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THE U.S. SUBPRIME CRISIS:
AN INTERNATIONAL AND
HISTORICAL COMPARISON

This chapter begins with a broad-brush “pictorial” overview of the global incidence of banking crises through the past century, taking advantage of the expansive amount of data collected for this book. Our aim is to place the international situation of the late 2000s, the “Second Great Contraction,” in a broader historical context.¹ We will then go on, in this chapter and the next, to look at how the late vintage U.S. subprime financial crisis compares with past financial crises. Broadly speaking, we will show that both in the run-up to the recent crisis and in its aftermath (as of the writing of this book), the United States has driven straight down the quantitative tracks of a typical deep financial crisis.

In addition to making our quantitative comparisons in this chapter, we will also discuss the re-emergence of the this-time-is-different syndrome—the insistence that some combination of factors renders the previous laws of investing null and void—that appeared on the eve of the meltdown. This task is not particularly difficult, for the remarks and written works of academics, policy makers, and financial market participants in the run-up to the crisis provide ample evidence of the syndrome. We will place particular emphasis on the debate over whether massive borrowing by the United States from the rest of the world prior to the crisis should have been seen as a critical warning sign.

A Global Historical View of the
Subprime Crisis and Its Aftermath

Before focusing on the Second Great Contraction, which began in 2007, it will be helpful to review the incidence of banking crises over a broader span of history, which we first examined in chapter 10. A closer look at those data shows that the earliest banking crisis in an advanced economy in our sample is that of France in 1802; early crises in emerging markets befell India in 1863, China (in several episodes) during the 1860s-1870s, and Peru in 1873. Because in this chapter we are interested in making broad cross-country comparisons, we will focus mainly on data for the period since 1900, for they are sufficiently rich to allow a systematic empirical treatment.²

Figure 13.1 plots the incidence of banking crises among the countries in our sample (which the reader will recall accounts for about 90 percent of world income on the basis of purchasing power parity, or PPP). The graph is, in fact, based on the same data as figure 10.1 except that here we concentrate only on banking crises and not on capital mobility. As before, the figure shows the percentage of all independent countries that experienced a banking crisis in any given year from 1900 through 2008, taking a three-year moving average. As in figure 10.1 and a number of similar figures throughout the book, the tally in figure 13.1 weights countries by their share of global GDP so that crises in larger economies have a greater impact on the overall shape of the graph. This weighted aggregate is meant to provide a measure of the “global” impact of individual banking crises. Therefore, a crisis in the United States or Germany is accorded a much greater weight than a crisis in Angola or Honduras, all of which are part of our sixty-six-country sample. The reader should be aware that although we believe that figure 13.1 gives a fair picture of the proportion of the world in banking crisis at any one time, it is only a rough measure, because banking crises are of varying severity.

As we noted in chapter 10, the highest incidence of banking crises during this 109-year stretch can be found during the worldwide Great Depression of the 1930s. Earlier, less widespread “waves” of global financial stress were evident during and around the Panic of 1907, which originated in New York, as well as the crises accompanying the outbreak of the First World War. Figure 13.1 also reminds us of the relative calm from the late 1940s to the early 1970s. This calm may be partly explained by booming world growth but perhaps more so by the repression of the domestic financial markets (in varying degrees) and the heavy-handed use of capital controls that followed for many years after World War II. (We are not necessarily implying that such repression and controls are the right approach to dealing with the risk of financial crises.)

Figure 13.1. The proportion of countries with banking crises, 1900–2008, weighted by their share of world income.
Sources: Kaminsky and Reinhart (1999), Bordo et al. (2001), Maddison (2004), Caprio et al. (2005), Jácome (2008), and the additional sources listed in appendix A.3, which provides the dates of banking crises.
Notes: The sample size includes all sixty-six countries listed in table 1.1 that were independent states in the given year. Three sets of GDP weights are used, 1913 weights for the period 1800–1913, 1990 weights for the period 1914–1990, and finally 2003 weights for the period 1991–2008. The dotted line indicates all crises, the solid line systemic crises (for instance, for the 1980s and 1990s, the crises in the Nordic countries, then Japan, then the rest of Asia). The entries for 2007–2008 indicate crises in Austria, Belgium, Germany, Hungary, Japan, the Netherlands, Spain, the United Kingdom, and the United States. The figure shows a three-year moving average.

