ALSO BY MENZIE D CHINN THE ECONOMIC INTEGRATION OF GREATER CHINA: REAL AND FINANCIAL LINKAGES AND THE PROSPECTS FOR CURRENCY UNION (with Yin-Wong Cheung and Eiji Fujii) (2007) ALSO BY JEFFRY A FRIEDEN GLOBAL CAPITALISM: ITS FALL AND RISE IN THE TWENTIETH CENTURY (2006) DEBT, DEVELOPMENT, AND DEMOCRACY: MODERN POLITICAL ECONOMY AND LATIN AMERICA, 1965–1985 (1991) BANKING ON THE WORLD: THE POLITICS OF AMERICAN INTERNATIONAL FINANCE (1987) For Laura & Anabela Contents Figures Preface Acknowledgments CHAPTER Welcome to Argentina: How America Borrowed Its Way into a Debt Crisis CHAPTER Borrowing, Boom, and Bust: The Capital Flow Cycle CHAPTER Risky Business Models CHAPTER The Death Spiral CHAPTER Bailout CHAPTER Economy in Shock CHAPTER The World’s Turn CHAPTER What Is to Be Done? CHAPTER Conclusion Notes Index FIGURES FIGURE From deficit to surplus and back again: U.S federal budget balance as a percentage of GDP, 1980–2010 FIGURE The housing boom, 1987–2010 FIGURE The rise and fall of securitization, 2000–2007 FIGURE Risky business: leverage, measured as assets to capital, in the financial sector, July 2007–September 2007 FIGURE Response of the central banks: overnight interbank interest rates in the United States and euro area, 2000–2010 FIGURE The very wealthy get even wealthier: share of pretax income received by top percent of households, excluding capital gains, 1913–2007 PREFACE The midterm elections were over, and the Republicans had made stunning advances The GOP had picked up over seventy seats in the House of Representatives and seven seats in the Senate Perhaps just as important, the Republicans had taken a number of crucial governorships from the Democrats, including the pivotal states of Michigan, Ohio, and Pennsylvania The election was a dramatic reversal of the Democrats’ landslide victory two years earlier, and was a particular blow to the president, who had swept into office in the midst of a devastating economic crisis Certainly the Democrats could be satisfied with some major legislative accomplishments, passed with their previous majorities But now, a disappointing economy and stubbornly high unemployment rate had brought back to life a Republican Party that had appeared moribund two years earlier For the foreseeable future, the Republicans, together with allies among conservative Democrats, would be able to block or force changes in just about any initiative the president had in mind The year was 1938, and the economic recovery from the Great Depression was in deep trouble Back in 1933, when Franklin D Roosevelt became president, the country was in the fourth year of the deepest depression in its history The Roosevelt administration had moved quickly and aggressively to try to bring the country’s economy back to life Roosevelt and his fellow Democrats in Congress purged the nation’s banking system and imposed stringent new regulations They created an ambitious array of federal programs to put the millions of unemployed to work And they initiated the first serious federal social program in American history, Social Security By 1936 the economy was recovering The unemployment rate had fallen to 14 percent, still high but down from where it was, 25 percent, when Roosevelt took office Both national income and the stock market were rising rapidly In light of the upturn, the Roosevelt administration resolved to tackle the federal government’s budget deficit, which in 1936 had reached nearly percent of gross domestic product (GDP), a level unprecedented in peacetime Delivering on promises to trim the deficit, the administration cut spending by 20 percent and raised taxes by even more; within a year the budget was practically back to balance Meanwhile, the Federal Reserve tightened monetary policy, apparently to avoid a resurgence of inflation In the aftermath of the fiscal and monetary retrenchment, in the summer of 1937 the American economy collapsed into a steep recession Industrial production dropped by one-third, the stock market plummeted more than 40 percent, and the unemployment rate shot back up to 19 percent As the American economy slumped, the administration’s popularity faded rapidly And the result of the 1938 midterm election reflected this loss of confidence in the federal government’s ability to bring the nation out of the Depression.1 Today the United States and the world are slowly recovering from the most serious international economic crisis since the Great Depression of the 1930s As was the case in the late 1930s, the causes and consequences of the crisis are hotly debated And just as then, a great deal rides on an appropriate understanding of why and how