US Financial Crisis: Is It the Moment for Bretton Woods II?

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US Financial Crisis: Is It theMoment for Bretton Woods II?

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The Post-BrettonWoods Informal System After the BrettonWoods breakdown, the informal system that prevailed evolved out of a set of decisions of the individual countries such asUS, Japan, SaudiArabia and later byChina.This informal system is sustained by differing but complementary national policies of the key and emerging economies. The US accepted the adverse effects of trade deficits on its employment situation in exchange for its trade deficits being funded by emerging economies. And the emerging economies accepted a lower standard of living in exchange for its export-led growth. For decades, without incurring the need to depreciate its own currency, the US has been running enormous trade deficits with the easy recourse to massive budget deficits. On the other side of the coin, Japan kept its yen intentionally undervalued compared to dollar to perpetuate its trade surplus and dollar accumulation to carry on its export-led growth.

US did not retaliate since Japan did not use the dollars in exchange for the yen but recycled them back in the US by purchasing US treasury bills and other dollar-denominated assets amounting to hundreds of billions of dollars. Japan’s strategy, followed by China and others, has kept on swelling the foreign holdings of the US treasury securities, which stood at $2,846.4 billion as on September 30th 2008. The major buyers of the US treasury securities such as China, Japan, UK, Oil Exporters and Brazil held around $1,800 billion.

Impact on the US Interest Rate and the Housing Boom

The US was thus freed from the necessity of keeping yield rates on treasury securities high to attract the treasury bill buyers. The yield rate on a 30-year treasury bond, for example, ruled at a measly 4.2%⁶ .As a result, the US could afford to bring down the Federal Reserve rate, for instance, from 6% at the outset of the year 2001 to a mere 1% in 2003 after a succession of 11 cuts.⁷ The successive interest rate cuts enabled by net foreign purchase of the US securities (Exhibit IV) made mortgage loans attractive, fuelled demand for houses and led to increases in their prices resulting in the housing boom.

Unfolding of the Global Financial Crisis

The US-originated financial crisis (2008) has been ascribed to the ultra easy credit often with zero down payment in the early 1990s, topped with Clinton administration’s pressure in the late 1990s on the nation’s biggest homemortgage underwriter FannieMae to devise a way to grantmore loans to “borrowers whose incomes, credit ratings and savings are not good enough to qualify for conventional loans”.⁸ Thus, loans flowed even to the subprime borrowers, who were hardly able to pay these back. The newly devised ‘originate and distribute’ model through securitisation of mortgage assets took away the necessity of exercising due diligencewhile lending to subprime borrowers.Unlike in the traditional lending model where the safeguards used to be checks by banks themselves, in the Mortgage-Backed Securities (MBS)model, the safeguards were checks by independent agencies that had a vested interest in endorsing more home loans in order to earn more fees.

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6] “A Billion Here, A Trillion There: Calculating the Cost of Wall Street’s Rescue”, http://knowledge.wharton.upenn.edu/ article.cfm?articleid=2084, October 29th 2008
7] “Global Credit Crunch - Towards a Crisis of Globalisation”, http://www.fifthinternational.org/index.php?id=259,1303,0,0,1,0, Autumn 2007
8] Holmes Steven A., “Fannie Mae Eases Credit To Aid Mortgage Lending”, http://query.nytimes.com/gst/ fullpage.html?res=9C0DE7DB153EF933A0575AC0A96F958260&sec=&spon=&partner=permalink&exprod=permalink