The roots of the financial crisis

By Philip Zelikow 

Picking up on what I said here about my unease over the stimulus, how then do we diagnose the problem?

The financial crisis was caused by a failure of the global financial system.  It was not caused by inadequate aggregate global, or U.S., demand. Even now, the decline in U.S. demand is more of a consequence of the financial crisis, with the popping of asset price bubbles and contraction of credit as banks clean up their balance sheets.

Thus, this crisis is not like the crisis of the 1930s. That crisis certainly included popping bubbles and systemic financial issues, but it was also deeply marked by structural demand problems which many historians lay at the door of the gold standard ("golden fetters") or monetary stringency.  These fundamental constraints were compounded by politics-related failures in international coordination, especially within Europe.  These aggregate demand problems were then reinforced by the collapse of world trade.

This crisis does not seem as related to inherent strictures in generating aggregate demand. Monetary policy was loose before the crisis. Aggregate demand was strong — too strong. The Fed was not alarmed, since it measured price stability against indices of consumer prices. And consumer prices remained stable — at least in part, because the demand was diffused into a vast global supply chain. That supply chain had plenty of room for cheap expansion of capacity. But the huge demand and large global imbalances manifested themselves in another way: the rapid inflation of asset prices. 

Asset price inflation was not seen as a threat to "price stability." Yet, to quote from the G-20 Declaration of November 15, 2008, "weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage" were endangering the system.  That statement goes on to say that policymakers in the leading countries, including ours, "did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions."  This is an unusual spectacle of self-flagellation.

So the first priority is to address the financial crisis, or even the microeconomics of the housing crisis. This is a foreign policy issue: It should include international coordination of intervention policy harmonizing criteria about which institutions or firms to support. It should include international agreement on how best to set new capital requirements.  If the underlying crisis goes unresolved while we concentrate on stimulus, the U.S. will be transfusing blood into a patient with blocked arteries.  That is why a recent IMF report took care to stress, despite its call for urgent fiscal stimulus, that in past cases of success, "the solution to the financial crisis always precedes the solution to the macroeconomic crisis." 

Remember, too, that any major policy initiative has political opportunity costs. To drum up support for a giant stimulus, the President-elect Obama is already putting dire warnings at the top of his communications agenda. Is this message, in essence, one of a desperate need to borrow, really the right message of hope?  And, with a huge initial focus on the domestic stimulus/investment package, how vigorously and intensively can the administration simultaneously devote itself to getting global coordination of a common approach to fiscal stimulus, especially from countries with more fiscal space to invest? 

Nor is it clear that the stimulus should take precedence over building a predictable global financial framework to rebuild effective operation of the international capital market. And I am also uneasy that the clamor of domestic salvation will drown out attention to protecting the health of the global economy — including the global trading system — as it comes under fresh, recessionary pressures.