Crisis Economics Part 12

The Decline of the Dollar.

In the late 1950s the United States was at the peak of its power. It ran a current account surplus, and the dollar served as the international reserve currency. Under the famed Bretton Woods agreement, signed shortly before the end of World War II, other nations made their currencies convertible into dollars at certain fixed rates, and the United States pledged to convert those same dollars into gold.

Most economists of the day-particularly American economists-thought Bretton Woods was a good idea, but Robert Triffin, a Belgian-born economist, begged to differ. In 1960 he spoke against the idea of having one nation's currency simultaneously serve as an international reserve currency. Such an arrangement, he warned, contained the seeds of its own destruction. Triffin observed that nations that issue reserve currencies-Britain in the nineteenth century, the United States in the twentieth-generally maintain current account surpluses. In the case of the United States, that meant that more dollars flowed into the country than flowed out.

So far, so good. But other countries, Triffin pointed out, would need to hold the reserve currency. The resulting demand for dollars would create a countervailing force, causing dollars to flow out of the United States. Those pressures, Triffin argued, would eventually create a current account deficit, which would eventually undercut the economic standing of the United States and, by extension, the dollar. In effect, Triffin pointed out that the needs of the United States would collide with the needs of the rest of the world, paving the way for the decline of the dollar. That was precisely what happened in 1971, when President Nixon reneged on the pledge to convert dollars into gold.

Triffin's Dilemma remains relevant today. The dollar is no longer convertible into gold, but it remains the world's de facto reserve currency, even as that demand contributes to ever-greater global imbalances. Some economists have claimed that this arrangement-the so-called "Bretton Woods II" system-can persist for the foreseeable future, as dollars flow out of the United States and pile up in the vaults of central banks in Asia and the Middle East.

In fact, this uneasy arrangement shows serious signs of strain. Back in 2001 dollars made up a little over 70 percent of the currency reserves held overseas. Over the succeeding decade, as the fiscal deficits and current account deficit of the United States spiraled out of control, that percentage declined, reaching 63 percent in 2008. In the second half of 2009 foreign central banks displayed a p.r.o.nounced aversion to the dollar and a strong preference for the euro and the yen; in the third quarter of 2009, dollars const.i.tuted only 37 percent of newly acquired reserves-a far cry from the average 67 percent a decade earlier. Gold and even some emerging-market currencies const.i.tute a growing percentage of these reserves.

The ongoing effort to diversify away from the dollar is all the more apparent in the world's sovereign wealth funds. These state-owned investment funds-organizations like the China Investment Corporation-have started to avoid the U.S. Treasury debt that has long been a staple of central bank reserves, focusing instead on higher-yield investments, in everything from hedge funds to mineral rights.

That trend is likely to continue in the coming years. With any luck, the transition will be a gradual process, not a sudden, disorderly collapse. Possibly the United States may follow in the footsteps of Britain, whose power-and currency-ebbed over many decades. Indeed, though the United States surpa.s.sed Britain as the world's biggest economy sometime around 1872, the pound sterling remained the world's premier currency for two more generations. Only after World War I, when Britain went from being a net creditor to a net debtor, did the pound sterling seriously slip, and other countries began diversifying their currency holdings, though as late as 1928 the world's currency reserves still contained twice as many pounds as dollars. After Britain abandoned the gold standard in 1931, the dollar did displace the pound. The Bretton Woods agreement helped cement the dollar's supremacy, though only with the Suez Crisis of 1956-and the further collapse of the pound sterling-did the dollar become the world's unrivaled reserve currency.

The fall of the pound took three-quarters of a century, and we may reasonably hope that the dollar's decline will also proceed at such a leisurely pace. But this sort of historical a.n.a.logy shouldn't be taken too far. China, which occupies roughly the same position that the United States did a century ago, is climbing the global economic ladder far more quickly than any other nation in history. It will likely surpa.s.s j.a.pan as the world's second-largest economy in 2010 or 2011, and it may dethrone the United States from the top spot sooner rather than later. All of this has happened with astonis.h.i.+ng speed. While the United States took a century to rise to power, China has managed to go from second-rate status to global power in only twenty years.

