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ConsumerDebtandFinancialFragility
RobertGuttmann(HofstraUniversity,NewYork)
&DominiquePlihon,(CEPN,UniversitParis13)
Duringthesummerof2007theUShousingcrisismorphedintoaglobalcreditcrunchdisrupting
theworldeconomy.Wearenow(April2009)facingtheworstfinancialcrisissincetheGreat
Depression,followedbypossiblyprolongedrecession.Thisdramaticturnhasputintoquestion
thelong-termviabilityofaglobalgrowthpatternwhichforthelastcoupleofdecadeshas
heavilyreliedonAmericaastheworldsbuyerofthelastresort.Inthispaperwewishto
explorethiscentralpillaroftheglobaleconomyandwhyithascavedtosuchhorribleeffect.(1)
1.Debt-FuelledGrowth
Debtaccumulationbytheeconomysprincipalactorsgovernments,corporations,
households,andthefinancialinstitutionsthemselves-hasnowforquitesometime
constitutedakeyelementinthegrowthdynamicofcapitalisteconomies.Thecompositionof
debthasevolvedcontinuouslyaseachofthesekeysourcesofaggregatedemanduseddebt
financingtoturnitselfintoauniqueengineofgrowth.
1.1.TheChangingCompositionofDebt:Propelledtoamuchgreaterroleintheeconomy
bytheGreatDepressionofthe1930sandWorldWarII,counter-cyclicalgovernment
spendinganchoreditselfatthecenterofoureconomicsystemastheWelfareStatecameto
maintainminimumincomelevelsacrossallleversoftheeconomy(unemploymentbenefits,
farmsubsidies,corporatetaxbreaks,lossguaranteesforbanks,etc.).Publicsectorspending
cameunderincreasedupwardpressureduringthestagflationcrisisofthe1970s,matchedby
inflation-inducedintensificationoftaxburdens.Thisconfluencesetthestageforthe
conservativecounter-revolutionunderReaganandThatcher,laterextendedtocontinental
Europe,whichaimedtolimittheroleofgovernmentandreduceitsdeficit-spending
proclivities.Whilepublicdebtrosefrom20.5%ofGDPin1980to42%in1995inthemajor
OECDcountries,itactuallyfellproportionatelyduringthesubsequentdecade(e.g.from50%
to38%ofGDPintheUSA).Overall,governmenthasactuallyendedupabsorbinga
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progressivelysmallershareofthetotalU.S.debt(i.e.from44%oftheaggregatein1958to
just17%in2008).
Thecorporateuseofdebtalsocametoplayanimportantroleinthepost-wargrowth
dynamic,firsttofundmass-productiontechnologyandinternationalexpansionamongmulti-
nationals,then(fromthemid-1980sonward)tolaunchaboominmergersandacquisitions.
Underthenewdictumofshareholdervaluemaximizationfirmsextendedthisgrowing
relianceonexternalgrowthtofinancialization,thegrowingaccumulationoffinancialassets
andliabilities.The1990ssawmassiveamountsof(debt-fuelled)capitaldirectedtowardthe
NewEconomybubbleuntilitsdemisein2000.AtthesametimeEuropeanandAmerican
firmsmanagedintheearly1990sandearly2000stocomeoutofrelativelyshortdownturns
byrestoringtheirprofitabilitytorespectablelevelswithoutboostinginvestmentspending
proportionately.Thisdisconnectionboostedtheirself-financingcapacityandmadethemless
dependentondebt-financingofproduction,withcorporateUSdebtdecliningfrom67%of
GDPin1991to55%in1995andfrom69%ofGDPin2001to64%in2004.
Followingderegulationofbankingactivities(EUsSecondBankingDirective1989,
FinancialServicesModernizationActof1999inUS),bankshadmuchgreaterscopefor
innovationandsotransformedthecreditsystemawayfromloansandtowardsecurities.This
alreadystartedintheUSwiththeemergenceofjunkbondsinthe1980s,butreachedawhole
newdimensionwhenbanksbegantopooltogetherloansandturnthoseintosecurities.Such
securitizationtransformedthetraditionalindirectfinancemodeloftakingdepositsand
makingloansintoanoriginate&distributemodel,whichenabledthebankstoearnhuge
flowsoffeesandcommissionswhiledramaticallyboostingtheirfundingvolumes.Centered
aroundanunregulatedandhighlyleveragedshadow-bankingnetwork,thebanksbuiltinthe
processamulti-layeredsystemtyingloans,short-termmoney-marketinstruments,long-term
securities,andvariousderivativestogether.Adollaroftraditionaldebtfundingproductive
spendingthuscametobecarriedafloatbyfour,five,six,perhapsevenmoredollarsofpurely
self-enclosedfinancialtransactions.Underlyingthisprofoundtransformationofourcredit
systemwasahugeexpansionofthefinancialsector,especiallyintheUnitedStateswhere
financialinstitutionsshareintotalU.S.profitsgrewfromastable16%shareinthe1973-85
periodtoarangeof21%to30%inthe1990sallthewaytoapeakshareof41%in2007.
Evenmoreimpressively,financialsectordebtintheUnitedStatesgrewfrom25%ofGDPin
1982to49%in1991andanastoundinglyhigh121%in2008.
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Muchofthefinancialsectorsextra-ordinaryexpansionoccurredfromthemid-1990sonward
whenbanksextendedtheirnewsecuritization-basedfundingmachinetoconsumerdebt,in
particularthefundingofhousingbymeansofmortgage-backedsecurities.Thisfuelledoneof
historysgreatboomperiods,butalsosetthestateforagreatcrisiswhenanexcessively
speculation-pronefinancialsectorgotrendereddangerouslyfragilebytheoverextended
Americanconsumer.Itisthisinteractionthatwewanttohighlightinourpapertogetabetter
understandingofthesystemiccrisiswefacetoday.
