Interfluidity carried a seminal piece last week on the current financial crisis, arguing that the root cause of the current crisis is neither financial innovation, nor subprime mortgages, nor any of the other paper tigers that have come forward in the past year.
Rather, the financial history of the past fifteen years belongs to a longer, twofold process, in which the inherent weakness of the American economy after the breakdown of manufacturing was masked by a wild growth in credit created in myriad unsustainable forms and fed by the insatiable demand of foreign central banks for US dollar-denominated obligations.
We see this insight as the first step towards the United States realizing not only that its economy is on the verge of collapse, but that the much-lauded gains of the past years have been illusory.
One notable contribution to the masking of economic weakness in the US has been the complicity of government. We have changed our methodology for calculating inflation twice since the 1970s, leading to structurally lower numbers for inflation -- lower by 5% or more. In this light, the growth numbers (which use the GDP deflator, not the CPI –- but they have crucial similar flaws) of past years look much worse.
Hank Paulson has argued the current crisis is only a crisis of liquidity, with no implications for the solvency of American financial institutions or the US consumer -- either willful or crafty, but in either case ignorance. Meanwhile, President Bush is in Cloud-Cuckoo-Land.
Beware of calls for concerted action across party lines. Roosevelt's actions in the Hundred Days enjoyed far from bipartisan support; however we go about it, fixing the situation the United States is in will not be good for everyone.