As we also observed in chapter 10, since the early 1970s, financial and international capital account liberalization—reduction and removal of barriers to investment inside and outside a country—have taken root worldwide. So, too, have banking crises.³ After a long hiatus, the share of countries with banking difficulties first began to expand in the 1970s. The break-up of the Bretton Woods system of fixed exchange rates, together with a sharp spike in oil prices, catalyzed a prolonged global recession, resulting in financial sector difficulties in a number of advanced economies. In the early 1980s, a collapse in global commodity prices, combined with high and volatile interest rates in the United States, contributed to a spate of banking and sovereign debt crises in emerging economies, most famously in Latin America and then Africa. High interest rates raised the cost of servicing large debts, which were often funded at variable interest rates linked to world markets. Falling prices for commodities, the main export for most emerging markets, also made it more difficult for them to service debts.

The United States experienced its own banking crisis, rooted in the savings and loan industry, beginning in 1984 (albeit this was a relatively mild crisis compared to those of the 1930s and the 2000s). During the late 1980s and early 1990s, the Nordic countries experienced some of the worst banking crises the wealthy economies had known since World War II following a surge in capital inflows (lending from abroad) and soaring real estate prices. In 1992, Japan's asset price bubble burst and ushered in a decade-long banking crisis. Around the same time, with the collapse of the Soviet bloc, several formerly communist countries in Eastern Europe joined the ranks of nations facing banking sector problems. As the second half of the 1990s approached, emerging markets faced a fresh round of banking crises. Problems in Mexico and Argentina (in 1994–1995) were followed by the famous Asian crisis of 1997–1998 and then the troubles of Russia and Colombia, among others.⁴ That upswing in the banking crisis cycle was closed by Argentina in 2001 and Uruguay in 2002. A brief tranquil period came to an abrupt halt in the summer of 2007 when the subprime crisis in the United States began in earnest, soon transforming itself into a global financial crisis.⁵

As is well known, the U.S. financial crisis of the late 2000s was firmly rooted in the bubble in the real estate market fueled by sustained massive increases in housing prices, a massive influx of cheap foreign capital resulting from record trade balance and current account deficits, and an increasingly permissive regulatory policy that helped propel the dynamic between these factors (a pattern that we will quantify further). To place the housing bubble in historical perspective, figure 13.2 plots the now-famous Case-Shiller housing price index deflated by the GNP deflator (the picture is essentially unchanged if the consumer price index is used).⁶ Since 1891, when the price series began, no housing price boom has been comparable in terms of sheer magnitude and duration to that recorded in the years culminating in the 2007 subprime mortgage fiasco. Between 1996 and 2006 (the year when prices peaked), the cumulative real price increase was about 92 percent—more than three times the 27 percent cumulative increase from 1890 to 1996! In 2005, at the height of the bubble, real housing prices soared by more than 12 percent (that was about six times the rate of increase in real per capita GDP for that year). Even the prosperous post–World War II decades, when demographic and income trends lent support to housing prices, pale in comparison to the pre-2007 surge in prices.⁷ By mid-2007, a sharp rise in default rates on low-income housing mortgages in the United States eventually sparked a full-blown global financial panic.

Figure 13.2. Real housing prices: United States, 1891–2008.
Sources: Shiller (2005), Standard and Poor's, and U.S. Commerce Department.
Notes: House prices are deflated by the GNP deflator. Real housing prices are indexed to equal 100 in 2000.

The This-Time-Is-Different Syndrome and
the Run-up to the Subprime Crisis

The global financial crisis of the late 2000s, whether measured by the depth, breadth, and (potential) duration of the accompanying recession or by its profound effect on asset markets, stands as the most serious global financial crisis since the Great Depression. The crisis has been a transformative moment in global economic history whose ultimate resolution will likely reshape politics and economics for at least a generation.

