Mary: I believe the history of the financial crisis started in 1985 with Reagan. It was then that the Plaza agreement took place. Secretaries and economic ministers from the G7 got together at the Plaza Hotel in NYC and decided to install a new parity exchange program where the monetary units of some of the most important economies around the world were going to keep their value higher than the dollar so that the USA could have higher exports, higher revenues with sustained solid economic growth. At that time the US was borrowing heavily to keep the Star Wars program working in order to drive the Soviet Union bankrupt through the arms race. The Plaza agreement was the contribution of European countries like Germany and Asian countries like Japan to help finance this program.
Nancy: I know that’s why Clinton in 1995 had to payback those countries by raising the dollar’s value so that their economies could start growing again.
Mary: Yes and then Asian nations began to do very well and to have large excess revenues investing large amounts of money in us every year. This money became available at low interest rates and helped later to create the internet bubble and market crash. During that interval of time we started to raise our imports from China and Japan considerably, therefore our commercial deficit grew way beyond reasonable expectations. And as you also know after the internet bubble crash it came the mortgage bubble.
Nancy: Globalization together with the privilege nation status we gave China in the early 80’s, after doing something similar with Japan, helped dismantle whole sectors of our economy that moved mainly to Asia and in particular to China because of the cheap labor they had to offer. Also of course we shouldn’t forget Clinton’s and Rubin’s changes to the laws of the Federal government, creating the condition for the mortgage bubble and the speculation related to that sector of the economy.
Mary: I think there were three factors that since 1995 contributed mainly to the crisis. First the large level of liquidity which generated economic growth and prosperity. It was the Federal Reserve with Allan Greenspan who were responsible for allowing the availability of such a large capital flow without doing something about it to regulated.
In spite of all this money flowing we had no inflationary problems because China, Brazil and India brought in their labor force to the world markets doubling labor’s world supply in between 1990 and 2005. This brought in turn a growing demand of goods and a growing supply, keeping the world’s financial markets in good shape and creating economic stability mostly due to cheap labor and American buying power, with borrowed money of course.
We have to remember that under a normal economic cycle, in any country, as production factors as labor, run out due to growth there is an incremental increase in labor’s salary that eventually brings higher prices of goods and services because workers have more buying power which in turn causes inflation and the raise of interest rates by the feds to stop the spiral of salary growth and inflation from getting out of control.
Nancy: Yes and the cheap labor of China, Brazil and India did not allow for the normal cycle you just described to occur because these countries had so many people unemployed that they were eager to work for very low wages. I believe that I know now what the third factor is: the technological revolution that brought the computer and satellites allowing almost instant investments in between world markets, as well as the transfer of technology through the internet around the world
Mary: Yes you are right, and all of these factors brought the large period of economic expansion that generated high levels of spending and consumption due to the abundant amount of flowing cash in the world. From 1980 to 2007 GDP growth went from 163% to 346% and it was American families who contribute most to this growth and hence their debt grew from 50% to 100% during the same period while the financial sector debt grew from 21% to 110% for the same reasons.
Nancy: The Keynesian laws did not take effect because world circumstances changed. And now we are in big trouble not only we over spent increasing our debt way beyond normal limits but also banks don’t lend money to other banks, something they did all the time, because trust is gone, many banks are holding toxic bonds and other kinds of investment instruments that lack value therefore healthy banks don’t know if they can recover their money if they lend to other banks.
Even the rescue package might not be good enough there are close to 57 trillion dollars in Hedge funds and Credit default swaps which have uncertain value. These over the counter instruments are handled through investment banks which are not the traditional banks we are acquainted with. Also many corporations can’t borrow because credit been so tight and they might fold weakening the economy considerably.
I guess it may get to a point where governments around the world will have to intervene and save almost everyone.