1.2.ConsumerDebtandWageStagnation:Anyeconomysincreaseinproduction
capacity,whichfirmscanfundbeyondearningsthroughbankloans,corporatebonds,and
newequityshares,hastobeaccompaniedbyproportionateincreasesindemandontheother
sideofthemarketequation.Whilethosecancomeaboutfrombusinessspendingitselforgovernmentspending,wearemorelikelyespeciallywhenlookingatthisintheaggregate
togetthesedemand-sideboostsfromhouseholdconsumption(whichinmosteconomies
marksbyfarthelargestcomponentofdemand,astaggering72%oftotalGDPintheUnited
States).Butduringthelastthreedecadeswehaveseenstubbornwagestagnationinthe
industrialnations.Thattrendfirstappearedinthe1970swhenindustrialwagescouldnot
keeppacewithacceleratinginflation,thenintensifiedduringtheextensivecorporate
restructuringofthe1980s,andfinallyextendedevenfurtherwiththesuddenentryof3
billionnewhumansintotheworldeconomyfollowingthecollapseofcommunismin1991.
AccordingtoIMF(2007),laborsincomeshareintheadvancedcapitalistcountriesfellfrom
68%in1980to61.5%in2005.Thiserosionwasfurthercompoundedbywideninginequality
betweenaminorityofglobalizationwinnersandmajorityofglobalizationlosers.Allthis
threatensdomesticeconomicstabilitybyfosteringthepossibilityofoverproduction
conditionsnecessitatingrecessionaryadjustments(torestorethebalancebetweensupplyand
demand).
Manycountries,especiallytheemerging-marketeconomiesandsuchtraditionalindustrial
power-housesasJapanorSouthKorea,havebeenabletoescapesuchanimbalanceby
launchingexport-ledgrowthstrategies,oftenfuelledbykeepingthedomesticcurrency
undervaluedthroughactiveexchange-ratemanagement.Obviouslynoteveryonecanrun
current-accountsurpluses.Somecountriesmustabsorballthoseproductsfromsurplus
countriesbyrunningdeficitsintheirtradebalance.Consumersinthosecountriescan,of
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course,contributetosuchabsorptioneveninthewakeofstagnantwageincomesbysaving
lessand/orworkingmore(ashashappenedwiththeUnitedStatesespeciallyand,toalesser
extent,alsoinEurope).Intheend,however,eitheroftheseresponseshasitsphysicallimits.
Inthatcontextthefacilitationofadequatehouseholdspendinginthefaceofstagnantincome
ismoreeffectivelyassuredbyaccesstoconsumerdebtwherebyhouseholdspendingcanbe
decoupledwithinlimitsfromconsumerincome.
Weseethistrendplayoutinallmajoradvancedcapitalisteconomies.Everywhereinthe
industrializedworldweobserveoverthelastcoupleofdecadeacorrelationbetween
stagnant,evenfallingwagesharesandrisinguseofconsumerdebt.Wesuspectthatthere
mayevenbeasymbioticrelationshipbetweenthetwointhesensethattherebydebt-boosted
consumptionlevelsstayedhighenoughandthushelpedboostgrowthofdomesticGDP
sufficientlytosustaininturnthegrowinguseofdebtbyhouseholdsoveralongperiodof
time.Table1showstheriseinconsumerdebtasapercentageofdisposableincomeinthe
UnitedStatesandFrancebetween1975and2006atrendconfirmedbyseveralrecent
studies(e.g.ECB,2007b).
Table1:Householddebtas%ofdisposableincome
1975 2006
UnitedStates 62 127
France 33 68Source:OECD
Theoveralltrendnotwithstanding,wehavetoaskourselveswhyAmericanfamilieshave
takenonsomuchmoredebtthantheirEuropeancounterparts. Aconstellationof
institutionalcomplementaritieshavetogethercreatedthatbiasinfavorofhigherlevelsof
indebtednessamongAmericans.Forone,thereisanationalconsensus,rapidlyadoptedeven
bythemostrecentimmigrantwishingtointegrate,ofpursuingtheAmericanDreamwhich,
forallpracticalpurposes,translatesintoenjoyinghomeownershipandarisingcapacityto
spend.Apowerfullyentrenchedget-rich-quickmentality,barelyrestrainedbyorganized
religionand/oranti-capitalisttraditionsfoundelsewhere,allowstherichtosetthesocial
normsofconsumptionfortherestofAmerica.Ideologicalpreferencesinfavorofsmall
governmenthavealsoledAmericanstoentrustcertainnecessities,whichintherestofthe
worldareprovidedaspublicgoodsbythegovernmentitself,tomarketregulationandhence
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enduppayingalotforthose-education,health,transportation,etcetera.Muchofthisis
financedbydebt,suchasstudentloansorcarloans.Thesewidelyavailablechannelsof
specializedloansareoneexpressionofahighlydevelopedsystemofconsumerdebt.This
popularsegmentoftheU.S.creditsystem,pushedaggressivelybycommercialbanksand
morespecializedlenders(e.g.creditunions,financecompanies)inaverycompetitive
environment,hasbeensupportedformanydecadesnowbytheU.S.governmentwitha
combinationoftaxbreaks,regulatoryrelief,andgovernment-sponsoredconcessionary
lendersassignedtopromotetheirsegmentofconsumerdebt(e.g.FannieMaeandFreddie
Macformortgages,SallyMaeforstudentloans).IntheendtheU.S.hasbuiltawhole
economyaroundconsumerdebt,includingcreditbureausevaluatingthecreditworthinessof
everyAmericanhousehold,debtcounselors,collectionagencies,andfinancialadvisors.
Americanshaveincreasinglymatchedtheirproclivityfordebtwithalowregardforsaving,
theexactoppositepreferenceprofilefromthatofmostEuropeansandEastAsians.
2.FinancialInnovationsandtheU.S.HousingBubble
Thetrendtowardshigherlevelsofdebtisfuelledbylendersfindingnewwaystoentice
moreborrowingandthefundingthereof.Financialinnovationisacrucialaspectof
finance-ledcapitalism.Anendogenousforcewithinanycreditsystem,itisinitiatedby
financialinstitutionsrespondingtospecificconstraintsforwhichtheyseeknewescapes
andsolutions.Alotofinnovationsareaimed,forinstance,atbypassingregulatory
restrictionsorothertypesofinstitutionalbarrierstothegrowthoffinancialtransactions.
Andmostofthisactivityendsupfacilitatingthebanksextensionofcredit.Wecansee
thistrendclearlywithregardtomortgages.