That raises the unnerving prospect that the dollar's days may be numbered in years rather than decades. How such an abrupt and disorderly decline might play out is difficult to know. Historically, currencies had some relations.h.i.+p to gold or silver; only in the 1970s was this connection severed entirely. The world's monetary system now rests not on gold but on a fiat currency-a currency that has no intrinsic value, is not backed by precious metals, and is in no way fixed in value. In a way, the dollar occupies the role that gold once did, and its collapse would be no less calamitous than if the regents and bankers of centuries past had opened their vaults one day to find that their precious piles of coin had turned to dust.

That may happen one day if the United States keeps running spiraling deficits. While China will likely continue to purchase debt, other, smaller countries may start to edge toward the exit. That may eventually prompt a stampede that even China would be tempted to join. Whatever the advantages of the present system for China, at some point the costs will outweigh the benefits.

The United States stands at a crossroads. If it doesn't get its fiscal house in order and increase its private savings, such a seismic event will only become more likely. It's all too easy to imagine a scenario where this plays out, particularly if a political stalemate develops: Republicans veto tax increases, Democrats veto spending cuts, and monetizing the deficits-printing money-becomes the path of least resistance. The resulting inflation will erode the dollar value of the public and private debt held around the world. Faced with such an "inflation tax," investors around the world dump their dollars, moving them into the currency of a country with a far better reputation for fiscal responsibility.

Should that take place, the United States would pay the price. Up to now, we have been able to issue debt in our own currency rather than a foreign one, s.h.i.+fting the losses of a fall in the value of the dollar to our creditors. If other countries effectively revoked this "exorbitant privilege," the burden would fall back on us, and our borrowing costs would shoot upward, dragging down consumption, investment, and ultimately economic growth. The price of imports-everything from cheap plastic toys from China to barrels of oil from Saudi Arabia-would rise, crimping a standard of living that Americans have come to consider their birthright. In the process, the dollar would become just another currency in the crowd.

But that invites a question: what would take its place?

The Almighty Renminbi?

At first glance, the Chinese currency-the renminbi or the yuan-seems the obvious candidate to follow in the footsteps of the American dollar. Few other currencies pose serious compet.i.tion. The British pound, the j.a.panese yen, and the Swiss franc remain minor reserve currencies. They may offer temporary refuge from an eroding dollar, but they're the currencies of countries in decline. The same could be said, on a larger scale, of the euro, whose continued survival depends on the unity of a fractious group of countries, many of which shoulder staggering deficits, aging populations, and growing compet.i.tion from emerging markets.

Far less feasible is a return to gold. For all its recent l.u.s.ter, the idea of making gold the basis of the monetary system remains what Keynes rightly called a "barbarous relic." While it may provide a temporary sanctuary from a collapsing dollar, its rising value is largely a function of fear and anxiety about the future. Gold is a place to hide, not a foundation for a new monetary order. It has few practical uses, is difficult to store, and exists in minute quant.i.ties relative to the present size of the global economy. None of these features make it a good candidate for a reserve currency.

That said, if governments resort to monetizing their deficits, triggering higher inflation, gold could rise sharply in price. But should that happen, central banks would probably not try to corner scarce supplies of gold. More likely they would invest more in oil and other commodities as a hedge against inflation. In other words, they would rush into real a.s.sets as they fled fiat currencies like the dollar.

That leaves the renminbi as the long-term alternative to the dollar. China looks much like the United States did when it came to power: it runs large current account surpluses, has become the world's biggest exporter, has a relatively small budget deficit, and carries much less debt relative to other countries. It has already taken subtle steps to challenge the dollar. For example, it has permitted financial inst.i.tutions in Hong Kong to issue Chinese public debt denominated in the yuan, a crucial step in creating a regional market in the debt and, by extension, the currency. The Chinese finance ministry tellingly described this move as an effort to "promote the renminbi in neighboring countries and improve the yuan's international status."

