The Global EconomyAnd

Foreign Economic Policy:

Where do the Candidates Stand?

Today’s Discussion•Historical Context: The Great Depression and American Leadership•The Cause: Absence of a Leader•The Solution: Global Financial Institutions•The United States as Leader•Globalization: Unregulated markets•Today’s Crisis•The candidates and their solutions

The Business Cycle

•Prosperity•Transition•Trough•Recovery

The Big Contradiction

• Market Mechanisms vs.

• Society’s needs

• the market threatens the very essential bonds that hold society together.

: Globalization in Early 20th Century: The Prosperity Phase

• International Interdependence and the division of labor

• Credit and International interdependence

• Britain as the world’s creditor and lender of last resort in the “through” phase of the business cycle

A bit like the Clinton era…….

Growth of production

Growth of consumerism

The Business Cycle with Britain as Global creditor

Britain isThe World’sCreditor

Great Depression

Hidden Problems

• Britain no longer able to provide credit

• Wages lagged behind profits, so that mass purchasing power could not absorb the vast output that it was technically possible to produce.

Crash and Spread

• The crash of 1929 and the spread of economic crisis

• Britain could no longer be the lender of last resort, the buyer of other’s exports, or infuse credit into the system

• The spread of the depression from finance to industry

• The internationalization of the crisis

Market solution: “purge rottenness out of the system”

•  After the 1929 crash, Treasury Secretary Andrew Mellon advised the government to cut spending to balance the budget, and leave desperate banks, businesses, and families to fend for themselves because the market alone would "purge the rottenness out of the system."

Government intervenes: Smoot-Hawley Tariff

Don’t Trade

Protectionism

The Global Response: Protectionism

• . “every country for itself”

• Tariffs and qualitative restrictions

• Trade became bilateral

• Currency devaluations to stimulate exports

The end of international interdependence

Protectionism makes things worse….Unemployment 25%

Then and Now….

Global Depression

• The combined output of the world's seven biggest economies declined nearly 20% from 1929 to 1932.

• The unemployment rate soared in the U.S. and Germany to a peak above 33%.

• World trade collapsed by two-thirds, not least because of retaliation to the Smoot-Hawley tariff.

Depression and War

The Unemployed are Mobilized

Germany’s debt exceeded its national income in 1923 and could not pay its international debts. The government

printed money which led to hyperinflation

Germany invades Poland

Causes? Solutions? Leadership

• a central source of the Great Depression in the 1930s was a lack of British leadership and the unwillingness of the U.S. to provide leadership in the world economy.

• Leadership is needed to stabilize the world economy

• leadership means three things:1. providing a market for distress goods2. providing long-term lending 3. discounting in crisis

Leadership for Stability: Post-war Global Financial Institutions

• Market Anarchy caused the Depression

• Market can be tamed by government intervention

• Global Markets need global governance and intervention

IMF

World Bank Paul Wolfowitz he head of World Bank (2005-07), visited a mosque during an official visit to Turkey. Obeying local customs, he removed his shoes and revealed two

large holes in his socks! 

WTO

American Leadership

• the United States assumed primary responsibility for the management of the world monetary system, beginning with the Marshall Plan and partially under the disguise of the IMF.

• The dollar became the basis of the international monetary system.

• The US took in the world’s distressed goods and began to build a trade deficit

Multilateralism, American style

Marshall Plan

Marshall plan in action

The U.S.: market for world’s distressed goods, source of credit, lender of last resort

• US becomes market for world’s distressed goods

• Source of credit

• Lender of last resort

• How?

European Cooperation

The US Trade deficit: 1950-1973

Too many dollars

Vietnam war: more inflation

War on Poverty

Value drops

Value drops

inflation

Free Trade

Casino Economy

The more free trade, the higher the income

Decline in real wages

Rise of Temporary workers

Growth of a low wage work force

• Between 1975 and 1990, the percentage of low wage employees in the total work force grew by 142 per cent, from 17 per cent to 40 per cent

Rise in unemployment

But No Capital shortages

• . Capital markets are grew more quickly than demand for capital, and new calculations show that Asia could very well finance much of its growth through savings.