the United States got to where it is today How could the world’s richest economy go broke? How did the world’s most powerful banks collapse? Why would the most conservative government in modern American history nationalize enormous portions of the U.S economy? Why did millions of American families lose their homes, and millions more their jobs? Whose fault is it all? We have a unique perspective on these debates We have spent, between the two of us, more than fifty years working on debt crises We have lived through and studied financial and currency disasters in Europe, Latin America, Asia, and Russia We have witnessed firsthand, and analyzed in detail, the human, social, and political wreckage of irresponsible borrowing We have watched country after country lose decades of economic progress to the austere aftermath of financial crises But we never feared that we would see a classic debt crisis in our own homeland And we never imagined that our country could face the prospect of almost two decades lost to misguided policies, an unnecessary crisis, and a daunting task of economic reconstruction Nonetheless, there is value in our ability to compare the current crisis to those we have known and investigated As we examine the events of the past decade, and look toward the decade to come, we can draw on a wealth of comparative and historical experiences to guide our analysis The United States is in the midst of the greatest failure of economic policy, and of financial markets, of recent times This is the story of how and why it got there, and of what the nation must to repair a wounded economy The crisis The most serious economic crisis of the past seventy-five years began as the summer of 2008 ended In August and September, credit markets everywhere entered a downward spiral that spun faster and faster until, in the first two weeks of October, it seemed that the world economy might be coming to an immediate end During those dark weeks and months, an international economic order that had inspired faith bordering on rapture around the world appeared to have turned on its creators and strongest supporters The United States, the very center of economic globalization, was gripped in a panic that threatened to destroy the world economy The collapse seemed to surge out of nothing and nowhere One week there was mild concern about a sluggish housing market in the American Sunbelt, the next week the whole world was staring over a precipice into the end of global capitalism The world’s strongest economy turned into the sick man of international capitalism The American paragon of capitalist virtue, protector of the free-market faith, took over huge swaths of the private sector What happened? How could this come to pass? The United States borrowed and spent itself into a foreign debt crisis Between 2001 and 2007, Americans borrowed trillions of dollars from abroad The federal government borrowed to finance its budget deficit; households borrowed to allow them to consume beyond their means As money flooded in from abroad, Americans spent some of it on hard goods, especially on cheap imports They spent most of the rest on local goods and services, especially financial services and real estate The result was a broad-based economic expansion This expansion—especially in housing—eventually became a boom, then a bubble The bubble burst, with disastrous effect, and the country was left to pick up the pieces The American economic disaster is simply the most recent example of a “capital flow cycle,” in which capital floods into a country, stimulates an economic boom, encourages high-flying financial and other activities, and eventually culminates in a crash In broad outlines, the cycle describes the developing-country debt crisis of the early 1980s, the Mexican crisis of 1994, the East Asian crisis of 1997–1998, the Russian and Brazilian and Turkish and Argentine crises of the late 1990s and into 2000–2001—and, in fact, the German crisis of the early 1930s and the American crisis of the early 1890s We can best, and most fully, understand the current debt crisis by understanding the dozens of debt crises that have come before it What causes such crises? What can we learn from the paths to them, through them, and out of them? To be sure, the most recent American version of a debt crisis was replete with its own particularities: an alphabet soup of bewildering new financial instruments, a myriad of regulatory complications, an unprecedented speed of contagion Yet for all the unique features of contemporary events, in its essence this was a debt crisis Its origins and course are of a piece with hundreds of episodes