China has taken other steps to bolster its monetary power. It has set up currency swaps with several countries, including Argentina, Brazil, Belarus, and Indonesia. It has also pushed some of its trading partners to use the yuan to settle accounts-that is, to denominate their invoices in yuan. This may seem like a small matter, but it's not: at present, much invoicing in international trade uses the dollar as the "unit of account," even when the trade doesn't involve the United States. This deference-similar to the respect accorded the pound sterling a century ago-reflects the dollar's real and symbolic status as the international reserve currency. If the yuan gains widespread acceptance in the world's account books, the dollar will see its reserve-currency status usurped.

For now, however, the renminbi faces an uphill battle to become the world's premier currency. Even the Chinese may not want it to happen too quickly. The exchange rate would have to become more flexible, allowing the renminbi to appreciate far more than it has already, and making China's exports less affordable to other countries. In addition, China would need to implement reforms it may not wish to take: easing restrictions on money entering and leaving the country, for example, and making its currency fully convertible for such capital transactions. China would also need to accelerate domestic financial reforms and start issuing much greater quant.i.ties of yuan-denominated debt.

Though the Chinese clearly want a greater role for the renminbi, they don't seem eager for it to become the world's reserve currency anytime soon. In 2009 Zhou Xiaochuan, governor of the People's Bank of China, proposed something very different: a new, supra-sovereign currency that would compete with the dollar. Zhou suggested a revision of the Special Drawing Rights (SDR), a quasi-currency created in 1969 under the auspices of the IMF, that can't pa.s.s from hand to hand the way a paper dollar or euro does but is purely a unit of account used by the IMF. It derives its value from four underlying currencies that are weighted in different ways: the dollar is the predominant ingredient, followed by the euro, the yen, and the pound. Anyone holding SDRs has a claim on the various currencies contained in the underlying "basket." The instruments can be used for a variety of purposes, like discharging debts owed to the IMF.

The relative quant.i.ties of the currencies in the basket get recalculated every five years, and Zhou's broadside made it clear that China expects its currency will be included. But wanting to sit at the table is not the same as wanting to run the show. In fact, Zhou cited Triffin's Dilemma in forcefully arguing for the creation of "an international reserve currency that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies."

In framing this proposal, Zhou looked back to the Bretton Woods Conference of 1944. That year John Maynard Keynes pushed the attendees to contemplate the creation of a global supercurrency, called the "bancor," that would derive its value from a basket of some thirty underlying commodities. The Americans rejected the idea and pushed for the dollar to become the world's reserve currency. Zhou criticized that fateful step as misguided. Keynes, he claimed, had been "far-sighted," and the SDR might be a way of resurrecting his ideas.

For now, the idea of turning the SDR into a global reserve currency remains fanciful. A significant number of private and public parties would have to use it as a unit of account, and so far there's no sign of that happening; the SDR remains a creature of the IMF. Nonetheless, the growing interest in expanding its role highlights the degree to which China and many other emerging markets want to replace the dollar with something a bit more stable and resistant to crisis and collapse.

But that's not going to happen without international cooperation. So one of the other inst.i.tutions that emerged from that fateful 1944 conference will have to be reformed: the IMF.

Global Governance.

The swift rise of the economically powerful BRICs-Brazil, Russia, India, and China-and other emerging market economies has underscored the need to reform global economic governance. The original G-7-the United States, j.a.pan, Germany, France, the United Kingdom, Canada, and Italy-cannot possibly claim to speak for the rest of the world. In order to resolve global imbalances, other players must sit at the table. To some extent they already are: in the past few years, the G-20 has started to supplant its more selective sibling, bringing Brazil, Indonesia, South Africa, Saudi Arabia, and other countries into the fold.

While more may be merrier, the G-20 is unlikely to make substantive changes in the global economy and the international monetary system. The G-7 has had enough trouble doing that; more than doubling the number of members may make it impossible, absent a more formal framework for discussing and implementing policy-and most of the world's economies would still have no voice.

