The stagnant u.s. economy and the imbalances of savings and incomes

1.
University of BELGRANO
School of Economic Sciences
Bachelors in Business Administration
The stagnant U.S. economy and the imbalances of
savings and incomes.
Federico Gustavo Dominguez
(Course 29633)
Tutor: Omar Socca

2. Index
I. Crisis (2008-2009)
1.1 Gestation .…....……………………………..………………………………….…......…3
1.2 Neoliberals …………………………………..………………………………………..….4
1.3 Making money from money ...………………..…………………………………..…….8
1.4 The Bubble …………………………………………………………………………......12
1.5 The illusion of wealth ………………………………………………………………...14
1.6 Preventing the collapse ...……………………………………………………………..15
II. The concentration of wealth
2.1 Qualified vs. Non-qualified …..….………………..…………………………………..18
2.2 Efficiency and unbalances ……………………..……………………………………..22
2.3 Aristocracy of Merit ……………………………..…………………………….…….....25
III. The next crisis
3.1 More of the same old prescriptions …………….……………………………………26
3.2 Deleveraging and the equation of the 3 sectors …………………………………...27
3.3 Why stimulus programs fail ……………………………….……………………..…...28
IV. Conclusion…………………………………………………………………………………...5
IV. Bibliography................................................................................................................5

3. 1. The Crisis (2008-2009)
1.1 Gestation
The crisis that erupted in 2008 began to take shape almost 10 years ago.
In November of 1999 the United States Congress passed the Gramm-Leach-Bliley (GLB) law,
also known as the law for the modernization of financial services. The law was signed by
President Bill Clinton which replaced the Glass-Steagall Act that separated deposit banking
from investment banking.
The Glass-Steagall Act had given stability to the financial system for over 70 years. It was
passed in 1933 by the Franklin D. Roosevelt administration in order to prevent a reoccurrence
of the 1929 crisis. The features of the act include the separation between deposit banking and
investment banking. This law was accompanied by antitrust laws that prevented the formation
of financial conglomerates and reduced systemic risk.
The enactment of the Gramm-Leach law allowed for one institution to be able to carry out
investment banking, commercial banking and corporate securities activities. All of this with
minimum capital requirements needed.
"The result was the current system, in which companies such as Citigroup and JP Morgan
Chase is capable of being a commercial bank, a financial intermediary, its own investor, an
insurer, an asset manager, a hedge fund and a venture fund capitalist, all scattered within the
same institution…"
To further increase the systemic risk, in 2000 the law was passed to modernize the market of
commodities and futures, allowing the proliferation of complex financial instruments such as
CDS (credit default swaps) which had an important role in the crisis. These instruments will
be discussed later in this paper.
From this moment the bases was constructed for the biggest crisis since the 1930’s.
After the bloody terrorist attacks of September 11, 2001, in fear that the economy would
freeze up because it was already weak after the dot-com bubble burst, Fed Chairman Alan
Greenspan began lowering interest rates on federal funds reaching up to 1%.
This monetary loosening mainly impacted prices of commodities and financial assets. Unlike
was has happened in the past, monetary loosening had no impact on the price of industrial
products and services. Later we will see why core inflation (excluding food and fuel prices)
remained low.
The impact on asset prices was mainly due to the high level of leverage in the financial
market. It not only raised property prices but also of bonds and all kinds of financial assets.
To make matters worse, investors began to forget about the risks of different investments.
Traditional "risky" activities began to offer low yields. The main culprits were the credit rating
agencies who began to offer high marks to risky products.
Less than 10 years of financial deregulation, coupled with reckless fiscal policies by George
W. Bush administration was enough to make the world to burst. That was a part of the
problem. But the biggest problem is that we are still on the same road that already took us to
the brink of a disaster.

4. 1.2 Neoliberals
On January 20
th
, 2001 U.S. President George W. Bush took over as leader and received a
United States that was relatively strong, with a growing economy, low inflation, record budget
surplus, low military spending and low oil prices.
Between 2001 and 2003 the government of George W. Bush launched a general tax cut. The
minimum rate of income tax under 15% to 10%, 27% rate dropped to 25%, the rate of 30% to
28%, and the maximum rate of 39.6% lowered to 35%. Along with these measures, tax cuts
were passed for capital gains. These cuts mainly benefited higher-income Americans and
weakened the government's fiscal position.
The total government tax revenue as percent of GDP in 2010 was the lowest in United States
over the past 50 years
It was hoped that with the tax cuts there would be cuts in public spending. But there were
none. Public spending continued to grow.