in the modern international economy For a century American policymakers and their allies in the commanding heights of the international financial system warned governments of the risks of excessive borrowing, unproductive spending, foolish tax policies, and unwarranted speculation Then, in less than a decade, the United States proceeded to demonstrate precisely why such warnings were valid, pursuing virtually every dangerous policy it had advised others against Most analysts of the crisis miss this central point Each of the many accounts published since 2008 has focused on one or another limited aspect of the crisis Some follow the financial meltdown and response blow by blow, yielding vivid insights into the personalities and institutions involved Other accounts emphasize the role of financial regulators in the collapse, documenting the influence of Wall Street over the deliberations in the halls of Washington, D.C Yet others explain how the financial crisis caused so deep a global recession Our analysis starts with the macroeconomic drivers of the experience, includes the political pressures, incorporates the regulatory enablers, and puts the crisis into a comparative and historical context, drawing parallels and lessons from the dozens of similar episodes from the past The American crisis immediately spread to the rest of the international economy The world learned a valuable lesson about global markets: they transmit bad news as quickly as good news The American borrowing binge had pulled much of the world along with it—drawing some countries (Great Britain, Ireland, Iceland, Spain, Greece) into a similar debt-financed boom, and tapping other countries (China, Japan, Saudi Arabia, Germany) for the money to make it possible The collapse dragged financial markets everywhere over a cliff in a matter of weeks, with broad economic activity following within months Impact and implications The global crisis raises the specter of global conflict As governments scramble to protect their citizens, their actions can be costly to their neighbors: a bailout favors national over foreign firms, devaluation puts competitive pressures on trading partners, big deficits suck in capital from the rest of the world The 1929 recession became a depression largely because of the collapse of international cooperation; the current crisis may head in that direction if international collaboration similarly fails With or without broader international complications, the United States faces hard times The country lost the first decade of the twenty-first century to an ill-conceived boom and a subsequent bust It is in danger of losing another decade to an incomplete recovery and economic stagnation In order to not lose the decade to come, the United States will have to bring order to financial disarray, gain control of a burgeoning burden of debt, and re-create the conditions for sound economic growth and social progress None of this will be easy The tasks are made more difficult by the fact, which we have learned to our alarm, that all too many policymakers and observers cling to the failed notions that got the country into such trouble in the first place If Americans not learn from this painful episode, and from others like it, they will condemn the nation to another lost decade zero, 132, 134, 137 interest rate swaps, 59 international finance, xv, 11, 43, 118, 125, 126, 163, 220 growth of, 4, malignant misuse of, 222 International Monetary Fund (IMF), 3, 24, 33, 42–43, 188, 234n financial crisis and, 126, 143, 245n International Trade Commission, 54 Internet savings accounts, 189 investment, investors, 4, 20, 51, 157, 173, 200, 217, 222, 223 borrowed funds and, 33, 207 crowding out of, 138 energy-saving, 218 foreign in U.S., 5, 14, 16–19, 169–70, 253n–54n government control over, in parking meters, 151 regulation and, 211 in SIVs, 57–58 three broad classes of, 16–17 uncertainty about rate of return on, 22 U.S financial, 41 investment banks, 32, 43, 78, 87, 92, 98, 210 Fed’s lending to, 106 loss of confidence in, 100, 101, 102 regulation and, 77, 78, 80–81, 115, 211, 238n in shadow banking system, 72, 74 top executive earnings in, 172 total of assets in, 237n see also specific banks Iraq War, 29, 205, 220 Ireland, xv, 55, 175–77, 186–89, 225, 230n bank run in, 118, 175–76, 189 debt-financed consumption in, 48, 193 deposit guarantee in, 176–77, 191 economic growth in, 25–26 housing prices in, 48–49, 50, 175 isolationism, 173, 184 Italy, 49, 84, 143, 186, 187, 188 Jackson Hole, Wyo., 43 Japan, xv, 1, 18, 147, 152–53, 158–62, 181, 193, 195 bank bailout in, 123–24, 158 Chinese exports to, 17 deflation in, 134, 135, 159 