The IMF may be more representative, but it has its own problems. Much of the IMF's decision making takes place via its executive board, which has twenty-four directors, each of whom represents a different global const.i.tuency. Unfortunately, European nations are overrepresented, while emerging economies in Asia and Africa are underrepresented. A similar problem bedevils the way the IMF calculates "shares"-the votes each country receives by virtue of its contributions to the IMF. One recent study found that in 2000 and 2001, the collective voting power of China, India, and Brazil was 19 percent less than that of Belgium, Italy, and the Netherlands, despite the fact that by one measure the former cl.u.s.ter of countries had a GDP four times the size-and a population twenty-nine times the size-of the latter.

So far the Europeans have been unwilling to cede power. That's foolish: if the IMF is to have any credibility in the coming years, its allocation of chairs and shares will have to reflect the interests and input of the emerging-market economies. That's true at the very top of the organization too. An informal precedent dictates that an American heads the World Bank while a European leads the IMF. So far, calls to dump this antiquated practice have fallen on deaf ears, further threatening the organization's legitimacy.

The IMF needs to be reformed in other ways too. While it has leverage over its members, this leverage applies only during times of crisis, and only to smaller countries that have trouble meeting payments on their debt. China, j.a.pan, and Germany, nations that act as creditors to the rest of the world, can ignore the IMF. So can the United States, which runs current account deficits but gets to borrow in its own currency. In effect, the IMF can do nothing to force China, Europe, and the United States to change their ways. Worse, it has been reluctant to use the bully pulpit, failing to name and shame countries whose actions threaten the stability of the global economy.

That doesn't mean the IMF should be abandoned. Even with its limited resources, it can tackle one problem in particular: current account imbalances. As we have seen, emerging economies came away from the crises of the 1990s with two lessons: avoid running current account deficits, and ama.s.s a war chest of foreign currencies in antic.i.p.ation of an international liquidity crunch. These strategies paid off during the recent crisis: countries in Asia and Latin America that had surpluses and substantial foreign currency reserves aggressively intervened to prop up their own currencies, rea.s.suring foreign investors that they could deal with a liquidity crisis without having to beg for support from the IMF.

However commendable, independence from the IMF has come at a serious price. Not only do these strategies contribute to unsustainable balances, but the real cost of such self-insurance-trillions of dollars stuck in low-yield a.s.sets-is high. Moreover, if left unattended, these reserves can help fuel a.s.set bubbles in the countries that ama.s.s them. While governments sometimes deal with this problem by selling government bonds to soak up or "sterilize" the surplus cash, they end up paying high rates of interest on these new obligations-yet another cost to bear.

The IMF can address these problems, at the very least providing more liquidity in times of crisis. Until recently IMF loans came with strings attached: countries that accepted them had to agree to undertake economic reforms that the IMF deemed necessary. But not every country that suffers from a liquidity crunch needs to overhaul its economy. So during the recent crisis, the IMF offered a so-called Flexible Credit Line to qualifying countries. This is a good start. In the future, precautionary lines of credit should be made available to a greater range of countries as soon as signs of a crisis appear.

The IMF can also expand its issue of SDRs, particularly in times of crisis. In 2009 it obtained the right to issue $250 billion worth of SDRs, some of which went to emerging-market economies. That program should be expanded, especially through the issuance of international bonds denominated in SDRs. Central banks could purchase them to bulk out their reserves without contributing to the potential instability that conventional currency purchases cause (because the SDRs effectively spread the burden among several currencies rather than targeting a single one). Here the IMF should attach some strings: any recipients of SDRs should be forced to reduce their current account surpluses and otherwise reduce their acc.u.mulation of foreign currency reserves.

These modest proposals may go a long way toward weaning the global economy off the kinds of imbalances that played a role in the recent crisis. But if the world is going to move away from an obsolescent monetary system dependent on the declining dollar, much more will have to be done. A greater reliance on SDRs is a good first step but only a small one.

