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2010 Annual Assessment

The financial crisis began with the sins of credit, which grew unregulated and unchecked in the parallel banking system of investment banks to which Lehman Brothers belonged, and which almost caused the collapse of the entire world system.4 The credit that grew unrestrained by matching equity capital (Lehman reached a 1:30 relation between capital equity and credit – an enormous degree of leverage), led to a situation in which every minor shock impaired borrower ability to repay loans. This credit served to fuel the real estate bubble, as it allowed households and entrepreneurs to borrow ever more, in the hope that they would continue to profit from real estate deals. When housing prices fell, the borrowers and lenders fell with them. As lending banks did not hold enough reserves to absorb the loss, several were forced to declare bankruptcy. The collapse of some major financial institutions led to a series of collapses, as every bank limited the credit available to others, as they doubted their ability to recover it. In order to prevent the collapse of the entire financial system following the collapse of Lehman Brothers, massive government intervention was needed. The global collapse was indeed averted by massive injections of capital and liquidity made by central banks and governments in various countries, led by the United States (and Britain) the epicenter of the financial earthquake.

Households and entrepreneurs borrowed ever more, in the hope that they would continue to profit from real estate deals

What fundamental elements enabled the expansion of credit and prevented government oversight? The first is an increasingly widely shared pro-market ideology, a belief that markets are capable of running themselves and that they do so optimally without oversight. The academic foundation for this ideology was the “efficient market” doctrine that argued, and showed with statistical data, that financial markets work efficiently – and therefore do not require government oversight.5 The previous Chairman of the Federal Reserve, Alan Greenspan, presided over the final deregulation of the capital markets in President Clinton’s time, a policy that had bi-partisan support. During his time the Federal Reserve also employed a low interest rate policy that fueled cheap money and the search for higher returns through taking bigger risks.

Other fundamental factors relate to structural problems in the American economy, some of which are known and others less so. Today it is already known that the very low level of American savings was responsible for the crisis due to two factors that are connected to it.

The government deficit created during the George W. Bush presidency depleted all the reserves accumulated in the social security system during Clinton’s presidency

First, the surplus in consumption was funded by credit – the same credit that expanded and fed the real estate bubble.
As can be seen in the graph, American credit rose from 94.6% of income in 1997 to 137.6% in 2007; in other words it multiplied by a factor of almost 1.5. In 2008 a decline can be seen. A higher rate of increase can be found only in Britain – an increase by a multiple of 1.7, from 107.1% to 185.8% in the same period. And indeed these two countries were the major casualties of the crisis. It is noteworthy that European countries borrowed much less, as did Canada, which did not increase consumer credit in the decade prior to the crisis. And indeed, the banking crisis was considerably more moderate in these countries. In Israel consumer credit is much smaller than in the other countries shown in the graph, and it is even trending down.

Second, alongside the low level of private savings in the United States, which continued to decline and actually reached zero before the crisis, there was a government deficit created during the George W. Bush presidency, which depleted all the reserves that had accumulated in the social security system during Clinton’s presidency. Negative national savings are usually manifest in a deficit in the balance of payments, which was indeed the case in the United States.

Table 2 shows the development of the deficit in the American BOP and its deterioration up to 6% of GDP in 2006, compared to an average deficit of zero among OECD member countries. The table also shows the relative strength of the German economy, with a large export surplus that pulled it out of the crisis, the surplus in Japan’s exports and Canada’s quite reasonable situation. In Israel there is a notable and constant improvement in the current account, which transitioned from negative to positive in the beginning of the decade.

The policy of expanding consumption to raise aggregate demand, thereby creating growth, is not new to the United States where consumption is the main engine of growth. Every year, in the period before Christmas, the economic press observes with trepidation consumer spending – waiting to see if it is large enough to herald continuing growth. The novelty is that consumption had grown without growth in income and, therefore, had to be funded by a growth in credit. The American economy indeed did grow in the previous decade, but due to the growth in inequality, the added income went to the top income decile and primarily to the top percentile.

At the global level, the country that allowed the United States to enjoy continued growth by increasing consumption, the country that funded the consumption of the richest country in the world was a lot less well off – China. For the past several years China has been maintaining the rate of exchange of its currency at a higher level than that of equilibrium, and in order to prevent the strengthening of its currency it purchases hundreds of billions of dollars and invests them in US government bonds and other assets. In this manner China can maintain an export surplus at the expense of an American import surplus, and at the same time China experiences growth and accumulates wealth while the United States becomes poorer and grows only artificially, at the expense of debts to China and the rest of the world.

Therefore, the adjustment required by the United States is seemingly simple: reduce growth in consumption, increase exports and investment in the United States and reduce the federal deficit. For this purpose the dollar must be devalued in real terms relative to other world currencies and especially relative to the Chinese Yuan. Such a devaluation will encourage exports, make American citizens effectively poorer, and will therefore encourage savings and discourage consumption. This is a structural change that takes time as the economy and all its units must adjust to it. However, the American government does not have time. The ongoing crisis exacts two, heavy political prices. First – a high rate of unemployment that does not decrease despite relative growth (jobless recovery) and second – a continued increase in the deficit and in federal debt.

Israel managed to negotiate the crisis quite well, relatively speaking, but it suffers from structural problems

These are fundamental, structural elements and therefore the resolution of the crisis depends on fixing them. The problem is that fixing these elements makes it difficult for the United States and the rest of the world to quickly emerge from the crisis. Remaining in crisis means an unemployment rate that does not decrease and this, in turn, exacts a heavy political price from the American government.

In the immediate term, the way out of the crisis is to be found – despite everything – in increased consumption, since, as yet, no other element has managed to replace it as an engine for growth.6 In the long term, other elements of American aggregate demand must rise, such as an export surplus or fixed investments, in order to bridge the gap that will be created between the drop in consumption and the rise in national savings.

The increase in inequality of income is attributed by many economists to the technological and economic changes of the past decades, which created a high premium for education. The United States, which was a world leader in secondary and university education, now trails behind Europe in the number of university graduates and thus loses growth potential. American infrastructure also lags behind European infrastructure.

In order to put the United States back on a track of sustainable growth, structural changes are needed that will support a more balanced growth in incomes and higher productivity of the American worker. Mainly, this means improving the education system and infrastructure. But in the shorter term, the fiscal aspect will also require treatment in order to ensure a decrease in debt relative to GDP.