Causes of the Crisis: Why Debt Is Bad

By James Kwak

Menzie Chinn, one of my favorite bloggers, and Jeffry Frieden have a short and highly readable article up on the causes of the financial crisis. Chinn is not given to ideological ranting and is a great believer in actually looking at data, so I place significant weight in what he says.

Chinn and Frieden place the emphasis on excessive American borrowing, by both the public and private sectors.

This disaster is, in our view, merely the most recent example of a “capital flow cycle,” in which foreign capital floods a country, stimulates an economic boom, encourages financial leveraging and risk taking, and eventually culminates in a crash.

They have little patience for the idea that the financial crisis was the fault of Chinese over-saving:

It is necessary to dispense with the view that all this excess saving from the rest of the world was “forced” upon us. The rest of the world’s capital flowed to us, in part, because we wanted to borrow, and we wanted to borrow because of the Bush administration’s emphasis from 2001 to 2008 on cutting taxes while still spending.

They do endorse as exacerbating factors the low interest rates set by the Federal Reserve earlier this decade, and the growth of a large and unregulated financial sector:

Essentially, the development of an unregulated financial sector has circumvented the entire panoply of banking regulation created in the wake of the Great Depression. This made the financial system vulnerable to traditional “bank panics,” or “runs” on the financial system. The abdication of regulatory oversight (particularly in allowing high leverage) in the presence of too many institutions “too large to fail” meant the buildup of implicit financial liability on the part of the government.

But the overall story is that high borrowing brought in foreign capital; insofar as the borrowing was spent on nontradable goods, such as housing and financial services, necessarily pushing up prices (there is no way for competition from houses in China to keep U.S. housing prices down).

I think it’s hard to argue against the idea that a huge debt-financed bubble was a bad, bad thing. I still think, as you might predict, that the nature of our particular financial system both made the bubble larger than it might otherwise have been, and made its collapse more spectacular than it had to be.

The article is drawn from a book they are working on, which I will be sure to buy.

Comments

[Michael Clark:]

Thanks for the post, Baseline. Interesting read.

Aug 28 02:44 PM

[TinyTim:]

"the nature of our particular financial system both made the bubble larger than it might otherwise have been, and made its collapse more spectacular than it had to be."

James-
Sorry, but your article makes it sound like it's all over.
There's a massive Treasury bubble just waiting to pop right now.

Aug 28 02:57 PM

[Graham and ...:]

This "excess capital flow" to the United States started after (and resulted from) the victory in the Persian Gulf War, and is ending like about now. But that's 17-18 years of excess.

Aug 28 03:29 PM

[jimboy:]

Like a dog going back to a favorite bone the Fed has been forcing interest rates down below market levels at the first sign of financial market distress (creating moral hazard) and when it looks like the wider economy needs pepping up (often failing to raise rates when the pepping has taken effect). This is an excuse for an economic policy which has produced a grotesquely disjointed economy with some sectors bloated (financial, state and health) and some emaciated (industry, infrastructure). The foreign inflows have simply allowed the lunacy to go on and on way past the point where it is correctable without a depression.
That was a rant, sorry.

Aug 28 04:32 PM

[pslater:]

Mr. Kwak, I think it is disingenuous of the authors of the upcoming book you mentioned to ignore the role of Congress in bringing the bubble to life. In many ways they are more culpable than the Fed. I also disagree emphatically with "..because of the Bush administration’s emphasis from 2001 to 2008 on cutting taxes while still spending."

Tax revenues to the govt exploded in the 2003 - 2007 period just as they have every time taxes have been cut in the past. Politicians, as the President's Chief of Staff Rahm Emanuel noted "hate to waste a good crisis (or opportunity)", ramped up the spending in one of their typical porcine binges.

After all, the political class will fall on their swords before they let the myth of Keynesian economic policies be proven. In other words, if revenues go up, spending MUST go up more.

Aug 28 05:02 PM

[rosey99:]

Interesting perspective. In many ways this was indeed a "perfect storm." I am becoming more persuaded that the "Asian savings glut," is in fact just another way of saying "American debt binge." Pettis has a really interesting take on this at:

mpettis.com/2009/08/ye.../

Put this together with lax (non?) regulation, and you might get a trade deficit that is larger than what it otherwise would be, along with a nice bank panic to boot. I think we would have had a genuine credit bubble in any case, perhaps just a smaller and less damaging one, as the Asian savings glut and the American debt binge are really the same thing.

Somewhere, Hyman Minsky is smiling.

Aug 28 05:09 PM

[perceptions...:]

Debt is only one of the factors that have got us here, but it is one of the major factors.

However, there are other & greater factors, which combined to form a once in history, "Perfect Financial Storm".

The eye of this Hurricane is currently passing overhead, but when the government spending stops, which it must, the winds will come back, stronger than before.

That said, It does need to be understood, that debt is not inherently bad, but the way it has been applied & used, in recent times, IS!