recovery of, 144 U.S car factories of, 191–92 U.S investment of, 5, 16 zero interest rate in, 132, 142 jobs: creation of, 18, 172 discouraged seekers of, 149 federal hiring freeze and, 167 in financial sector, 36, 48 loss of, 37, 40, 52, 138, 219 security of, 172 Johnson, Simon, 156–57, 166, 210, 259n J.P Morgan and Company, 75, 184 JPMorgan Chase & Co., 105, 114, 121 Kansas City, Mo., 151 Keating, Charles, “Keating Five,” Keynes, John Maynard, 132, 190 Keynesianism, 138, 139 King, Mervyn, 113 King County, Wash., 57–58, 59, 95, 98 Koizumi, Junichiro, 159 Korea, 18, 191–92, 209 Kristol, Irving, 13 Krugman, Paul, 129, 132, 140 Kudlow, Larry, 46 Kuttner, Robert, 117 Kuwait, 32 labor, 153, 172, 217, 218, 219 labor unions, decline of, 253n Laffer, Arthur, Laffer curve, 2, 3, 4, 12–13 Las Vegas, Nev., 28–29, 35, 42, 46, 89, 149 Latin America, 1–2, 16, 54, 178, 200 debt crisis in (1982), 37, 146–47, 153, 195, 208–9 see also specific countries Latvia, 55 Lausanne Conference (1932), 181 law firms, 172 League of Nations, 178, 179 Lehman Brothers, 80 bankruptcy of, 108–14, 132, 136, 142, 142, 165, 261n lender of last resort, 74–75, 102, 133, 211 Lereah, David, 47 leverage, leveraging, 100, 105, 126, 163, 211 asset vs liability side of, 62 defined, 61 of risk, 61–64, 70, 79, 79, 80, 82, 85 Lewis, Kenneth, 122 Liberal Democratic Party, Japanese, 147 LIBOR (London Interbank Offered Rate), 63, 68, 102, 236n Lincoln Savings and Loan Association of Southern California, liquidationists, 138 liquidity, bank problem with, 124–25, 126, 133 liquidity trap, 132 Lithuania, 55 Lloyds Bank, 242n loan officers, 22–23 loans, lending, 14, 16, 193, 195, 213, 222, 223 auto, 65, 66 bad debt and, 22–23, 161 business, 157 capital requirements and, 70, 237n consumer, 36 student, 65, 66 U.S sources of, 16–19 see also mortgages local government, 151 London, 20, 25, 48, 77, 176 AIGFP in, 109, 110, 156 financial center of (The City), 48 housing prices in, 48 World Economic Conference in, 181–82 “looting,” use of term, 227n Los Angeles, Calif., 41, 89 low-income Americans, 253n–54n low-skilled workers, 253n Luxembourg, 26, 118 macroeconomic policy and conditions, 33, 61, 131, 144, 152, 167, 177, 194, 223, 226, 232n–33n borrowing and, 55, 56 Bush’s views on, forecasting of collapse and, 262n “freshwater,” 138 global imbalance and, 183–86, 190, 193 in Japan, 132 recovery and future policy and, 201 “saltwater,” 139 Volcker’s views on, Madrid, 49, 50 Mainsail II, 58 Malaysia, 18, 38 manufacturing, 39, 40, 48, 52–55 Chinese, 17, 195, 196, 197 U.S., 37, 54, 173, 191, 192, 197, 200, 220 Markit, 96 Martin, William McChesney, Jr., 44 Maryland, University of, 234n McCain, John, 136 McConnell, Mitch, 204 Medicaid, 168, 170, 204, 206 medical care, see health care Medicare, 8, 13, 168, 170, 190, 204, 206 Part D, 252n, 257n Medicare Modernization Act (2006), 168 Mellon, Andrew, 138 Mendoza, Enrique, 234n Merrill Lynch, 34, 58, 108, 121, 156, 238n Mexico, 29, 37, 153, 187, 225 capital inflow to, 15 debt crisis of (1982), 1–2, 21 debt crisis of (1994), xiv, 21, 38, 51, 234n steel prices in, 39 Miami, Fla., 35, 41, 59, 89 middle class, 147, 152, 153 middle-class Americans, 14, 15, 129, 148, 233n inequality and, 154–55, 156, 172 taxes and, 13, 252n upper-, 140 Middle East, 17 see also Persian Gulf states middle-income countries, 177 military spending, 7, 29 Miller, James, III, 46 Minnesota, University of, 138 Mises, Ludwig von, 247n Mississippi, 21 monetary policy, 3, 8, 31, 55, 139, 141, 144, 163, 224, 226, 261n euro, 49 loose, 9, 30, 41, 103–4, 158, 201 recession and, xii, 131–36, 227n in recovery and future policy, 215–16 tightening of, xii, 30 Treasury securities and, 8–9 money market funds, 87, 113 Money Market Investor Funding Facility, 133 money market mutual funds, 73, 112–13 money markets, short-term, 60, 100, 117, 125 money supply, temporary increase of, 245n Moody’s, 58, 67, 68, 71, 73, 96 moral hazard, 23, 76, 108, 128–31, 165 Morgan, J P., 20 Morgan Stanley, 121 mortgages, 6, 15, 34, 35, 40, 43–46, 85, 104–7, 114, 115, 126, 232n bonds based on, 58 commercial, 66, 66, 70 defaults on, 29, 43, 64, 90, 94, 97–98, 104, 105, 107 fixed-rate, 64 houses worth less than (underwater), 89, 149 interest rates for, 49, 63, 68, 89, 90 originate-to-distribute, 65, 94, 164 originate-to-hold, 65, 72 politics and, 45 refinancing of, 36, 150 risk and, 62 secondary market for, 69 securities backed by, see securities, U.S., mortgage-backed special purpose entity and, 66, 236n subprime, 43, 45, 56, 63–64, 68, 69, 85, 90–91, 93–96, 98, 104, 110, 115, 165 tax deductions and, 207 2/28 interest-only adjustable-rate (ARM), 63–64 multinational corporations, 