Addressing these challenges will require a level of international cooperation that has been noticeably absent in recent years. Whether the world's major economies will cooperate for the common good is an open question. If the United States and China continue to focus on short-term national interests, imbalances will continue to pile up, and an already-fragile international monetary system may fall victim to acc.u.mulated strain and stress.

In fact, the historical record would suggest that we live at a particularly vulnerable moment in financial history. In the past, international banking crises like the recent one have often been a prelude to waves of sovereign debt defaults and currency crashes. Economies damaged by the effects of a.s.set bubbles gone bust and the consequent banking crises may limp along for a little while, but many will ultimately succ.u.mb, victims of acc.u.mulated injuries. That's going to be especially likely if the sorts of current account balances that preceded the recent crisis continue to spiral out of control. If they unravel, what happened to Iceland may be a harbinger of things to come in the world at large.

The Road Ahead.

In chapters 8 and 9 we laid out ways that nations might reform their financial systems, imposing regulations on the banks and other firms that played a role in precipitating the recent crisis. But the push for reform can't end there: in the coming years policy makers will have to address the kinds of imbalances that can eventually cause national, regional, and even global financial crises. Every economy will have to do its share rather than try to free-ride on the system, using imbalances for its own advantage.

These reforms can approach the problem on the demand side and on the supply side; so far reforms on both fronts have been woefully insufficient. On the demand side, the excessive demand for foreign reserves by emerging-market economies has seriously exacerbated global imbalances. This problem needs to be addressed by the presence of a more stable and reliable international lender of last resort in order to avoid the risk of international liquidity crises. Only then will these economies' need for reserves start to diminish.

On the supply side, the menu of international reserve a.s.sets should be expanded beyond the U.S. dollar and a few other currencies: over time the SDR can and should play a greater role. Likewise, in the coming years, central banks and sovereign wealth funds may start to hold currencies of emerging-market economies as part of their reserves. In the short term, this won't threaten the role of the dollar as the major reserve currency; the U.S. dollar has no clear alternatives. But if the United States keeps running large twin deficits-or worse, starts to monetize its fiscal deficit-the resulting high inflation will accelerate the decline of the U.S. dollar as a major reserve currency, with unpredictable results.

Let's a.s.sume that the United States doesn't go down that road, and that the reforms we've described can bring about an orderly adjustment of global imbalances. There's one more piece of the puzzle. A substantial change in the inst.i.tutions of global economic governance is necessary and desirable within both the G-20 and the IMF. The needed changes would provide more formal and effective power to emerging-market economies and ease the transfer of economic power from one part of the globe to another.

Will the world's major economies truly cooperate for the common global good? Or will they keep on following their national interests, eventually destabilizing the global economy and the global financial system? The question remains open, but both China and the United States in particular need to contemplate it in the coming years. Neither country stands to win from a continuation of the status quo, and everyone-emerging and advanced economies alike-stands to lose.

Conclusion.

Throughout most of 2009, Goldman Sachs CEO Lloyd Blankfein repeatedly tried to quash calls for sweeping regulation of the financial system. In speeches and in testimony before Congress, he begged his listeners to keep financial innovation alive and "resist a response that is solely designed to protect us against the 100-year storm."

That's ridiculous. What we've just experienced wasn't some crazy once-in-a-century event. Since its founding, the United States has suffered from brutal banking crises and other financial disasters on a regular basis. Throughout the nineteenth and early twentieth centuries, crippling panics and depressions. .h.i.t the nation again and again.

Financial crises disappeared only after the Great Depression, a period that coincided with the rise of the United States as a global superpower. At the same time the U.S. government reined in financial inst.i.tutions with legislation like the Gla.s.s-Steagall Act and sh.o.r.ed them up by creating agencies like the SEC and FDIC. The dollar became the ballast of an extraordinarily stable international monetary system, and crises came to seem like things of the past. Though serious cracks started to appear in the facade after the 1970s, economists in developed nations kept the faith, wors.h.i.+pping at the altar of the Great Moderation.

