The following is the author's testimony on the causes of and cures for the
economic crisis to be given on March 12 before the US House of Representatives
subcommittee on terrorism, nonproliferation and trade of the committee on
The United States is beset by the most troubling economic crisis since the
Great Depression and perhaps the most complex and difficult to resolve set of
economic challenges in the peacetime history of our nation.
This crisis has origins in domestic and international economic policies pursued
by the United States and other nations. Often well intentioned and consistent
with prescriptions of the consensus of economists, these policies have
create what may prove to be a perfect storm - confounding assumptions about
economic policy held dear and championed by enlightened policymakers and
economists, including this one, for two generations.
Effective national response that ensures prosperity and a reasonable measure of
equity require that we acknowledge our mistakes - both those of
well-intentioned policymakers from both political parties and the community of
analysts and academics that advise them. Also, effective responses require that
businesses acknowledge that strategies that have served their interests in the
short term have not served the public good over the long haul, and the
resulting systemic calamity serves no one's interests and threatens the vibrant
market economy that sustains all our wealth and the hope we all share for our
What caused the crisis?
Most fundamentally, the recession, which may now become a depression without
more-effective policy responses, has origins in the interaction of changes in
our banking and financial systems, energy policies and trade policies, and in
the actions of foreign governments.
The US economy enjoyed two long economic expansions, interrupted by a
reasonably benign recession in 2001. During the 1990s, the expansion was
export-led for most of the decade, whereas the expansion of this decade has
been characterized by growing trade deficits, averaging more than 5% of gross
domestic product (GDP) from 2004 through 2007 and receding, with the onset of
recession, to a still high 4.7% in 2008.
Some critics warned of the dangers of such large deficits, while others argued
that the resulting inflows of capital represented investments in the United
States and confidence in quality of economic policy and future growth of the US
The fact is most of the money was raised by borrowing or selling off fixed
assets and was not new productive investments. Much was used to prop up
consumption, and some was used to leverage investment schemes that proved more
speculative than productive. Much was provided by sovereigns and near
sovereigns who were merely looking for hard-currency parking places for cash
and safe political environments in the event political conditions changed
elsewhere in the world.
The largest components of these deficits were net imports of oil, principally
to fuel automobiles, and a growing trade deficit with China. In 2008, those
components alone totaled 96% of the trade deficit.
The trade deficit on oil was the result of domestic policies that neglected
domestic oil and gas development and that failed to fully exploit alternatives
to conventional fuels and build out energy-conserving technologies.
Those policies maximized dependence on foreign sources of oil. Coupled with
rapid growth and fuel subsidies in the developing countries of Asia, US energy
policies helped push up global crude oil prices and the US petroleum trade
China controls foreign-exchange transactions and manages the value of its
currency. It set the yuan-dollar exchange rate at an artificially low value in
1994 and fixed that rate from 1995 to 2005. From mid-2005 to mid-2008, China
permitted some modest revaluation of the yuan; however, this was not nearly
enough, and the yuan remains significantly undervalued. Since July 2008, the
value of the yuan has not changed much.
The undervalued yuan provides Chinese manufacturers with a huge export subsidy
and a hidden tariff on imports. China is using its currency as a development
tool, but this victimizes otherwise competitive businesses and their employees
in the United States.
In response to the recession, China has again frozen the level of the yuan and
laid on additional export subsidies, seeking to export its recession in the
worst tradition of Smoot-Hawley. 
In addition, China maintains high explicit import tariffs. Through these and
other regulations, it essentially requires foreign manufacturers to locate in
China to service its market and for their suppliers to relocate to China,
further accelerating the decline in US manufacturing. This creates a pattern of
international trade, specialization and production that confounds expectations
for trade based on comparative advantage - the kind of trade that was expected
to follow from China's accession to the World Trade Organization in 2001.
China essentially exports products where its abundant supply of low-skilled
labor offers an advantage, and it refuses to import products such as metals and
automotive products, where it does not enjoy a comparative advantage. In fact,
China exports some products that it would import with free trade based on
comparative advantages, instead of managed trade based on its mercantilist
This has deprived the United States of the macroeconomic benefits of free trade
with China, driving down US living standards. In recent years, living standards
were propped up by borrowing from China and others, creating a false sense of
national economic security, but the depth and length of the current recession
has now exposed that fallacy.
Along with similar policies elsewhere in Asia, China's mercantilism has given
rise to a global imbalance in production and consumption. China, other Asian
countries and the Middle East oil states often produce more than they consume,
and the United States and other Western countries consume more than they
produce. Surplus countries amass reserves of dollars, euros and other hard
currencies, and invest those in Western capital markets.
Until recently, Western banks recycled those savings into the hands of US and
Western consumers by letting them borrow on their homes and through unsecured
or weakly secured credit card and auto loans. Foreign funds were also recycled
into the hands of hedge funds and private equity firms, which frequently made
foolish investments with cheap capital - consider Cerberus's purchase of
In the United States, rising trade deficits should have caused one of two
things to happen. Either the value of the dollar should have fallen to
facilitate an increase in exports and decrease in imports, or inadequate
aggregate demand would have caused a recession.
The foreign exchange value dollar could not adjust to adequately redress the
trade deficit because Middle East and other oil exporters price petroleum in
dollars, and China simply intervened in foreign-exchange markets, buying more
and more dollars, to keep its currency from rising in value as it should have.
