The housing bubble itself was the outcome of the Federal Reserve's low interest rate policy in the aftermath of the burst of the "dot-com" bubble in 2001, the lack of appropriate financial regulation, and housing policies aimed at expanding the mortgage market to low-income borrowers. It was possible to maintain the large trade deficits of the United States for such a long period of time because of the dollar's reserve currency status. When the housing bubble in the United States burst, the global crisis ensued. The paper also analyzes why China's trade surplus increased significantly in general and with the United States in particular in recent years, and argues that this increase was caused by both the relocation of the labor-intensive tradable sector of East Asian economies to China and high corporate saving rates in China as a result of its dual-track approach to reform.
The world is currently still struggling with the aftermath of the worst economic crisis since the Great Depression. While a handful of economists predicted the crisis, it was largely unforeseen. As late as April 2007, the IMF in its World Economic Outlook concluded that risks to the global economy had become extremely low, and that, for the moment, there were no great concerns. Despite large and widening global imbalances before the crisis, optimism on the robustness of the world economy emanated from confidence in the United States‘ system of financial regulation, its financial and political system and the fact that it had the world‘s largest capital markets. Global imbalances were viewed as sustainable, given that rapidly growing developing economies needed a secure place to invest their funds for diversification purposes and increased global financial integration was deepening global capital markets and allowing countries to sustain higher debt burdens over the long term. In addition, the U.S. was considered to have superior monetary policy institutions and monetary policy makers. Only a few economists did not share these views and expressed concern about a disorderly unwinding of
rising global imbalances, as well as of the housing bubble.
The concerns of these economists were dramatically validated by the unfolding of the global financial crisis since September 2008. The coordinated policy response by the G-20 nations helped the world avoid a global depression. According to the IMF, these interventions involved cash infusions, debt guarantees, and other assistance to the tune of a staggering $10 trillion.
However, economic growth remains fragile. Recovery is taking place at two different paces: on the one hand, there are the high-income countries that are experiencing a sluggish recovery. On the other hand, there are the developing countries whose economic performance isfar superior to that of the advanced countries. The recovery of the world economy is threatened by high unemployment in the advanced economies, high levels of sovereign debt and the crisis in the Euro-zone. Moreover, the severity of the recent global crisis has highlighted the need to revisit basic policy recommendations, e.g., in the area of capital flows, the supervision of the financial sector, and macroeconomic management. And with emerging and developing economies recovering from the global economic crisis much faster than advanced countries, it also reinforced a trend toward a new multi-polar world economy with several growth poles, a trend that had already become apparent before the crisis.
The precise genesis of the global crisis remains subject to debate. While global imbalances are widely viewed to have played an important role in its evolution, some economists consider them to be the primary cause of the crisis, while others view them as only facilitating its development.8 A correct diagnosis of the genesis and driving forces behind the crisis is, however, important in order to draw appropriate conclusions to prevent its recurrence.
Section II describes the world economy before the crisis, and the eruption, evolution and consequences of the global crisis. Section III reviews alternative hypotheses for the causes of the global economic crisis as well as their empirical evidence. We will refute the frequently voiced view that the global crisis was caused by global imbalances that reflected the export-oriented strategy of East Asian countries, the accumulation of international reserves for self-insurance motives by countries with surpluses, China‘s undervaluation of its exchange rate and the global savings glut. Instead, we will argue that global imbalances were the result of the large excess demand in the U.S. over an extended period—the financing of which was made possible by the reserve currency status of the US dollar. This excess demand resulted from both the public debt in the U.S. arising from the Afghanistan and Iraqi wars, tax cuts and the overconsumption by households supported by the wealth effect from the housing bubble in the U.S. The housing bubble itself was the outcome of the Fed‘s low interest rate policy in the aftermath of the burst of the ―dot-com‖ bubble in 2001, the lack of appropriate financial regulation after the deregulation
in the 1980s and housing policies aimed at expanding the mortgage market to low-income borrowers which was primarily a result of lobbying by the financial sector aimed at increasing profits through further deregulation. When the housing bubble in the U.S. burst, the global crisis ensued. Section IV discusses why China‘s trade surplus increased significantly in general and with the U.S. in particular in recent years. We will argue that this increase was caused by both the high corporate saving rates in China as a result of its dual-track approach to reform and the relocation of the labor-intensive tradable sector of East Asian economies to China, which started in the 1980s but accelerated after China‘s accession to WTO in 2001. Finally, the paper reflects on the lessons for policy prescriptions from the crisis.
Author: Lin,Justin Yifu; Treichel, Volker. Document Date: 2012/01/01.Document Type: Policy Research Working Paper. Report Number: WPS5937
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