Causes: Too Much Debt

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.

Originally published at The Baseline Scenario and reproduced here with the author’s permission.

2 Responses to "Causes: Too Much Debt"

  1. Guest   August 28, 2009 at 11:32 am

    Taking a look at the revenue at the federal government level for the period of 1999 to 2007. Did it go up or down? I think you will find the revenue increased greatly! The problem is spending even increased more!!!!!!!!

  2. benfan101   August 30, 2009 at 9:25 pm

    “…and we wanted to borrow because of the Bush administration’s emphasis from 2001 to 2008 on cutting taxes while still spending.”Of course the government has to plan and approve fiscal spending. Bernanke’s Asian Spending Glut Hypothesis is not arguing that Chinese saving forced our Legislative/Executive branch to spend more than the tax revenues. What Bernanke was essentially saying was that there was obviously as much or more demand for our debt than supply because interest rates decreased. The word “forced” refers to the argument that if China kept saving the money they could have been paying their manufacturing employees than America’s unemployment would have increased because Chinese could be more price competitive than the US.Thus, in reality, China “forced” America to decide between two choices that COULD have unhappy endings: higher unemployment or more debt. Chinn and Frieden seem to suggest that if America didn’t have this huge fiscal debt, other economic indicators would look similar to what they have looked like since 1997. But of course every dollar that we don’t borrow has consequences just like every dollar we do borrow has consequences.