o threaten
the entire financial system was required to precipitate the inevitable conglomeratisation.
The other key element in the crisis was the set of policies giving rise to globalimbalances. The Bush Administration cut taxes, causing government dissaving.The Federal Reserve cut interest rates in response to the 2001 recession. All thewhile the financial innovations described above worked to make credit even
cheaper and more widely available to households. This of course is just the story,in another guise, of the subprime, negative-amortization and NINJA mortgagespushed by subsidiaries of the like of Lehman Brothers. The result was increasedU.S. consumer spending and the decline of measured household savings into negativeterritory.
Of equal importance were the rise of China and the decline of investment inmuch of Asia following the 1997–8 crisis. With China saving nearly 50 per cent ofits GNP, all that money had to go somewhere. Much of it went into U.S. Treasuries
and the obligations of Fannie Mae and Freddie Mac. This propped up the dollar.
It reduced the cost of borrowing for U.S. households by, on some estimates, 100
basis points, encouraging them to live beyond their means. It created a morebuoyant market for Freddie and Fannie and other financial institutions creatingclose substitutes for their agency securities, feeding the originate-and-distribute
machine.Again, these were not outright policy mistakes. The emergence of China is agood thing. Lifting a billion Chinese out of poverty is arguably the single mostimportant event in our lifetimes. The fact that the Fed responded quickly to thecollapse of the high-tech bubble prevented the 2001 recession from becomingworse. But there were unintended consequences. Those adverse consequences
were aggravated by the failure of U.S. regulators to tighten capital and lendingstandards when abundant capital inflows combined with loose Fed policies toignite a ferocious credit boom. They were aggravated by the failure of China to
move more quickly to encourage higher domestic spending commensurate with
its higher incomes.
Now we are all paying the price. As financial problems surface, a bloated financial
sector is being forced to retrench. Some cases, like the marriage of BofA and Merrill,
are happier than others, like Lehman. But either way there will be downsizing and
consolidation. Foreign central banks like China’s are suffering immense capital losses
for their unthinking investment. As the People’s Bank and other foreign central
banks absorb their losses on U.S. Treasury and agency securities, capital flows toward
the United States will diminish. The U.S. current account deficit and Asian surplus
will shrink. U.S. households will have to begin saving again. All this is of a piece.
216 The First Global Financial Crisis of the 21st Century Part II
The one anomaly is that the dollar has strengthened in recent weeks against
pretty much every currency out there. (The one exception is the yen, which is
being supported by Mrs. Watanabe keeping more of her money at home.) With
the U.S. no longer viewed as a supplier of high-quality financial assets and the
appetite of foreign central banks for U.S. treasury and agency securities falling off,
one would expect the dollar to weaken. The dollar’s strength reflects the reflex
action of investors rushing into U.S. treasuries as a safe haven. It is worth recalling
that t
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