5. On the other hand in response to the terrorist attacks of September 11, 2001 the Bush
administration invaded Iraq and Afghanistan. This produced a sharp increase in military
spending with an increase from 3.73% of GDP in 2000 to 5.13% of GDP in 2008. In addition
to the tax cuts increased military spending contributed to the weakening of the fiscal situation.
As a result of this increased spending and tax cuts the budget deficit sky rocketed. Upon the
outbreak of the crisis, the U.S. fiscal situation was already very weak so it left the new
government assumed by Barak Obama with a narrow margin to maneuver in response to the
biggest crisis in 80 years.

6. The increase in conflicts in the Middle East marked the beginning of what would be the
increase of a barrel of crude oil from $ 20 in early 2002 to $ 150 in 2008 before the outbreak
of the crisis. At first what triggered the price of a barrel of oil was the Iraq war, but then it
remained high and continued to rise due to increased demand (especially in emerging
countries), the weak dollar, and speculation about market price of derivatives and futures.
Oil price
This increase was offset a little by increased product efficiency (especially by more efficient
cars) The United States cut its oil consumption between 2000 and 2010 but its economy
remains very vulnerable with respect to changes in oil prices . A $ 10 increase in the value of
a barrel of oil hits 0.3% in GDP growth due to the impact they have on the trade balance.

7. 1.3 Money from Money
"If you have ten thousand dollars and you manage to gather twelve thousand, that's work. If
you have one hundred million and you make one hundred twenty million, that is simply
inevitable. "
Alan Greenspan was the main driver of the financial deregulation. As chairman of the Federal
Reserve between 1987 and 2006 he played a key role in pushing measures to deregulate the
financial market. In particular he was a strong supporter of the Gramm-Leach law and
Modernization Act of commodities and futures market that allowed for the proliferation of
financial instruments such as CDS (credit default swaps).
On the other side from early 2001 until mid-2003, 550 basis points were rebated on interest
rates on federal funds. This easy money policy helped to maintain the credit and housing
boom.
Rate of Federal Funds
But there was an unexpected factor. In early 2004, when inflation began to rise and signs that
a bubble in asset prices was being created, it was already very evident, Greenspan began to
raise the rates. But nothing happened. The major tool of monetary policy would be ineffective.
"Interest rates increased in the period of 2004-2006, although the types of long-term interest
and mortgage rates barely changed. The tightening of monetary measures was not effective,
and it turned out that there were many sources of easy money abroad. Over the last decade,
China, Japan and Germany had accumulated huge reserves of savings, which were lent to
the U.S. to finance budget deficits and the excessive demand for loans by all kinds of
organizations, from families to businesses. That's how China gave Americans the rope they
used to hang themselves. "
The United States no counted with one of the main instruments of monetary policy, but they
not attempt to curb the credit boom by other mechanisms.
Another factor that played a role in the increased value of assets was the financial leverage.

8. "Suppose that a wealthy individual borrowed three million dollars from the bank, adding
another million dollars of his own capital and invests it in one of fund baskets, which in turn
invests in other hedge funds. This point has a leverage of 4 to 1. Suppose then that this
basket of funds takes those four million dollars and borrows another $ 12 million from another
bank, and invests in another hedge fund. Again, the leverage is 4 to 1 but the initial
investment of 4 million has increased to 16 million. Imagine now that a hedge fund borrows
another 48 million (again a four to one leverage) to invest a total of 64 million dollars in some
high-risk stages of a CDO. Illustrating the power of exponential math, a tiny initial involvement
of a million dollars has become the basis of a $ 64 million bet. "
To make matters worse in 2003 the SEC (Securities and Exchange Commission) made
capital requirements easier for investment banks. The debt by capital was at levels of 15 to 1
increasing levels from 33 to 1 and even more. This meant that with a fall of 3% of the value of
their assets many organizations were to become insolvent.
The other key factor in this crisis was the "transfer or release of risks" that caused a major
"systemic risk". There are four elements that permitted and encouraged this process.
Securitization, credit default swaps, the credit reporting agencies and system of
compensation for banks.
Let's start with the securitization. The banks provide mortgages for 30 years, but most of the
deposits they receive are short term. To resolve this problem they created securitization,
which is what consisted of gathering groups of mortgages and sold them to investment banks,
which in turn were put together with other groups of mortgages and loans and were sold to
customers which were insured by CDS bought by these titles.
Although the securitization is good because it allows for extending the term of the loans, the
danger of this mechanism is that the banks gave out 100% of the risks associated with the
credits granted, and thus it was with the complicity of the rating agencies that such mortgages
gave the highest ratings, stopped worrying about who they would lend to and started offering
loans for up to one hundred percent of the value of the property and to people who in many
cases could not cope with them.

