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Jane D’Arista

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Jane D’Arista

A dominant role for the dollar in the global economy was inevitable given US economic and financial strength after the Second World War. But the delinking of the dollar from gold in 1971 eliminated constraints on the increase in the use and amount of the key currency and allowed its value to be determined by market forces. Acceptance of a national currency for international payments required other countries to rely on export-led growth to earn that currency and required the US to run trade deficits financed by capital inflows. American growth came to depend on foreign savings that expanded credit and increased debt at home and to residents and governments of other countries. The continuation of this system depends on confidence in America’s ability to maintain the level of growth needed to service its debts to the rest of the world.

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Jane D’Arista

Official foreign exchange reserves are the keystone of the global monetary system. They are created when payments in a key currency are exchanged for local currency by individuals and companies with their country’s central bank. The central bank invests the funds in a key currency country’s debt securities to earn a return. Its reserve holdings create credit for the country in which they are invested and backing for credit generated by the central bank that owns them. Since the majority of foreign exchange reserves are denominated in dollars and constitute an enormous inflow of foreign savings, it would be remarkable if the US had not experienced a run of general prosperity beginning in the 1990s. But the mirror image of the build-up in official and private foreign debt was the immense increase in US private sector indebtedness that set the stage for the crisis.

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Jane D’Arista

Rising volumes of capital flows in the 1990s propelled the external and domestic debt of many countries to historically high levels and coincided with robust rates of economic growth. Developing nations assumed an advancing role in the global economy with developing Asia in the lead. But financial crises had encouraged many of these countries to increase their reserve holdings and, by 2002, emerging economies as a group supplied a larger share of net outflows than the euro area. This shift in the global makeup of capital flows channeled financial resources from the poor to the rich, strengthening US growth rates as it made America the dominant importer of both goods and capital.

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Jane D’Arista

The halting recovery of the US from a brief economic contraction at the beginning of the new millennium cast doubt on assumptions about the benefits of globalization. At a conference in November 2003, Federal Reserve chairman Alan Greenspan addressed concerns about global imbalances but thought they would be defused in time by market forces. By contrast, the June 2003 Annual Report of the Bank for International Settlements anticipated the possibility of a financial crisis and recession and the problems that would be caused by deflation and lagging demand. It endorsed the idea that monetary authorities should adopt unconventional means to provide liquidity when interest rates reach the zero bound, using any financial asset to supplement their balance sheets to contain deflation.

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Jane D’Arista

Crises struck the periphery of the global system in the 1980s. Deregulation and monetary instability left national governments and central banks defenseless in responding to increasingly large international capital flows followed by equally sizable capital outflows; growth in many emerging market countries had come at a heavy cost. Crises for these countries included the “Lost Decade” in Latin America (1982–90), the Mexican crisis of 1994–95, the Asian crisis of 1997–98, and the “Synchronous Downturn” of 2002. Low growth in Latin America was particularly disheartening. NAFTA’s forced opening of the Mexican financial sector to foreign institutions shifted credit flows to export sectors that could borrow and repay in strong currencies, and the fall in domestic credit and in the production of goods and commodities for domestic consumption exacerbated Mexico’s position as a client state tied to its northern neighbor.

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Jane D’Arista

The Federal Reserve’s increases in policy rates in 2004 encouraged speculation as private investors borrowed lower interest rate yen to invest in higher-yielding dollar assets. The build-up in international liquidity continued in 2005 for the fourth consecutive year with an excessive inflow into the US that prompted outflows for investment in higher-yielding emerging market assets. Many emerging economies bought dollar inflows to prevent inflation and falling exchange rates. But by investing these new reserves in dollar assets, they re-exported the problem back to the US and fueled another round of capital outflows that would make the same round-robin trip to emerging markets and back to the US. The search for yield also spurred demand for euro-denominated government debt to back borrowing and for credit derivatives such as credit default obligations to boost returns. In the spring of 2006, the International Monetary Fund and Bank for International Settlements warned that borrowing for speculation had come to dominate cross-border transactions.

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Jane D’Arista

The Federal Reserve’s adherence to free market ideology contributed to its failure to recognize that changes in the structure of financial markets and the role of banks had weakened its ability to implement countercyclical monetary policy. Allowing reserve requirements to wither as a policy tool, it lost influence over the supply of credit and its reliance on interest rates to influence demand became increasingly counterproductive as rising rates increased capital inflows and falling rates triggered outflows. The loss of influence over the supply of credit resulted in a rise in the total debt of all US borrowers from $5 trillion in 1982 to $25 trillion at the end of the 1990s. But the debt bubble continued to grow and reached 352.6 percent of GDP at the end of 2007 — a clear signal that the economy could no longer generate sufficient income to service debt.

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Jane D’Arista

The household, business, and financial sectors posted dramatic increases in debt in the decade before the crisis. Rising mortgage borrowing and the use of home equity loans fed a housing bubble that eroded households’ disposable income while a decline in saving and higher debt lowered their net worth. Business borrowing surged as corporations issued bonds to finance stock buy-backs, replacing equity with debt as they had in the 1980s. The debt of the financial sector rose by 222 percent from 1990 to 2000 and rose further in the years before the crisis. Explosive growth in security repurchase agreements financed banks’ leveraged speculation, mortgage activity by the government-sponsored agencies (GSEs), and the proliferation of other asset-based securities issuers. The shift in foreign investments from a dwindling supply of low-yield US treasuries to higher-yielding GSE securities also channeled credit to housing.

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Jane D’Arista

The multifaceted risks embedded in the debt bubble and housing boom raised questions about the role of central banks in targeting asset prices. Chairman Greenspan argued that such efforts would be ineffectual and, on the subject of rising debt, he argued that low interest rates made it possible for households to carry more debt. The Fed did not address evidence that, as household debt continued to rise in the five years before the crisis, high-income families were less affected while families with less wealth and rising debt-service payments became more vulnerable. In addition, the Fed continued to ignore the degree to which the availability of US credit depended on the support of foreign capital inflows.