Aug 29 08:25 AM

[john s. gordon:]

you seem to have forgotten one of the major causes -
rating agencies gave AAA to FFF garbage. who paid them to do this?
> jack

Aug 29 09:55 AM

[Glen L.:]

I like the hurricane analogy. This is a category 6, we're in the eye, and the FED is FEMA. And it all started with a butterfly flapping its wings somewhere in China.

Aug 29 11:40 AM

[Crocodilian:]

Author writes:
"They have little patience for the idea that the financial crisis was the fault of Chinese over-saving:"
----------------------...

"Fault" is too simple a term here.

There are two sides to every loan: someone who wants to spend more money than he has, and someone who has more money than he wants to spend.

You needed imprudent demand in America _and_ dollars piling up offshore in accounts of exporting nations to blow up the US leverage bubble.

Aug 29 01:04 PM

[BRUCE E. W.:]

Tracking a "cycle" through a trajectory of expectations; even granting for equasive counterbalance, is teleological and recursive; devoid of contextual complexity and meaningful historical content. There is value in accurate measures but it is not causal but merely contingent.

Aug 29 03:48 PM

[gato:]

James,
Nice.. "puff-piece"...However, a few points on Mr. Chinn. You said Chinn doesn't rant..Well!..o.k.! ..I googled him, and here what I got, which shows (like all of us) every one's got an agenda:
"I think Sarah Palin is so stupid that I can't even articulate why" · said University of Wisconsin professor ...Hmmm? Looks like a rant to me, even though I agree.
My main problem with his "Causes for the financial..etc" ('an I read.. "the whole".. the snooze piece..It's old wine in new bottles .nothing that the average joe doesn't know..just plain dull verbiage) And, it is vey apparent that it was not written to inform, only to polish the good professors Bio. (we know, in his line of (Ahemm!) work it's publish or die) which is extensive..check this out (his puffed up description of what "He" did in "one"..(Ykes!).. year!

"In 2000-2001, Professor Chinn served as Senior Staff Economist for International Finance on the Council of Economic Advisers. He is a Research Associate in the International Finance and Macroeconomics Program of the National Bureau of Economic Research, Senior Fellow of University of Wisconsin-Madison Center for the World Affairs and the Global Economy, and on the advisory council of the Institute for International Economics. He has been visiting scholar at the International Monetary Fund, the Congressional Budget Office and the Federal Reserve Board.
His work has been cited in The Economist, Financial Times, Reuters, Wall Street Journal, Business Week, and he has been interviewed on CNBC.(end quote)
("Look ma!..no hands!)
Is this guy full of hot air or what?... gimme a break!
gato

Aug 29 04:48 PM

[John Lounsbury:]

ptater - - -

Although you make some good points, you are off base when you say:

"After all, the political class will fall on their swords before they let the myth of Keynesian economic policies be proven. In other words, if revenues go up, spending MUST go up more."

That can nowhere be inferred from anything Keynes ever said or wrote. It does correctly summarize how a majority of politicians in both parties have behaved for nearly 30 years.

Comment stream has rounded out the discussion nicely. I would add one thing:

If you spend all your money and max out your credit card to throw the party, there is no way to pay for the clean-up.

Aug 29 08:48 PM

[punk_ash:]

You are right on. I skimmed through the article in about 5 minutes and could figure what they want to say. There is no new information in the article.


On Aug 29 04:48 PM gato wrote:

> James,
> Nice.. "puff-piece"...However, a few points on Mr. Chinn. You said
> Chinn doesn't rant..Well!..o.k.! ..I googled him, and here what I
> got, which shows (like all of us) every one's got an agenda:
> "I think Sarah Palin is so stupid that I can't even articulate why"
> · said University of Wisconsin professor ...Hmmm? Looks like a rant
> to me, even though I agree.
> My main problem with his "Causes for the financial..etc" ('an I read..
> "the whole".. the snooze piece..It's old wine in new bottles .nothing
> that the average joe doesn't know..just plain dull verbiage) And,
> it is vey apparent that it was not written to inform, only to polish
> the good professors Bio. (we know, in his line of (Ahemm!) work
> it's publish or die) which is extensive..check this out (his puffed
> up description of what "He" did in "one"..(Ykes!).. year!
>
> "In 2000-2001, Professor Chinn served as Senior Staff Economist for
> International Finance on the Council of Economic Advisers. He is
> a Research Associate in the International Finance and Macroeconomics
> Program of the National Bureau of Economic Research, Senior Fellow
> of University of Wisconsin-Madison Center for the World Affairs and
> the Global Economy, and on the advisory council of the Institute
> for International Economics. He has been visiting scholar at the
> International Monetary Fund, the Congressional Budget Office and
> the Federal Reserve Board.
> His work has been cited in The Economist, Financial Times, Reuters,
> Wall Street Journal, Business Week, and he has been interviewed on
> CNBC.(end quote)
> ("Look ma!..no hands!)
> Is this guy full of hot air or what?... gimme a break!
> gato

Aug 30 04:11 AM