new return wasthat the remaining class o assets, commodities, becamethe next bubble, with oil quadrupling in price and basic

oodstus rising between 40 and 70 percent in a little overa year. However, with the exception o oil, these were small

markets, too small to sustain such volumes o liquidity,

and these bubbles burst quickly. The commodity market

collapse combined with losses in the subprime sector o the

mortgage derivatives market triggered the current crisis.

Although it is reerred to as the subprime crisis,

it is perhaps better described as a subprime trigger or a

systemic crisis caused when all these actors came together

through inancial actors risk management practices. While

Container ships with imports rom Asian countries are unloaded at New Jersey docks.APImages


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eJournaluSa 7

banks and other inancial irms have sophisticated models

or managing their various risks (credit, liquidity, and the

like), those same technologies can create instabilities in

markets by either blinding their users to tail risks, which

causes a channeling o risk into common portolios across

asset classes as everyone hedges the same way, or by linking

assets together in a search or liquidity as positions are

unwound as banks de-leverage. So what is rational or one

bank can create systemic risk or all banks as asset positions

become serially correlated on the upside and the downside

o the bubble.

Once the entire banking system had loaded up on

mortgage derivatives and credit deault swaps, the crisis

was just waiting to happen. It came when losses at several

major U.S. banks triggered the all o Lehman Brothers,

which in turn caused massive losses in systemically linkedmarkets, particularly the massive credit deault swaps

market. Liquidity dried up, and the crisis had begun. How

it unolds rom here is really anyones guess, but does this

mark the end o American capitalism? There are several

reasons to think that this is not the case, and that Mark

Twains injunction still stands.

markTWainand ThreereasonsTo be hoPefuL

It is worth noting that whileFederal Reserve Chairman Bernanke

said that we aced the greatest crisis

since the Great Depression, he did

not say that we ace a crisis as big

as the Great Depression. Twenty

to 40 percent unemployment, a

collapse o world trade, ruinous

competitive currency devaluations,

absurd tari levels, and the collapse

o democracy were the reality o the

Great Depression across the world.

We ace challenging times in thecurrent crisis, and there is always

the possibility that things could

get much worse, but things are

nowhere near this severe. This gives

me reason or optimism regarding

Twains observation, mainly because

there is a huge dierence between

the world o the 1930s and the world that we live in today.

Times arrow means that we always live it orward, such

that the conditions o the present are never the same as

the conditions o the past. Three o those conditions that

pertain today and that are dierent rom those o the 1930s

give us the opportunity to avoid the mistakes o the past.

The irst lesson learned is that lessons can be learned.

We are not doomed to repeat the 1930s precisely because

we can relect upon how bad the 1930s were and how

actions taken to protect ourselves individually in this

period made us all worse o collectively. Those lessons

learned made states across the world build automatic

stabilizers into their economies in order to stave o

collapses in consumption that would lead to protectionist

and nationalist demands in the event o an external crisis,

and to rely on multilateral cooperation to orestall obviouspolicy errors. One can legitimately argue that dierentcountries learn dierent lessons. Hence, the Germansare worried about the inlationary consequences o thespending the Americans want the Europeans to undertaketo avoid the unemployment that the Americans ear.But the point o meetings such as the G-20 is to airthose dierences and ind room or policy agreements.The question is one o balance between stimulus andregulation, and both sides o the Atlantic know that they

On Black Friday in 1929, investors watch the chalkboard as stock values plummet.

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eJournaluSa 8

need to ind common ground to move orward.My second reason or optimism derives rom the

new MAD. During the Cold War, we spoke o mutually

assured destruction, in which the United States and theSoviet Union had so many nuclear weapons that one sidecould not destroy the other without destroying itsel. Swapmutually or monetarily and you get the new MAD monetarily assured destruction which exists betweenChina and the United States. One consequence o theinancialization o the U.S. economy was that we managedto get China to swap real goods or paper, and a terriblerate o return on holding the paper, or more than 20years, in the course o which the Chinese (and other EastAsian economies) built up astonishingly large trade andcurrent account surpluses. Essentially, without anyone ever

making such a wager ormally, the United States made aone-way bet that we could run our economy on inance ina global division o labor in which China made the goodsin return or dollars that would be lent back to us so wecould consume their products. That system has also cometo an end. China needs to consume more and the UnitedStates needs to produce something besides mortgagederivatives, and both sides know this. Getting therewill be painul, but the alternative, monetarily assureddestruction, where the dollar is dumped and the exchangescollapse, is another individually rational and collectivelydisastrous policy that all parties know, this time around, toavoid.

Third, another ideology has ailed. The beliethat markets are uniquely good and sel-regulatingentities, while states are always and everywhere bad and

overregulating monstrosities, is a recurring nightmare inthe history o capitalism. The 1930s taught us that thisbelie in markets and sel-regulation was allacious and

gave us the Keynesian era o regulated inance and welarestates. The 1970s, the other crisis period o the 20thcentury, taught us that Keynes was wrong and that openmarkets and unregulated inance were the way to go. Thatsystem, what might be called neoliberal globalization, wasthe system that just blew up. So what will be the lessonlearned this time?

The lesson still to be ully learned rom this crisisis that markets and states are always and everywheremutually overlapping, constitutive, antagonistic, andgenerative. Capitalism as a system thrives best in anenvironment o prudential regulation provided by states,

and U.S. capitalism is no dierent. The precise balancebetween state and market is a political question to bedecided by dierent states. But that there needs to be abalance is something that most states, even the UnitedStates, now accept.

So Mark Twains injunction stands. Reports o thedeath o U.S. capitalism are exaggerated and will likelyremain so as long as we are willing to learn that lessonsrom the past can indeed be learned. n

The opinions expressed in this article do not necessaril reect the views or

policies o the U.S. government.


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eJournaluSa 9

Economists know the atal law in our internationalmonetar sstem but the cant agree on how to ix it.

John B. Judis is a senior editor at theNew Republicand a visiting ellow at the Carnegie Endowment orInternational Peace.

The past ew months have been a crash coursein the abstract and obscure instruments andarrangements that have derailed the worlds

economy. From mortgage-backed securities to creditdeault swaps, the international monetary system is in bigtrouble.

For decades, the United States has relied on atortuous inancial arrangement that knits together its

economy with those o China and Japan. This inormalsystem has allowed Asian countries to run huge exportsurpluses with the United States, while permitting theUnited States to run huge budget deicits without havingto raise interest rates or taxes, and to run huge trade

deicits without abruptly depreciating its currency. Quitea ew bankers, international economists, and high oicialssuch as U.S. Federal Reserve Chairman Ben Bernankethink this inormal system contributed to todays inancialcrisis. Worse, they ear that its breakdown could turn thelooming downturn into something resembling the globaldepression o the 1930s.

The original Bretton Woods system dates rom aconerence at a New Hampshire resort hotel in July 1944.Leading British and American economists blamed the

Debt Man Walking

John B. Judis

In 1944, the United Nations Monetar y and Financial Conerence at Bretton Woods, New Hampshire, decided that the dollar

would replace the British pound as the accepted global currency.

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Great Depression and, to some extent, World War II onthe breakup o the international monetary system in theearly 1930s, and they were determined to create a more

stable arrangement in which the dollar would replace theBritish pound as the accepted global currency.