Deregulation and corruption

1920s

1930s Depression

1945-73 U.S. LeadershipInternational Financial

InstitutionsInternational Trade Organizations

1970’s Recession

1980’s1990’s

GlobalizationAbsence of Leadership and Regulation….Govt = “private good, public bad”

Follow the crisis….• 1. Housing values remain stable for 100 years to 1995• 1995-2005 Housing prices double +• 2. Wage stagnation and income inequality +• 3. Deregulation of financial markets

• 4. Easy money easy mortgages as bets on in housing prices + Run of

CDOs and derivatives + borrowing to buy them (betting on in value) + rating fraud + easy insurance (AIG) highly leveraged banks

Housing supply overwhelms demand housing prices fall + mortgage defaults

CDOs lose value + Bank stock prices fall credit drys up Begin the bailout (hopefully) more credit (hopefully) save businesses and jobs (hopefully) economic growth

Fannie Mae Freddy Mac• pened The Floodgates• MISDIAGNOSING THE CAUSES OF THE CRISIS COULD LEAD BOTH TO REGULATORY OVERKILL AND TO MORE RECKLESS RISK TAKING.• by Stuart Taylor• Saturday, Oct. 18, 2008•

• President Bush, his Securities and Exchange Commission appointees, other free-enterprise dogmatists who have stood in the way of regulating risky and opaque financial manipulations, and greedy Wall Streeters deserve the blame heaped on them for the financial meltdown that has so severely shaken America.

• But the pretense of many Democrats that this crisis is altogether a Republican creation is simplistic and dangerous.• It is simplistic because Democrats have been a big part of the problem, in part by supporting governmental distortions of the marketplace through mortgage giants Fannie Mae and Freddie Mac, whose reckless lending practices necessitated a $200

billion government rescue last month. It is dangerous because misdiagnosing the causes of the crisis could lead both to regulatory overkill and to more reckless risk taking by Fannie, Freddie, or newly created government-sponsored enterprises.• Fannie and Freddie aside, it's worth pointing out that many, if not most, of those greedy Wall Street barons are Democrats. And that the securities and investment industry has given more money to Democrats than to Republicans in this election cycle.

And that opposing regulation of risky new financial practices by private investment banks and others has been a bipartisan enterprise, engaged in by the Clinton and Bush administrations alike.• But the roles of Fannie and Freddie are my focus here. Powerful Democratic (and some Republican) advocates of affordable housing, including Senate Banking, Housing, and Urban Affairs Committee Chairman Christopher Dodd, D-Conn.; Sen.

Charles Schumer, D-N.Y.; and House Financial Services Chairman Barney Frank, D-Mass., have been the GSEs' most potent and ardent champions in recent years. Meanwhile, the agencies and their employees have orchestrated a gigantic lobbying effort (costing more than $174 million between 1998 and 2008). They have also made campaign contributions of more than $14.6 million between the 2000 and 2008 election cycles, with some of the largest going to Dodd and Barack Obama.

• A leading illustration of this Democrat-GSE symbiosis came in summer 2005. The Senate Banking Committee adopted a bill to impose tighter regulation on Fannie and Freddie, with all Republicans voting for it. But the Democrats voted against it in committee and killed it on the floor.

• Also in 2005, Fannie and Freddie began buying vast amounts of subprime and "alt-A" mortgages with, in many cases, virtually no down payments, that had been taken out by people with low credit scores and low incomes relative to their monthly payments. To finance more and more affordable housing, as leading Democrats, and some Republicans, had urged, the GSEs dramatically lowered their traditional underwriting standards.

• Between 2005 and 2007, Fannie and Freddie "sold out the taxpayers" by financing almost $1 trillion in such highly risky mortgages, according to "The Last Trillion Dollar Commitment: The Destruction of Fannie Mae and Freddie Mac," a carefully researched essay posted on the conservative American Enterprise Institute's website by Peter Wallison of AEI and Charles Calomiris of Columbia Business School.