The recent cataclysm marks the beginning of the end of this dangerous illusion. It also marks the end of the financial stability ushered in by the Pax Americana. As American power erodes in the coming years, crises may become more frequent and virulent, absent a strong superpower that can cooperate with other emerging powers to bring the same stability to the global economy. Far from being a once-in-a-century event, the recent financial disaster may be a taste of things to come.

A new era demands new ways of thinking. We should jettison bankrupt ideas about the inherent stability, efficiency, and resilience of unregulated markets, and we should let crises take their rightful place in economics and finance. Sadly, many otherwise intelligent people cling to the belief that the recent crisis was an unpredictable, unheralded event. No one could have seen it coming, they say, and we'll never see the likes of it again-at least not in our lifetimes.

We can wait for a new financial calamity to deal a coup de grace to this continuing complacency. Or we can embrace understanding a new economics: crisis economics.

Tragedy and Farce.

Crises, as we have seen, are as old and ubiquitous as capitalism itself. They arose hand in hand with capitalism in the early seventeenth century, and like the plays that Shakespeare first staged at this time, they have remained with us ever since, in much the same form. The staging changes, as do the audiences, but everything else-the cast of characters, the order of the acts, and even the lines-remains remarkably consistent from crisis to crisis, century to century.

Almost all crises begin the same way: modestly. Subtle developments set the stage for the real drama down the line. This scene setting can take years, even decades, as numerous forces create conditions hospitable to a boom-and-bust cycle.

The crisis that exploded in 2007 was no exception. Decades of free-market fundamentalism laid the foundation for the meltdown, as so-called reformers swept aside banking regulations established in the Great Depression, and as Wall Street firms found ways to evade the rules that remained. In the process, a vast shadow banking system grew up outside regulatory oversight.

Over the same period banks increasingly adopted compensation schemes like bonuses that encouraged high-risk, short-term leveraged betting, even though such bets would undercut a financial firm's long-term stability. They effectively s.h.i.+fted negative consequences away from traders and bankers and onto the backs of the firm's shareholders and other creditors. Such problems, part of a larger epidemic of moral hazard, had been percolating throughout the U.S. financial system long before the crisis finally broke. The Federal Reserve played an instrumental role, rescuing the financial system in its time of need and giving rise to the famed "Greenspan put."

But setting the stage is not the same thing as creating a bubble. A bubble requires a catalyst. In previous financial crises the catalyst was a shortage of some coveted commodity or the opening of a new market overseas. Or a technological innovation stirred investors to believe that the old rules of valuation no longer applied. Fresh ways of doing things could originate in the financial system itself: a new way to package investments, or a new way of managing risk.

Unfortunately, the recent financial crisis fell into this final category, as financial inst.i.tutions embraced securitization on a ma.s.sive scale, giving us an alphabet soup of increasingly complex structured financial products. While securitization had been around for many years, it exploded in importance in the years immediately preceding the bubble. "Originate and distribute" became a vehicle for originating junk mortgages, slicing, dicing, and recombining them into toxic mortgage-backed securities, and then selling them as if they were AAA gold.

Another axiom of crisis economics is the straightforward observation that a bubble can grow only if investors have a source of easy credit. It might come courtesy of a central bank, or from private lenders-or from both, especially if unwary regulators allow the credit bubble to grow and fester. Easy credit might even come from an unexpected source of surplus cash slos.h.i.+ng around the global economy in search of an investment.

Here too the recent crisis followed a predictable plot. Greenspan slashed interest rates after September 11 and kept them too low for too long. Banks and shadow banks leveraged themselves to the hilt, loaning out money as if risk had been banished. Regulators and supervisors, captivated by industry and by an ideology of laissez-faire self-regulation, failed to do their jobs. And plenty of savings flowed into the United States, courtesy of savers in emerging economies around the world.

At a certain point bubbles become self-sustaining. Banks and other financial inst.i.tutions eager to cash in on rising prices make even more credit available. Every a.s.set that investors purchase can then become collateral for yet more borrowing and more investing. Using the magic of leverage, growing numbers of investors build soaring towers of debt-a sure sign that a bubble is brewing. And that's precisely what happened in the bubble that reached remarkable proportions by 2005. Vaulting ambition and utter greed kept pus.h.i.+ng this process forward, as developers built innumerable tract homes, speculators snapped them up, and bankers packaged the resulting mortgages into increasingly fragile financial instruments.