Should the crisis have come as a surprise, especially in its deep impact on the United States? Listening to a long list of leading academics, investors, and U.S. policy makers, one would have thought the financial meltdown of the late 2000s was a bolt from the blue, a “six-sigma” event. U.S. Federal Reserve Chairman Alan Greenspan frequently argued that financial innovations such as securitization and option pricing were producing new and better ways to spread risk, simultaneously making traditionally illiquid assets, such as houses, more liquid. Hence higher and higher prices for risky assets could be justified.

We could stop here and say that a lot of people were convinced that “this time is different” because the United States is “special.” However, given the historic nature of the recent U.S. and global financial collapse, a bit more background will help us to understand why so many people were fooled.

Risks Posed by Sustained U.S. Borrowing from the
Rest of the World: The Debate before the Crisis

Chairman Greenspan was among the legion that branded as alarmists those who worried excessively about the burgeoning U.S. current account deficit.⁸ Greenspan argued that this gaping deficit, which reached more than 6.5 percent of GDP in 2006 (over $800 billion), was, to a significant extent, simply a reflection of a broader trend toward global financial deepening that was allowing countries to sustain much larger current account deficits and surpluses than in the past. Indeed, in his 2007 book, Greenspan characterizes the sustained U.S. current account deficit as a secondary issue, not a primary risk factor, one that (along with others such as soaring housing prices and the notable buildup in household debt) should not have caused excessive alarm among U.S. policy makers during the run-up to the crisis that began in 2007.⁹

The Federal Reserve chairman was hardly alone in his relatively sanguine view of American borrowing. U.S. Treasury Secretary Paul O'Neill famously argued that it was natural for other countries to lend to the United States given this country's high rate of productivity growth and that the current account was a “meaningless concept.”¹⁰

Greenspan's successor, Ben Bernanke, in a speech he made in 2005, famously described the U.S. borrowing binge as the product of a “global savings glut” that had been caused by a convergence of factors, many of which were outside the control of U.S. policy makers.¹¹ These factors included the strong desire of many emerging markets to insure themselves against future economic crises after the slew of crises in Latin America and Asia during the 1990s and early 2000s. At the same time, Middle Eastern countries had sought ways to use their oil earnings, and countries with underdeveloped financial systems, such as China, had wanted to diversify into safer assets. Bernanke argued that it was also natural for some developed economies, such as Japan and Germany, to have high savings rates in the face of rapidly aging populations. All these factors together conspired to provide a huge pool of net savings in search of a safe and dynamic resting place, which meant the United States. Of course, this cheap source of funding was an opportunity for the United States. The question authorities might have wrestled with more was “Can there be too much of a good thing?” The same this-time-is-different argument appears all too often in the speeches of policy makers in emerging markets when their countries are experiencing massive capital inflows: “Low rates of return in the rest of the world are simply making investment in our country particularly attractive.”

As money poured into the United States, U.S. financial firms, including mighty investment banks such as Goldman Sachs, Merrill Lynch (which was acquired by Bank of America in 2008 in a “shotgun marriage”), and the now defunct Lehman Brothers, as well as large universal banks (with retail bases) such as Citibank, all saw their profits soar. The size of the U.S. financial sector (which includes banking and insurance) more than doubled, from an average of roughly 4 percent of GDP in the mid-1970s to almost 8 percent of GDP by 2007.¹² The top employees of the five largest investment banks divided a bonus pool of over $36 billion in 2007. Leaders in the financial sector argued that in fact their high returns were the result of innovation and genuine value-added products, and they tended to grossly understate the latent risks their firms were taking. (Keep in mind that an integral part of our working definition of the this-time-is-different syndrome is that “the old rules of valuation no longer apply.”) In their eyes, financial innovation was a key platform that allowed the United States to effectively borrow much larger quantities of money from abroad than might otherwise have been possible. For example, innovations such as securitization allowed U.S. consumers to turn their previously illiquid housing assets into ATM machines, which represented a reduction in precautionary saving.¹³