172, 173, 174, 196, 200 municipal funds, 98, 103 Musgrave, Marilyn, 129 Naples, Fla., 46 Nation, 129 National Association of Home Builders, 35–36, 44 National Association of Realtors, 44–45, 47 National Banking Act (1863), 120 National Bureau for Economic Research, 131 National Economic Council, 136 National Economists Club, 135 National Flood Insurance Program, 209 nationalization, 129–30 of banking, 118, 124, 127, 161, 162 National Review, 46 Nazis, 179, 185 Netherlands, 12, 27, 118, 180 Iceland bank branches in, 189 net international investment position, 230n Nevada, 28–29, 35, 42, 45, 46, 89, 149 New Century Financial, 68 New Classical position, 138 New Jersey, 151 New York City, 25, 48, 75, 109 New Yorker, The, 94 New York Mercantile Exchange, 82 New York Stock Exchange, 84 New York Times, 42, 129, 132 New Zealand, 180–81, 182, 192 nonregulation, 82 Norquist, Grover, 166 North America, 1, 17, 153 see also specific places North American Equity Opportunities (NEO), 103 North American Free Trade Agreement (NAFTA), 153 North Carolina, 37 Oakland, Calif., 59 Obama, Barack, 128, 129, 162–63, 203 economic policy makers announced by, 136 stimulus proposal of, 137, 139–40, 141 trade policy and, 192, 198–99 “Objectivist” movement, 30 Obstfeld, Maurice, 24 office space, in Bangkok, 28 oil, oil exporters, 1, 17, 18, 218, 261n price of, 5, 6, 51, 61 oil shocks, 43, 218 open market operations, 131, 135, 245n options, 82 Orange County, Calif., 59, 235n originate-to-distribute mortgages, 65, 94, 164 originate-to-hold mortgages, 65, 72 Ormond Quay, 70–73, 100–101 Orphanides, Athanasios, 230n output, 154, 216, 217, 225, 250n, 262n outsourcing, 54 overnight market and rate, 103, 132, 142 ownership society, 35–36 PACs, see political action committees panic of 1907, 75 panics, 86, 100, 210–11 Paraguay, 147, 153 parking spaces, metered, 151 Pasadena, Calif., 106 Paul, Ron, 138 Paulson, Henry M., Jr., 80, 84, 87, 107, 110 bailouts and, 120–22, 127 congressional leaders’ meeting with, 113–17 Paulson, John, 95, 172, 241n Paulson plan (“cash for trash”), 116, 129 pay-as-you-go (PAYGO), 206, 257n–58n Pelosi, Nancy, 87 Pension Benefit Guaranty Corporation, 151 pension funds, 98, 149, 190 pension plans, 150–51 Persian Gulf states, 59, 193, 218 personal services, 38–39 Philadelphia, Pa., 59 Phoenix, Ariz., 35 PIIGS (Portugal, Ireland, Italy, Greece, and Spain), 187, 188 Pinochet, Augusto, 1, 147 political action committees (PACs), 44–45 politics, politicians, 50–51, 54, 152, 162, 179, 221, 226 and absence of reason in public debate, 170–71 contributions and, 44–45 deficits and, 12–13 finance and, 83–84 financial crisis and, 189, 190, 224–25 home ownership and, 35–36 Medicare and, 206 responsibility and, 202 tax increases and, 204 polls, bailout in, 128–29 Ponzi schemes, 232n poor Americans, 140, 203 inequality and, 154, 155 unemployment of, 148–49 poor countries, 18, 39, 177, 256n scarcity of capital in, 16 wage competition from, 172 Portugal, 186, 187, 188 prescription drugs, 168, 205 prices, 22, 51, 53 credit default swaps and, 164 deflation and, 134–35 exchange rates and, 40–41 housing, see housing, price of stability of, 27, 30, 34, 215–16 stock, 75, 106, 148, 149, 175, 234n Primary Dealer Credit Facility, 133 productivity, 85, 152, 202, 207, 219 protectionism, 54, 173, 178–81, 185, 191, 192, 194, 198, 219, 261n purchasing power, 17 QFI (Qualifying Financial Institution), 121 quantitative analysts (quants), 67, 91, 210 Rajan, Raghuram, 42–43 Rand, Ayn, 8, 30 rational procrastination, 51 Reagan, Ronald, 2–5, 12, 13, 40, 46, 139, 204 budget deficits and, 3, 5, 7, 10, 10, 12, 40 dollar’s value and, 54 Greenspan appointed by, 8, 30 tax cuts of, real, Brazilian, 52–53 real estate, 84, 158 as nontradeable, 39–40, 41 speculation in, 1, in Thailand, 28, 38 U.S., xiv, 5, 44, 224 see also housing realtors, 44–45 recession, 7, 9, 43, 51, 56, 59, 131–39, 141, 154, 167, 213, 259n in 1840s, 21 fiscal policy in, 136–37, 143 global, xv of 1921, 138, 178 of 1929, xvi, 177 of 1937, xii, 227n of 2001, 59, 60 of 2007 (Great Recession), 89, 131–36, 148, 150, 168, 201, 203, 216 of 2008, 128, 137, 176 of 2009, 159 recovery and future policy, xvi, 144, 157, 201–21 cost of, 225 fiscal policy and, 202–7 global rebalancing, global growth and, 218–20 hidden debts and, 208–10 monetary policy and, 215–16 overborrowing and, 207–8 regulation and, 210–15, 221, 260n U.S exceptionalism and, 220–21 redlining, reduction of, 231n regional trade agreements, 153 regulation, 27, 75–83, 86, 163–66, 202, 220, 223–26, 261n of banks, xii, 5, 70, 71, 72, 76, 77, 78, 80–81, 100, 115, 163–64, 213, 223, 238n British, 108 micro-prudential concerns vs systemic