The dollar became the accepted medium ointernational exchange and a universal reserve currency.I countries accumulated more dollars than they couldpossibly use, they could always exchange them withthe United States or gold. But with the United Statesconsistently running a large trade surplus meaning thatcountries always needed to have dollars on hand to buyAmerican goods there was initially little danger o arun on the U.S. gold depository.

Bretton Woods began to totter during the Vietnam

War, when the United States was sending billions odollars abroad to inance the war and running a tradedeicit, while deicit spending at home sparked inlationin an overheated economy. Countries began trying toswap overvalued dollars or deutschmarks, and Franceand Britain prepared to cash in their excess dollars at FortKnox (the United States gold depository). In response,President Richard Nixon irst closed the gold window andthen demanded that Western Europe and Japan agree tonew exchange rates whereby the dollar would be worthless gold, and the yen and the deutschmark would beworth more, relative to the dollar. That would make U.S.exports cheaper and Japanese and West German importsmore expensive, easing the trade imbalance and stabilizingthe dollar.

By imposing a temporary tari, Nixon succeeded inorcing these countries to revalue, but not in creating anew system o stable exchange rates. Instead, the values othe currencies began to luctuate. And as inlation soaredin the late 1970s, the system, which still relied on thedollar as the universal currency, seemed ready to explodeinto euding currencies.

breTTon Woods ii

Thats when a new monetary arrangement began toemerge. Economists oten reer to it as Bretton WoodsII, but it was not the result o a conerence or concertedagreement among the worlds major economic powers.Instead, it evolved out o a set o individual decisions irst by the United States, Japan, and Saudi Arabia,and later by the United States and other Asian countries,notably China.

Bretton Woods II took shape during PresidentRonald Reagans irst term. To combat inlation, PaulVolcker, then the chairman o the Federal Reserve, jacked

interest rates above 20 percent. That precipitated a steeprecession unemployment exceeded 10 percent in theall o 1982 and large budget deicits as governmentexpenditures grew aster than tax revenues. The value othe dollar also rose as other countries took advantage ohigh U.S. interest rates. That jeopardized U.S. exports,and the U.S. trade deicit grew even larger as Americansbegan importing underpriced goods rom abroad whileoreigners shied away rom newly expensive U.S. products.The Reagan administration aced a no-win situation: Tryreducing the trade deicit by reducing the budget deicit,and youd stile growth; but try stimulating the economy

by increasing the deicit, and youd have to keep interestrates high in order to sell an adequate amount o Treasurydebt, which would also stile growth. At that point, Japan,along with Saudi Arabia and other OPEC (Organizationo Petroleum Exporting Countries) nations, came to therescue.

At the end o World War II, Japan had adopted astrategy o economic growth that sacriiced domesticconsumption in order to accumulate surpluses thatit could invest in export industries initially labor-intensive industries such as textiles, but later capital-intensive industries such as automobiles and steel. Thisexport-led approach was helped in the 1960s by anundervalued yen, but, ater the collapse o Bretton Woods,Japan was threatened by a cheaper dollar. To keep exportshigh, Japan intentionally held down the yens value bycareully controlling the disposition o the dollars it reapedrom its trade surplus with the United States. Instead ousing these to purchase goods or to invest in the Japaneseeconomy or to exchange or yen, it began to recycle themback to the United States by purchasing companies, realestate, and, above all, Treasury debt.

That investment in Treasury bills, bonds, and notes

coupled with similar purchases by the Saudis andother oil producers, who needed to park their petrodollarssomewhere reed the United States rom its economicquandary. With Japans purchases, the United Stateswould not have to keep interest rates high in order toattract buyers to Treasury securities, and it wouldnthave to raise taxes in order to reduce the deicit. As aras historians know, Japanese and American leaders neverexplicitly agreed that Tokyo would inance the U.S. deicitor that Washington would allow Japan to maintain an


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undervalued yen and a large trade surplus. But theinormal bargain described brilliantly in R. TaggartMurphys The Weight o the yen became the cornerstoneo a new international economic arrangement.

Over the last 20 years, the basic structure o BrettonWoods II has endured, but new players have entered thegame. As Financial Timescolumnist Martin Wol recountsin his bookFixing Global Finance, Asian countries, led byChina, adopted a version o Japans strategy or export-ledgrowth in the mid-1990s ater the inancial crises thatwracked the continent. They maintained trade surpluseswith the United States. And instead o exchangingtheir dollars or their own currencies or investing theminternally, they, like the Japanese, recycled them intoTreasury bills and other dollar-denominated assets. Thiskept the value o their currencies low in relation to the

dollar and perpetuated the trade surplus by which theyacquired the dollars in the irst place. By June 2008,China held more than $500 billion in U.S. Treasury debt,second only to Japan. East Asias central banks had becomethe post-Bretton Woods equivalent o Fort Knox.

uPsidesand doWnsides

Until recently, there have been clear upsides tothis bargain or the United States: the avoidance o

tax increases, growing wealth at the top o the incomeladder, and preservation o the dollar as the internationalcurrency. Without Bretton Woods II, it is diicult to

imagine the United States being able to wage wars inIraq and Aghanistan while simultaneously cutting taxes.For their part, China and other Asian countries enjoyedalmost a decade ree o inancial crises. And the worldeconomy beneited rom low transaction costs and relativeprice stability rom having a single currency that countriescould use to buy and sell goods.

But there have been downsides to Bretton Woods II.A nation could conceivably blackmail the United Statesby threatening to cash in its dollars. O course, i a nationsuch as China actually began to unload its dollars, itwould jeopardize its own inancial standing as much as it

would jeopardize Americas. But economists Brad Setserand Nouriel Roubini argue that even the implicit threato dumping dollars or o ceasing to purchase them could limit U.S. maneuverability abroad. The ability tosend a sell order that roils markets may not give Chinaa veto over U.S. oreign policy, but it surely does increasethe cost o any U.S. policy that China opposes, theywrite.

In Japan, China, and other Asian countries, there hasalso been a downside to the grand bargain. The surplusdollars gained rom trade with the United States have notbeen used to raise the standard o living, but rather havebeen squirreled away in Treasury securities. Writes MartinWol: China has about 800 million poor people, yetthe country now consumes less than hal o GDP [grossdomestic product] and exports capital to the rest o theworld.

O more immediate concern, Bretton Woods IIcontributed to the current inancial crisis by acilitatingthe low interest rates that ueled the housing bubble.Heres how it happened: In 2001, the United Statessuered a mild recession largely as a result o overcapacityin the telecom and computer industries. The recession

would have been much more severe, but, becauseoreigners were willing to buy Treasury debt, the Bushadministration was able to cut taxes and increase spendingeven as the Federal Reserve lowered interest rates to 1percent. The economy barely recovered over the nextour years. Businesses, still worried about overcapacity,remained reluctant to invest. Instead, they paid downdebt, purchased their own stock, and held cash. Banks andother inancial institutions, wary o the stock market since

At a U.S. Senate hearing in 1945, oreign currency is displayed.

ThomasD.McAvoy/

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the dot-com bubble burst, invested in mortgage-backedsecurities and other derivatives.

