How Did The Financial Crisis Happen?

So, how did we let this whole financial crisis happen? Ask 10 people and you are likely to get an array of answers, none of them necessarily wrong. After all, with so many glaring problems with the US and other economies of the world, it is hard to say for certain what the exact cause of the huge mess we are in actually was. If anyone would know the answer, though, Paul Krugman would probably be at the top of the list. Mark Thoma looks at a recent article from Krugman that attempts to answer this question in his blog post below:

[From Revenge of the Glut, by Paul Krugman, Commentary, NY Times.] You must hate getting asked this all the time, but how did the financial crisis happen?

The answer, I’d suggest, can be found in a speech Ben Bernanke ... gave four years ago. ... The speech,... “The Global Saving Glut and the U.S. Current Account Deficit,” offered a novel explanation for the rapid rise of the U.S. trade deficit in the early 21st century. The causes, argued Mr. Bernanke, lay not in America but in Asia.

What was so novel about his explanation?

In the mid-1990s, he pointed out, the emerging economies of Asia had been major importers of capital, borrowing abroad to finance their development. But after the Asian financial crisis of 1997-98..., these countries began protecting themselves by amassing huge war chests of foreign assets, in effect exporting capital to the rest of the world. The result was a world awash in cheap money, looking for somewhere to go.

That sounds like a good thing. Small countries are wealthier and looking for productive places to invest their money. Where did they invest the money? In their own countries?

Most of that money went to the United States — hence our giant trade deficit... But ... money surged into other nations as well. In particular, a number of smaller European economies experienced capital inflows that ... were ... large... compared with the size of their economies.

So most of the money came here? That seems backwards given all the needs that developing countries have, that's why we call them "developing." Why did that happen?

Mr. Bernanke cited “the depth and sophistication of the country’s financial markets (which, among other things, have allowed households easy access to housing wealth).” Depth, yes. But sophistication? Well, you could say that American bankers, empowered by a quarter-century of deregulatory zeal, led the world in finding sophisticated ways to enrich themselves by hiding risk and fooling investors.

You could, and did, passionately too I might add. Sorry -- go on.

And wide-open, loosely regulated financial systems characterized many of the other recipients of large capital inflows. This may explain the almost eerie correlation between conservative praise two or three years ago and economic disaster today. “Reforms have made Iceland a Nordic tiger,” declared a paper from the Cato Institute. “How Ireland Became the Celtic Tiger” was the title of one Heritage Foundation article; “The Estonian Economic Miracle” was the title of another. All three nations are in deep crisis now.

You mean the flat tax didn't save Estonia? John Stossel will be so disappointed. So what burst Stossel's bubble economy?

For a while, the inrush of capital created the illusion of wealth..., just as it did for American homeowners: asset prices were rising, currencies were strong, and everything looked fine. But bubbles always burst sooner or later, and yesterday’s miracle economies have become today’s basket cases...

Here in the U.S., shouldn't the fact that the bubble was located mostly in the zoned zone have protected flatlanders? Why is the recession so widespread?

In America, the housing bubble mainly took place along the coasts, but when the bubble burst, demand for manufactured goods, especially cars, collapsed — and that has taken a terrible toll on the industrial heartland. Similarly, Europe’s bubbles were mainly around the continent’s periphery, yet industrial production in Germany — which never had a financial bubble but is Europe’s manufacturing core — is falling rapidly, thanks to a plunge in exports.

Did you know that, according to one survey, one third of the people are losing sleep over the economy? Is there a simple way to explain to them how this happened?

If you want to know where the global crisis came from, then, think of it this way: we’re looking at the revenge of the glut.

And the saving glut is still out there. In fact, it’s bigger than ever, now that suddenly impoverished consumers have rediscovered the virtues of thrift and the worldwide property boom, which provided an outlet for all those excess savings, has turned into a worldwide bust.

I don't think you're helping anyone's sleep. Should they just pull pillows over their heads until this is over? How long do they have to wait for morning in America?

One way to look at the international situation right now is that we’re suffering from a global paradox of thrift: around the world, desired saving exceeds the amount businesses are willing to invest. And the result is a global slump that leaves everyone worse off.

So that’s how we got into this mess. And we’re still looking for the way out.

Thanks. We'll all sleep so much better now, especially when we remember how capable policymakers have proved themselves to be up to this point.

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