Where did academics and policy economists stand on the dangers posed by the U.S. current account deficit? Opinions varied across a wide spectrum. On the one hand, Obstfeld and Rogoff argued in several contributions that the outsized U.S. current account was likely unsustainable.¹⁴ They observed that if one added up all the surpluses of the countries in the world that were net savers (countries in which national savings exceed national investment, including China, Japan, Germany, Saudi Arabia, and Russia), the United States was soaking up more than two out of every three of these saved dollars in 2004–2006. Thus, eventually the U.S. borrowing binge would have to unwind, perhaps quite precipitously, which would result in sharp asset price movements that could severely stress the complex global derivatives system.¹⁵

Many others took a similarly concerned viewpoint. For example, in 2004 Nouriel Roubini and Brad Setser projected that the U.S. borrowing problem would get much worse, reaching 10 percent of GDP before a dramatic collapse.¹⁶ Paul Krugman (who received a Nobel Prize in 2008) argued that there would inevitably be a “Wile E. Coyote moment” when the unsustainability of the U.S. current account would be evident to all, and suddenly the dollar would collapse.¹⁷ There are many other examples of academic papers that illustrated the risks.¹⁸

Yet many respected academic, policy, and financial market researchers took a much more sanguine view. In a series of influential papers, Michael Dooley, David Folkerts-Landau, and Peter Garber—”the Deutschebank trio”—argued that the gaping U.S. current account deficit was just a natural consequence of emerging markets’ efforts to engage in export-led growth, as well as their need to diversify into safe assets.¹⁹ They insightfully termed the system that propagated the U.S. deficits “Bretton Woods II” because the Asian countries were quasi-pegging their currencies to the U.S. dollar, just as the European countries had done forty years earlier.

Harvard economist Richard Cooper also argued eloquently that the U.S. current account deficit had logical foundations that did not necessarily imply clear and present dangers.²⁰ He pointed to the hegemonic position of the United States in the global financial and security system and the extraordinary liquidity of U.S. financial markets, as well as its housing markets, to support his argument. Indeed, Bernanke's speech on the global savings glut in many ways synthesized the interesting ideas already floating around in the academic and policy research literature.

It should be noted that others, such as Ricardo Hausmann and Federico Sturzenegger of Harvard University's Kennedy School of Government, made more exotic arguments, claiming that U.S. foreign assets were mismeasured, and actually far larger than official estimates.²¹ The existence of this “dark matter” helped explain how the United States could finance a seemingly unending string of current account and trade deficits. Ellen McGrattan of Minnesota and Ed Prescott of Arizona (another Nobel Prize winner) developed a model to effectively calibrate dark matter and found that the explanation might plausibly account for as much as half of the United States’ current account deficit.²²

In addition to debating U.S. borrowing from abroad, economists also debated the related question of whether policy makers should have been concerned about the explosion of housing prices that was taking place nationally in the United States (as shown in the previous section). But again, top policy makers argued that high home prices could be justified by new financial markets that made houses easier to borrow off of and by reduced macroeconomic risk that increased the value of risky assets. Both Greenspan and Bernanke argued vigorously that the Federal Reserve should not pay excessive attention to housing prices, except to the extent that they might affect the central bank's primary goals of growth and price stability. Indeed, prior to joining the Fed, Bernanke had made this case more formally and forcefully in an article coauthored by New York University professor Mark Gertler in 2001.²³

On the one hand, the Federal Reserve's logic for ignoring housing prices was grounded in the perfectly sensible proposition that the private sector can judge equilibrium housing prices (or equity prices) at least as well as any government bureaucrat. On the other hand, it might have paid more attention to the fact that the rise in asset prices was being fueled by a relentless increase in the ratio of household debt to GDP, against a backdrop of record lows in the personal saving rate. This ratio, which had been roughly stable at close to 80 percent of personal income until 1993, had risen to 120 percent in 2003 and to nearly 130 percent by mid-2006. Empirical work by Bordo and Jeanne and the Bank for International Settlements suggested that when housing booms are accompanied by sharp rises in debt, the risk of a crisis is significantly elevated.²⁴ Although this work was not necessarily definitive, it certainly raised questions about the Federal Reserve's policy of benign neglect. On the other hand, the fact that the housing boom was taking place in many countries around the world (albeit to a much lesser extent if at all in major surplus countries such as Germany and Japan) raised questions about the genesis of the problem and whether national monetary or regulatory policy alone would be an effective remedy.