The anemic economic recovery was driven by growth

in consumer spending. Real wages actually ell, butconsumers increasingly went into debt, spending morethan they earned. Encouraged by low interest rates along with the new subprime deals consumers boughthouses, driving up their prices. The wealth eect createdby these housing purchases urther sustained consumerdemand and led to a housing bubble. When housingprices began to all, the bubble burst, and consumerdemand and corporate investment ground to a halt. Theinancial panic quickly spread not only rom mortgage-backed securities to other kinds o derivatives, but alsorom the United States to other countries, chiely in

Europe, that had purchased these American inancialproducts.

And thats not all. As American demand or Chineseexports has stopped growing, Chinas economy has begunto suer. China would experience the equivalent o arecession, with repercussions throughout Asia. Moreimportantly or the United States, China would no longerhave the surplus dollars to prop up the market or U.S.Treasury bills.

needed adjusTmenTs

The consequences could be even more dire. In thepast, countries in recession could count on countries withgrowing economies to provide outlets or their exports andinvestments. The hope this time is that economic growthin Asia, and particularly in China, can backstop a U.S.and European recession. China depends on exports to theUnited States, and the United States depends on capitalrom China. I that special economic relationship breaksdown, as it seems to be doing, it could lead to a globalrecession that could morph into the irst depression sincethe 1930s.

Policy makers have to recognize that while BrettonWoods II is not the product o an internationalagreement, it is not a ree-market system that relieson loating currencies, either. Rather, it is sustained byspeciic national policies. The United States has acquiescedin large trade deicits and their eect on the U.S.workorce in exchange or oreign unding o our

budget deicits. And Asia has accepted a lower standard oliving in exchange or export-led growth and a lower risko currency crises.

China, Japan, and other Asian countries eitheron their own or with prodding rom the Obamaadministration will also have to play a part. Indeed,China may have already begun to do so by announcinglast all a $586 billion stimulus plan o public investmentin housing, transportation, and inrastructure. I Chinaplows its trade surplus back into its domestic economy, itwill increase demand or imports and put upward pressureon the yuan, reducing Chinas trade surplus with the West.

This kind o adjustment in which the UnitedStates commits itsel to reducing its trade deicit, andChina, Japan, and other Asian countries move away

rom their strategy o export-led growth is whatmany American policy makers avor. But there is alsogrowing sentiment, particularly in Europe, that beyondthese measures, the worlds leading economies have toagree on a new international monetary system or atleast dramatically reorm the existing one. British PrimeMinister Gordon Brown has explicitly called or a newBretton Woods building a new international inancialarchitecture or the years ahead. Brown would strengthenthe International Monetary Fund so it unctions as anearly warning system and a crisis prevention mechanismor the whole world. He would also have it or a neworganization monitor cross-border inancial transactions.

But adjustments to the dollars role are certainlyneeded. The era o the dollar may not be over, but thespecial conditions under which it reigned during thelast decades are being dashed on the rocks o the currentrecession and inancial crisis. The original Bretton Woodswas the product o deliberate agreement and laid the basisor stable growth. A new Bretton Woods agreement willdepend a good deal on the choices o the internationalcommunity. n

This article is excerpted rom an article o the same title that appeared inThe New Republic, December 3, 2008. Copright 2008 The NewRepublic, LLC.

The opinions expressed in this article do not necessaril reect the views orpolicies o the U.S. government.


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Globalization helped uel the current inancial crisis, and itwill undoubtedl be emploed to help resolve it.

Charles R. Geisst is proessor o inance at ManhattanCollege. His man books includeWall Street:A History, andhe is the editor o theEncyclopedia o American BusinessHistory.

In the decades ollowing World War II, the idea o

globalization became more and more popular whendescribing the uture o the world economy. Some day,markets or all sorts o goods and services would becomeintegrated and the beneits would be clear. The standardo living would be raised everywhere as barriers to trade,production, and capital ell. The goal was noteworthyand has been partially realized. But recently it hit a majorbump in the road.

Globalization has many connotations. Originally,it meant international ease o access. Barriers to trade

and investment eventually would disappear, and theinternational low o goods and services would increase.Free trade and common markets were created to acilitatethe idea. A world without barriers would help distributewealth more evenly rom the wealthy to the poor.

To date, only inancial services have succeeded inbecoming truly global. Fast-moving inancial markets,aided by speed-o-light technology, have swept awaynational boundaries in many cases, making international

investing eortless. Government restrictions have beenremoved in most o the major inancial centers, andoreigners have been encouraged to invest. This hasopened a wide panorama o investment possibilities.

This phenomenon is not new. Since World War II,many governments have loosened restrictions on theircurrencies, and today the oreign exchange market isthe worlds largest, most liquid inancial market, tradingaround the clock. And there is no distinction made in itbecause o those national peculiarities or restrictions or

Globalization and the U.S. Financial System

Charles R. Geisst

Speed-o-light technology makes international investing eortless.

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the major currencies. I governments allow their currenciesto trade reely, as most in developed countries, then adollar or a euro can trade in Hong Kong or Tokyo as easily

as it does in Dubai or New York.

Cross-borderTrading

Other inancial markets quickly ollowed thisprecedent. The government bond markets, corporatebond markets, and the equities markets all started todevelop links based on new and aster technology. Fortyyears ago, Gordon Moore, one o the ounders o sotwaregiant Intel, made his amous prediction (Moores Law)that microchip capacity would double every two years.New, aster chips were able to accommodate an increasing

number o inancial transactions, and beore long thatcapacity spawned even more transactions. Soon, traderswere able to cross markets and national boundaries withan ease that made the supporters o globalization in othersections o the economy jealous. During the same timeperiod, manuacturers had been promoting the idea o theuniversal car, without the same level o success.

Wall Street and the other major inancial centersprospered. Customers were able to obtain executions ortheir stock trades with a speed unimaginable in the mid-1990s. The NYSE (New York Stock Exchange) and theNASDAQ (National Association o Securities DealersAutomated Quotations) abandoned their old method oquoting stock prices in ractions and adopted the decimalsystem. Computers did not like ractions, nor did the oldmethod encourage trading at the speed o light. Customerswere now able to trade via computer in many majormarkets as quickly as in their own home markets. Truecross-border trading was born, making inancial servicesthe envy o other industries that long had dreamed oglobalization.

The results were astonishing. Volume on the NYSEincreased rom a record 2 billion shares in 2001 to a

record 8 billion in 2008. Volume on the oreign exchangemarkets was in the trillion-dollar equivalents on a dailybasis. The various bond markets were issuing more thana trillion worth o new issues annually rather than thebillions recorded in previous record years. The value omergers and acquisitions equally ran into the trillionsannually. The volumes and the appetite or transactionsappeared endless.

a TradiTionaL CyCLe

The U.S. economy traditionally had witnessed long

periods o prosperity beore slowing down substantially,usually brought to a temporary halt by an asset bubblethat inally ran out o hot air. The situation had beenreplayed many times since 1793, when the irst majoreconomic downturn was recorded in New York. Similarproblems were recorded at least eight times until 1929.Each boom was ollowed by a bust, some more severethan others. The post-1929 depression inally ushered inar-reaching reorms o the banking system and securitiesmarkets.

