The Loose Cannon Credit Crisis

Posted April 9, 2011

Starting in the 1970s, international credit flows began to destabilize the global economy. One country after another was plunged into crisis as dollar-denominated credit from abroad produced short-term booms followed by longer-lasting busts. Each crisis threatened the solvency of the international financial system; and in each crisis the large international banks that had made the loans were bailed out from their mistakes by rescue programs directed from Washington. The United States not only tolerated those credit flows, it encouraged them by promoting capital-account liberalization in those countries where it could exert influence. By bailing out the banks each time, Washington rewarded imprudent risk-taking and thereby encouraged the next round of foolish lending. The sums at stake grew from one decade to the next, so that each successive crisis required a larger bailout than the one before.

The Latin American debt crisis, the Mexican peso crisis, the Asian crisis, and the contagion that subsequently spread to Russia and Brazil, are generally viewed as separate, compartmentalized episodes. In reality, they are all part of one long crisis caused by unregulated cross-border credit flows. In the mid-1970s, enormous amounts of dollar-denominated credit began sloshing around the world. Like a loose cannon on a ship, the credit would reel from one side of the world when economic conditions tipped one way—wrecking havoc all along its path—and then rocket back across the deck of the world economy in another direction, causing more chaos, when macroeconomic conditions began to tilt in a different direction. International credit broke loose in the 1960s owing to the failure of US policymakers to control the Eurodollar market and the US banks that dominated it. By the late 1970s, it had produced its first destabilizing economic boom, in Latin America.

The crisis that began in Latin America in the 1980s, re-erupted in Mexico in 1994, engulfed Asia in 1997, and spread to Russia the next year hit New York in September 1998. In its earlier phases, this loose-cannon credit crisis had posed serious medium-term threats (of fluctuating severity) to the solvency of the world’s largest banks. But when genius failed at Long Term Capital Management, the global financial system was confronted with the prospect of immediate and complete collapse. When US policymakers were forced to cut interest rates to avert the meltdown, they lost control over the US economy. Consequently, over the following decade, the United States itself was to become overwhelmed by foreign capital inflows just as its smaller Latin American neighbours had been in the 1970s. Foreign capital blew the US economy into a bubble and in 2008 that bubble burst.

Unregulated cross-border credit flows, encouraged by moral-hazard-inducing IMF bailouts, were a key element behind the global economic disequilibrium that eventually produced the New Depression. Until international capital flows are brought under control, they are certain to continue destabilizing the global economy.

Note: For the details, please see The Corruption of Capitalism, Chapter 6: “The International Debt Crisis, Phases One Through Three”