9. CDS (credit default swaps) are a way to "assure" which protects the buyer of the CDS in case
a loan enters into default. If the loan goes into default the buyer can change (swap) the credit
for cash at face value.
This financial instrument has existed since the early 90's. By the end of the year 2007 the
total amount of CDS was 62 trillion dollars, falling to 38.6 trillion at the end of 2008.
The CDS had a central role in the crisis, one of the main factors responsible for the
"systemic" breakdown. In short, the CDS allowed banks and other financial organizations to
act as if they were insurance companies.
But deregulation went even further. If an investor wanted to he or she could buy a CDS
against default on payments on an asset that he or she did not possess. In short, the
business operated like a casino. Many investors made billions betting during the crisis on the
collapse of the housing bubble using these instruments.
Investment bank Goldman Sachs was investigated by the SEC because it sold to its
customers billions of dollars in mortgage securities and simultaneously bet on using CDS
against loss of value of these securities. At the outbreak of crisis customers lost their savings
and the bank earned 22 billion dollars on these bets.
Upon the outbreak of the crisis AIG was responsible for more than 500 billion dollars in CDS.
If the government had not intervened its fall would have opened destructively as the collapse
of Leman Brothers.
Going back to Goldman Sachs, their unsuspecting customers bought these titles because
many of them had the highest AAA credit ratings, the same as those who had U.S.
government bonds. When the crisis and the major rating firms had to appear before Congress
in the United States Senate they merely said that their ratings were "opinions" so they tried to
detach themselves from their responsibility in the crisis.
The compensation system of financial firms also played a major role in taking the same risks.
The bonus system received by bank executives is tied to short-term profit entities and does
not take into account the medium term.
"The <contribution> to somehow call it, from the financial sector to the GDP of the United
States surpassed 2.5% in 1947 then to 4.4 in 1977 and 7.7 in 2005. By then the financial
institutions accounted for 40% of the profits of the companies listed on the stock index
Standard & Poor's 500, and the participation of these companies in total market capitalization
of the Standard & Poor's 500 index has doubled to about 25%. More strikingly still is the fact
that the combined income of the directors of the 25 largest hedge funds in the country
exceeded the aggregate revenue of all chief executive officers (CEOs) of all companies listed
on the Standard & Poor's 500. In 2008, more than one out of every thirteen dollars of wages
paid to U.S. workers belonged to the financial sector. After the Second World War this figure
was one dollar for every forty ".
1.4 The bubble
Since the late 90's property prices began to rise sharply worldwide. Easy access to credit
enabled millions of people access to housing and people believed that housing prices would
never come down.
Prices got so high and access to credit was so easy for families of low and middle income
that they began to take second mortgages to spend more money on consumption, many
others in better positions began to build second homes used as a summer house and the
wealthy invested in funds that invested in properties ranging from multi-family homes in
Florida to castles in Europe.

10. In the following graph we see the total U.S. debt by sector as a percentage of GDP. Most of
this growth corresponds to the financial sector’s debt leverage and home mortgages.
Total debt by economic sector as% of GDP
"The demand for family housing in the United States had always been predominantly viewed
as a property for a home, with a proportion of purchases for investment purposes which rarely
exceeded 10%. However, in 2005, investors reported that 28% of homes purchased were for
investment purposes, according to the national association of real estate agents ".