Bernanke, while still a Federal Reserve governor in 2004, sensibly argued that it is the job of regulatory policy, not monetary policy, to deal with housing price bubbles fueled by inappropriately weak lending standards.²⁵ Of course, that argument begs the question of what should be done if, for political reasons or otherwise, regulatory policy does not adequately respond to an asset price bubble. Indeed, one can argue that it was precisely the huge capital inflow from abroad that fueled the asset price inflation and low interest rate spreads that ultimately masked risks from both regulators and rating agencies.

In any event, the most extreme and the most immediate problems were caused by the market for mortgage loans made to “subprime,” or low-income, borrowers. “Advances” in securitization, as well as a seemingly endless run-up in housing prices, allowed people to buy houses who might not previously have thought they could do so. Unfortunately, many of these borrowers depended on loans with variable interest rates and low initial “teaser” rates. When it came time to reset the loans, rising interest rates and a deteriorating economy made it difficult for many to meet their mortgage obligations. And thus the subprime debacle began.

The U.S. conceit that its financial and regulatory system could withstand massive capital inflows on a sustained basis without any problems arguably laid the foundations for the global financial crisis of the late 2000s. The thinking that “this time is different”—because this time the U.S. had a superior system—once again proved false. Outsized financial market returns were in fact greatly exaggerated by capital inflows, just as would be the case in emerging markets. What could in retrospect be recognized as huge regulatory mistakes, including the deregulation of the subprime mortgage market and the 2004 decision of the Securities and Exchange Commission to allow investment banks to triple their leverage ratios (that is, the ratio measuring the amount of risk to capital), appeared benign at the time. Capital inflows pushed up borrowing and asset prices while reducing spreads on all sorts of risky assets, leading the International Monetary Fund to conclude in April 2007, in its twice-annual World Economic Outlook, that risks to the global economy had become extremely low and that, for the moment, there were no great worries. When the international agency charged with being the global watchdog declares that there are no risks, there is no surer sign that this time is different.

Again, the crisis that began in 2007 shares many parallels with the boom period before an emerging market crisis, when governments often fail to take precautionary steps to let steam out of the system; they expect the capital inflow bonanza to last indefinitely. Often, instead, they take steps that push their economies toward greater risk in an effort to keep the boom going a little longer.

Such is a brief characterization of the debate surrounding the this-time-is-different mentality leading up to the U.S. subprime financial crisis. To sum up, many were led to think that “this time is different” for the following reasons:

•  The United States, with the world's most reliable system of financial regulation, the most innovative financial system, a strong political system, and the world's largest and most liquid capital markets, was special. It could withstand huge capital inflows without worry.

•  Rapidly emerging developing economies needed a secure place to invest their funds for diversification purposes.

•  Increased global financial integration was deepening global capital markets and allowing countries to go deeper into debt.

•  In addition to its other strengths, the United States has superior monetary policy institutions and monetary policy makers.

•  New financial instruments were allowing many new borrowers to enter mortgage markets.

•  All that was happening was just a further deepening of financial globalization thanks to innovation and should not be a great source of worry.

The Episodes of Postwar Bank-Centered Financial Crisis

As the list of reasons that “this time is different” (provided by academics, business leaders, and policy makers) grew, so did the similarities of U.S. economic developments to those seen in other precrisis episodes.

To examine the antecedents of the 2007 U.S. subprime crisis (which later grew into the “Second Great Contraction”), we begin by looking at data from the eighteen bank-centered financial crises that occurred in the post–World War II period.²⁶ For the time being, we will limit our attention to crises in industrialized countries to avoid seeming to engage in hyperbole by comparing the United States to emerging markets. But of course, as we have already seen in chapter 10, financial crises in emerging markets and those in advanced economies are not so different. Later, in chapter 14, we will broaden the comparison set.