2.1.MortgageInnovation:Bankingderegulationintheearly1980s(Depository
InstitutionsDeregulationandMonetaryControlActof1980,DepositoryInstitutionsAct
of1982)enabledU.S.bankstomoveawayfromtheDepression-eramortgagestandard
(30-yearmaturity,fixedinterestratewithmaximumceiling,20%downpayment),which
forsolonghadservedU.S.home-ownerswell.Insteadthebanksbegantointroduce
adjustable-ratemortgageswherethepriceriskwouldbebornebytheborrowerrather
thanthelender.Tomakethesemoreappealing,bankswouldchargeartificiallylow
interestratesatthebeginningoftheloancontractthatwouldberesettohigherlevels
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later.Fromthereitwasonlyasmallsteptoballoonmortgages,whichpostponedmost
ofthedebt-servicingchargesuntilmuchlater,ornegative-amortizationloanswherea
portionoftheinterestpaymentswouldbeaddedontotheprincipalratherthanbepaid
concurrently.
Theincreasedpaceofmortgage-relatedinnovationledbanksinthemid-1990stomake
twocrucialchangesintheirhome-loanpractices.Withinterestratesfinallycomingdown
fromtheirhighlevelsofthe1980s,bankersmadeiteasierandcheaperto refinance.
MillionsofAmericanhome-ownersweregivenachancetoreplaceanoldmortgage
beforematuritywithonecarryinglowerinterestratesand,correspondingtotheincreased
valueofthehomeservingasunderlyingcollateral,alsoalargerprincipal.Theother
changeconcernedtheintroductionofhome-equityloans,akindofsecondmortgagethat
couldbeusedforanyspendingpurposewhilestillaffordingborrowerstheadvantageof
tax-deductibleinterestpayments.Bothoftheseinnovationsmadeitpossiblefor
Americanhome-ownerstocashinontheappreciationoftheirhomeequity.The
beginningofthehousingboominthemid-1990sprovidedanextrastimulusfor
householdconsumptionwhichpushedtheU.S.economyontoahighergrowthpathfor
yearstocome.(2)
2.2.Securitization:Therapidspreadofre-financingsandhome-equityloansresulted
fromamassiveshiftinthesuppliesoffundstowardsreal-estateinvestmentsasyet
anotherkeyfinancialinnovationcametorevolutionizethefundingofAmericanhome
ownershipintheearly1990s.Theinnovationwearereferringtohereisthe securitization
ofloans,inparticulartheissueofmortgage-backedsecurities.ThoseMBSarecreated
whensimilartypesofmortgagesarepooledtogetherandusedascollateralforthe
issuanceofsecurities.Investorsinthosesecuritiesreceivepaymentsofprincipaland
interestoftheunderlyingloansinthepool,whicharepassedthrough(minuspayment
ofservicingandguarantyfees).Suchrepackagingofmortgageloansintomarketable
securitiesallowedbankstorecuperateloaned-outfundsquicklyforadditionallending
ratherthanbestuckwithanilliquidloanassetformanyyears.Themuch-accelerated
turnovermadeitpossibleforbankstoincreasetheirlendingvolumegreatlywhile
transferringdefaultriskstoinvestorsandearnawholelotoffeesassociatedwith
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securitization.Initiallylaunchedalreadyintheearly1980sbygovernment-sponsored
entities(GSE)likeFreddieMac,FannieMaeandGinnieMae,ittookawhileforthisnew
financialproducttocatchon.Bythemid-1990s,however,MSBstartedtoattractamuch
largercommunityofinvestorsbecauseoftheirrelativelyhighyieldsinalow-interest
environment,especiallywhenconsideringawidespreadperceptionoftheirlowrisk
becauseoftheirimplicitgovernmentbacking. (3)WhiletotalannualMSBissuesaveraged
about$500billionduringthe1990s,thataveragetripledafter2002to$1500billiona
figureimplyingthesecuritizationofabout80%ofallnewU.S.mortgagesoverthelast
fiveyears.
2.3.HomeEquityWithdrawals:CombinedwiththeFedkeepinginterestratesverylow
intheearly2000s,amplefundingprovidedbymortgagesecuritizationsetoffamajor
housingboomintheUnitedStates.Astheboomtookholdafter2002,re-financingsand
home-equityloansenabledU.S.homeownerstoborrowagainstthesoaringvaluesoftheir
homesandsoboosttheirspendingcapacityconsiderably.Amountingto9%ofdisposable
incomeandaveraging$840billionp.a.atthepeak,suchhome-equitywithdrawals
increasedconsumptionby3%p.a.inthe2002-05period,equivalenttoanannual
spendingboostofabout$300bn.,comparedto1.1%p.a.duringthe1990s(Greenspan&
Kennedy,2005).
Eagertoexpandmarkets,lendersacceleratedtheboomafter2004bypushingnew
mortgageproducts,suchaspiggy-backscoveringdown-paymentrequirement(for
effective0%self-financing),Alt-Aloanscarryinghigherratesinreturnforrelaxing
incomeverificationandotherrequirementsforproofofcreditworthiness,andsubprimes
toborrowerswithtroubledcredithistories.Thesenon-traditionalloanswereattractive,
sincetheycarriedmuchhigherratesandearnedloanofficersalsohighercommissions.
Banks,nowmuchmoreheavilyinvolvedinloansecuritizationthemselvesandissuing
after2004morethanhalfofallnewMSB,bundledthesenon-traditionalmortgage
products(includingso-calledjumbomortgagestoobigforFHAinsurance)intohigh-
yieldingloan-poolcombinationswhosesecuritizationwouldstillearninvestment-grade
ratingsandsoproveirresistibletoinvestors.Suchhigh-yieldingnon-agencyMSB
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issuedbythebankswerealsogobbledupbyforeigninvestors,upto$500bn.in2005
alone.(4)
2.4.StructuredFinance:From2005onwardthesecuritizationmachineshiftedtoward
non-agencyMBSwithlaxerunderwritingstandardsandcomprisedarapidlygrowing
shareofsubprimesandAlt-As.Aroundthattimebanksdevelopedaningeniouswayto
maintaintriple-AAAratingsforthebondsbackedbypoolsofinherentlyriskierloans.
Rootedinthelogicofriskreductionbydiversification,theyfurthersecuritizedMBSinto
so-calledcollateralizeddebtobligations(CDOs)whichtheyslicedintotrancheswith
differentdefaultrisksbasedontheirspotinthelosspay-offhierarchy.