11. Beginning in 2004 coupled with rising property prices, commodities prices began to rise
sharply which were driven primarily by demands from emerging countries.
This boom in prices was positive for many emerging countries dependent on the exportation
of commodities. The avalanche of dollars from the high prices of the commodities gave
macroeconomic stability to these countries and allowed for steady growth in their economies.
But the seriousness of this bubble is that unlike other bubbles it did not leave any positive
residual effect.
Nouriel Roubini wrote regarding the housing bubble "many bubbles begin when an explosion
of innovation and technological progress announces the birth of a new economy. In the
1840s, Britain experienced an obsession fueled by a new technology: the railroad. In 1830,
the first commercially successful railway began carrying passengers between Manchester
and Liverpool, thereafter; investors bought shares of companies that were to construct even
more profitable lines. During the height of the boom in the years 1845 and 1846, the railway
share prices skyrocketed and companies built thousands of kilometers of rails, many of them
absolutely unnecessary. Although the boom ended with a brutal blast, it was based partly on
the fundamentals: a new technology generates new business opportunities. While most rail
companies from the 1840s failed, they left behind a new transport infrastructure which was
critical to the country's economic expansion during the nineteenth century.
The same argument could be compared to the dotcom boom of the nineties. Although it
quickly became a speculative bubble, at least it was justified in part by a new technology (the
internet) and its many promising applications. When that bubble burst, many new companies
survived, as well as a new communications infrastructure consisting of coaxial cable lines,
wireless towers and other tangible technological improvements.
In contrast, the recent crisis has left behind few tangible benefits: abandoned houses
subdivided in Las Vegas are almost useless. And what's worse, the housing boom was not
founded by any technological revolution: the houses built in 2006 are no different from those
built one or two decades earlier. The most recent boom was something out of the ordinary, a
boom without any fundamental change. It was just a mere bubble."
1.5 The illusion of wealth
In recent years the wages of less skilled workers stagnated in the United States, yet their
level of consumption continued to increase much. Low interest rate credits and bubbles in

12. asset prices were the cause of this increase in consumption that led to American households
having negative savings rates.
"The Economists who analyzed housing prices in 20 countries, have estimated that between
2000 and 2005 the market value of the residential property in developed countries went up
from 40 billion to more than 70 billion dollars. Most of that increase - $ 8 billion - occurred in
American family homes."
The arrival of the crisis was terrible for many families. Millions of people could not pay their
mortgages and were forced to give up their homes to banks. More than 3 years after the crisis
around 24% of properties with mortgages in the U.S. are worth less than their mortgage.
1.6 Preventing the collapse
In early 2006, housing prices stopped rising and started to deflate the housing bubble.
"The party was winding down by the end of 2005, when first-time home buyers began to find
that prices were increasingly escaping their reach. Higher prices require larger mortgages,
which began to eat an overwhelming portion of their monthly income."
In late 2004 the Fed began to raise the benchmark rate from 1% to 5.25% in early 2006. The
variable rate mortgages began to rise. The property prices started to stagnate and later
began to fall. This resulted in a loss of wealth for the families who began to moderate their
consumption and caused a cooling of the economy that led the country into recession in
December 2007.
As a result of the recession, rising unemployment rates and falling property prices many
homeowners were unable to keep up with payments on their mortgages and many properties
transferred into the ownership of banks. Millions of properties were sold by banks at fire sale
prices. This further lowered prices and caused for even more properties to be worth less than
their mortgages.

