The crisis began with the development of a very substantial fiscal deficit in the United States, says Jeff Frieden.

Jeff Frieden: I think it’s important to understand that the current crisis begins quite some time ago. There is an immediate short term character of the crisis that has gotten all the headlines and has to do with the extraordinary loss of confidence in financial markets and in markets more generally that is sweeping around the world, but the real roots of this crisis go back 7, 8, even 10 years, and they begin in the United States, for all intents and purposes, and they begin with the development of a very substantial physical deficit in the US.

After the tax cuts of 2001, the US went from, the US government went from having a big surplus to having a large deficit. That deficit was financed principally by borrowing from the rest of the world. As the US government borrowed from the rest of the world and is its physical deficit stimulated the US economy, the rest of the US economy began to boom and it also began financing this boom from the rest of the world.

So, over the course of the period from 2001 ‘till 2007 and 2008, United States borrowed very, very heavily from people all over the world, heavily in the sense that we borrow between half a trillion and a trillion dollars a year from the rest of the world. Between 2001 and 2008, the US incurred an increased debt to the rest of the world of about 5 trillion dollars.

So, the fundamental origins of the crisis are in the accumulation of a very substantial debt to the rest of the world. Now, how did that work? That debt, the debt that we incurred to the rest of the world, the funds that were flowing in from the rest of the world, were spent in the US. They were spent largely on consumption. That is, they were lent out to Americans to buy new homes, to buy new cars, to expand their credit card debt, to consume more.

It also went into a lot of investments in the US, but the most important effect, for our purposes, for understanding the financial crisis, is that we borrowed enormous amounts of money from the rest of the world and very substantial portions of what we borrow from the rest of the world were spent on the domestic economy in the US. Spending that amount of money on the American domestic economy drove prices way up and led to a huge speculative expansion or a huge expansion of the housing market, of financial services, insurance, all sorts of economic activities whose prices we saw rise. Eventually, the increase in economic activity, in finance, in insurance, in real estate and housing markets, led to a speculative bubble which eventually burst. All right? What we’ve seen, in other words, is the American version of the kind of debt crisis that countries like Mexico in 1994 or East Asia in ’97, ’98, or Brazil or Argentina or Turkey or Scandinavia, many, many dozens, even hundreds of other experiences around the world where countries borrow very heavily from abroad, where that heavy borrowing goes in to expand domestic economic activity. Eventually, that expansion becomes a speculative bubble, and the bubble bursts.

We’re now in the bursting phase of that cycle, having borrowed all this money, having expanded the domestic economy very, very rapidly, having seen prices of things like housing spiral enormously out of control in ways that were clearly unsustainable, eventually it had to come to an end, and it has now come to an end. The downward spiral… We have the upward spiral of a speculative bubble, which, as I said, was unsustainable, we’re now in a downward spiral in which that speculative bubble is bursting.

That downward spiral is having some extraordinarily negative effects on financial markets, the most important of which is that major financial institutions around the world have lost so much money in the down turn, in the unwinding of this speculative bubble, the bursting of the speculative bubble, that they have become increasingly unwilling to lend any money out at all, and that means that the credit market have essentially become frozen, right? That even the best credit risks, big corporations, the State of California, governments around the world are finding it very difficult to borrow even at very short terms, that is, for a couple of days or a week or a month, to provide working capital so they can fund their operations. It’s very dangerous for a modern economy to have a financial system that isn’t working.

The financial system is the bloodstream of a modern economy. Businesses need to borrow to make payrolls, stores need to borrow to be able to refill inventory, states and municipal governments need to borrow in order to finance current activities. Even if they have gotten money coming in, tax revenue coming in or sales revenue coming in, they need to borrow in the short run in order to make their operations work in a more or less reliable way, and not being able to borrow, very short term, from the financial system can lead to a breakdown of a lot of different kinds of economic activity.

So, we go from the longer term picture in which America’s macro economic policies, its borrowing binge, its extraordinary accumulation of foreign debt, the inflow of funds from the rest of the world pumps up things like financial services, insurance and real estate, to a bursting of that bubble to a tremendous loss of confidence to the current spiral downward in which we’re not quite sure when the bottom will eventually be reached.

October 14, 2008