Thehigher-risktrancheswereplacedwithhedgefunds,structuredinvestmentvehicles
(SIVs),andotheroff-balance-sheetentitiestiedtobanksandfundedbythem.Muchof
thatfundingcamefromarapidlygrowingshort-termsecuritizationpillar,so-calledasset-
backedcommercialpaper(ABCP)backedbybundlesofshort-termdebts(e.g.student
loans,carloans,credit-carddebt),wheretheseintermediariescouldfundtheirpurchases
oflonger-termCDOs.
Thusemergedaself-enclosedfinancial-intermediationalternative.Thissystemofso-
calledstructuredfinancebundledloansintosecurities,slicedanddicedthoseinto
tranches,andsoldsaidtranchesofftoanewnetworkofopaque,highlyleveraged,and
risk-proneintermediaries.Thebankswerecentrallyinvolvedineverystepofthis
shadow-bankingcircuit.Theyissuedtheloans,earnedfeesfromtheirsecuritization,
andsetupthefundsmakingthemarketforthesesecurities.Sincemuchofthisactivity
occurredoutsidethebanksbalancesheets,theyneverprovidedadequatecapitalforit.
Insteadtheytriedtomanagetheriskbyinsuringthosesecuritizationinstrumentswith
credit-defaultswaps(CDS)whoseextensiveusegreatlyboostedtheissue-andtrading-
capacityofthisnewfundingsystem(seeIMF,2008).
3.ExcessU.S.ConsumptionandGlobalImbalances
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Bysecuritizingtheentirearrayofhouseholdloansintoaself-enclosedcircuit(ABCP->
CDOs+MBS=>consumerlending),theworldsleadingbankspropelledconsumerdebt
intothecenteroffinance-ledcapitalism.Whatweseehereunfoldisaconsumer-led
growthpatternintheUnitedStateswherehouseholdconsumptionhasrecentlymadeup
anastounding72%ofGDP,farhigherthanelsewhere.WithAmericasshareofwages
andsalarieshoveringinthe65%-68%rangethroughoutthe1990sand2000s,such
proportionatelyhighconsumptionlevelsnecessitatedsharpdeclinesinAmericas
personalsavingsrate(fromanaverage8%ofdisposableincomeatthebeginningofthis
periodtoanegative2%fifteenyearslater,in2006)aswellasincreasingrelianceon
consumerdebt.ThelatterexperiencedasignificantboostwhenAmericanhomeowners
wereallowedtoborrowmassivelyandcheaplyagainsttheirrapidlyrisinghousing
capital.Home-equitywithdrawalsprovidedmorethanhalfofAmericasnominalGDP
growthduringthepost-2001recovery.Theabilitytoboostdebt-financedconsumptionin
linewithrisinghousingpricesmakesitlessurgenttosave. Wecanobserveasteady
declineinhouseholdnetsavingintheUSsincetheearly1980s.Ourhypothesisisthatthere
isacloseconnectionbetweentheriseinUScurrentaccountdeficitandthefallindomestic
netsavingsinthehouseholdsector.Whilebothgovernmentandthecorporatesectorsmay
alsocontributetotheoveralldeclineindomesticsaving,theirroleseemstohavebeenless
predominantinthelongrun.Empiricalevidencesuggeststhatthelinkbetweenhouseholdnet
savingandcurrentaccountbalance,mostlikelymediatedthroughtheevolutionofassetprices(inparticularhousing),isinfactnotlimitedtotheUSandprevailsinseveralother
OECDcountries(ECB,2007a).
TheboostinUSconsumptionfromthehousingboomcarriedmajorspillovereffectsto
therestoftheworld.TheU.S.economy,findingitselfonceagainwithsignificantbudget
deficitsafter2001,hadtocompensateforagrowingimbalanceinprivatenetsavingwith
arelentlesslyrisingdeficitinnetexportswhichby2006hadgrowntoover$800bn.or
7%ofGDP.Inotherwords,theUnitedStatesspendscollectively7%morethanitearns
inanygivenperiodoftime,withthatgapbeinglargelyfinancedbyimportsofcapital
fromcountriesrunningchroniccurrent-accountsurpluses,notablytheoil-exporting
nationsofOPEC,Japan,andtheemerging-marketeconomies(EMEs)of,aboveall,Asia
(i.e.China,India).Therecyclingofthesesurpluseshasoccurredmoreorless
automaticallyoverthelastdecadetotheextentthatthosecountrieshavepeggedtheir
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undervaluedcurrenciestothedollar,whichobligesthemtobuyupdollar-denominated
assets(intheprocessofsellingtheirowncurrencies)whendefendingtheirpegsagainst
surplus-inducedcurrency-appreciationpressures.
3.1.TheUS-DollarasWorldMoney:Surpluscountriesacollectionofcommodity
producers,emerging-marketeconomies,andindustrialnations-havethusbeenableto
pursueexport-ledgrowthstrategies,rootedinconsciouslyundervaluedcurrencies,and
sustainthosebylendingtheirsurplusestotheonecountrywillingandabletoactasthe
worldsconsumerofthelastresort.TheUnitedStates,inturn,hasbeenabletolive
consistentlybeyonditsmeanswiththehelpofthesurplusnationssavings,thereby
endingupabsorbing75%oftheworldsaggregatetradeimbalances.Itshouldbenoted
thatthissymbioticrelationshipunderlyingtheglobalgrowthdynamicofthelastcouple
ofdecadeshasbeensupportedbyacrucialasymmetryintheworldeconomystemming
fromtheuseoftheleadingpowersnationalcurrencyasinternationalmoneyincross-
bordertransactions.Thatmoney,since1945theU.S.dollar,iscreatedwithintheleading
countrysbankingsystemandgetstransferredbycontinuousnetoutflowsfromthe
countryofissuetotherestoftheworld.Inotherwords,thecreationofinternational
liquidityrestsonchronicbalance-of-paymentsdeficitsoftheUnitedStateswhichother
countriesautomaticallyfinancetotheextentthattheyhold$-reservesorusedollarsin
internationalcirculation.TheUnitedStates,toputthatsameadvantageindifferentterms,
istheonlycountrycapableofborrowingfromabroadinitsowncurrencyandofdoingso
indefinitely.Itcanthereforeaccumulatelargerforeigndebtswithoutfeelingthesame
kindofdebt-servicingburdenandinthisfashionpursuemuchmorestimulativeeconomic
policiesforfarlongerthanothercountrieswouldbeableto.Thisrelaxationofitsexternal
constrainthasallowedtheUnitedStatestorunuphugecurrent-accountdeficits,have
thoseautomaticallyfinancedatlowcostbythesurpluscountries,andlivewithanegative
savingsrateeventhoughitistherichestcountryintheworld.