issues and, 212–13 private vs government, 83 in recovery and future policy, 210–15, 221, 260n of risk, 75–82, 164 of shadow banking system, 72, 83, 164, 211 in Sweden, 161 regulatory arbitrage, 77, 238n regulatory forbearance, 158, 160, 162, 251n Reich, Robert, 116 Reinhart, Carmen, 43, 234n Reinhart, Vincent, 234n renminbi, Chinese, 17–18, 196–99 “repo 105,” 242n Republicans, Republican Party, 2, 107, 116, 119, 127, 140 budget deficits and, 3–5, 7, 8, 12, 13, 171 construction industry and, 44 in elections, xi, 7, 15, 30, 31, 52 Greenspan and, 30 Roosevelt’s views on, 184–85 tax cuts opposed by, 204 unemployment benefits and, 167, 252n repurchase agreements, 237n, 241n, 242n, 245n Reserve Primary Fund, 112–13 reserve ratio, 229n Resolution Thrift Corporation (RTC), 160 retirement age, 206 retirement savings, 41, 149, 150 Reynolds, Alan, 46 Rhinebridge, 58, 70, 72, 73, 100–101, 103 rich Americans, inequality and, 15, 154–55, 155, 171–72 rich countries, 177, 256n risk, 51, 57–86, 88–95, 202, 208, 213, 221, 225 compounding of, 92–95 counterparty, 99–102 excess, 210, 212 ignoring of, 82–85 leveraging of, 61–64, 70, 79, 79, 80, 82, 84 long-term, 60, 61 mis-estimating of, 88–92 moral hazard and, 23, 76, 130–31 regulation of, 75–82, 164 securitization and, 64–69, 66 Rodriguez, Robert, 93–94 Rogoff, Ken, 24, 43 Romer, Christina, 136 Roosevelt, Franklin D., xii, 76, 181–82, 184–85 Rosengren, Eric S., 135 Rothschild family, 20 Roubini, Nouriel (Dr Doom), 24, 43, 187 Rubin, Robert, 84 Rudebusch, Glenn, 230n Rumsfeld, Donald, Russia, 152–53, 225 debt crisis in (1998), 16, 21, 29, 38 Ryan, Paul, 167, 252n Sachsen Landesbank, 70, 71 safety, 57–60, 67–68, 220 of money market mutual funds, 112 of SIVs, 57–58 safety net, U.S social, 15 sales tax, 205, 208 San Antonio, Tex., 35 San Diego, Calif., 35, 42, 89 S&P 500, 82 Santorum, Rick, 13 Sarbanes, Paul, 81 Saudi Arabia, xv savings, 41, 189, 208, 216, 217, 218 global supply of, 11, 59 retirement, 41, 149, 150 savings and loan industry, 71, 78, 114, 228n failures in, 6, 160–61 regulation of, 76–77 savings banks, leverage and, 79 Saxony, 71 Schumer, Charles, 87–88, 198 Seattle, Wash., 57, 58 securities, U.S., 212, 213 foreigners’ purchases of, 11, 40, 46, 228n lack of transparency and liquidity in, 46 mortgage-backed, 32, 43, 46, 58–59, 65–69, 66, 72, 92–98, 101, 104, 105, 106, 125, 126, 134, 157, 164, 237n “private label” mortgage-backed, 69 Treasury, see Treasury securities Securities and Exchange Commission (SEC), 77, 80–81, 82, 87, 95, 164, 238n, 241n securitization, 32, 72, 73, 99–100, 164 risk and, 64–69, 66 self-regulation, 80–81, 115, 211 semi-skilled workers, 154, 172 Senate, U.S., 116, 163 PAYGO and, 257n–58n Republicans in, xi, 7, 9, 140 September 11 attacks, 9, 29, 31 services, U.S., exports in, 174, 200 shadow banking system, 70–75, 78, 82, 83, 92, 99–102 loss of confidence in, 100–102 regulation of, 72, 83, 164, 211 see also conduits; hedge funds; special investment vehicles; special purpose entities Shanghai, 109 Shiller, Robert, 42 shocks, 82, 92 currency depreciation and, 180 oil, 43, 218 see also economy in shock Silverado Banking, Savings, and Loan Association, Simon, James, 172 Singapore, 18 SIVs, see structured investment vehicles Snohomish County, Wash., 59 Socialist parties, 147, 187, 189 Social Security, xii, 13, 168, 170, 190, 204, 228n policy changes for, 206 Soros, George, 172 South Africa, 173 South America, democracy in, 147 Southern Common Market (Mercosur), 153 sovereign wealth funds, 17, 18, 190 Spain, xv, 25, 26, 49–50, 55, 70, 186, 193, 223 and PIIGS, 187, 188 special investment vehicles, 164 special purpose entities (SPEs), 66, 70, 72, 81, 236n loss of confidence in, 100, 102 regulation of, 164, 211 spending, consumer, see consumption, consumer spending spending, government, 168 cuts in, xii, 7, 10, 13, 152, 167, 168, 202, 205–7, 252n increase in, 8, 29, 135–40, 201, 203, 206, 207 interest payments as, 169 spending, private, 138, 149 Springfield, Mass., 58–59 Standard & Poor’s, 58, 67, 68, 73, 239n standard of living, 17, 152, 169, 194 State Children’s Health Insurance Plan (SCHIP), 258n state government, U.S., 19–20, 21, 203 budget deficits of, 151 fiscal stimulus and, 140–41 funds of, 98 pension plans and, 151 State Street, 121 steel, 39 sterilization process, 18, 229n Stettinius, Edward, Jr., 153 Stiglitz, Joseph, 129, 140 Stockman, David, 4, 204 stock market, stock, 113, 118, 212 bailout and, 121, 127, 136 debt vs., 208 Lehman Brothers and, 108 prices of, 75, 106, 148, 149, 175, 234n regulation of, 77 retirement savings and, 150 Thai, 28, 38 U.S., xii, 4, 9, 41, 47, 208 value of, 117 stock market crash (1929), 