13. Rate of Unemployment
The trigger for the recent crisis occurred in September 2008. On September 15th of that year
due to its high exposure to mortgage debt as it had issued billions of dollars in CDS
investment bank Lehman Brothers filed for bankruptcy and the world panicked.
"Lehman Brothers had endured a civil war the banking crisis of 1907, very similar to the
present, it had also survived the economic crisis in the United States known as the Crash of
1929, trading scandals in bonds, hedge fund collapses but could not overcome the subprime
crisis of 2008, and with liabilities of $ 613,000 million, it was the largest bankruptcy in history
so far."
Two days later the insurer AIG had to be rescued by the federal government which injected
85 billion in capital and ensured all their debt. AIG had issued CDS worth more than 500,000
million dollars so its failure could have bankrupted much of the banking system.
The Dow Jones fell from 13,000 to 7,000 points in a few weeks and the world entered into
recession.
The problem was that nobody knew how far the risk would go. The financial system was
found to be interconnected in a way that it had never been before and the low ratios of capital
made it so the fall of one institution could drag many others down as well. Within days, many
entities had serious problems in trying to get cash.
Faced with the panic investors began to divest their assets. The sharp drop in the prices of these
made it so that many institutions at the outbreak of the crisis were illiquidity would then become
insolvent
Governments around the world launched huge incentive programs to keep the economy from
bursting. If they wouldn’t have done so the consequences would have been catastrophic and
we would have had a crisis of the same magnitude as that of the crisis of the thirties.
The Federal Reserve lowered rates to 1% and injected huge amounts of cash. On the other
hand they bough huge amounts of mortgage debt and injected large amounts of capital into
banks and other financial institutions to prevent them from bankruptcy. The government in
turn had to come to the rescue of large industrial conglomerates such as General Motors and
other well-known companies.
FED's Balance Sheet

14. On the other hand, the federal government incurred huge deficits to build up the economy,
but as we will see they were not applied in the right way. However, they were able to prevent
the worst from happening.

15. 2. Concentration of wealth
2. 1 Qualified vs. Unqualified
Since the mid 80’s there has been an increase in the world’s differences between skilled and
unskilled workers.
As a product of technological advancements and specializing, companies increasingly need
fewer employees and more qualified workers in order to produce the same things that they
were able to produce in the past. This does not leave a very encouraging outlook for low-
skilled workers.
The following table demonstrates the evolution of the middle-sized family’s income in the
United States based on what they studied.

16. There were many factors that on one hand helped to contain the wage demands of unskilled
workers and on the other put pressures on growing wages for those more qualified workers.
In his book, “The Age of Turbulence”, the former president of the Federal Reserve, Alan
Greenspan gives three reasons that contributed to the low inflation rates over the last fifteen
years.
1- The technological revolution
Since the early 90's the introduction of modern low-cost computers and the strong
development of the Internet helped to increase productivity in an amazing way.
Companies were able to require fewer and better-qualified employees. This significant
increase in productivity generated a significant increase in corporate profits and helped to
contain inflation.
2- Cheap imports from Asia.
Cheap imports from Asia have flooded the World with consumer products at cheap
prices. On one hand, Western consumers are able to purchase consumer goods at
low prices and on the other factories in developed countries have to contain their
prices in order to not succumb to foreign competition.
3- The containment of wage demands in developed countries.
Workers in many industries in developed countries, had to hold back on wage
demands in order to keep the companies in which they worked from not being able to
be competitive and from being forced to move production to other countries.
On the other hand there has been increased immigration in developed countries
(often illegal immigrants) that have flooded the labor market as unskilled labor which
has caused a stagnation of wages for unskilled workers.
As seen in the 3 points above, these factors contained prices and also kept a lid on wage
demands by low-skilled workers which allowed for 2 decades of low inflation. It also implies
an important shift of production to Asian countries which has strongly impacted the trade
balance.
At the same time the share of salaried as percent of the GDP decrease significantly.

17. While the share of low wages and average income has remained stagnant, consumption has
continued to grow as families finance their consumption by going into debt. Savings have just
recently returned to positive percentages but only after the crisis where families were forced
to begin the process of deleveraging.
2.2 Efficiency and imbalances
I want to return to the three factors that Alan Greenspan names that helped to keep inflation
low in developed countries.
• The technological Revolution (the internet and low cost computers)
• Transfer of production to Asia
• Low wage increases for skilled workers.
It is true that these factors helped to keep inflation low, but there are other consequences that
came from these changes listed above that are not often talked about. One of these
unspoken consequences is that corporate profits and capital gains rose dramatically.
Technological improvements led greatly to the increased output per worker. This coupled with
greater efficiency and low inflation allowed for corporate profits to soar.

