What lies behind the new international financial crisis?

Updated: 2011-08-09 17:49

By John Ross (chinadaily.com.cn)

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For the second time in three years a financial hurricane is blowing with Standard and Poor's downgrading the US's credit rating, Europe's widening debt crises, weak US economic recovery, and $8 trillion of loses on international share markets.

The reason a severe crisis has reappeared, and what determines its dynamic, is the failure of US and European policies to resolve the issues which created 2008's financial meltdown. These policies postponed the unwinding of the crisis without removing its underlying causes. Consequently the focus changed but the crisis was not resolved.

The financial crash of 2008 was caused by an unsustainable build-up of US private sector debt. By the 4th quarter of 2007, the peak of US economic expansion, households and private non-financial company debt was 168 percent of US GDP compared to government debt of 51 percent of GDP - i.e. private debt was over three times as large as government debt. The interest rate increases introduced in 2008 to deal with inflation resulted in the inability of the US private sector to finance this debt burden. The US sub-prime mortgage crisis was therefore simply the weakest link in the overall excessive US private debt.

The inability of the US private sector to meet its debt obligations, with consequent falls in asset values, destroyed US financial institutions’ balance sheets in 2008. Overall the US financial sector became insolvent. Therefore the US state had to step in to rescue the private financial system, with a similar process occurring in other countries. The new crisis is because the strength of the tools available to the US and European states themselves risk being overwhelmed.

The figures show this process. Following the onset of the US economic downturn in 2008, the overall US debt burden rose, reaching 247 percent of GDP in the 3rd quarter of 2009. Since then US debt has fallen but only marginally to 243 percent of US GDP - still 26 percentage points above pre-recession levels.

Merely the internal structure of US debt shifted. US private sector debt peaked at 180 percent of GDP in the 2nd quarter of 2009. It then fell to 163 percent of GDP – still 5 percentage points above its pre-recession level. But any recent decline in private sector debt has been almost entirely offset by increases in government debt created by budget deficits exceeding 10 percent of GDP.

The US simply ‘nationalized’ its debt problem – replacing private with public debt. The mechanisms by which this occurred were the indirect consequences of the financial crisis, with recession increasing welfare payments and reducing tax receipts as well as transfer of funds to the private sector in bank bailouts and similar measures.

Europe followed a similar path but with some countries, e.g. Greece and Italy, building up large public sector debts alongside the private ones in Spain and other countries. Europe’s situation is still more potentially threatening than the US as the Federal Reserve has greater resources than the European Central Bank.

None of the means used for tackling this debt problem in the US and Europe can avoid severe economic pain. The political fighting which has broken out is simply over how this pain should be shared.

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