75–76, 178 Stroessner, Alfredo, 147 structured investment vehicles (SIVs), 57–58, 59, 70, 72, 237n student loans, 65, 66 Summers, Lawrence, 24, 84, 136 super-rich Americans, 15 surpluses, 193, 195, 255n trade, 17 U.S budget, 7–11, 10, 29, 201, 205–6 Swagel, Phillip, 109 Sweden, 143, 161, 162 Swiss National Bank, 248n Switzerland, 26, 143 Swope, Gerard, 153 Taiwan, 18 Taleb, Nasim Nicholas, 91, 240n Tampa, Fla., 35 tariffs, 178–81, 197, 199 TARP, see Troubled Assets Relief Program tax cuts, 2, 3, 10, 13, 118, 201, 203–6, 217, 220–23, 228n consumer spending and, 29 fiscal deficits and, 12, 30, 171 fiscal stimulus and, 135–41 fiscal surplus and, 8, Greenspan’s preference for, of 2001, 12, 30–31, 168, 169, 204, 220, 257n of 2003, 168, 169, 204, 220, 257n taxes, xv, 85, 140, 165, 173, 221 borrowing promoted by, 207–8 capital gains, 208, 258n fiscal responsibility and, 202–7 increase in, xii, 7, 10, 152, 168, 170, 203–7, 228n, 257n sales, 205, 208 Social Security, 206 value added (VAT), 205, 208, 259n taxi rides, 39 tax rebate, 136, 139 Tax Reform (1986), 236n tax revenues, 210 Laffer curve and, tax cuts and, 2, Taylor, John, 30, 215, 230n Taylor rule, 30, 31, 132, 215, 230n technology, 4, 7, 31, 169, 173, 219 investment in, 14 Irish, 26 medical, 258n TED spread, 102, 117, 123, 127 televisions, 41 tender option bonds, 237n Term Asset-Backed Securities Loan Facility, 133 Term Auction Facility (TAF), 104 Term Securities Lending Facility (TSLF), 106, 133 Terrones, Marco, 234n terrorism, 9, 29, 31, 205 Tett, Gillian, 240n Texas, 5, 6, 35 textile producers, 37 Thailand, 38, 209, 225 capital inflow to, 15 construction boom in, 28 financial crisis in (1997), 28, 29 Thatcher, Margaret, 35 total debt, U.S., 32, 231n toxic assets, 93, 98, 99, 124, 127, 161 AIG and, 156 TARP and, 115–16 trade: international, 54, 144, 172–73, 174, 181, 192–99, 219–20 protectionism and, 54, 173, 178–81, 185, 191, 192, 194, 198, 219, 261n rebalancing and, 193–95 regional agreements and, 153 U.S.-China, 194–99 see also exports; imports Trade Adjustment Assistance, 219–20 trade deficit, 55, 234n British, 47 U.S., 37–38, 40, 194, 198, 216, 218, 261n trade surplus, 17 tranches, 67–68, 93, 94, 96, 98, 103 transparency, see financial transparency transportation, 19, 20, 39 Treasury, U.S., 9, 12, 87, 107, 110–17, 136 AIG failure and, 110, 111 bailout and, 111, 120–22, 124, 125, 130 Lehman Brothers bankruptcy and, 108, 109, 112 Office of the Comptroller of the Currency of, 76, 81 Office of Thrift Supervision of, 77, 78, 81 TARP and, 126–27 Treasury bills, 102, 104, 207 Treasury bonds, 4, 9, 252n foreign holdings of, 11, 59–60, 207 Treasury securities, 5, 8–9, 18, 32, 113, 134, 170, 236n foreign holdings of, 170, 218, 252n–53n long-term, 60 open market operations and, 245n short-term, 131 Troubled Assets Relief Program (TARP), 115–16, 118, 123–27, 141, 162, 167, 168, 209 Turkey, 16, 21 debt crisis in (late 1990s into 2000–2001), xiv, 38 2/28 interest-only adjustable-rate mortgage (ARM), 63–64 underemployed, 148–49, 150 unemployment, 146–50, 177, 219, 221 British, 157 financial crisis and, 136, 141, 147–50, 167, 225 in Great Depression, xi–xii, 179, 181, 182 in Japan, 159 Taylor rule and, 30 unemployment benefits, 137, 141, 167, 190, 252n United Kingdom, 26, 50, 55, 70, 143, 182, 186 butter for, 180 debt-financed consumption in, 47, 193 gold standard abandoned in, 180 housing market in, 47–48 Iceland bank branches in, 189 VAT in, 205 United States: borrowing of, see borrowing, U.S budget deficit of, see budget deficit, U.S economy in shock in, 147–57, 160–74 federal debt of, see debt, U.S federal United States (continued) financial crisis in, see financial crisis, U.S (2008– ) gap between the rich and the rest in, 15, 154–56, 155, 171–72 international confidence in, 11, 16, 17, 18, 24 survival of world economy and, 199–200 unskilled American workers, 154, 172, 253n upper-middle-class Americans, 140 Uruguay, 153 USA Today/Gallup Poll, 116 value added tax (VAT), 205, 208, 259n variable-rate demand notes, 237n Venezuela, 147 Viniar, David, 91 Virtue of Selfishness, The (Rand), 30 Visa, 113 Volcker, Paul, 2–3, Wachovia, 114 Wall Street, xv, 67, 84, 108, 116, 117, 156, 215 bailout and, 128, 129 Wall Street Journal, 8, 13, 78–79, 139 Wal-Mart, 113 War for Independence, U.S., 19 warrants, bailout and, 121 Washington Mutual, 114 Washington Times, 46 Wellington, Fla., 35 Wells Fargo, 114, 121, 122 Wen Jiabao, 196, 198 Weston, Fla., 35 Why the Real Estate Boom Will Not Bust (Lereah), 47 Wieland, Volker, 230n Wolf, Martin, 171 working class, 152 U.S., 15, 140, 148, 172, 203 World Bank, 9, 84, 143 World Economic Conference (1933), 181–82 World Trade