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Jane D’Arista

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Jane D’Arista

The global economy has been shaped by the US dollar’s role as key currency. Other countries rely on export-led growth to earn the dollars they need for cross-border transactions. The resulting US trade deficits are financed by foreign investments in dollar assets that have raised US net debt to the rest of the world to historically high levels relative to GDP. Credit generated by foreign savings also created historically high levels of domestic debt that were an underlying cause of the financial crisis of 2008. The unregulated offshore market compounded the problem by forcing deregulation on national markets and eroding the ability of the US central bank to control the credit supply and prevent the debt bubble. Since the key currency system depends on confidence in US economic strength and growth, ongoing US dependence on foreign savings and debt-fed growth will weaken its economy and undermine confidence in the dollar.

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Jane D’Arista

The shift from a bank-based financial system to a market-based system began with the creation of the unregulated Eurocurrency market in the 1960s. It accommodated the key currency international monetary system by providing foreign exchange and cross-border transactions denominated in currencies outside the borders of the countries that issued them. Institutions’ reliance on borrowing from, lending to, and dealing in derivatives with other financial institutions created a web of interconnectedness in the external market that was first tested by the failure of Franklin National Bank in 1975.

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Jane D’Arista

The expansion of US banks’ involvement in off-balance sheet contingency lending began in the aftermath of the collapse of the commercial paper (CP) market in 1970 when banks charged fees for contracts to lend to CP issuers in the event of another crisis. Their support for the major issuers (finance companies) led to the emergence of an unregulated parallel banking system funded by the primary buyers of their paper (money market mutual funds) that reduced banks’ share of lending to households and businesses and encouraged banks to expand into more sophisticated forms of guarantees such as derivatives. These contingency lending contracts and derivatives positions became known as shadow banking and had already greatly expanded off-balance sheet positions at the large banks in the 1980s.

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Jane D’Arista

Prompted by notable bankruptcies that resulted in the loss of promised pensions, the Employee Retirement Income Security Act (ERISA) of 1974 required companies to back pensions with assets. This requirement increased demand for securities in which plans could invest and initiated a move of household savings from bank deposits to the capital markets — a shift that increased risk for households, lowered their level of protection as bank deposit insurance covered a smaller share of savings, and increased the impact on economic activity of gains and losses in households’ net worth. Those risks intensified as falling asset prices eroded the value of the holdings of defined benefit plans and encouraged their sponsors to transfer potential losses to beneficiaries by switching to defined contribution plans.

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Jane D’Arista

The scale of intervention to shore up a collapsing financial system revealed the problems that had caused the crisis: the interconnectedness of institutions and markets; lack of transparency surrounding institutions, markets, financial activities, and assets; rising leverage and innovations that made institutions more profitable and added more risk. Particularly notable deregulatory actions that compounded these problems included the exemption of mortgage-backed securities from registration, the repeal of Glass-Steagall and authorization of multipurpose financial holding companies. Lack of oversight and failure to acknowledge the changes brought about by pro-cyclical market forces left regulatory authorities unprepared and groping for ways to make the systemic response required when AIG and Lehman Brothers began to fail. They had ignored the dissolution of the old system without creating a coherent framework of regulation and oversight for the system that replaced it.

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Jane D’Arista

Securitization shifted the channel for mortgage finance from an institutional framework to one that melded it into the capital markets and linked it to a growing number of financial sectors. The mortgages banks originated were removed from their balance sheets, pooled, and packaged as backing for securities. Banks saved on capital but, as the market for mortgage-backed securities (MBS) expanded and became the largest US credit market, the absence of capital backing for these securities introduced a higher level of risk that threatened all financial sectors and the net worth of households through MBS investments by pension funds.

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Jane D’Arista

Interconnectedness grew out of reliance on borrowing from and lending to other financial institutions, the primary channel for funding in offshore markets that migrated to the US market in the 1990s and resulted in growth in the financial sector as a share of GDP. Expansion of the market for repurchase agreements (repos) facilitated pyramiding as borrowing backed by one financial asset to buy another pushed up leverage and increased indebtedness within the financial sector. The repo market was the center of the loss of confidence in 2008 as it forced unwinding of positions and led to a run on the financial sector by the financial sector.

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Jane D’Arista

Loss of confidence in financial institutions’ dealings with other financial institutions was exacerbated by lack of transparency in markets for mortgage-backed securities and over-the-counter derivatives contracts for foreign exchange, credit default obligations, and other innovative financial insurance coverage as well as lack of information on off-balance sheet positions of the major dealers in these markets. Absence of information on the size of these markets had obscured the extent to which providing credit insurance had become a larger share of financial transactions than providing credit for economic activity; lack of on-time reporting on prices and the size of transactions led to a freeze in activity in these markets as the crisis emerged.