3.2.LookingattheOtherSideoftheCoin:Wehavebeenwitnessingaclearbias
amongAmericancommentatorsinfavorofexplainingthechronicimbalancesinthe
worldeconomynotasaresultoftheUnitedStatesabusingitsprivilegedpositionas
issuerofworldmoney,butinsteadasfosteredbypolicychoicesofsurpluscountries.One
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suchargument,pushedbycurrentFedChairBernanke(2005)andbyformerUSTreasury
SecretarySummers(2006),pointstoasavingsglutamongemerging-marketeconomies
intheaftermathoftheircrisisinthelate1990swhichcausedcapitalflows toreverse,
flowingnowfromdevelopingtoindustrializedcountries.TheEMEs,especiallythosein
Asia,havebuiltupexchangereservestosafeguardagainstpotentialfuturecapitaloutflows.
Indoingso,governmentofthesenationshaveendedupchannellingdomesticsavinginto
internationalcapitalmarkets.Thisexcesssavingexerteddownwardpressureonrealinterest
rates,stimulatingborrowingandconsequentlyasset-priceinflationindevelopedeconomies.
Arelatedview,putforwardbyM.Bordo&M.Flandreau(2001)orM.Dooley,D.
Folkerts-Landau&P.Garber(2003),characterizesthecurrentconfigurationasBretton
WoodsII.Thisargumentviewsthecurrentsituationnotunlikethepost-warfixed-rate
system,whichprevailedfromthelate1950stotheearly1970s.Theperipheryonceagain
seekstomaintainundervaluedcurrenciesatfixedratesforexport-ledgrowthandinthe
processendsupsupportingthecoresexternaldeficit.
Boththesavings-glutandBrettonWoodsIIargumentsignorethebasicasymmetryinthe
modusoperandiofthedollarstandard,theneedforchronicAmericanbalance-of-
paymentsdeficitswhichtodaytaketheformofU.S.current-accountdeficits
automaticallyfinancedbytherestoftheword.Thisseignioragebenefit,aspointedoutbyEichengreen(2007),putstheUnitedStatesattheactivecenteroftheworldeconomyand
rendersitfullyresponsibleforitsimbalances.Eichengreenstimelyanalysisendswith
thepertinentquestionwhetherthosesymbioticimbalancescanpersistindefinitelyand,if
not,whichwouldbethemostlikelyadjustmentscenarios. (5)
3.3.AdjustmentOptions:Anyeventualadjustmentprocessintherebalancingofthe
worldeconomywouldrequireasteady,significantimprovementinU.S.netexportsover
thenextfiveyears.SinceNixonssuspensionofBrettonWoodsin1971successiveU.S.
governmentshaveprovenwillingtolettheUS-dollardepreciateinordertoboostitsnet
exports(byrenderingUSexportscheaperabroadandimportsintotheUnitedStatesmore
expensiveforAmericans)andtore-valueUSassetsabroadin$-terms.Theproblemwith
thistypeofadjustmentisthat,withpricemovementsfasterthanvolumechanges,any
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depreciationraisesinitiallytheimportbillandsomakesthetradedeficitworsebeforeit
getsbetter(theso-calledJ-curve).Apartfromthedelayedreaction,thereisalsothe
problem,alreadyviolentlymanifestonceinOctober1979,ofanexcessivelylargedollar
depreciationbecomingself-feedingtothepointofacutelyendangeringtheworld-money
statusoftheUS-dollarespeciallynowthatithassince2002forthefirsttimeaserious
rivalintheeuro.SuchacrisismaymakeitimpossiblefortheUnitedStatestocoverits
twindeficitsoratleastrequiremuchhigherU.S.interestratestokeepforeigninvestors
attracted.
Anotheradjustmentoptionwouldinvolvecorrespondingchangesintheeconomicpolicy
posturesoftheUnitedStatesandthesurpluscountries.Americaspoliciestocutits
excessconsumption,throughtaxincreasesorincreasedforcedsavings,wouldhavetobe
matchedbyexactlyoppositepoliciesamongsurpluscountriestoboostdomestic
consumptionviacurrencyappreciation,taxcuts,and/oralaxmonetarypolicy.Whilethis
kindofsymmetricpolicy-drivenadjustmentmightultimatelybethesmoothest,itisalso
mostdifficulttoimplementintheabsenceofinternationalmechanismsforeconomic-
policycoordination.
Ultimately,despitesomepersistentdollardepreciationafter2006renderingitsproducts
moreprice-competitiveinglobalmarkets,theUnitedStatesfailedtousethisopportunity
toputitshouseinorder.Necessarymacro-economicpolicychangesprovedpolitically
toodifficulttocarryoutbothdomesticallyaswellasintherestoftheworld.U.S.policy-
makersmademattersworsebyinvadingIraqandlettingtherestoftheworldpayforthe
rapidlygrowingcostsofthismilitaryadventure.Theirlackofconcernfororderly
adjustmentswasrootedinoptimisticassessmentsdrawnfromAmericasevidentstrength
intradeinservicesanditscomparativelyhighforeign-investmentreturnswhichhave
keptitsnetinvestmentincomepositionbalanceddespiteitsverylargeforeigndebtin
excessof$3000bn.(6)Theproblemhereisthat,intheabsenceofanypolicy-driven
adjustments,globalimbalancesbecomeuntenableandtriggeracutecrisisasawayof
enforcingthenecessaryrebalancingbetweendeficitandsurpluscountries.Thisis
preciselywhathastranspiredsinceearly2007.