18. Both consequences are good, but as we will see as we continue is that the state is the actor that
failed in this scenario. Companies were made to become more efficient and earning more
money is always a good thing, however, what is not good is that they have done so a very
disproportionate way within a context in which they do not have to invest.
What can be said for sure is that the increase in corporate profits as a result of technological
change has caused serious imbalances in the distribution of income and savings
Asking companies to be inefficient would be foolish and simply doesn’t make sense. So what
could be contended instead is that higher taxes be applied to corporations and to the richest
families because they have an excess of savings that is freezing up the economy and creating a
bubble in asset prices.

19. If the economy were to have higher needs for investment it would be at odds with the higher
taxes, but in the current situation in which companies and wealthy households do not have to
invest it seems to be the most appropriate option.
In face of this situation of not having to invest, companies are increasing their amounts of
cash, lowering their debt levels and distributing their dividends.
At this moment there are two “saving’s vacuums” in the United States. One is that of the
current account deficit and the other are the corporations and wealthy families.

20. 2.3 Aristocracy of Merit
A millionaire is considered to be a person who has more than one million dollars in liquid assets.
When talking about liquid assets we are referring to stocks, bonds, bank deposits and other liquid
financial assets.
The Credit Suisse "Global Wealth Report" estimated that in mid-2010 there were 24.2 million
millionaires in the world, representing about 0.5% of the world’s adult population. These
millionaires control 69.2 billion dollars in assets, representing more than one third of the world’s
total and 41% of them live in the United States, Japan having 10% and 3% of these millionaires
are in China.
The richest 1% controls 43% of the world's assets and the richest 10% controls 83% of it. The
poorest 50% controls only 2% of the world’s assets.
But the curious fact is that compared to what the majority of people think; only 16% of these
individuals inherited their status as millionaires. The most common way of becoming a
millionaire is by starting one’s own business (47%).
Given this information, we can say that especially in developed countries we face a global
aristocracy who have built their own fortunes based on their own efforts, but this does not mean
that in a situation such as the current crisis they are the ones who need to contribute most to the
exit of this crisis since they were the ones that benefited the most by the current model.
Some of the world's richest people such as Warren Buffett and the owner of L'Oreal, Liliane
Bettencourt, have made proposals for increased taxes for the "super rich".

21. 3.
The
next
crisis
3.1 More of the same old prescriptions
Given the high public deficit even after they have exhausted much of the stimulus programs
the response of most governments is to cut spending.
In my opinion it would be much more accurate to search for a balance between spending cuts
and tax increases for the wealthiest.
Usually spending cuts are felt the hardest by the middle and lower classes of the population which
usually devote most of their income to consumption as opposed to the richer that devote a
significant portion of their income to savings and investments. Being from economies with excess
capacities there are not many investment opportunities to which to allocate this excess of savings.
On the other hand in developed economies the levels of investment as a percentage of the GDP
are much lower than in developing economies and therefore it is hoped that this excess of savings
of the richest families will contribute to the formation of price asset bubbles.
On the other hand these cuts impact the social safety nets forcing families to save more as a
precautionary method.
Paul Krugman wrote about the “the spill theory”
"To be watch the evolution of the economic debate in Washington in the last couple of years in
has been a daunting experience. Month after month they have forgotten the lessons of the 2008
financial crisis, and the same ideas that got us into this crisis - regulation is always bad, what is
good for bankers is good for America; the reduction tax is the universal elixir that has regained
their influence.
And now the economy has spilled over - anything that increases corporate profits is good for the
economy – it is making a comeback.
It seems strange that in the last two years, earnings have soared while unemployment has
remained surprisingly high.
So here's what you should say to anyone who defends the great gifts given to corporations: the
problem facing the United States are not due to a lack of corporate money. Large companies
already have the money to expand, what they lack is a reason to expand, as consumers are still
being held against the ropes and the government has cut spending.
What our economy needs is that the government believes that there is direct and public assistance
for consumer mortgage debt stress. What is least needed is a transfer of billions of dollars to
corporations that have no intention of hiring anyone besides lobbyists. "
Paul Krugman then wrote about Obama, saying:
"He surrendered last December, extending all the Bush tax cuts, he surrendered in the spring
when they threatened to shut down the government, and now he has surrendered on a grand
scale to the raw extortion placed on debt ceilings"
We must also highlight an important difference between the United States and Europe. The FED
has been much more active than the ECB in its role in boosting economic recovery. The ECB
acted alone when it saw the situation becoming too complicated.
The recent agreement between Democrats and Republicans to increase the limit of
indebtedness of the United States makes for a dark scary picture. The agreement will help
only make things worse. The same includes significant cuts in public spending starting in
2012 and no type of tax increases. In less than a week from the time of the agreement the
world's stock exchange were hit with heavy losses and many analysts predict a new
recession in 2012.

