In order to solve a problem it is essential to understand what caused it. The current crisis largely ensued from the development, and subsequent collapse, of a massive credit bubble. This bubble has been inflating for several decades, but began to reach absolutely astounding levels at the turn of the 21st century. During this time of unforeseen credit growth, the American and global economy, experienced severe asset price inflation, massive levels of malinvetments, as well as governments, corporations, and individuals all taking on unsustainable amounts of debt. Eventually it became evident that that vast majority of this debt could not be paid off and this led to the credit bubble bursting, which initiated the crisis. While there is no doubt that most, including even many politicians, understand that the economic problems which are being experienced are a result of a collapse in credit, very few actually understand how and why the credit bubble formed in the first place.
The current credit bubble, and as such this economic crisis, has it roots back nearly 40 years, and if one were to put a date on the "beginning of the end", August 15th 1971 would be a great choice. It was on this day that the Nixon administration ended that Bretton Woods system and severed the tie between the US dollar and gold. The destruction of the gold standard which existed under the Bretton Woods system completely changed the dynamic of the global economy and paved the way for the massive explosion of credit. This is due to the fact that under a gold standard massive credit expansion, to the degree which we has been seen in the past several decades, is not possible. A gold standard is explained by Nathan Lewis in his book Gold - The Once and Future Money in the following manner:
" A gold standard links the value of paper currencies to the value of gold. This is accomplished by some system to adjust the supply of base money such that the currency maintains a fixed value relative to gold."The Bretton Woods system operated whereby the US dollar was linked to gold at $35 an ounce, and the other major world currencies were linked to the US dollar at fixed exchange rates. This system, or in general, any gold standard, offers many significant benefits to an economy, and it is no surprise that gold standard currencies have been used countless times throughout history. However, with respect to the current economic crisis, the destruction of the Bretton Woods system made it possible for the formation of the great credit bubble by allowing the United States to easily accumulate a massive trade deficit, while at the same time allowing the US government to operate significant government deficits. It will first be shown how a gold standard limits trade imbalances and government budget deficits, and then the role that these imbalances played in the unsustainable growth of credit and malinvestment in not only the US, but across the globe will be examined.
Under a gold standard an automatic adjustment mechanism exists which prevents countries from deviating from trade balance for an extended period of time. If a country were to incur a trade deficit (i.e. like the one the US has had for most of the past few decades), then more gold would leave their country to pay for the excess amount of goods they imported from foreign nations, then would enter it. This decreased level of gold would lead to a contraction in the money supply and credit in the deficit country. Money supply and credit would collapse due to the fact that under a gold standard the value of the currency is fixed to gold, so a decrease in the amount of gold in a country means that the level of money and credit must decline to maintain the correct fixed ratio. This decrease in money supply and credit would depress economic activity in the deficit country leading to deflation and a fall in prices. Furthermore, the depressed economic activity would mean citizens of the deficit country would no longer be able to afford as many imports, while on the other hand deflation and falling prices would make their goods more attractive to foreigners, and as such trade balance would soon return.
The opposite would occur under a gold standard for a country which incurred a trade surplus. A surplus would result in a country accumulating a net increase in the level of gold permitting their banking system to expand the amount of money and credit in the system. This increase in money and credit would lead to increased economic activity and ultimately inflation and rising prices. As prices rose the surplus country would become less competitive, especially relative to those with trade deficits. Consequently, the demand for the surplus country's higher priced goods would decline, while their demand for imports from the lower priced deficit country would increase and again this would eventually lead to a return of trade balance.
A gold standard, also severely limits the growth of government deficits through a mechanism referred to as the crowding out effect. When a government decides to operate a large budget deficit this increases the net demand for credit in the economy. The increase in demand by the government, which under a gold standard would be on a restricted supply of credit, crowds out private borrowing and furthermore drives up interest rates. A situation like this obviously has very negative implications for an economy and it is no surprise that under the Bretton Woods system, as well as the gold standard that operated earlier in the 20th century, government deficits in the United States were extremely rare.
With the abolition of the Bretton Woods system in 1971 and world currencies no longer linked to gold, the new age of paper money creation began with governments free to print as much money as they desired. The United States, however, was put in the most unique position post-Bretton Woods, given that the dollar was adopted to replace gold as the world's new reserve currency. What this meant was that the US could now settle its foreign trade debt in its own currency, which in the absence of the gold standard, was now available to them in an unlimited amount. Furthermore, the US government now had the ability to run large and prolonged budget deficits. The crowding out of private investment that existed when a gold standard was in place, was no longer an issue, as the supply of money and credit was not restricted by the amount of gold in the economy.
This new dynamic, quickly transformed the US and global economy. After Nixon abolished the Bretton Woods system, the US government began to consistently increase their deficits. Between the end of World War II and 1971, the US budget deficit exceeded 2% of Gross Domestic Product (GDP), only 3 times (1959 at 2.5%, 1968 at 2.8%, and 1971 at 2%). However, between 1975 and 1995 the budget deficit averaged an astounding 3.5% of GDP, and only dropped below the 2.5% level once, while in 2009 the budget deficit skyrocketed to nearly 10% of GDP. These budget deficits have had profound negative implications on the American economy, as greater amounts of capital are now being distributed by politicians and bureaucrats who are in most cases more influenced by lobbyists, special interest groups, and their desire to survive the next election, then by the free market desire to efficiently expand wealth and earn a profit.