The crisis episodes employed in our comparison are listed in table 13.1.

Among the eighteen bank-centered financial crises following World War II, the “Big Five” crises have all involved major declines in output over a protracted period, often lasting two years or more. The worst postwar crisis prior to 2007, of course, was that of Japan in 1992, which set the country off on its “lost decade.” The earlier Big Five crises, however, were also extremely traumatic events.

The remaining thirteen financial crises in rich countries represent more minor events that were associated with significantly worse economic performance than usual, but were not catastrophic. For example, the U.S. crisis that began in 1984 was the savings and loan crisis.²⁷ Some of the other thirteen crises had relatively little impact, but we retain them for now for comparison purposes. It will soon be clear that the run-up to the U.S. financial crisis of the late 2000s really did not resemble these milder crises, though most policy makers and journalists did not seem to realize this at the time.

TABLE 13.1
Post–World War II bank-centered financial crises
in advanced economies

Sources: Caprio and Klingebiel (1996, 2003), Kaminsky and Reinhart (1999), and Caprio et al. (2005).

A Comparison of the Subprime Crisis with
Past Crises in Advanced Economies

In choosing the variables we used to measure the U.S. risk of a financial crisis we were motivated by the literature on predicting financial crises in both developed countries and emerging markets.²⁸ This literature on financial crises suggests that markedly rising asset prices, slowing real economic activity, large current account deficits, and sustained debt buildups (whether public, private, or both) are important precursors to a financial crisis. Recall also the evidence on capital flow “bonanzas” discussed in chapter 10, which showed that sustained capital inflows have been particularly strong markers for financial crises, at least in the post-1970 period of greater financial liberalization. Historically, financial liberalization or innovation has also been a recurrent precursor to financial crises, as shown in chapter 10.

We begin in figure 13.3 by comparing the run-up in housing prices. Period t represents the year of the onset of the financial crisis. By that convention, period t - 4 is four years prior to the crisis, and the graph in each case continues to t + 3, except of course in the case of the recent U.S. crisis, which, as of this writing and probably for some time beyond, will remain in the hands of the fates.²⁹ The figure confirms what case studies have shown, that a massive run-up in housing prices usually precedes a financial crisis. It is a bit disconcerting to note that, according to this figure, the run-up in housing prices in the United States exceeded the average of the “Big Five” financial crises, and the downturn appears to have been sharper (year t +1 is 2008).

Figure 13.3. Real housing prices and postwar banking crises: Advanced economies.
Sources: Bank for International Settlements (2005); Shiller (2005); Standard and Poor's; International Monetary Fund (various years), International
Financial Statistics; and the authors’ calculations.
Notes: Consumer prices are used to deflate nominal housing price indices. The year of the crisis is indicated by t; t - 4 = 100.

Figure 13.4. Real equity prices and postwar banking crises: Advanced economies.
Sources: Global Financial Data (n.d.); International Monetary Fund (various years),
International Financial Statistics; and the authors’ calculations.
Notes: Consumer prices are used to deflate nominal equity price indices. The year of the crisis is indicated by t; t - 4 = 100.

In figure 13.4 we look at real rates of growth in equity market price indexes.³⁰ We see that, going into the crisis, U.S. equity prices held up better than those in either comparison group, perhaps in part because of the Federal Reserve's aggressive countercyclical response to the 2001 recession and in part because of the substantial “surprise element” in the severity of the U.S. crisis. But a year after the onset of the crisis (t + 1), equity prices had plummeted, in line with what happened in the “Big Five” financial crises.

In figure 13.5 we look at the trajectory of the U.S. current account deficit, which was far larger and more persistent than was typical in other crises.³¹ In the figure, the bars show the U.S. current account trajectory from 2003 to 2007 as a percentage of GDP, and the dashed line shows the average for the eighteen earlier crises. The fact that the U.S. dollar remained the world's reserve currency during a period in which many foreign central banks (particularly in Asia) were amassing record amounts of foreign exchange reserves certainly increased the foreign capital available to finance the record U.S. current account deficits.