Until 1929, these recessions were called panics. Theterm depression was used once or twice in the early 20th

century, but during the 1930s the term became associatedexclusively with that decade. The traditional cycle is stillin evidence. The recession o 2001 ollowed the dot-combust, and many o the day traders who had employedthe new computer technology retreated to the sidelinesmuch as their orebears had done in the 19th century. Arecession ollowed, temporarily slowing down the appetiteor speculative gains.

The 19th and the 21st centuries had more incommon than might have been imagined. Ater gainingits independence rom Britain, the United States had beendependent on oreign capital or the irst 120 years oits existence. Until World War I, much o the Americaninrastructure and industry had been inanced with oreignmoney, mostly in the orm o bonds. Americans producedmost o the goods and services they needed, but capitalwas always in short supply until the war changed the aceo geopolitics.

The situation remained unchanged until the late1970s, when the position again was reversed. The U.S.household savings ratio declined and oreign capitalpoured into the country. Bonds were the avorite again,but the equities markets also beneitted substantially.

Consumers, accounting or about two-thirds o the U.S.gross domestic product since the 1920s, bought domesticand oreign goods, while oreigners supplied the capitalnecessary to inance the ederal government and manyAmerican industries. The situation persists today, withabout hal the outstanding U.S. Treasury bonds in thehands o the Chinese government alone.


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The morTgage boom

Ater the dot-com bust and the Enron andWorldCom scandals, it appeared that Wall Street was dueto take a breather or lack o new ideas to uel anotherbubble. But it was a combination o cyclical trends thatreappeared and together ueled the greatest short-termboom yet. Globalization, an inlux o oreign capital,and esoteric inancial analytics combined with residentialhousing to produce the most explosive and potentiallydestructive boom/bust cycle ever witnessed inAmerican history.

The recent market bubble was created by the boomin residential housing. Normally, housing ollows stockmarket booms but has not caused them. In the wake othe dot-com bust and the post-September 11 trauma, thesituation became reversed. The home became the centero many investors attention. First-time buyers abounded,and many others clamored to reinance their existingmortgages. The new thing was really an older thingdressed up by modern inance.

This phenomenon was diicult to detect in its earlystages. All o the actors that converged to produce ithad been seen beore. Many were well-known and time-proven methods in inance. Securitization had been usedor several decades by the U.S.-related housing inanceagencies to convert pools o residential mortgages intosecurities that were purchased by investors. This providedeven more available unds or the housing market at a timethat demand was very high ater 2001. The new thing onWall Street became inancing the American Dream

the idea that everyone should own hisor her own home.

Demand or the securitized

bonds proved strong, so strong thatWall Street securities houses begancranking them out at increasingly astspeed. Much o the demand camerom oreign investors centralbanks, banks, sovereign wealthunds, and insurance companies all drawn by their attractive yields.Dollars were being recycled by theseinvestors, especially central banks andthe sovereign wealth unds, rom thecurrent account balances they were

accumulating with the United States.The money let the United States asAmericans purchased imports rom

oreign producers and ound its way back as investments.

viCTimsof TheiroWn suCCess

The mortgage boom began ater 2001, and withina couple o years it was in ull stride. Demand remainedstrong or mortgage-backed securities, and soon subprimemortgages, credit deault swaps, and other exotic collateralbased on derivatives became part o the asset backing. Bythe late summer o 2007, as short-term interest rates roserom historically low levels, cracks began to appear inthis collateral and asset values began to collapse, creatingthe banking and insurance crises within months. In thepast, without the technology, the results would have takenyears.

The boom was aided immeasurably by thederegulation o the U.S. inancial markets in 1999,oicially culminating over two decades o a gradual easingo once stringent rules. The new inancial environment itcreated allowed banks and investment banks to cohabit,

something that had not been allowed since 1933. Whenthey began to share the beneits o deregulation underthe same roo, older ideas o risk management began tocrumble in a greater quest or proit.

The credit market and collateral crisis marks theend o the almost 40-year legacy o the ederally relatedhousing agencies and all o the beneits they providedsince the social legislation passed during the 1960s. WallStreet, the credit markets, and the U.S. housing industryall were victims o their own success when the markets

The housing boom in the Silicon Valley, Caliornia, beore the dot-com asset bubble presaged the

mortgage crisis o 2008.

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collapsed in 2008. Greed, lack o regulatory oversight, andthe sophistication o structured inance, which createdmany o these exotic inancial instruments, all played a

role in the most recent setback or the markets and theeconomy as a whole.

Most importantly, the crisis demonstrates the pitallso deregulation and globalization. Unortunately, theappropriate skepticism that must accompany everyboom has been missing. Globalization helped uel thecrisis and will undoubtedly be employed to help resolveit. Deregulation will be swept aside in avor o morestringent institutional controls on inancial institutions

designed to prevent raud and deceit. It took almost ouryears ater the market crash o 1929 to erect a regulatorystructure to separate dierent types o banks and establish

national securities laws. Moores Law suggests that it willoccur aster this time around. The orces that shapedglobalization will demand it. n


Newspaper headline rom the stock market crash o 1929.

FPG/HultonArchive/GettyImages


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AP Images

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Moving Forward on the econoMy

Barack Obama, President o the United StatesWe must lay a new oundation or growth and prosperity a oundation

built upon fve pillars that will grow our economy and make this new centuryanother American century: new rules or Wall Street that will reward drive andinnovation; new investments in education that will make our workorce moreskilled and competitive; new investments in renewable energy and technologythat will create new jobs and industries; new investments in health care that willcut costs or amilies and businesses; and new savings in our ederal budget thatwill bring down the debt or uture generations.

President Barack Obama, A New Foundation or the Economy, Washington,D.C., April 14, 2009.

http://www.america.gov/st/texttrans-english/2009/April/20090414142247eaias0.3019068.html

Timothy Geithner,Secretary o the TreasuryWe are a strong and resilient country. We came into the current crisis withoutthe authority and tools we needed to contain the damage to the economy romthe fnancial crisis. We are moving to ensure that we are equipped with both inthe uture, and in the process, that we modernize our 20th-century regulatorysystem [to] meet 21st-century fnancial challenges.

Treasury Secretary Timothy Geithner, Hearing beore the House FinancialServices Committee, Washington, D.C., March 26, 2009.

http://www.realclearpolitics.com/articles/2009/03/geithner_announces_regulator.html

Ben Bernanke,Chairman o the Federal ReserveIn sum, the challenge aced by regulators is to strike the right balance: to strive or the higheststandards o consumer protection without eliminating the benefcial eects o responsibleinnovation on consumer choice and access to credit. Our goal should be a fnancial system inwhich innovation leads to higher levels o economic welare or people and communities at allincome levels.

Federal Reserve Board Chairman Ben Bernanke, Financial Innovation and ConsumerProtection, Washington, D.C., April 17, 2009.http://www.realclearpolitics.com/articles/2009/04/17/fnancial_innovation_and_consumer_protection_96048.html


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BUBBLeS and

PUrPorted BUBBLeS

WikimediaCommons

1637 Tulip Mania The Nity Fity American Stocks othe Late 1960s and Early 1970s

Florida Speculative Building Bubble 1926A

PImages

1920s American Economic Bubble

APImages

1840s Railway ManiaM

aryEvansPictureLibrary

1720 Mississippi Company

1720 The South Sea Company

Tulip Mania

At the peak o the Dutchtulip mania in February1637, tulip uturescontracts sold or more

than 10 times the annualincome o a skilledcratsman.