In every such drama, a new character arrives onstage around this time: the self-proclaimed visionaries who spring up to explain why this boom will continue to yield perpetual profits-why "this time is different" or why the old economic rules no longer apply. The appearance of these boosters and their empty claims are a sure sign that things have started to spin out of control.

The recent housing bubble attracted hordes of such charlatans, all of whom disregarded history and common sense to claim that housing was a safe investment whose value would only increase. Their numbers included everyone from s.h.i.+lls for the real estate industry to investment bankers who packaged dubious mortgages into AAA securities labeled as no riskier than supersafe government bonds.

These mountebanks may dominate the drama, but they do not go unchallenged. Inevitably, a handful of people who can see through the bogus claims speak up. Hardheaded realists, they point to acc.u.mulating weaknesses, but their warnings often go unheeded. One of the authors of this book played that role in the recent crisis, warning early on of a coming crash with remarkable specificity. Other prominent economists and a.n.a.lysts also pointed to the writing on the wall, but to no avail.

Like all bubbles, this one eventually stopped growing. And as in most bubbles, the end began with a whimper, not with a bang. Prices moved sideways; a strange sort of stasis came over the markets. The bubble boosters insisted this lapse was momentary; prices would rise again soon. But they did not. At this point in the drama, they rarely collapse overnight. They simply stall.

Then they collapse, a few inst.i.tutions at first, then many. The effects reverberate throughout the financial system. Fear and uncertainty grip the markets, and while the price of the bubbly a.s.set crumbles, the real action lies in the financial inst.i.tutions that provided the credit behind the bubble. Deleveraging begins, and faced with overwhelming uncertainty, investors flee toward safer, more liquid a.s.sets.

The recent crisis stuck to this script. At first a few big mortgage lenders went under, stirring anxiety. Then came a series of higher-profile collapses, each one bigger than the last. Some big hedge funds failed. Eventually, other leading parts of the shadow banking system crumbled too. While many of these inst.i.tutions didn't look like banks, their death throes would have been instantly recognizable to anyone familiar with financial crises from the seventeenth century onward. Like countless financial inst.i.tutions before them, these twenty-first-century shadow banks swiftly succ.u.mbed to a crisis of liquidity and, in many cases, insolvency.

Rarely do the banks collapse all at once. In fact, one dramatic bank collapse may be succeeded by an interlude of relative peace, as a superficial calm returns to the markets, inducing a sucker's rally. But things continue to deteriorate beneath the surface, setting the stage for even more dramatic failures, and panic grows. The recent crisis displayed precisely these sorts of fluctuations, worsening, as in previous disasters, with each high-profile failure. The biggest crises have another defining characteristic: they rarely respect national boundaries. They can begin anywhere in the world, but they have a habit of going global, as problems in one country surface elsewhere, or problems in one country spread via channels-commodities, currencies, investments, derivatives, and trade-to other countries. When it comes to financial crises, all the world's a stage.

Though the recent crisis first surfaced in the United States, other countries soon exhibited the same symptoms. And no wonder: like Greenspan, central bankers around the world had adopted easy-money policies, fostering numerous housing bubbles. Banks overseas showed the same reckless appet.i.te for risk displayed by their counterparts in the United States. With a few exceptions, they took on plenty of leverage and drank from the same poisoned chalice, investing in billions of dollars of the same b.u.m a.s.sets generated by the magic of "financial innovation."

Crises often climax in one failure so spectacular that it overshadows all the rest. In the recent crisis, the calamitous collapse of Lehman Brothers played this role, making it seem that this one event was to blame for the tragedy that engulfed the global economy. As with earlier crises, explaining this one by a single high-profile failure is a simplistic way of looking at things that obscures more than it reveals. Lehman caused tremendous damage to the global financial system, but its failure was less a cause than a consequence.