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4.TheMakingsofaSystemicCrisis
Theprevailingglobalgrowthpatterncouldnotbere-balancedintime,becauseithadserved
bothsidesoftheequationsowellforsolong.TheUnitedStates,obligedbytheworld-money
statusofitscurrencytorunlargeexternaldeficitsautomaticallyfinancedbytherestofthe
world,usedthisprivilegetofundexcesslevelsofconsumptionthatkeptAmericanshappy
despitelargelystagnantincomesamongamajorityofthem.Andtherestoftheworld,
especiallytheemerging-marketeconomieswhose3billioncitizenshadjustbeenallowedto
joincapitalismafterthecollapseoftheSovietUnion,enjoyedthebenefitsofexport-led
growthandtransformationintocreditornationswithlargecurrencyreserves.Thatmutually
beneficialarrangementfuelledaglobalengineofamplecreditsuppliesatlowinterestrates.
Atthecenterofthatenginewasafinancialinnovation,namelysecuritization,whichenabled
Americanstoborrowever-growingquantitiesagainsttheirrapidlyappreciatinghomesfrom
thesaversoftheworld.
Suchagrowthpatternhashadtheadvantageofallowingspendingandsavingspatternstobe
separatedfromincome.Americansspentfarmorethanwarrantedbytheirincomelevels
whiletheemergingmiddleclassesinthenewlyindustrializingcountriesaccumulatedsavings
evenfasterthantheiralreadyimpressiveincomegrowth.Thisseparationofincomeand
spending,attheheartoffinance-ledcapitalismsglobalization,maintainedaggregatedemand
atsufficientlyhighlevelstoforestallrecessionaryadjustments.Sincethelastmajordownturn
intheearly1980stheworldeconomy,notablytheU.S.economyasitslargestcomponent,
hadexperiencedonlytworelativelyshallowandshort-liveddownturns(1990/91,2000/01).
Bothofthesewereovercomerelativelyswiftlybyaggressivemonetarypolicyactionpushing
interestrateslower,sharplyrisingbudgetdeficitsboostingspending,andcontinuedcredit
suppliesmaintainingprivatesectorspendingdespitestagnantorevendecliningincomes.
4.1.FinancialFragility:Butsuchlongperiodsofstabilitycarrytheirownseedsofself-
destructionbyengendering,asH.Minsky(1964)arguedsoconvincingly,increasinglyfragile
financialstructures,whicheventuallywillleadtomajorcrisis.Asdeficit-spendingunits(i.e.
businesses,households)experiencesuccesswiththeirpreviousactions,theybecomemore
inclinedtotakeongreaterriskintheirsubsequentengagements.Thesamebiasalsotakes
holdamongtheirlenders.Intheabsenceofanymajorrecessionaryadjustmenteconomic
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actorslosesightofthepossibilityoffailure.Theybecometoooptimistic,inclinedto
downplayrisksinthechaseforhigherreturns.Sucheuphoriaissociallyconstructed,hence
widelyshared.Overtime,usuallyasamatterofacoupleofdecadesoraquarterofcentury
withoutmajordownturns,financingpositionsofdebtorsandcreditorsalikewillthushave
becomeprogressivelymoreprecariousasaresultofincreasedrisk-taking.
InthiscontextMinskydistinguishedbetweenthreefinancingpositionshedgefinance
wherethenetcash-flowpositionofdebtorsissufficientlypositivenotevertoendangerthe
servicingofdebts;speculativefinancewherenetcash-flowpositionscanbeattimes
inadequatetomeetpaymentcommitmentsastheyaccrue,andPonzifinancewhereadditional
debtisnecessarytomeetexistingdebt-servicingcharges.Intheabsenceofanyrecessionary
adjustmentswipingoutthemostvulnerabledebtorsandsoremindingeveryoneelseofthe
dangersofexcessiverisk-taking,thefinancialstructurebecomesprogressivelymorefragile
bycontainingagrowingproportionofspeculative-andPonzi-financeunitsinthelatephases
ofalongboom.Itisatthispointthatan(otherwiserelativelyminor)eventcanexposethe
degreeofoverextensionprevalentinthefinancialstructureoftheeconomyandtriggera
panicreactionthatbreaksopenachainreactionofdefaults,forcedassetsales,financial-
marketcollapses,andgeneralizedshortageofaffordablecreditthemakingsofafinancial
crisis.
WehavegoodreasontoaskourselvestowhatextentMinskysvisionofincreasedfinancial
fragilitybuildingupduringalongboomoverseveralcyclesdoesnotapplyalsotothe
averageAmericanfamilyanditshugebuild-upofconsumerdebtoverthelast25years,with
theburstingofthehousingbubbleservingasthecatalystforamajorfinancialcrisisona
globalscale.Ifthatisindeedthecase,thenwehavejustenteredacrisis-drivenadjustment
processthatgoesinbothlengthanddepthbeyondamererecessionaryadjustment.
4.2.TheBurstingoftheBubble:Followingatwo-yearperiodofpersistenttighteningby
theFed(i.e.seventeenconsecutiveinterest-hikes)in2004-06,theU.S.housingbubbleburst
duringthesecondhalfof2006whenhomesales,construction,andevenpricesallstartedto
tumble.Atthatpointnon-traditionalmortgages,especiallysubprimes,begantoseetheir
initiallylowteaserrates(of1.5%to3%)resettomuchhigherlevels(usuallybetween10%
and15%,butinsomecasesrisingto18%)whichimmediatelycausedmanyofthosehigher-
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riskborrowerstofaceseriousdebt-servicingproblems.Inthespringof2007itbecameclear
thatuptoathirdofallsubprimemortgagesmightendupindefaultoncemostscheduled
interest-rateresetswouldhaveruntheircoursebymid-2009,triggeringintheprocess
perhapsasmuchas5millionforeclosuresandtherebyassuringacontinuouslydeepening
real-estatedownturnboundtolastovertwoyears.Thisstarkrealizationputintoquestionthe
investment-graderatingsofmanyMSBcontainingsubprimesintheirpools.Asaresult
ratingsagencies,underpressuretoacknowledgetheirmistake,begantodowngradealotof
MSBbelowinvestment-gradelevelwhichdisqualifiedthemfrombeingboughtorheldby
mutualfundsorpensionfunds.