The Nity FityAmerican Stocks

Rising prices o stockshares attracted theattention o investors.Additional investmentprovided buoyancy to theprice, regardless o the

true value o the asset.

Florida SpeculativeBuilding Bubble

Floridas irst real estatebubble was based onoutside speculators, easycredit access or buyers,and rapidly appreciatingproperty values orFlorida swampland.

American EconomicBubble o the 1920s

Americans overextendedthemselves to takeadvantage o the soaringstock market andexpanding credit. When

the Federal Reserveraised interest rates, thestock market crashed and

the bank panics began.

Railway Mania

During the BritishRailway Mania o

the 1840s, the newlyemerging middle classinvested their savingsin prospective railwaycompanies; many o

those lost everythingwhen the bubblecollapsed.

A

n economic bubble can occur when the price o an assetrises ar higher than the item is actually worth. Theassumption is that the next buyer will pay an even higher

price or the asset. Bubbles can be triggered by inexplicablephenomena (ads or crazes), or kindled by the manipulative actionso individuals or corporations.


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Real Estate Bubble

1997 Asian Financial Crisis

1995 - 2001The Dot-Com Bubble

APImages/MarkD.P

hillips

1980s Japanese Asset Price Bubble

Sports Cards and Comic Booksin the 1980s and Early 1990s

Spider Man

The comic bookspeculator marketreached a saturationpoint in the early 1990sand inally collapsedbetween 1993 and1997.

Beanie Babies

Stued animal BeanieBaby toys were a craze in

the early 1990s. Scarcitycreated increased demandand higher and higherprices..

Asian FinancialCrisis

Large quantities ocredit became available,creating a housing boomand pushing asset prices

to an unsustainable level.

Dot-Com Bubble

The dot-com bubbleo the late 1990s wasbased on speculativeactivity arising rom thedevelopment o new

technologies.

A

PPhoto/JohnL.R

ussell

Beanie Babies 1996

Images.com/CORBIS


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eJournaluSa 20

While international regulation must be strengthened or theglobal inancial sstem to survive, we must also beware ogoing too ar. Markets are imperect, but regulations are evenmore so.

George Soros is chairman o Soros Fund Managementand ounder o the Open Societ Institute. He is the author

o nine books, including, most recentl, The New Paradigmor Financial Markets: The Crisis o 2008 and What ItMeans.

We are in the midst o the worst inancial crisissince the 1930s. The salient eature o thecrisis is that it was not caused by some external

shock such as the Organization o Petroleum ExportingCountries raising the price o oil. It was generated by the

inancial system itsel. This act a deect inherent inthe system contradicts the generally accepted theorythat inancial markets tend toward equilibrium, anddeviations rom the equilibrium occur either in a randommanner or are caused by some sudden external event towhich markets have diiculty in adjusting. The current

approach to market regulation has been based on thistheory, but the severity and amplitude o the crisis provesconvincingly that there is something undamentally wrongwith it.

I have developed an alternative theory that holds thatinancial markets do not relect the underlying conditionsaccurately. They provide a picture that is always biased ordistorted in some way or another. More importantly, thedistorted views held by market participants and expressedin market prices can, under certain circumstances, aect

Revise Regulation: The Theory of Market

Equilibrium Is WrongGeorge Soros

A Chinese investor reacts as he watches the real-time display o the Shanghai Composite Index in September 2008.

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the so-called undamentals that market prices are supposedto relect.

I call this two-way circular connection between

market prices and the underlying reality relexivity. Icontend that inancial markets are always relexive, and onoccasion they can veer quite ar away rom the so-calledequilibrium. In other words, inancial markets are proneto producing bubbles.

The rooTsofThe Crisis

The current crisis originated in the subprimemortgage market. The bursting o the U.S. housingbubble acted as a detonator that exploded a much largersuper-bubble that started developing in the 1980s, when

market undamentalism became the dominant creed. Thatcreed led to deregulation, globalization, and inancialinnovations based on the alse assumption that marketstend toward equilibrium.

The house o cards has now collapsed. With thebankruptcy o Lehman Brothers in September 2008,the inconceivable happened. The inancial system wentinto cardiac arrest. It was immediately put on artiicialrespiration: The authorities in the developed worldeectively guaranteed that no other important institutionwould be allowed to ail.

But countries at the periphery o the global inancialsystem could not provide equally credible guarantees.This precipitated capital light rom countries in EasternEurope, Asia, and Latin America. All currencies ell against

the dollar and the yen. Commodity prices dropped like astone, and interest rates in emerging markets soared.

The race to save the international inancial system

is still in progress. Even i it is successul, consumers,investors, and businesses are undergoing a traumaticexperience whose ull impact is yet to be elt. A deeprecession is inevitable, and the possibility o a depressioncannot be ruled out.

CounTerbaLanCingThe markeTs

So what is to be done?Because inancial markets are prone to creating

asset bubbles, regulators must accept responsibilityor preventing them rom growing too big. Until

now, inancial authorities have explicitly rejected thatresponsibility.

O course, it is impossible to prevent bubblesrom orming, but it should be possible to keep themwithin tolerable bounds. This cannot be done simply bycontrolling the money supply. Regulators must also takeinto account credit conditions, because money and creditdo not move in lockstep. Markets have moods and biasesthat need to be counterbalanced. To control credit asdistinct rom money, additional tools must be employed or, more accurately, reactivated, since they wereused in the 1950s and 1960s. I reer to varying marginrequirements and the minimal capital requirements obanks.

Todays sophisticated inancial engineering can renderthe calculation o margin and capitalrequirements extremely diicult,i not impossible. Thereore, newinancial products must be registeredand approved by the appropriateauthorities beore being sold.

Counterbalancing the mood othe market requires judgment, and

because regulators are human, theyare bound to get it wrong. They havethe advantage, however, o gettingeedback rom the market, whichshould enable them to correct theirmistakes. I a tightening o margin andminimum capital requirements doesnot delate a bubble, regulators cantighten some more. But the process isnot oolproo, because markets can alsoIn New Yorks Times Square, fnancial news is displayed on the news ticker in September 2008.

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be wrong. The search or the optimum equilibrium is anever-ending process o trial and error.

This cat-and-mouse game between regulators andmarket participants is already ongoing, but its true naturehas not yet been acknowledged. Alan Greenspan, theormer U.S. Federal Reserve Bank chairman, was a mastero manipulation with his Delphic utterances, but insteado acknowledging what he was doing, he pretended thathe was merely a passive observer. That is why asset bubblescould grow so large during his tenure.

The imf: a neWmission

Because inancial markets are global, regulations mustalso be international in scope. In the current situation, theInternational Monetary Fund (IMF) has a new mission in

lie: to protect the periphery countries against the eectso storms that originate at the center, namely, the UnitedStates.

The U.S. consumercan no longer serve asthe motor o the world

economy. To avoid a globaldepression, other countriesmust also stimulate theirdomestic economies. Butperiphery countries withoutlarge export surpluses arenot in a position to employcountercyclical policies. It isup to the IMF to ind waysto inance countercyclicaliscal deicits. This couldbe done partly by enlisting

sovereign wealth unds andpartly by issuing SpecialDrawing Rights so thatrich countries that can

inance their own iscaldeicits could cede to poorercountries that cannot.