However, at the same time budget deficits began to grow, trade deficits were also ballooning and this process played a huge role in the development of the credit bubble, and consequently, the ensuing economic collapse. Starting in the early 1980s, American consumers began to import more and more goods from other nations, especially Asian economies, whose cheap and ample labour provided Americans with extremely low priced products. These growing deficits were not viewed as detrimental to the economy by government officials because not only were American consumers able to fill their homes with massive amounts of cheap imports, but the low prices of these imports also benefited the government as it enabled them to expand their debt more rapidly. This was due to the fact that they no longer needed to worry about rapid expansions in debt (and as such the money supply to finance the debt), contributing to severe consumer price inflation, as prices were now kept in check by cheap imports. Also the growing deficits America incurred with foreign nations led to booms in countries such as Japan, Korea, Taiwan, Thailand, Malaysia, Indonesia, Mexico, and later China. This new economic paradigm of debt-financed trade was believed by many to be extremely beneficial to not only Americans but also to emerging economies across the globe, few ever considered the dire implications these deficits would have in the near future.
The new ability for America to settle their trade balances by printing more dollars allowed the US to import $7.4 trillion more than it exported between 1982 and 2008. However, the global boom that ensued was nothing more than a mirage, as it was creating an absolutely unsustainable process, for both America and its trading partners. As increased amounts of dollars entered economies such as those in Asia, the recipients of those dollars (i.e. the manufacturers of the goods destined for America) increased the demand for their home currency as they deposited the American dollars they earned into their home banks. Thus, central banks of the surplus countries faced a dilemma; if they left their money supply unchanged the rapidly increasing demand for their currency, due to the influx of American dollars in their banking system, would lead to a vast appreciation in their currency. This was undesirable as it would make their goods less competitive and subsequently lead to a decline in the demand for their exports (this is the process which would occur if gold was the reserve currency). However, without a gold standard, and central banks free to print as much money as they pleased, these central banks just increased their own money supply to purchase these American dollars. This process depressed the value of their currency and kept their export industries competitive, spurring continued demand from American consumers.
The process which led to America's downturn was much different from the credit bubble crises which occurred in places like Latin America, Mexico, and Asia in the 1980s and 1990s. This is due to the fact that America was, and still is, a net importer, but also because they control the global reserve currency, the dollar. As America's trade deficit expanded foreign nations accumulated increasing numbers of dollars, and as was mentioned most of these dollars found their way to the central banks in order to prevent currency appreciations. (These dollars in the hands of foreign central banks are referred to as foreign exchange reserves.) The amount of reserves obtained by countries across the globe reached trillions of dollars, with China alone obtaining in excess of $2 trillion. With such vast dollar reserves foreign central bankers were faced with the dilemma of what to do with them, as it was undesirable to just leave them in a vault where they would earn zero return. The central banks and government authorities who controlled the majority of these reserves decided the best place to reinvest them was back into the economic power house that is the US. This created a circular process whereby American consumers purchased imports which spurred foreign economies and eventually provided foreign central banks with vast dollar reserves. Next, these dollars would return to the US, as foreigners who had dollar surpluses purchased massive amounts of American debt and other assets, such as real estate and equities, in order to earn a return on their dollar reserves.
This process, whereby the dollars used to finance the United States trade deficit returned to the US, allowed the US government, government sponsored-enterprises (GSEs), and even corporations in America to easily expand their debt levels as there was a massive demand for debt instruments, both domestically and from foreigners. Furthermore, this dynamic allowed the Federal Reserve to maintain extremely low interest rates for a prolonged period of time, because as was mentioned earlier, they did not need to worry about severe price inflation in consumer goods given the influx of cheap imports. These low rates further influenced the credit fuelled boom in the US, accelerating corporate profit levels, investment levels, and consumer demand for imports, which only further amplified the recycling of dollars across the globe.
The demand for "safe" assets, by both foreigners with their massive levels of dollar denominated reserves, and by domestic market participants with their boom profits, allowed the two giant housing market GSEs, Freddie Mae and Fannie Mac, to easily issue massive levels of debt. Between 1998 and 2003 they issued approximately $3 trillion of new debt (refer to Federal Reserve Flow of Funds here). With these new funds they went out and purchased a phenomenal amount of mortgages from commercial banks. This in turn freed those banks of liabilities and allowed them to issue even more mortgages at very attractive rates due to the ultra low interest rates maintained by the Fed. This cycle eventually drove real estate prices to dazzlingly high record levels across all of America. Home owners rushed to take advantage of record valuations and many re-mortgaged their homes. Again this just provided more money for consumers to purchase goods both domestically and from abroad, continuing the cycle.
To conclude, as American dollars flowed around the globe, and cheap foreign goods flowed into America, foreign banks' dollar asset levels increased, the United States Fed was able to maintain ultra low interest rates, government budget deficits increased, a massive increase in demand for American debt and other assets was created, and consequently asset prices in the US (especially real estate) increased to extreme values. All of these interrelated occurrences created a dynamic which led to a massive explosion of credit in the United States, with the ratio of debt to GDP reaching an astounding 350% in 2007, just prior to the collapse. Eventually, this recurring, circular cycle, of expanding trade deficits and credit growth brought asset prices too high, created too much malinvestment, and ultimately saddled Americans with amounts of debt which were just too great.
In 2008 the unsustainability of the credit bubble became evident, and the first signs came with a very large number of homeowners defaulting on their mortgage payments. However, the problems quickly spread throughout the economy leading to the house of cards that is the American economy to begin its collapse. Politicians and government officials quickly stepped in and implemented their twin ideas of an increase in the role of government (i.e. the record government budget deficits) and massive increases in the money supply. These "solutions", however, show that those in power greatly misunderstand the problem as essentially all they are attempting to do is re-inflate the credit bubble and get American dollars flowing back around the globe. Unfortunately, this credit bubble appears to have reached a level that is so unsustainable that any attempts to re-inflate it will be futile. Instead, sooner or later, America and the rest or the world will have to face the true causes of the crisis which will only be solved by a return to a sound currency and the free market determining the distribution of all capital.
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