InAugust2007thisdeterioratingsituationexplodedsuddenlyintoafull-blownglobalcredit
crunch.OncethespikeofsubprimedefaultsbegantospilloverintothemarketforMSB,it
spreadpanickyfeartoseveralothersecuritizationlayers.Thenextmarkettocollapsewas
thatofcollateralizeddebtobligations(CDOs)whichbundledifferentkindsofdebttogether,
includingcorporatebonds,mortgage-backedsecurities,andcredit-carddebt.Anumberof
investorsheavilyengagedinthenow-paralyzedCDOmarket,notablyhedgefunds,private-
equityfunds,structuredinvestmentvehicles,andotherbank-runspecial-purposeentitiesthat
hadbeenkeptoffthebooks,suddenlyfoundthattheynolongerhadrecoursetoshort-term
fundsmobilizedviaissueofasset-backedcommercialpaper(ABCP),thethirdsecuritization
layertocollapseinthefallof2007.(7)Thisforcedthemtodrawmassivelyonemergency
bankloansputasideforpreciselysucheventualities.Thesuddenhikeindemandforsuch
fundsputalotofpressureontheinter-bankmarketwhichbanks,nowsuddenlyfearfulof
whatlosseslaidahead,werenotwillingandabletorespondtomeaningfully.Aseventhe
shortest-term(overnight)inter-bankratesshotfarabovecentralbanktargetsoncedemand
forfundsstartedtooutpacesupplyoffundsconsistently,theworldsleadingcentralbanks
hadtostepinrepeatedlywithhugeliquidityinjectionstopreventtheinter-bankmarket,the
nervecenteroftheglobaleconomy,frombecomingparalyzed.
4.3.GlobalCreditCrunch:Wearenowinthemidstofanunprecedentedglobalcredit
crunch.Thecoordinatedandunprecedentedlender-of-last-resortinterventionsoftheECB,
theFed,theBankofEnglandandothermonetaryauthoritiesboughthebankssometimeto
copewiththehugetrillion-dollarlossfromthecollapseoftheshadow-bankingsystemin
August2007.Beingforcedbynew(mark-to-market)accountingrulestodeclarelosses
rapidly,thebankswereluckythatthemarketsnolongerfunctionedtogivethemanyreliable
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signalsaboutcurrentfair-marketprices.Theythuscouldestimatetheirlossesastheysaw
fitbasedontheircomputermodels(mark-to-modelaccounting).Mostbankschosetodeclare
theirlossesgraduallyonaquarterlybasiswhileatthesametimemobilizingrecurrentcapital
injectionswithwhichtocoverthosewrite-downlosses.
Theproblemwiththatgradualiststrategywasthatbankswouldeventuallyrunoutoftime.At
somepointthemercilesscombinationofinvestorlossesanddecliningsharepriceswould
makeitincreasinglydifficulttoattractnewcapitalatatimewhenmuchmorewasneeded.
Firsttohitthiswall,inMarch2008,washighlyleveragedinvestmentbankBearStearns
whoseFed-assistedmergerwithJPMorganChasewipedoutthefirmsshareholders.The
panicfromthiscollapseonceagainsentshuddersthroughthecreditmarkets,promptingthe
Fedtowidendramaticallytherangeofpermissiblecollateralagainstwhichbankscould
borrow(throughthenewTermSecuritiesLendingFacility)andtoextendthatliquidity
protectionbeyondcommercialbankstoinvestmentbanks(thePrimaryDealersCredit
Facility).
Eventhoughthesemeasurescalmedthingsdownforafewmonths,thepsychological
damagewasdone.Shareholderfearsofgettingwipedoutwhenafailedbankhadtobe
rescuedbythegovernmentledinvestorstofleebanks,therebyreducingtheircapitalbase
whilemakingrecapitalizationmoredifficult.Banksrumoredtobeintroublesawtheircredit-
defaultswappremiashootupwhich,inturn,wouldsparksell-offsthatwerefurtherfuelled
byshortsellers.InSeptember2008thedeepeningU.S.housingcrisisfinallyknockedoutthe
hugegovernment-sponsoredmortgagelendersFannieMaeandFreddieMac,attheexpense
ofa$200bn.bail-outbytheUSgovernment.Fearingthemoral-hazardimplicationsofits
toobigtofaildoctrine,theUSgovernmentdecidedtoletfailingLehmanBrothersgo
bankruptbarelyaweeklater.Thatcollapsetriggeredadevastatingchainreactionofextreme
stressconditionsamongcredit-defaultswaps,corporatebondmarkets,moneymarketfunds,
commercialpaper,andthentheinter-bankmarket.Morethansixmonthsofimpairedbank
lendingandseverelydepressedcapitalmarketshavebynow(lateApril2009)prompted
multi-trilliondollarbail-outsintheUnitedStatesandEuropeanUnionwhileatthesametime
triggeringagloballysynchronizedrecession.Withgovernmentsobligedtorecapitalizebanks,
guaranteetheirliabilities,andbuyouttheirtoxicassets,theywillbeinclinedtousetheir
dramaticallyextendedpowersoverbankstoimposeanewregulatoryregimeonfinance.
5.ExitStrategies
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Lookingatthiscrisis,oneistemptedtocompareitsunfoldingtoanine-inningbaseballgame.
Usingthatmetaphor,weareprobablysomewhereinthemiddleofthefifthinning.The
gamestartedwhenthesub-primebulletwentoffamidstaburstingU.S.housingbubblein
early2007.Asthebulletricochetedthroughthecreditsystem,ittookdownthethree
principalsecuritizationpillarsaroundwhichbankshadconstructedaglobalshadow-banking
system.Thatcollapse(inAugust2007)leftmanyoftheworldsleadingbankswith
enormouslossesforwhichtheydidnothaveenoughcapitalonhand.Thebanksthendecided
todeclaretheirlossesgradually,moreorlessinproportiontothemobilizationofnewcapital
sourceswithwhichtowriteofftheselosses.ThisstrategywascutshortinMarch2008when
therescueofBearStearnswipedoutitsshareholdersandsoleftpotentialsourcesofprivate
bankcapitaldissuaded.Thefourthinningsawanewtypeofbankrun,asrumorsofabanks
imminentdemisesentitscredit-defaultswappremiumshootthroughtheroofwhichinturn
triggeredmassiveshortsellingofthebanksbondsandequityshares.Inthefaceofrapidly
mountingattacksonthesolvencyofkeyfinancialinstitutionstheU.S.governmentlet
LehmanBrothers,WallStreetsfourth-largestinvestmentbank,collapseon15September
2008.Theexplosivefall-outfromthatbankruptcy,triggeringseverepanicconditionsin
severalcrucialfinancialmarkets,morphedveryrapidlyintoaglobalcreditcrunchthat
grippedtheentireworldeconomywithparalyzingforce.Sincethenwehaveexperienceda
freefallineconomicactivityacrosstheentireglobe,fuelledbycollapsingassetvalues,steep
productioncutbacks,andenormousdestructionofjobs.Aconfluenceofbankingcrisis,
collapsingreal-estatemarkets,andstockmarketcrashsincethenmayleadtoadeflationary
spiralintheJapanesestyle(seeBoyer,Dehove&Plihon,2004).