While international regulation must be strengthenedor the global inancial system to survive, we must alsobeware o going too ar. Markets are imperect, butregulations are even more so. Regulators are not onlyhuman; they are also bureaucratic and subject to politicalinluences. Regulations should be kept to the minimumnecessary to maintain stability. n

The Daily Starpublishes this commentar in collaboration with ProjectSndicate copright 2008, The Dail Star. All rights reserved.http://www.dailstar.com


As global demand or expor ts slowed, the Chinese pushed orward a stimulus package to increase domestic

spending or goods.

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No doubt, economic historians will argue or ears to comeabout the causes o the global inancial crisis. The primarcausal actor was macroeconomic, but appropriate regulationmight have averted or ameliorated the crisis.

Joel P. Trachtman is proessor o international law atthe Fletcher School o Law and Diplomac, Tuts Universit.

His publications includeThe Economic Structure oInternational LawandInternational Law and Politics.

The global inancial crisis has eclipsed Iraq,Aghanistan, North Korea, and other crises as atopic o concern making these critical threats

to global stability seem modest by comparison. Eveni our perception is myopic and too greatly ocused onour pocketbooks, the global inancial crisis is signiicant,

and it has spread to many places around the world. Inorder to address the current crisis and to prevent uturecrises i, indeed, that is possible it is necessary tounderstand what caused this crisis. Diagnosis is not easybecause this crisis was caused by a complex interaction omacroeconomic mismanagement, incomplete inancial

regulation, and deective corporate governance. For thesame reason, prevention o uture crises is not a simplematter.

The inancial crisis began in the United States witha housing price bubble and risky mortgages. Mortgagesseemed like solid investments while housing pricesrose, but looked much less attractive as housing pricesdeclined. And this decline ed on itsel, as reducedwillingness to lend and oreclosures on mortgages causedurther reductions in home prices. Many o the original

Global Financial Trouble:

Causes, Cures, ResponsesJoel P. Trachtman

A currency trader at the Korea Exchange Bank in Seoul, South Korea, April 9, 2009.APImages


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mortgages were securitized, and banks and other inancialinstitutions, as well as investors, eagerly purchased andtraded the resulting securities in their never-endingsearch or high-yielding investments. But the holders othese securities ound that their value declined sharply.For inancial institutions, the losses on these securitiesimpaired their capital and their ability to do business.This reduced their ability to inance businesses, resultingin a substantial depressing eect on the real economy. Thecredit reeze is only now showing signs o thawing.

While the crisis began in the United States, it is nowglobal. It became global because the inancial system isglobal, and the inancial institutions that engaged in thesubprime mortgage business in the United States includedboth U.S. multinationals and oreign multinationals.In addition, some oreign inancial institutions didsimilar businesses abroad, emulating the U.S. domesticexperience. Financial contagion meant that as the irst,mostly U.S., inancial institutions were threatened withailure, their counterparts around the world were also

threatened. Finally, economic contagion through trade andinvestment has brought a sharp reduction in exports to theUnited States and in investment abroad rom the UnitedStates.

The Causes

No doubt, economic historians will argue or years tocome about the causes o the global inancial crisis. Theprimary causal actor was macroeconomic, but appropriateregulation might have averted or ameliorated the crisis.

Low interest rates in the United States, Japan, andelsewhere, Chinas exchange rate policies, and the growtho oil wealth and other wealth in sovereign wealth

unds all contributed to excess liquidity, which in turncontributed to the development o an asset bubble. Therewas a lot o cheap money around, and it needed to bereinvested. Not only that, but because there was a lot ocheap money, investors were constantly seeking increasedreturns. Those who promised them higher returns couldcommand great ollowings and ees.

Much o this excess liquidity lowed into U.S.housing. During the run-up to the crisis, U.S. housinghad the characteristics o a classic bubble. Those whoinvested in housing, either as owners or as lenders, lookedlike inancial geniuses. Mortgage lenders could not really

lose money because the value o their collateral wouldcontinue to rise, orgiving lending mistakes. As legendaryinvestor Warren Buett has said, Its only when the tidegoes out that you learn whos been swimming naked.

Mortgage lenders were no longer the traditionallocal savings and loan associations, planning to hold themortgage loans that they originated until maturity. Rather,these loans were packaged into pools and these pools weresecuritized, with individual investors and merchant bankstrading in and investing in these securities. Thereore,the mortgage lenders oten did not take a long-term viewand did not worry about the ability o their borrowersto service their mortgages in a inancial downturn. Theamount o mortgage-backed securities issued skyrocketedbeginning in late 2003. The proit model or manyinancial institutions had changed rom one based oninterest rate spreads to one based on ees and trading. Thischanging business model also brought with it changes incompensation providing bonuses or executives whowere able to produce these ees and trading proits.

Securitization required good pools o loans, accordingto the underwriting requirements speciied, and it alsooten required credit enhancements through insurance

or other backing. These mortgage-backed securities,meeting the requirements speciied by rating agenciessuch as Moodys and Standard & Poors, generally receivedtop credit ratings. The rating agencies competed withone another or business and oten relied on historicalexperience, rather than on orward-looking models thatincluded the possibility o an asset bubble, to determinethe creditworthiness o these pools.

The U.S. regulatory structure may be accused oboth sins o commission and sins o omission. The

The currencies o the United States and China.AP

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Bush administration sought to extend home ownershipto lower-income people through zero-equity lending.Increased capital requirements imposed on U.S.mortgage giants Fannie Mae (Federal National MortgageAssociation) and Freddie Mac (Federal Home LoanMortgage Corporation) opened the home inancingmarket to securitization by other institutions. The Baselcapital requirements provided incentives or securitization,and the expected reduction in capital requirementsrelating to mortgages under Basel II induced U.S. banksto increase their holdings o mortgage-backed securities.Investment banks were permitted to increase theirleverage. All o these regulatory changes may be said tohave been driven by the available liquidity and to haveaccentuated the growth o the mortgage-backed securitiesmarket and o its risks. While individual regulators mayhave seen some o the problems growing, the authoritieslacked the political will to intervene strongly.

The corporate governance o many inancialinstitutions was placed under severe stress by the ee andtrading-based model, the drive to promote businesses that

produced greater proits, the competitive pressure resultingrom other irms risky activities, and the inability todevelop a persuasive model o long-term risk. Underthese circumstances, shareholders, boards o directors,and senior management were unable to assess and curtailthe risk that their institutions absorbed. In congressionaltestimony in October 2008, Alan Greenspan, ormerchairman o the U.S. Federal Reserve Bank, stated thatthose o us who have who looked to the sel-interesto lending institutions to protect shareholders equity

mysel especially are now in a state o shockeddisbelie. This is a stunning indictment o Americancorporate governance: The mechanisms o corporate

governance are insuicient to ensure that executives willmanage in the long-run interests o shareholders, ratherthan in their own short-run interest.

The Cures

Each o the causes o the inancial crisis will meritcareul consideration in order to prevent uture crises.O course, we need to remember that mere retrospectiveprevention o crises like those we have already experienced,such as the French militarys Maginot Line in WorldWar II, will not prevent uture crises. Rather, we must

understand the types o structures that cause crisis, andseek to establish mechanisms to see new crises coming andto restructure our regulation to respond.