Lehman's failure coincided with a scene commonly glimpsed in the final act: banks begging some lender of last resort-a central bank or some government ent.i.ty-to step into the breach and prop up the financial system. Such requests invariably spark a debate: Should floundering banks be saved, fostering moral hazard? Or should the market be left to its own devices, leaving ailing patients to minister to themselves?

That debate played out in stark terms in the recent crisis, and in the end Ben Bernanke threw lifeline after lifeline to the deserving and undeserving alike on an unprecedented scale. Like some colossal deus ex machina, the Federal Reserve and other central banks brought the crisis to a rather abrupt, if somewhat unsatisfying, close, leaving plenty of questions unanswered and problems unresolved.

Indeed, when the dramatic phase of a crisis comes to an end, other troubles invariably begin, as the effects of the financial meltdown echo through the rest of the economy. The damage runs deep, and the wounds take a long time to heal-not months, but years. While all manner of palliative measures can be taken-stimulus packages, for example-the road to recovery can be rough, as households, banks, other financial firms, and corporate firms need to deleverage. Countries wounded by a financial crisis may falter, weighed down by debts acc.u.mulated in better times and by the socialization of private losses during the crisis. Eventually some countries will default on their debt or wipe it out with high inflation and suffer a currency crash.

This is the point where we find ourselves now. In the aftermath of previous crises, chastened politicians have enacted sweeping reforms of the financial system. We too have that opportunity. We must seize it. If we fail to do so, we may find, as many have before us, that what's past is prologue.

The Road to Redemption.

For the past half century, academic economists, Wall Street traders, and everyone in between have been led astray by fairy tales about the wonders of unregulated markets, and the limitless benefits of financial innovation. The crisis dealt a body blow to that belief system, but nothing has yet replaced it.

That's all too evident in the timid reform proposals currently being considered in the United States and other advanced economies. Even though they have suffered the worst financial crisis in generations, many countries have shown a remarkable reluctance to inaugurate the sort of wholesale reform necessary to bring the financial system to heel. Instead, people talk of tinkering with the financial system, as if what just happened was caused by a few bad mortgages.

That's preposterous. As we've made clear throughout this book, the crisis was less a function of subprime mortgages than of a subprime financial system. Thanks to everything from warped compensation structures to corrupt ratings agencies, the global financial system rotted from the inside out. The financial crisis merely ripped the sleek and s.h.i.+ny skin off what had become, over the years, a gangrenous mess.

The road to recovery will be a long one. The first steps will entail undertaking the reforms outlined in chapters 8 and 9. For starters, traders and bankers must be compensated in ways that bring their interests into alignment with those of shareholders. That doesn't necessarily mean less compensation, even if that's desirable for other reasons; it merely means that employees of financial firms should be paid in ways that encourage them to look out for the long-term interests of the firms.

Securitization must be overhauled as well. Simplistic solutions like asking banks to retain some of the risk won't be enough; far more radical reforms will be necessary. Securitization must have far greater transparency and standardization, and the products of the securitization pipeline must be heavily regulated. Most important of all, the loans going into the securitization pipeline must be subject to far greater scrutiny. The mortgages and other loans must be high quality, or if not, they must be very clearly identified as less than prime and therefore risky.

Equally comprehensive reforms must be imposed on the kinds of deadly derivatives that blew up in the recent crisis. So-called over-the-counter derivatives-better described as under-the-table-must be hauled into the light of day, put on central clearinghouses and exchanges, and registered in databases; their use must be appropriately restricted. Moreover, the regulation of derivatives should be consolidated under a single regulator.

The rating agencies must also be collared and forced to change their business model. That they now derive their revenue from the firms they rate has created a ma.s.sive conflict of interest. Investors should be paying for ratings on debt, not the inst.i.tutions that issue the debt. Nor should the rating agencies be permitted to sell "consulting" services on the side to issuers of debt; that creates another conflict of interest. Finally, the business of rating debt should be thrown open to far more compet.i.tion. At the present time, a handful of firms have far too much power.