• They base their trillion-dollar figure, which is much higher than most published estimates, on detailed analysis of what they call "accounting practices that made it difficult to detect the size of those exposures."• Fannie and Freddie appear to have played a major role in causing the current crisis, in part because their quasi-governmental status violated basic principles of a healthy free enterprise system by allowing them to privatize profit while socializing risk.

That is, their special privileges as GSEs -- created decades ago to promote homeownership by buying mortgages from banks, which could then use the cash to make more loans -- enabled them to lend at high rates to reap enormous profits for their private stockholders and executives and to borrow at low rates based on the government's implicit promise to rescue them from any failure, as it has now done.

• • Unbeknownst to the investment banks, the experts at Fannie and Freddie knew very well that their bosses were taking reckless risks.• • Many conservatives have gone so far as to blame Fannie, Freddie, and their Democratic sponsors for the entire meltdown. Some (not including Wallison and Calomiris) also blame the Community Reinvestment Act of 1977, which forced banks to lend

and invest more in minority and low-income areas.• This accusation has spurred furious rebuttals by Democrats and their media friends. Some have been well reasoned. Some -- especially a July 14 column by  New York Times columnist Paul Krugman, who was awarded the Nobel Prize in economics

this week -- have been flat-out incorrect.• As Wallison and Calomiris demonstrate, Krugman was egregiously wrong in writing that "Fannie and Freddie had nothing to do with the explosion of high-risk lending." He was wrong again in stating that "they didn't do any subprime lending, because

they can't ... by law." He was further wrong in writing that the GSEs were "tightly regulated with regard to the risks they can take."• Others in the don't-blame-Fannie-and-Freddie camp reasonably point out that private Wall Street investment banks and others financed even more of the $3 trillion in substandard mortgages than Fannie and Freddie did, and that these investment

banks and many of the mortgage lenders who made (and then sold) the loans were not covered by the Community Reinvestment Act.• Wallison agrees that the 31-year-old law does not appear to have been a major cause of the current crisis. He also notes that although the Clinton administration pushed the GSEs to finance more affordable housing by purchasing subprime

mortgages, it was not until 2005 that the GSEs began financing risky loans in huge amounts.• Why did Fannie and Freddie dive into the subprime mortgage market? And were their practices just one facet -- or the most important cause -- of the crisis? The questions are related and the answers debatable.• Freddie and then Fannie had been ravaged in 2003 and 2004 by accounting scandals that led to the departures of top executives, including Fannie Mae CEO Franklin Raines, a former Clinton administration official who had collected $90 million in

compensation from 1998 through 2004. The scandals brought warnings from Alan Greenspan, then the powerful chairman of the Federal Reserve Board, that the government should restrain the mortgage giants' growth. Meanwhile, three Fed economists published a study casting doubt on whether Fannie and Freddie had much effect on mortgage interest rates. All of this put the two agencies on the defensive in Congress.

• By the time Daniel Mudd succeeded Raines in 2004, according to an in-depthNew York Times article on October 5 by Charles Duhigg, "his company was under siege. Competitors were snatching lucrative parts of its business. Congress was demanding that Mr. Mudd help steer more loans to low-income borrowers. Lenders were threatening to sell directly to Wall Street unless Fannie bought a bigger chunk of their riskiest loans.

• "So Mr. Mudd made a fateful choice," Duhigg wrote. "Disregarding warnings from his managers that lenders were making too many loans that would never be repaid, he steered Fannie into more-treacherous corners of the mortgage market, according to executives.

• "For a time, that decision proved profitable. In the end, it nearly destroyed the company and threatened to drag down the housing market and the economy."• (So much for Krugman's analysis.)• Duhigg added, "The ripple effect of Fannie's plunge into riskier lending was profound. Fannie's stamp of approval made shunned borrowers and complex loans more acceptable to other lenders, particularly small and less sophisticated banks." The

banks had little incentive to avoid risky loans as long as they could sell them to the GSEs and others long before any defaults.• Duhigg also implies, however, that Fannie and Freddie joined the junk-mortgage binge, rather than led it, to avoid losing business to private companies such as Bear Stearns, Lehman Brothers, and Goldman Sachs. Other analysts plausibly argue that