First, macroeconomic management must be able toidentiy asset bubbles and to muster the political will torespond. Second, we must be careul to recognize thatregulatory reorms oten have pro-cyclical motivations:accentuating dangerous phenomena. As we engage inregulatory reorm, we must be careul to ask the WarrenBuett question: Will we be seen to be naked whenthe tide goes out? Third, inancial regulation mustbe understood as a special response to the particularincentive incompatibilities o inancial institutions. Wemust recognize that corporate governance alone can beinadequate to restrain short-sighted management. We alsomust recognize that shareholders o inancial institutionsmay themselves have inadequate incentives to ensurethat inancial institutions avoid excess risk: The rest o usmay, through deposit insurance and government bailouts,absorb signiicant components o the risk. This moralhazard oten requires a regulatory response.

required resPonses

Domestic regulation is oten needed when irms donot bear all the risks o their actions or when the peoplewho control irms do not bear all the risks o their actions.Furthermore, international regulation is needed whenstates do not bear all the risks o their regulatory actions.International externalities may occur through contagion:Financial institutions maintain dense international webso interbank relationships, and the ailure o one bankmay hurt others. International externalities may also

Former Fannie Mae chie executives testiy beore U.S. congressional

committees, December 2008.

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occur through regulatory competition: When one statereduces its standards, it may increase the short-termcompetitiveness o its inancial institutions, imposingcompetitive harm on oreign inancial institutions. Finally,a U.S. economic slump has repercussions around theworld through the mechanism o trade and investment.

What kind o international regulatory response isrequired? States must take greater responsibility or thesolvency regulation o their inancial institutions in orderto limit the risk o contagion. It may be appropriate orstates to agree on the scope o this responsibility.

But this will not be enough. Corporate governanceproblems that induce irms to take excessive risk mustbe addressed, either through regulation or through sel-regulation by the inancial industry. An international

regulatory response will be needed to ensure that statesdo not have incentives to reduce regulation in order topromote the competitiveness o their own irms. The Baselcapital regulation was partially motivated by this concern,but much more work needs to be done.

Finally, greater sobriety and humility inmacroeconomic management, and greater attention to theconcerns o other states regarding national macroeconomicmanagement, will be needed in order to avoid theconditions or asset bubbles or other macroeconomic-based crises. n


As homeowners deault on mor tgages, For Sale signs pop up on the street.

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During the late 19th and earl 20th centuries, there waslittle coordination o international inances. That changedsubstantiall ater World War II, and the change is continuing

toda.A specialist in economic histor and public polic,

Richard Vedder is distinguished proessor o economics at OhioUniversit. His books includeOut o Work: Unemploymentand Government in Twentieth-Century AmericaandTheAmerican Economy in Historical Perspective.

T

he prosperity o the world has been immeasurablyenhanced by the growth in international economicrelations trading in goods and services, and

the migration o labor, capital, and ideas across theplanet. The principle o comparative advantage suggeststhat the wealth o nations is enhanced by each countryspecializing in those economic activities or which it haslow opportunity costs. Yet all this economic activity mustbe inanced, and the stability o the world inancial systemis critical to the continued growth in world trade. This iscomplicated by the act that most nations have their owncurrency, and that the rules and regulations governinginancial transactions vary widely between countries.

The Evolving Global Financial System

Richard Vedder

Seamstresses in Mexico sew clothes or the U.S. market.

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During the late 19th and early 20th centuries, therewas little coordination o international inances. Theworlds inancial capital was London, and most major

trading nations were on the gold standard, meaninginancial obligations were settled in currencies redeemablein gold. I a nation used its currencies excessively to buyimports or invest overseas, it lost gold reserves, orcingit to restrict money supply and credit, usually causingdelation. This made the countrys exports more attractiveand imports less desirable, thereby correcting the balance-o-payment imbalance problem. Many scholars believe thesystem worked reasonably well between 1871 and 1914.

World War I involved vastly larger internationalcapital lows than ever beore, as European nations suchas Britain and Germany went deeply in debt, borrowing

heavily rom other nations, especially the United States.The Versailles Treaty (1919) provided or punitivereparation charges against Germany, which then engagedin hyperinlationary policies that severely damaged thatnation economically. An attempt to restore the goldstandard in the 1920s was short-lived: Britain let the ullgold standard permanently in 1931, as did the UnitedStates two years later.

The Great Depression o the 1930s resulted partiallyrom sharply declining international trade caused, inpart, by high taris. Beginning in 1934, however, nationsstarted to reduce ruinous trade barriers, led by theReciprocal Trade Agreements Act in the United States.However, return to normalcy in international inancewas shattered by the outbreak o World War II in 1939,the most costly war ever ought, which disrupted worldtrade and led to international cooperative arrangements toacilitate economic stability and growth.

neWinTernaTionaL insTiTuTions

A large number o major developments between1944 and 1960 prooundly altered the nature o the

international inancial system. Concerned about hugedeiciencies o hard currencies to pay or goods, services,and the reconstruction o war-torn economies, BritainsJohn Maynard Keynes and the United States HarryDexter White successully proposed a new internationalinancial order at the Bretton Woods Conerence in1944. The International Monetary Fund (IMF) and theInternational Bank or Reconstruction and Development(World Bank) were created.

The IMF would help nations with balance-o-payments problems and with diiculties maintainingreserves consistent with agreed upon ixed exchange rates

deined in terms o gold. While the ixed-rate systembroke down ater 1971, the IMF continues with expandedresponsibilities. For example, it has played a key role inaverting or reducing national and regional inancial crises,serving as a lender o last resort to nations in iscal stress.The World Bank originally provided loans to war-torncountries to inance reconstruction, although by the 1950sthe bank had moved to broader lending to inance newdevelopment projects. Although both the IMF and WorldBank are headquartered in Washington, D.C. (givenAmericas prominence as a global inancial power), theseorganizations are truly international in orientation and

control.The most important international organization, the

United Nations, began in San Francisco in 1945. Whilenot ocusing primarily on economic and inancial issues,

The European Central Bank in Frankor t, Germany.

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those issues have been important to U.N. agencies such asUNCTAD (U.N. Conerence on Trade and Development)and UNESCO (U.N. Economic, Social, and CulturalOrganization). The principle o international assistanceto meet inancial strains received a prominent boostwith the Economic Recovery Program (Marshall Plan)o the United States (1948-1952), which provided aid tomany European nations. The Marshall Plan promotedinternational cooperation among the recipients o itsmore than $12 billion in economic assistance in theorm o loans. The Cold War ater 1945 led to neworms o political and economic regional cooperation asa by-product o the creation o two military alliances,NATO (North Atlantic Treaty Organization) and theWarsaw Pact o nations allied with the Soviet Union.

More direct orms o inancial cooperation began,leading to the creation o a system o internationalinancial arrangements. In 1947, the General Agreementon Taris and Trade (GATT) began, which provided

a ramework or a series o negotiations (such as theKennedy Round and the Uruguay Round) that over thenext hal century led to dramatic reductions in barriers tointernational trade, especially in goods and services.

