Introduction
Currently the United States is in the midst of the worst global financial crisis of the 2l century, which traced its origins to the sub-prime mortgage disaster that began to unravel in 2007. The shocks of global crisis are devastating: homeowners filed for bankruptcies and faced foreclosures in record high numbers, leading Wall Street firms such as Bear Sterns and Merrill Lynch crumbled under their massive exposure to sub-prime mortgage holdings that turned into toxic had assets and over $50 trillion in wealth had been wiped out within the last two years. No financial crisis since the Great Depression prompted many policy reactions as governments scrambled to map out rescue ...view middle of the document...
Mortgage issuers approved loans based on “stated income” or “stated value” rather than borrowers’ actual income or creditworthiness. Credit rating agencies also played a significant role; companies such as Moody’s and Standard and Poor’s were paid by the securities issuers themselves and “AAA” ratings were handed out very easily. In addition, the financial institutions repackaged sub-prime loans into innovative financial instruments, such as collateralized debt obligations (CDOs). There was little regulatory oversight over these new financial instruments, which were usually bought by commercial banks, hedge funds, and European and Asian investors. Also, Former Fed chairman Alan Greenspan’s policy to keep interest rates at around 1% for more than three years starting in 2001 played a significant role in this crisis. As the U.S. economy emerged from the 2001 dotcom burst, Greenspan believed that low interest rates were necessary to keep the economy growing. The problem was that rates stayed too low for too long and financial institutions sought alternative ways to make profits as traditional loans were generating low returns. Investment banks became highly leveraged and market players were content with the booming housing market that offered huge profit opportunities. In addition, financial markets’ appetite for risk was robust under the prevailing belief that the housing market would continue to rise. Following a herding behavior, homeowners saw an opportunity to buy a bigger house at lower mortgage rates, while investments banks saw their competitors making handsome profits through creative financial instruments and wanted to do the same, combined with Greenspan’s core beliefs that markets were self-sufficient and could regulate themselves, the housing market and the economy spiraled down into what is now known biggest financial crisis since the Great Depression.
How is the U.S. current account deficit related to the sub-prime meltdown? Why is the U.S. current account running such a big deficit and is it sustainable?
The inflow of foreign capital reflected the attractiveness of the U.S. economy as a destination for investment. The financial intermediation (driven by global financial deregulation) helped to finance the widening of current account deficits and surpluses around the world. Surpluses were primarily generated in commodity export countries, due to the surge in global commodity prices; East Asian countries, such as China and Korea, who built up their foreign currency reserves to protect themselves against sudden capital outflows following the 1997-1998 Asian financial crisis. Together, they built what Fed Chairman Ben Bernanke called the “global savings glut.” These countries chose to invest their surpluses and become lenders in the global economy. In addition, there has been a reversal in “home bias”, a global phenomenon in which an increasing number of investors choose to invest their domestic savings into foreign assets. This...
