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1-Page Summary of The Trillion Dollar Meltdown
Two Roads and a Choice
In June 2007, two Bear Stearns hedge funds collapsed due to a downgrade. The firm had to pay billions of dollars to assume the hedge funds’ mortgage-backed securities holdings. Shortly after that, contagion spread as banks worldwide took hefty write-offs. Central banks in North America and Europe opened the money spigot, but it was ineffective. Experts seemed unable to predict how far the value of complex mortgage-backed securities could fall – and how much damage their collapse would cause throughout the financial system. History marked out two roads for policy makers: they could take Volcker’s approach from the late 1970s and early 1980s or Japan’s approach in its bubble economy during that same time period. Volcker restored confidence in America’s financial institutions by tackling inflation head on; Japan concealed its problems rather than dealing with them straightforwardly (and still hasn’t recovered). In this crisis, America seems ready to follow Japan down that path (by not admitting its problems or taking responsibility).
Liberalism: In Dollar Terms
From 1973 to 1982, the U.S. experienced a low GDP growth rate, high inflation and a collapsing currency. Its industries were uncompetitive in both domestic and international markets. Oil exporters drove up prices only in dollar terms; when calculated in gold, the price of oil was rather stable. Foreigners bought up America’s corporate crown jewels during this decade because of three reasons:
Business failure – In the 20th century, U.S. businesses were not innovative and competitive because they engaged in anti-competitive market sharing arrangements, such as those seen in the steel industry; labor was also involved in this arrangement for a share of the spoils. As a result, corporations became unwieldy conglomerates that focused on diversification instead of learning how to create more value through their core businesses. Business schools taught students how to administer large organizations bureaucratically rather than what it takes to be an effective leader on the shop floor. Japanese and German competitors entered the market with greater efficiency than U.S.-based companies because they were more innovative and competitive due to their superior business practices.
In the 1970s, there was a large number of baby boomers who were ready to work. They had little experience and skills, so they weren’t very productive. The abundance of cheap labor in that decade led to lower wages for workers. Less investment occurred due to this scenario.
Bad economic management – In the ’70s, inflation was out of control and the economy suffered. It would have been very difficult to fix the problem by raising interest rates because that would cause a recession. Instead, President Richard Nixon reduced taxes while controlling wages and prices (through wage-price controls) in order to prevent a recession. However, this caused more harm than good since it destroyed faith in government’s ability to manage the economy. This led to an increase in money supply which resulted in rapid inflation and devaluation of currency leading to high unemployment rate by late ’70s.
Wall Street Comes to Chicago
A new ideology, “Chicago-school” economics, which supported free markets and limited government intervention in the economy took America by storm. This was partly because pundits mistook correlation for causality. A reduction in the capital gains tax preceded a sharp increase in venture capital and investment, helping such startups as Apple Computer, Compaq Computer Corporation, FedEx Corporation and Sun Microsystems Inc., among others. However, did the tax cut lead to this boom? No; most of the new capital came from pension funds that were exempt from taxes so they didn’t need a tax break to invest.