22. The news coming from Europe is no more encouraging than that of the State. The debt crisis
in Ireland, Portugal and Greece has begun to expand into Spain and Italy. The cost of Italian
government funding rose to more than 6 percent and would not have fallen if it would not
have been for the intervention by the ECB. There is social instability, high youth
unemployment rates and not even the slightest sign that this will change any time soon.
There are other risks for the global economy coming from the BRIC countries. On one side
China has an investment level of 50% of its GDP which is difficult to sustain over a long
period of time and its banks face heavy losses arising from its loans to municipal
governments for infrastructure needs. It is estimated that many of these credit loans could go
into a ceasing of payments in 2013. All of this suggests a decline in the growth rate of the
“Asian Giant” in mid-2012. And on another note, Brazil faces the problem of an overvaluation
of its currency and an important current account deficit, its economy is expected to grow only
3.5 this year.
3. 2 Deleveraging and the equation of the 3 sectors.
It seems that many economists are forgetting one basic economic equation:
Private savings = state savings + the current account balance sheet.
At the start of the 2008 crisis, the government incurred huge fiscal deficits in order to keep the
economy from falling apart. These stimulus programs involved a huge transfer of deposits
from the public sector to the private sector. In the United States the private sector when from
having a negative savings rate to having a very positive one. Then the process of
deleveraging began in the private sector. In short, what is happening is a transfer of private
sector debt to the public sector.
Now we see that in some countries such as the United States, the economy is showing signs
of growth. Perhaps at low rates and without a growth in employment but there is none the
less growth occurring. In other countries like the PIGS (Portugal, Ireland, Greece and Spain)
the economy is growing directly anemic or into recessions. Like the United States, all of the
PIGS countries have high current account deficits, elevated public deficits and positive private
savings.
The euro-zone countries cannot devalue in order to make exports more competitive and
improve their current account balance sheets. If we lower the public deficit and the current
account balance does not improve, the only option available to close the equation is that
consumers save less or stop saving which in economies with a total lack of trust is very
difficult to make happen. It is expected that in a situation of uncertainty the private sector
wants to reduce its savings rate, so we enter a vicious circle of recession. This is what is
happening in Europe and will get worse every month until the situation becomes
unsustainable.
The hope is not to be overly simplistic with the analysis. There are other factors such as
foreign direct investment and increasing the valuation of assets that could increase savings.
But in the case of the PIGS countries these two factors can be deducted. Investors reduce
their positions in these countries and asset prices fall.
In the past imbalances in trade balance and current account deficits were easier to sustain
over time because the share of international trade and capital flows were much lower in
relation to GDP.
In the following graph we look the share of international trade (exports plus imports) as
percentage of GDP in the United States. Participation has been growing since 1969 up
through today.

23. 3. 3 Why stimulus programs have failed
While incentive programs helped to avoid what could have been an even worse economic
crisis they focused on fiscal deductions and tax cuts but did not attack the problem of
imbalances and creating jobs.
Facing a major crisis both businesses and households want to increase their savings. But this
is exactly where the problem lies. For the economy to return to a path of sustained growth it is
necessary for consumers and businesses to save less. Consumers with low and middle
incomes are heavily indebted and devote most of their income to consumption. In order to
shrink the fiscal deficit without affecting consumption and GDP growth there need to be
higher taxes on corporations and higher income households.
In the previous chapter we saw that companies have maintained a high level of earnings and
savings despite the economic crisis. The problem is not that they are earning so much money; the
problem is that they don’t have anything to invest in. Companies are saving at very high rates,
while before the crisis their savings were negative. Dividends paid by corporations end up mostly
in the hands of high-income households, who then put this money towards savings instead of
consumption. Large corporations and wealthy households act as a money vacuum that prevents
the economy from circulating.
Public spending cuts directly impact GDP growth, while higher taxes placed on the wealthiest
families and corporations will have minimal impact on growth.
They are throwing away hundreds of billions of dollars on stimulus programs that end up
being spent on businesses and households of the richest. As previously stated companies do
not invest because in many cases they do not have anything to invest in and richest
households do not spend because they have a good level of consumption and prefer to put
more money towards savings. The tax deductions to companies in a context of stagnation
with increased profits are a waste of taxpayer money.
On the other hand the early termination of stimulus programs will mean that the world is
heading towards another recession. Politicians forget that after the great depression of the
1930s when they began to cut government spending the GDP shrank. In 1938 the U.S. GDP
contracted by 3.8% and if not for defense spending at the outbreak of World War II there
would probably have been another recession. Stimulation programs should be phased out
and must always be looking at the medium term.