WorLd eConomiCand finanCiaL inTegraTion

The inancial stress o World War II contributedto the hastening o an abrupt decline in colonialism, asliterally dozens o new nations emerged. Most dramatic,

perhaps, was Indias independence in1947, but large parts o Asia and Aricaalso became independent nations in the

next two decades. This greatly acceleratedthe need or international inancialorganizations such as the IMF and WorldBank. Each new nation typically hadto establish a currency that would gainwidespread international acceptance,needed to borrow considerable sumso money rom oreign nations despiteuncertain abilities to repay loans, andoten had to learn to live within the ruleo law and the discipline imposed bymarket conditions. Organizations such

as the IMF and the World Bank becameincreasingly important in acilitatingthese actors.

The move toward world economic/inancial integration was advanced by important newinstitutions, especially in Europe. A European PaymentsUnion was developed in 1950 to acilitate ways o dealingwith the dollar shortage that made international paymentsdiicult. The Organization or Economic Cooperationand Development (OECD) began to collect uniormeconomic inormation on major industrial countries,ultimately including nations in Asia and Latin America aswell as Europe and North America. Most important wasthe Treaty o Rome, signed in 1957, creating the EuropeanEconomic Community (Common Market), which hasgrown rom a six-nation customs union in 1958 to a27-nation group that has integrated much o its economicstructure into todays European Union, including acommon currency covering over hal the area (the euro)and an EU central bank.

The European eort has been duplicated elsewhereon a much smaller scale, with Asian, Arican, and LatinAmerican nations moving to integrate their economies

more regionally. The Asian Development Bank, orexample, is an institution o about 40 nations designedto urther the creation and ree low o capital in oneimportant region o the world (making over $10 billionin loans in 2008), while the North American Free TradeAgreement (NAFTA) o 1994 extended the customs unionapproach to the Americas.

Four urther extensions o the world inancial system are

important. In 1995, the World Trade Organization (WTO)

replaced the GATT, and it was given wide authority to

Workers walk near a container ship in Tianjin Port, China, March 2009.

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enorce international standards relating to trade and cross-

border inancial dealings. The Group o Seven (G-7) was

originally a meeting o the inance ministers o seven leading

industrial nations, but it has expanded numerically, now

encompassing 20 nations (the G-20) that meet regularly

to agree on policies governing international economic and

inancial arrangements. Other, nongovernmental sponsored

conerences, especially in Davos, Switzerland, bring together

corporate and inancial leaders, oten sowing seeds or later

policy reorms. Finally, a number o multilateral tax treaties

have tried to standardize to some extent tax treatment or

those engaged in international activities; recently, small tax-

haven nations have agreed to modiy bank secrecy provisions

to deal with tax evasion.

CoordinaTion is key

The evolving global inancial system has beenboth a cause and a consequence o the rapid growth

in globalization. For most nations, international trade

comprises a larger portion o output than a generation

or two ago. International capital lows have grown

extraordinarily.

Beyond that, institutions

such as the IMF and World

Bank have been critical both

in terms o inancing long-term development needs and

stabilizing shaky inancial

systems. Two noteworthy

examples are the inancial

crises o 1998 beginning in

Asia but ultimately spreading

beyond, especially to Russia,

and the 2008 worldwide crisis

that has caused signiicant

stress to inancial institutions

and economies worldwide. In

both instances, the IMF andWorld Bank made important

inancial inusions in stressed

countries such as Thailand

and Russia. The development

arm o the World Bank makes

sot loans o around $10 billion annually, or example.

Additionally, large-nation central bankers and inance

ministers have met and coordinated the provision o credit

to ease panic and the potential collapse o major banks,

insurance companies, and other inancial institutions.

As international economic and inancial interaction

grows, the need or coordinated rules o behavior becomes

greater than ever uniorm accounting rules, international

standards o permissible conduct, provision or emergency

loans, and the like. No doubt existing institutions will

continue to evolve, perhaps into a new umbrella organization

encompassing all acets o inancial regulation. n


Foreign currency notes are displayed in a commercial area o Karachi, Pakistan, October 2008.

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Bretton WoodsA 1944 conerence held at Bretton Woods, NewHampshire, that designed the structure o theinternational monetary system ater World War II andset up the International Monetary Fund (IMF) and theWorld Bank. It was agreed that the exchange rates o IMFmembers would be pegged to the dollar, with a maximumvariation o 1 percent on either side o the agreed rate.

bubbleA situation that can occur when the price o an asset risesar higher than the item is actually worth. The assumptionis that the next buyer will pay an even higher price orthe asset. Major speculative economic bubbles have beenknown to occur rom time to time, oten with ruinouseects. Sometimes they are triggered by inexplicablephenomena (ads or crazes) or are kindled by themanipulative actions o individuals or corporations.

corporate governanceAn internal company system encompassing policies,processes, and people that serves the needs oshareholders and other stakeholders by directing andcontrolling management activities with good businesssavvy, objectivity, accountability, and integrity. Soundcorporate governance relies on external marketplacecommitment and legislation, plus a healthy board odirectors culture that saeguards policies and processes.

credit debt swapA contract between a protection buyer and a protectionseller. The buyer makes a series o payments to the seller

and, in exchange, receives a payo i the bond or loangoes into deault (is not paid). Credit debt swap contractshave been compared with insurance because the buyerpays a premium and, in return, receives a sum o money ione o certain speciied events occurs.

derivativeA inancial contract whose price is derived romunderlying assets such as stocks, bonds, commodities,currencies, interest rates, and market indexes. Most

derivatives are characterized by high leverage, that is, theinvestor only pays a small amount o the actual cost o thecontract and borrows the rest rom the seller or the broker.

dot-comA company whose operations are Internet-based; itsbusiness model would not be possible i the Internetdid not exist. While dot-com can reer to present-daycompanies, it is also used to reer to companies with this

business model during the late 1990s.

externalityThe side eect o an economic transaction on people whoare not involved in it. A classic negative example is the airpollution produced by a power plant.

Fannie MaeThe Federal National Mortgage Association (FMNA), acongressionally chartered corporation that buys mortgageson the secondary market, pools them, and sells themas mortgage-backed securities to investors on the openmarket. Monthly principal and interest payments areguaranteed by FNMA but not by the U.S. government.

Federal ReserveThe central bank o the United States, which providesthe nation with a sae, lexible, and stable monetary andinancial system.

Freddie MacThe Federal Home Loan Mortgage Corporation(FHLMC), a government-chartered corporation that buys

qualiied mortgage loans rom the inancial institutionsthat originate them, securitizes the loans, and distributesthe securities through the dealer community. Thesecurities are not backed by the U.S. government. Themarket value o these securities prior to maturity is notguaranteed and will luctuate.

Glossary


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G-20Established in 1999, the Group o Twenty inanceministers and central bank governors rom industrialized

and developing economies that meet and discuss key issuesin the global economy.

International Monetary FundAn organization set up in 1944 to lower trade barriersbetween countries and to stabilize currencies bymonitoring the oreign exchange systems o membercountries and lending money to developing nations.

Lake WobegonThe town that time orgot and the decades cannotimprove as described by radio host Garrison Keillor. Over

the past 30 years, Keillor has shared with listeners to theweeklyA Prairie Home Companionthe latest news romthe little ictional town where all the women are strong,all the men are good looking, and all the children areabove average.

liquidityThe ability o an asset to be converted into cash quicklyand without any price discount.

macroeconomicsThe branch o economics

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