Understanding today’s
crisis
Prof. Wood – Oct. 18, 2012
Let’s think about…
 How a market economy is supposed to work, then
 What’s not working now
 and what’s especially difficult about today’s situation
Basics of an economy…
 People buy and sell from each other
 People who have good reason to spend more today than
they have borrow from those with more than they need
 They rely on being paid back
Governments create money
through Central Banks
 To guard against politicians creating too much money
just before elections, Central Banks usually have
independence from politicians
 If they create money too freely, “easy money” can
 lead to inflation
 make manipulations of the economic system easier
 Example: mortgage fraud in U.S. in 2007
If everybody decides the
banks are not trustworthy…
 everybody will want to take their money out
 The banks have to stop making loans
 There’s a panic
This has happened twice in
the last 5 years
 Banks lent for houses and derivatives based on house
loans in US and other countries 2004-2007
 Fraudulent loans became easy to make
 Institutions throughout the system bought bonds based
on the loans
 Banks lent to countries in Europe throughout the
2000s
 Greece and Iceland certainly, and probably other
countries, borrowed and spent far more than could be
justified
 Banks and countries faced panic from 2010
Panics have happened many
times in the past
 But they’ve never happened as frequently as in the last
15 years
What’s going on?
 Sources of new growth (the Internet, emerging nations) have
always increased instability
 The period and place with the greatest previous number
of panics was the 19th Century U.S.
 There’s a big surplus of savings in the world
 China, Japan, Taiwan and Germany are producing more
than they spend
 Others have to spend more than they save to balance
this out
 It’s often hard to tell how much borrowing and spending is
too much
 Economists didn’t do their jobs. In the 1990s and
2000s they often asserted that the self-regulating
pursuit of self-interest would prevent or minimize
panics
 They did this despite data such as that in our
Kindleberger & Aliber reading that shows panics
have been common since the Holy Roman Empire
 See the optional Hill 2009 reading in the packet
 So mechanisms to prevent mania and panic were
neglected
The Euro created new
problems
 In the U.S., we have a mechanism under which cities,
counties, and states can go bankrupt
 Orange County, one of the largest and richest counties in
the U.S. – home of Disneyland – went bankrupt in 1995
 A county treasurer had pursued strategies not too different
from those that Iceland pursued more recently
 The county went to court, reorganized, went on austerity to
cut costs, issued $1 billion in long-term bonds, a few years
later emerged.
 The real economy was hardly affected
 The International Monetary Fund has a similar
mechanism for nations outside the EuroZone
 Mexico
 Argentina
 Thailand
 Great Britain in 1976
 IMF resembles a global Central Bank
 Restructurings are very painful – heavy austerity
 But countries get out fairly predictably
There’s nothing similar inside
the EuroZone
 Europe has prospered by integrating
 Germans and French wanted to integrate further
 When the Euro was launched, investors seemed to
think they didn’t need to worry about European
countries any more
 They seemed to think the richer countries (Germany)
were guaranteeing borrowings of the periphery
 Germany wants to avoid making it too easy to escape
debt in Europe
Germany seems to want rules
requiring conservatism
 Everybody should balance their budgets like Germans
But…
 As long as the Chinese, the Germans, and the
Japanese run surpluses, somebody has to run a deficit
 Who will judge how much borrowing is too much?
 Can we ever have rules that politicians can’t
cheat on?
 Can we get out of this without a
U.S.-style, IMF-style solution:
 letting the markets decide about a country most of the
time and then
 having a central referee to work things out when things
get really bad?
Recently, Central Banks are
supporting countries
 European Central Bank says it will lend to nations that
have an economic restructuring agreement with
European Union agencies
 It’s starting to act like the International Monetary Fund
 Germany voted against, but didn’t veto when it could
 Federal Reserve (the U.S. Central Bank) is pumping
money into the U.S. economy although there’s no big
emergency
What’s next?
 What happens after the U.S. election?