And foreign borrowing permitted Americans to consume much more than they
produced and for the US economic expansion to go on much longer than it should
have. Foreign borrowing delayed the recession that should have happened sooner,
and if it had, would have been much more benign than the crisis we now
Essentially, a 5% trade deficit requires Americans to spend 105% of what they
produce and earn to sustain aggregate demand for what they produce. Without
exchange-rate adjustments that rebalance trade or massive foreign borrowing,
that deficit in aggregate should have caused inventories to mount and produced
Foreign private investors should not have been expected to provide such credit
because foreign investors should have expected the bonds and loans of an
economy consuming so much beyond its means to default eventually and for the
values of its real assets (stocks and real estate) to drop in value. In fact,
that is what eventually happened in the United States when the reckoning
Much of the credit was provided by China and other sovereigns and near
sovereigns whose motivations were not merely to obtain safe returns on fixed
income assets when they purchased US bonds, bank deposits and property, but
rather to facilitate export-led growth and park money in politically safe
places. That is one important reason why Americans were permitted to borrow so
recklessly, and why the recession did not happen sooner and the recession is
now so severe.
Role of banking policy
Changes in the US banking system permitted American consumers and investors -
hedge fund and private equity managers, corporations engaging in leveraged
buyouts, and others - to enjoy access to inexpensive financing that would have
not been possible three decades ago.
The savings and loan crisis of late 1980s and early 1990s was caused by the
deregulation of interest rates (principally, repeal of regulation Q ), the
growth of nonbank depositories (principally, brokerage depositories and venues
for medium-term deposits that compete with bank certificates of deposit, or
CDs) and changes in US tax laws that limited deductions on rental property held
by private individuals.
In a nutshell, banks were caught with long-term mortgages on their books, whose
rates reflected lower, regulated deposit rates of years past. They were
compelled to compete for deposits and pay higher interest rates than the
mortgages on their books were paying.
Correctly, banks concluded that without regulated rates on deposits and those
of competing non-bank depositories, banks could no longer, as much, lend long
and borrow short. Hence, they could no longer hold on their books as many
long-term mortgages financed solely by deposits and CDs.
After the savings and loan crisis, banks turned increasingly to securitizing
loans. The banks wrote mortgages, auto and other loans and sold those to money
center banks, which in turn bundled those loans into bonds and sold the bonds
to fixed income investors, like life insurance companies, pension funds,
private investors, and foreign sovereigns.
Those investors could better bear long-term interest rate risk than banks.
However, securitization resulted in a disconnection between those who wrote the
loans and those institutions that held the loans and bore repayment risk. That
created subtle and for a long time unnoticed changes in the incentives for
those agents who actually take mortgage applications.
The repeal of Glass Steagall in 1999  made possible the completion of a
reorganization of the ownership of banks. Increasingly, large money center
banks, which underwrite mortgages and securitize regional bank loans for sale
to fixed income investors, combined with brokerages, securities dealers,
investment banks, private equity, and even hedge funds. Historically, those
nonbank businesses compensated executives at higher salaries than banks -
simply, dealmakers and salesmen are paid better than other executives in most
branches of the economy.
Unfortunately, folks that performed heretofore conventional banking services
began to expect to be compensated by bonus systems that paid much more than
traditional banking entities paid. It is simply not possible to pay those in
the chain of lending and securitization - from the mortgage broker in Topeka,
to the regional aggregator in St Louis, to the New York banker that securitizes
loans - the kinds of salaries paid to many others in the financial sector by
borrowing at 5% and lending at 7% - without writing irresponsible mortgages and
creating derivatives that cannot deliver on their promises. However, that is
exactly what happened for at least three sets of reasons.
First, bond rating agencies did not effectively evaluate the collateralized
debt obligations (CDOs) and mistook credit default swaps for real, effectively
collateralized insurance. Payment systems for bond ratings contributed
importantly to blinders at these institutions, as well as simple moral failure
by executives and their economists and finance specialists.
Second, a good deal of the money flowing into US and other credit markets was
provided by sovereigns and near sovereigns (Middle East royals and other
private actors with easy access to very cheap funds) who often do not look at
financial instruments with the same discerning eye as someone who needs to
answer to shareholders or private individuals putting up nest eggs to retire,
educate children or leave a legacy.
Third, a good deal of the money was put at play by US investment managers
incentivized to take big risks - through heads I win, tails you lose, bonus
schemes - and that created an appetite for credit that should have made banks
wary but did not.
At banks, moral failure resulted when the culture of hedge-fund and private
equity fund risk-taking infected their assessment of risks along with the
adoption of bonus based compensation schemes.
The expansion of the US economy and trade deficits through the middle and
latter half of this decade should have resulted in a much sharper devaluation
of the US dollar than was experienced from late 2005 through mid-2008 and in a
very different structure of devaluation against other currencies. Such currency
realignments would have substantially curtailed imports of oil and goods from
China and elsewhere in Asia; or a recession would have happened much sooner
than it did.
Instead, foreign sovereigns and US banks helped American consumers, businesses
and investors become overleveraged. Eventually, the preposterousness of many of
the loans became apparent and those loans failed, setting off a chain reaction
that has been euphemistically called deleveraging and the negative feedback
As importantly, the largest and most important US banks got stuck with many of
their own poorly written CDOs [collateralized debt obligations] and loans on
their books when the collapse came. The latter were often insured by credit
default swaps that lacked adequate collateral, such as those written among
major securities dealers and banks and by AIG.
The bad judgment that bankers had recommended their investor customers embrace
became the noose that hung them too. In a tragedy of the legal system and
manifest inequity, bank stockholders have been ruined, while bank executives
have been protected by the indemnity of employment contracts and escaped with
We have heard a lot about the moral hazard that could be created by forgiving
mortgage debt. However, the sense of betrayal among ordinary people engendered
by the great escape of bankers' fortunes may fray faith in honest work far