Organization, 191, 195, 198, 219 World War I, 183–84 yield, search for, 61–69 leveraging risk and, 61–64 securitization and, 64–69, 66 Young Plan, 178 Zandi, Mark, 141 zero interest rate policy (ZIRP), 132, 137, 139, 142 zombie banks, 159, 162 More Praise for Lost Decades “[A] superbly clear and readable evocation of the decisions and actions that have led to America’s becoming a debtor nation on a horrifically grand scale.” —Andrea Axelrod, Chase Alumni Association “[An] important book, which deserves to be widely read and debated.” —Publishers Weekly “An important perspective in the ongoing debate on the 2008 financial disaster This excellent book is accessible to general readers.” —Mary Whaley, Booklist “The best book-length treatment of [the] argument [that] the explosion of international lending and the indebtedness of the United States [to] foreign investors caused the housing bubble[.] The book is capable of dealing with some of the most complicated economic arguments about the crisis in a way that is straightforward and capable of being understood by its audience.” —Seeking Alpha “An excellent read [Chinn and Frieden] anticipated a movement like Occupy Wall Street.” —Occupy Wall Street forum “If you want to learn how the U.S got into the financial mess we’re in, I recommend you pick up a copy of Lost Decades by Menzie D Chinn and Jeffrey A Frieden It is singularly one of the best books on the subject I have read The book provides a clear, concise, and impartial explanation of how we got here.” —Alan Caruba, Bookviews “An intelligent, vivid, and accessible account of the first great crisis of the twenty-first century Drawing on comparisons that will bother recalcitrant believers in American economic exceptionalism, the authors depict a gloomy panorama for the years to come unless policymakers get serious about fiscal reform This is a must-read for the expert and the layman alike.” —Ernesto Zedillo, director of the Yale Center for the Study of Globalization, former president of Mexico “This wonderful book by two leading political economists identifies the roots of the recent financial crisis and the deep recession that followed, but more important, tells us what awaits us if we not fix the underlying problems It is political economy as it was meant to be—accessible and concise, even while deeply troubling.” —Raghuram G Rajan, Booth School of Business, University of Chicago “You will not read a better political-economic synthesis of America’s financial crisis than this book.” —Dani Rodrik, author of The Globalization Paradox “Through pointed historical and comparative illustration, the authors show how financiers, politicians, and ideologues ushered in the crisis, and highlight the challenges we must overcome to avoid another lost decade.” —Nouriel Roubini, Stern School of Business, New York University Copyright © 2011 by Menzie D Chinn and Jeffry A Frieden All rights reserved First printed as a Norton paperback 2012 For information about permission to reproduce selections from this book, write to Permissions, W W Norton & Company, Inc., 500 Fifth Avenue, New York, NY 10110 For information about special discounts for bulk purchases, please contact W W Norton Special Sales at specialsales@wwnorton.com or 800-233-4830 Book design by Charlotte Staub Production manager: Devon Zahn Library of Congress Cataloging-in-Publication Data Chinn, Menzie David Lost decades : the making of America’s debt crisis and the long recovery / Menzie D Chinn and Jeffry A Frieden — 1st ed p cm Includes bibliographical references and index ISBN 978-0-393-07650-9 (hardcover) Debts, Public—United States Debts, External—United States Budget deficits—United States United States—Economic conditions—2009– Financial crises—United States I Frieden, Jeffry A II Title HJ7537.C45 2011 336.3’4350973—dc22 2011012043 ISBN 978-0-393-34410-3 pbk eISBN 978-0-393-08050-6 W W Norton & Company, Inc 500 Fifth Avenue, New York, N.Y 10110 www.wwnorton.com W W Norton & Company Ltd Castle House, 75/76 Wells Street, London W1T 3QT 1234567890 ... 1994, the East Asian crisis of 1997–1998, the Russian and Brazilian and Turkish and Argentine crises of the late 1990s and into 2000–2001 and, in fact, the German crisis of the early 1930s and the. .. high-flying financial and other activities, and eventually culminates in a crash In broad outlines, the cycle describes the developing-country debt crisis of the early 1980s, the Mexican crisis of. .. United States is in the midst of the greatest failure of economic policy, and of financial markets, of recent times This is the story of how and why it got there, and of what the nation must to