what started the ball rolling was an August 2004 decision by the big bond-rating agencies, Moody's and Standard & Poor's, to loosen their guidelines for rating mortgage-backed securities.• Wallison and Calomiris disagree. "The most plausible explanation for the sudden adoption of this disastrous course [by Fannie and Freddie] is their desire to continue to retain the support of Congress after their accounting scandals in 2003 and 2004,"

they argue. In an October 15 Wall Street Journalop-ed, Wallison adds, without qualification, that this was "the source of the financial crisis we are wrestling with today."• But why would investment banks take foolish risks with their own money, as well as that of investors, just because Fannie and Freddie were doing so? In an interview, Wallison theorizes that the companies wrongly assumed that these must be sound

investments because the leading experts on the mortgage market -- Fannie and Freddie, with their vast databases and sophisticated computer programs -- thought so. But unbeknownst to the investment banks, the experts at Fannie and Freddie knew very well that their bosses were taking reckless risks.

• Perhaps a congressional investigation will someday sort out the extent to which Congress itself -- by pressuring Fannie and Freddie to take such risks -- brought about the current crisis.

British Leadership (again?)

• At a special European summit meeting on Sunday, the major economies of continental Europe in effect declared themselves ready to follow Britain’s lead, injecting hundreds of billions of dollars into banks while guaranteeing their debts. And whaddya know, Mr. Paulson — after arguably wasting several precious weeks — has also reversed course, and now plans to buy equity stakes rather than bad mortgage securities (although he still seems to be moving with painful slowness).

1990’s GlobalizationNo Leader!!!! No regulation!!!! “Private Good, Public Bad”

2008

Global Leadership? Britain? G8?International Organizations?

Wage stagnation

HousingBubble

Easy Money Future?

McCain solutions• Sen. John McCain is proposing a new set of tax cuts aimed at helping investors weather the financial crisis. It

includes temporary reductions on capital gains tax, on taxes paid by senior citizens when they withdraw money from retirement accounts, and on taxes paid on unemployment benefits.

• The total package would cost $52.8 billion, according to senior policy adviser Douglas Holtz-Eakin. All of the proposals would apply for 2009 and 2010.

• The McCain campaign has struggled to figure out the best response to the economic crisis, suggesting a number of proposals over the last few weeks. None of them appears to have caught fire with the public, though, as polls show voters trust rival Sen. Barack Obama more on the economy. The Democratic nominee has been gaining in national and battleground state polls with Election Day just three weeks away.

• The Obama campaign called the McCain initiative “a day late and 101 families short,” saying it will not spur job growth for the middle class.

• “His trickle-down, ideological recipes won’t strengthen our economy and grow our middle-class, but Barack Obama’s pro-jobs, pro-family economic policies will,” Obama spokesman Bill Burton said in a statement. He added that a capital gain tax cut won’t be very helpful in a year when people don’t have many capital gains.

• The McCain plan would reduce the tax on long-term capital gains to 7.5% from 15% for 2009 and 2010. The campaign said this would “strengthen incentives to save, invest and restore the liquidity of the markets.” That would cost $10 billion.

• He also wants to increase the amount of capital losses that can be used to offset ordinary income from $3,000 to $15,000.

• The most expensive part of the plan would lower the tax rate on money seniors withdraw from IRAs and 401(k) retirement plans to the lowest rate — 10%. This would apply to the first $50,000 withdrawn from these accounts each year. The campaign estimated it would help nearly 9 million Americans over age 60 and would cost $36 billion.

Obama solutions

• Obama proposed tax breaks for businesses that create new jobs, a freeze on foreclosures by banks that participate in the government's rescue program and a public-works fund to rebuild the nation's infrastructure while keeping people employed. He embraced McCain's proposal to suspend the rule that would require retirees to start liquidating their 401(k) holdings at the bottom of the stock-market crash. And he went a step further, proposing that Americans should be able to withdraw some of those retirement savings without penalty during the economic crisis.

Back in the USA: Keynes Triumphs?

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