The Crash of 2008 and the Decline of the West?

Roger Altman, at Foreign Affairs, argues that the collapse of the American economy in 2008 will accelerate the decline of the United States and Europe as the leading actors in the international balance of power. I'm always skeptical of the decline thesis. In Altman's case he makes dramatic claims of America's lost hegemony, then concludes the article with a number of points that weaken his arguments. In particular, Altman makes emphatic claims that China is now the main beneficiary of U.S. economic woes, and that Beijing - with trillions of dollars in surplus reserves - will be the next global "lender of last resort." Yet then he proposes strengthening U.S.-dominated world financial institutions like the IMF, which were American creations at the end of World War II. He also concedes at the conclusion of the article that the U.S. "will remain the most powerful nation on earth for a while longer." Such an initial dramatic case for American decline and inevitable international systemic change ends up having as much firepower as a pop-gun.

I've written on this topic plenty of times (see the discussion of Robert Lieber's counter-thesis, in "Resurgent Declinism in International Relations). Still, Altman's essay does include a penetrating explanation for the collapse of financial markets in 2008. So, considering my post yesterday, I'll leave readers with that:

Conventional wisdom attributes the crisis to the collapse of housing prices and the subprime mortgage market in the United States. This is not correct; these were themselves the consequence of another problem. The crisis' underlying cause was the (invariably lethal) combination of very low interest rates and unprecedented levels of liquidity. The low interest rates reflected the U.S. government's overly accommodating monetary policy after 9/11. (The U.S. Federal Reserve lowered the federal funds rate to nearly one percent in late 2001 and maintained it near that very low level for three years.) The liquidity reflected, among other factors, what Federal Reserve Chair Ben Bernanke has called "the global savings glut": the enormous financial surpluses realized by certain countries, particularly China, Singapore, and the oil-producing states of the Persian Gulf. Until the mid-1990s, most emerging economies ran balance-of-payments deficits as they imported capital to finance their growth. But the Asian financial crisis of 1997-98, among other things, changed this in much of Asia. After that, surpluses grew throughout the region and then were consistently recycled back to the West in the form of portfolio investments.

Facing low yields, this mountain of liquidity naturally sought higher ones. One basic law of finance is that yields on loans are inversely proportional to credit quality: the stronger the borrower, the lower the yield, and vice versa. Huge amounts of capital thus flowed into the subprime mortgage sector and toward weak borrowers of all types in the United States, in Europe, and, to a lesser extent, around the world. For example, the annual volume of U.S. subprime and other securitized mortgages rose from a long-term average of approximately $100 billion to over $600 billion in 2005 and 2006. As with all financial bubbles, the lessons of history, including about long-term default rates on such poor credits, were ignored.

This flood of mortgage money caused residential and commercial real estate prices to rise at unprecedented rates. Whereas the average U.S. home had appreciated at 1.4 percent annually over the 30 years before 2000, the appreciation rate roared forward at 7.6 percent annually from 2000 through mid-2006. From mid-2005 to mid-2006, amid rampant speculation in the housing market, it was 11 percent.

But like most spikes in commodity prices, this one eventually reversed itself -- and with a vengeance. Housing prices have been falling sharply for over two years, and so far there is no sign that they will bottom out. Futures markets are signaling that, from peak to trough, the drop in the value of the nation's housing stock could reach 30-35 percent. This would be an astonishing fall for a pool of assets once valued at $13 trillion.

This collapse in housing prices undermined the value of the multitrillion-dollar pool of lower-value mortgages that had been created over the 2003-6 period. In addition, countless subprime mortgages that were structured to be artificially cheap at the outset began to convert to more expensive terms. Innumerable borrowers could not afford the adjusted terms, and delinquencies became more frequent. Losses on these loans began to emerge in mid-2007 and quickly grew to staggering levels. And with prices in real estate and other asset values still dropping, the value of these loans is continuing to deteriorate. The larger financial institutions are reporting continuous losses. They mark down the value of a loan or similar asset in one quarter, only to mark it down again in the next. This self-reinforcing downward cycle has caused markets to plunge across the globe.

The damage is most visible at the household level. Americans have lost one-quarter of their net worth in just a year and a half, since June 30, 2007, and the trend continues. Americans' largest single asset is the equity in their homes. Total home equity in the United States, which was valued at $13 trillion at its peak in 2006, had dropped to $8.8 trillion by mid-2008 and was still falling in late 2008. Total retirement assets, Americans' second-largest household asset, dropped by 22 percent, from $10.3 trillion in 2006 to $8 trillion in mid-2008. During the same period, savings and investment assets (apart from retirement savings) lost $1.2 trillion and pension assets lost $1.3 trillion. Taken together, these losses total a staggering $8.3 trillion.

Such large and sudden hits have shocked U.S. families. And because these have occurred amid headlines reporting failing financial institutions and huge bailouts, Americans' fears over the safety and accessibility of their deposits are now more pervasive than they have been since 1933. This is why Americans withdrew $150 billion from money-market funds over a two-day period in September (average weekly outflows are just $5 billion). It is also why the Federal Reserve established a special $540 billion facility to help these funds meet continuing redemptions.

There's more at the link.