CHAPTER 1

The Damaged Economy

It is tempting to say that the crisis is over. The "Great Recession," as it isbeing called, did not turn into a second Great Depression. Unprecedentedintervention by central banks and governments averted worldwide economiccatastrophe.

And signs of stabilization have appeared: optimistic experts increasinglyoutnumber pessimistic experts, the slump has bottomed out, and pockets of growthhave emerged.

So why not declare an end to this gloomy chapter and get back to normal?

Because, unfortunately, the fundamental problems of the world economy have notyet been resolved. The dependence on heavy-spending consumers (particularly U.S.consumers) remains; many important banks are still weak, and it will take yearsbefore they return to full health; and the economic scoreboard shows a drop ineconomic activity not seen since World War II.

According to recent estimates from the International Monetary Fund (IMF), theworld economy shrank by 1.1 percent in 2009. The advanced economies (especiallythe exporting ones such as Germany, Japan, and Korea) suffered the most,shrinking by 3.4 percent during this period.

But even the emerging economies fared poorly—except China, whose growthrate (buoyed by fiscal stimulus) slowed to 8.5 percent in 2009 from 9.0 percentin 2008 and 13.0 percent in 2007. Russia contracted by 7.5 percent, having grownby 5.6 percent in 2008 and by 8.1 percent in 2007. Brazil fell by 0.7 percent,having enjoyed growth of 5.1 percent in 2008 and 5.7 percent in 2007. And Indiasaw growth of 5.4 percent, down from 7.3 percent in 2008 and 9.4 percent in2007.

The impact of the crisis on world economies would have been even worse withoutthe drastic measures taken by governments and central banks. Governmentsmobilized an unprecedented amount of money in an attempt to right their economicships. Estimates range from a massive $5 trillion to a truly staggering $18trillion to stabilize the financial sector and $2.5 trillion to stimulate demandin the "real economy"—where the production and consumption of goods andnonfinancial services takes place. The IMF puts the estimate at an impressive 29percent of 2008 gross domestic product for the advanced economies. Meanwhile,leading central banks have lowered interest rates and taken aggressive measuressuch as quantitative easing—the direct purchasing of financialassets such as government bonds. As a result, the balance sheets of the centralbanks have grown significantly since the crisis started in the summer of 2007.The U.S. Federal Reserve's balance sheet grew by 229 percent from July 2007 toJuly 2009.

These measures have arrested a slump that was, until the summer of 2009, lookingvery similar to the Great Depression of the 1930s. This was the picture paintedby Professors Barry Eichengreen of the University of California, Berkeley, andKevin H. O'Rourke of Trinity College in Dublin in their paper, "A Tale of TwoDepressions." Between 2007 and 2009, production and world trade dropped evenfaster than they did in the Great Depression. The major difference between thenand now has been the fiscal and monetary policy and the aggressive measurestaken to stabilize the global financial system. In making these moves,politicians and bankers did, in fact, heed the lessons of the Great Depressionand the Lost Decade in Japan. In so doing, they were acting on therecommendations of Depression-era economists such as Irving Fisher and JohnMaynard Keynes. Thanks to these coordinated efforts, a second Great Depressionwas avoided.

Even so, we need to recognize that the initiatives to "reflate" the globaleconomy amount to an unprecedented and historic experiment. Some of thesemeasures, although discussed theoretically, have not been put into practicebefore. So the big question remains: Is this the end of the crisis, or will thecrisis simply follow a different pattern?

To answer this question, we need to examine the background of the currentfinancial and economic upheaval since it burst into the public consciousness in2007.

How It Happened

We all know that a crash in U.S. property prices triggered a leverage crisis inthe subprime-mortgage securitization market. This, in turn, triggered a globalliquidity crisis, which itself contributed to a solvency crisis among some banksand an increase in the pressure to deleverage. When this led to a furtherdecline in asset prices, the whole cycle repeated itself.

It was inevitable that such enormous financial dislocation would lead tosignificant collateral damage to the real economy. Falling asset prices and theprospect of an economic slowdown dented consumer confidence. Lower demand and ashortage of credit—because of the liquidity squeeze—combined todrive companies toward conserving cash, reducing output, lowering capitalexpenditure, and laying off workers. Small and medium-sized enterprises wereparticularly affected as banks cut back their lending in an effort to stabilizetheir balance sheets, which, in turn, made a bad situation worse and drove somecompanies into bankruptcy.

The bottom line: the subprime crisis led to a solvency crisis in the financialsector. This, in turn, led to a recession in the real economy, which furtheramplified the problems for the financial sector as credit losses increased. Andas losses continue to increase and credit tightens, the constraints in thefinancial system collide with an increasing number of personal and corporateloan defaults that naturally follow when economic conditions deteriorate. Thetwo cycles feed off each other.

If there is one phenomenon that best characterizes the irrational behavior thatunderpins the crisis, it is the history of home values in the United States. AsRobert Shiller, an economics professor at Yale University, has demonstrated,U.S. house prices in any given year up to 1997 had virtually always been withinabout 15 percent of house prices in 1890, when adjusted for inflation (the onlyexception being the 25 percent drop between the two world wars). In 1997,though, U.S. house prices started to rise dramatically. In just 10 years, theinflation-adjusted price of a U.S. house doubled. In 2006, at the peak of thebubble, Shiller's index reached 202.9 (in 1890, the index stood at 100).

The increase in U.S. house prices was underpinned by the ready availability ofdebt, particularly after interest rates were cut to 1 percent in order tostimulate a faltering economy in the wake of the 9/11 terrorist attacks. From2005 to 2007, additional impetus was provided, first, in the form of aggressiverisk taking by highly leveraged financial...