Thisdeclineisdrivenbytwonegativefeedbackloopsofsystemic-crisisproportions.One,
especiallypronouncedwithintheUnitedStates,combinesadepressioninrealestatewitha
broadeconomicdownturntoundermineanalreadymuch-weakenedbankingsector.Hence
renderedunwillingandunabletolend,thebanksareparalyzed.Cutofffromcredit,heavily
indebtedactorsareobligedtoreducetheirdebtservicingburdensbycuttingbackspending
andsellingoffassets.Thesecondloop,internationalinnature,concernsthefrightfullyrapid
andextensiveunravelingoftheworldeconomy.Theglobalfinancialcrisishasreinforced
massivecutbacksinshort-termcapitalflows,whichhavehelpeddepresslonger-termdirect
investmentactivityand,bycreatingamassiveshortfallincrucialtradefinance,hampered
trade.Hopefully,theforthcomingG-20summitswilldealwiththereformoftheinternational
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monetarysystemandthequestionofthefutureinternationalcurrencyinthecontextofa
multipolarglobalizationprocess.
Wehavetostoptheseinter-connectedspiralsofde-leveragingandde-globalizationlestwe
wanttofindourselvesdrivenintoaglobaldepression,whichitwillbemostdifficultto
emergefrom.Policy-makersallovertheworldunderstandthisimperative,butitremainsto
beseenwhethertheycanactaccordingly.Wehaveseenarapidandunifiedpolicyresponse
inmostindustrialandemerging-marketeconomies,consistingoffiscalstimulus,monetary-
policyeasing,andassistancefortheirbattereddomesticbankingsystems.Andanewglobal-
governancestructurehasemergedtoaddresstheinternationaldimensionsofthiscrisis,the
G-20.ButitsLondonsummitinApril2009hasrevealedthelimitsofcollectivecrisis
management.WhileusefullyboostingtheresourcesoftheInternationalMonetaryFund,the
G-20leadersfoundthemselvesdividedoverfurtherglobalstimulation.Atleasttheyare
beginningtomapoutthebroadoutlinesofaconsensusconcerningfinancialre-regulation,
helpedbysignificantoverlapsbetweentheObama-Geithnerplan,theEUsDeLarosire
Report,andtheUKsTurnerReport.TherewillbemanymoreG-20summits,eachofwhich
havingitsagendashapedbytherespectivephaseofthecrisisprevailingatthetime.
InthemeantimeweneedtopayspecialattentiontotheactionsoftheFederalReserve.Led
byaspecialistondebt-deflationcrises,BenBernanke,theFedhasprobablybeenthemost
innovativeofthecrisis-fightingpolicy-makers.Anditalsooccupiesamoststrategicposition
attheapexofbothde-leveragingandde-globalizationspiralswhichhasenabledittoattack
bothaggressively.Ithastriedtotackletheformerwithanarrayofnewliquidity-injectionand
asset-swappingschemestounclogtraditionalfundingchannelsandrebuildabrokencredit
system.Andithasbeguntoinsertitselfmoreaggressivelyinmanagingthedollar-based
internationalmonetarysystem,usingintheprocessacombinationofdirectmonetizationof
U.S.debt(throughitsnewbondpurchases),currencyswapswithothercentralbanks,
prudentialregulationofbanks,andglobal-governancereforms(IMF,FinancialStability
Forum,etc.).Inthatsenseitiswellpositionedtoplayacrucialroleintheunfoldingofthe
crisisanditseventualresolution,dedicatingthemiddleinningsofthegametotherecovery
ofthefinancialsystemandhelpingtomanagetheendgamestransitiontoamoremulti-polar
systemthatmaywellrequireagooddealofglobalcoordination.
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Notes
1)Seeinthiscontextamoreextensiveversionofthispaper(Guttmann&Plihon,2008).2)SeeM.McConnell,R.Peach&A.Al-Hashimi(2003)formoredetailsontheeffectsof
refinancingandhome-equityloansonboostingconsumerspendinganddepressingthepersonalsavingsrate.3)Three-quartersofthenearly$5000billioninMSBoutstandingin2006hadbeenissuedbygovernment-sponsoredlendersFreddieMacorFannieMae,withalotofthemcarryingGinnieMaeguaranteesorFHAinsurance.ThosekindsofMSBcarriedatthatpointayield1.5%to2%abovethe4.5%returnearnedona5-yearTreasurynotewhereastheriskiestMSB,composedofsubprimesandentirelyunsecured,couldfetchasmuchas15%atthe2006peak.4)SeeR.Simon,J.Haggerty&J.Areddy(2005)formoredetails.
5)Thatquestionhasalsocometopre-occupypost-KeynesianeconomistsgroupedaroundWynneGodleyattheLevyInstitute(www.levy.org)andC.FredBergstenatthePetersonInstituteforInternationalEconomics(www.iie.com).SeealsotheinterestingreportbyEuropeanCentralBank(2007a)onthatquestion.6)Thisinvestment-returndifferential,whichgoesevidentlyfarbeyondobviousdifferencesinthecompositionofclaimsandliabilitiesintheUnitedStatescapitalaccount(e.g.proportionatelylargerforeignpurchasesoflow-yieldingTreasurysecurities,moreforeigndirectinvestmentbyUSmultinationalsabroad),hasbeenthesubjectofmuchdiscussioninrecentyears.See,forinstance,BankforInternationalSettlements(2007)orS.Curcuru,T.Dvorak&F.Warnock(2007).7)FormoreonthecollapseofthevarioussecuritizationlayersseeR.Guttmann(2007).
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