24. 4. Conclusion
Given the weak situation that the economy has found itself in, it is no longer possible to get of
it by simply using traditional economic tools because the majority of these have already been
exhausted. With a fiscal deficit of around 9% of GDP, the federal funds rate at 1%, families in
debt and property prices still dropping, the solution requires a much broader and with a
stronger political component.
It must carry out tax reforms to reduce public deficit in the medium term and boost the
economy in the short term. To start with, they need to abolish the tax cuts implemented
during the tenure of George Bush and eliminate some tax breaks to businesses. As we saw in
previous chapters there is not much room to cut spending (except for the defense budget) so
that deficit reduction must come from the sectors of the economy that have an excess of
savings.
They must carry out a reform regarding the energy matrix in order to reduce the dependence
on imported oil, which would significantly improve the current account balance and increase
the security of the country by becoming less dependent on oil imported from areas of conflict
(such as the Middle East and Venezuela). It should raise taxes on gasoline and set a
minimum price of oil to create a framework for developing renewable energy. On the other
hand they must create major public works to improve the efficiency of transport in many large
American cities where big traffic jams occur which implies a huge waste of fuel. Ambitious
targets should be imposed in this regard and energy policy should be a priority and of the
government stimulus programs.
This change in the energy matrix increases both the private and public investment which will
help growth.
It should seek a solution to the problem of mortgages. Starting with a period of one year to
reduce capital payments by 50% and for a period of 2 years to impose a maximum interest
rate of 2% paid to the debtors. This would have a strong impact as families allocate 11.5% of
their disposable incomes to interest payments. On the other hand in areas where property
values fell a lot they should restructure the mortgages by subtracting from the capital amount
so that the amount of the mortgage does not exceed the value of the property. This is very
important because many Americans can not move from their home to get better jobs because
doing so would mean losing their homes.
One should also keep in mind the enormous health care spending that takes place in the
United States. A good step in this direction would be the implementation of a tax on junk food
and the banning of advertising by companies selling these products. It must attack the
sedentary lifestyle that many Americans have. Much of the spending on health is due to
chronic diseases like diabetes or hypertension. With a population that were to do more
exercising and were to eat better, the country could save hundreds of billions of dollars in
medical expenses.
There should also be a reduction in the huge military spending. The reduction in military
spending would help to reduce the public deficit and bring with it a technological progress due
to industries engaged in military technology that could be transformed to meet the civilian
markets needs. To start with on would have to reduce military spending to less than 3.8% of
GDP as it was before the arrival of George Bush as U.S. president.
As for the money the FED’s decision to hold rates at 1% until 2013 is a good measure. I think
a third round of the buying of bonds by the FED would be a good measure as well. All these
measures help to keep low the value of the dollar and would generate inflation especially in
emerging countries. This helps make U.S. exports more competitive and increases the cost of
imports. As for inflation borders within in a context of a weak economy there is no evidence
than this can have a major impact but they could have a major impact on the global price of
commodities and financial assets.

25. 5. Bibliography
http://en.wikipedia.org/wiki/Gramm–Leach–Bliley_Act
http://es.wikipedia.org/wiki/Ley_Glass-Steagall
Bureau of labor statistics
Federal housing finance agency
Como salimos de esta – Nouriel Roubin
The Age of turbulences – Alan Greenspan
http://www.worldbank.org/