Understanding today’s crisis Prof. Wood – Oct. 18, 2012

Let’s think about… How a market economy is supposed to work, then What’s not working now and what’s especially difficult about today’s situation

Basics of an economy… People buy and sell from each other People who have good reason to spend more today than they have borrow from those with more than they need They rely on being paid back

Governments create money through Central Banks To guard against politicians creating too much money just before elections, Central Banks usually have independence from politicians If they create money too freely, “easy money” can lead to inflation make manipulations of the economic system easier Example: mortgage fraud in U.S. in 2007

If everybody decides the banks are not trustworthy… everybody will want to take their money out The banks have to stop making loans There’s a panic

This has happened twice in the last 5 years Banks lent for houses and derivatives based on house loans in US and other countries Fraudulent loans became easy to make Institutions throughout the system bought bonds based on the loans

Banks lent to countries in Europe throughout the 2000s Greece and Iceland certainly, and probably other countries, borrowed and spent far more than could be justified Banks and countries faced panic from 2010

Panics have happened many times in the past But they’ve never happened as frequently as in the last 15 years

What’s going on? Sources of new growth (the Internet, emerging nations) have always increased instability The period and place with the greatest previous number of panics was the 19 th Century U.S.

There’s a big surplus of savings in the world China, Japan, Taiwan and Germany are producing more than they spend Others have to spend more than they save to balance this out It’s often hard to tell how much borrowing and spending is too much

Economists didn’t do their jobs. In the 1990s and 2000s they often asserted that the self-regulating pursuit of self-interest would prevent or minimize panics They did this despite data such as that in our Kindleberger & Aliber reading that shows panics have been common since the Holy Roman Empire See the optional Hill 2009 reading in the packet So mechanisms to prevent mania and panic were neglected

The Euro created new problems In the U.S., we have a mechanism under which cities, counties, and states can go bankrupt Orange County, one of the largest and richest counties in the U.S. – home of Disneyland – went bankrupt in 1995 A county treasurer had pursued strategies not too different from those that Iceland pursued more recently The county went to court, reorganized, went on austerity to cut costs, issued $1 billion in long-term bonds, a few years later emerged. The real economy was hardly affected

The International Monetary Fund has a similar mechanism for nations outside the EuroZone Mexico Argentina Thailand Great Britain in 1976 IMF resembles a global Central Bank Restructurings are very painful – heavy austerity But countries get out fairly predictably

There’s nothing similar inside the EuroZone Europe has prospered by integrating Germans and French wanted to integrate further When the Euro was launched, investors seemed to think they didn’t need to worry about European countries any more They seemed to think the richer countries (Germany) were guaranteeing borrowings of the periphery Germany wants to avoid making it too easy to escape debt in Europe

Germany seems to want rules requiring conservatism Everybody should balance their budgets like Germans

But… As long as the Chinese, the Germans, and the Japanese run surpluses, somebody has to run a deficit

Who will judge how much borrowing is too much? Can we ever have rules that politicians can’t cheat on? Can we get out of this without a U.S.-style, IMF-style solution: letting the markets decide about a country most of the time and then having a central referee to work things out when things get really bad?

Recently, Central Banks are supporting countries European Central Bank says it will lend to nations that have an economic restructuring agreement with European Union agencies It’s starting to act like the International Monetary Fund Germany voted against, but didn’t veto when it could Federal Reserve (the U.S. Central Bank) is pumping money into the U.S. economy although there’s no big emergency

What’s next? What happens after the U.S. election?