"Anatomy of a Crisis"

Barry Eichengreen says two key regulatory changes, one in the 1970's and one in the 1990's, are key factors in the crisis:

Anatomy of a Crisis, by Barry Eichengreen, Commentary, Project Syndicate: Getting out of our current financial mess requires understanding how we got into it in the first place. ...I would insist that the crisis has its roots in key policy decisions stretching back over decades.

In the United States, there were two key decisions. The first, in the 1970’s, deregulated commissions paid to stockbrokers. The second, in the 1990’s, removed the Glass-Steagall Act’s restrictions on mixing commercial and investment banking. In the days of fixed commissions, investment banks could make a comfortable living booking stock trades. Deregulation meant competition and thinner margins. Elimination of Glass-Steagall then allowed commercial banks to encroach on the investment banks’ other traditional preserves.

In response, investment banks branched into new businesses... They borrowed money and put it to work to sustain their profitability. This gave rise to the first causes of the crisis: the originate-and-distribute model of securitization and the extensive use of leverage.

It is important to note that these were unintended consequences of basically sensible policy decisions...

The other element in the crisis was the set of policies that gave rise to global imbalances. The Bush administration cut taxes. The Fed cut interest rates in response to the 2001 recession. Financial innovation, meanwhile, worked to make credit even cheaper and more widely available. This, of course, is just the story of subprime mortgages in another guise. The result was increased US spending and the descent of measured household savings into negative territory.

Of equal importance were the rise of China and the decline of investment in Asia following the 1997-1998 financial crisis. With China saving nearly 50% of its GNP, all that money had to go somewhere. Much of it went into US treasuries and the obligations of Fannie Mae and Freddie Mac. This propped up the dollar and reduced the cost of borrowing for US households, encouraging them to live beyond their means. It also created a more buoyant market for the securities of Freddie and Fannie, feeding the originate-and-distribute machine. ...

Now, a bloated financial sector is being forced to retrench. ... The one anomaly is that the dollar has strengthened in recent weeks. With the US no longer viewed as a supplier of high-quality financial assets, one would expect the dollar to have weakened. The dollar’s strength reflects the knee-jerk reaction of investors rushing into US treasuries as a safe haven. It is worth remembering that the same thing happened in August 2007, when the sub-prime crisis erupted. But once investors realized the extent of US financial problems, the rush into treasuries subsided, and the dollar resumed its decline. Now, as investors recall the extent of US financial problems, we will again see the dollar resume its decline. ...