Figure 13.5. Ratio of current account balance to GDP on the eve of postwar banking crises: Advanced economies.
Sources: International Monetary Fund (various years), World Economic Outlook; and the authors’ calculations.

Financial crises seldom occur in a vacuum. More often than not, a financial crisis begins only after a real shock slows the pace of the economy; thus it serves as an amplifying mechanism rather than a trigger. Figure 13.6 plots real per capita GDP growth on the eve of banking crises. The U.S. crisis that began in 2007 follows the same inverted V shape that characterized the earlier crisis episodes. Like equity prices, the response in GDP was somewhat delayed. Indeed, in 2007, although U.S. growth had slowed, it was still more closely aligned with the milder recession pattern of the average for all crises.

In 2008, developments took a turn for the worse, and the growth slowdown became more acute. At the beginning of 2009, the consensus—based on forecasts published in the Wall Street Journal— was that this recession would be deeper than the average “Big Five” experience. Note that in severe Big Five cases, the growth rate has fallen by more than 5 percent from peak to trough and has remained low for roughly three years.

Our final figure in this chapter, figure 13.7, illustrates the path of real public debt (deflated by consumer prices).³² Increasing public debt has been a nearly universal precursor of other postwar crises, although, as we will see in chapter 14, the buildup in debt prior to a crisis pales in comparison to its growth after the crisis has begun, for weak growth crushes tax revenues. The U.S. public debt buildup prior to the 2007 crisis was less than the Big Five average. Comparisons across private debt (which we have already alluded to for the United States) would be interesting as well, but unfortunately, comparable data for the range of countries considered here are not easy to obtain. In the case of the United States, the ratio of household debt to household income soared by 30 percent in less than a decade and could well collapse as consumers try to achieve a less risky position as the recession continues.

Figure 13.6. Growth in real per capita GDP (PPP basis) and postwar banking crises: Advanced economies.
Sources: International Monetary Fund (various years), World Economic Outlook, and Wall Street Journal.
Notes: The consensus forecast (-3.5 percent) for 2009 is plotted for the United States as of July 2009. The year of the crisis is indicated by t.

One caveat to our claim that the indicators showed the United States at high risk of a deep financial crisis in the run-up to 2007: compared to other countries that have experienced financial crises, the United States performed well with regard to inflation prior to 2007. Of course, the earlier crises in developed countries occurred during a period of declining inflation in the rich countries.

Figure 13.7. Real central government debt and postwar banking crises: Advanced economies.
Sources: U.S. Treasury Department; International Monetary Fund (various years), International Financial Statistics; appendixes A.1 and A.2 and sources cited therein; and the authors’ calculations.
Note: Consumer prices are used to deflate nominal debt. The year of the crisis is indicated by t; t - 4 = 100.

Summary

Why did so many people fail to see the financial crisis of 2007 coming? As to the standard indicators of financial crises, many red lights were blinking brightly well in advance. We do not pretend that it would have been easy to forestall the U.S. financial crisis had policy makers realized the risks earlier. We have focused on macroeconomic issues, but many problems were hidden in the “plumbing” of the financial markets, as has become painfully evident since the beginning of the crisis. Some of these problems might have taken years to address. Above all, the huge run-up in housing prices—over 100 percent nationally over five years—should have been an alarm, especially fueled as it was by rising leverage. At the beginning of 2008, the total value of mortgages in the United States was approximately 90 percent of GDP. Policy makers should have decided several years prior to the crisis to deliberately take some steam out of the system. Unfortunately, efforts to maintain growth and prevent significant sharp stock market declines had the effect of taking the safety valve off the pressure cooker. Of course, even with the epic proportions of this financial crisis, the United States had not defaulted as of the middle of 2009. Were the United States an emerging market, its exchange rate would have plummeted and its interest rates soared. Access to capital markets would be lost in a classic Dornbusch/Calvo-type sudden stop. During the first year following the crisis (2007), exactly the opposite happened: the dollar appreciated and interest rates fell as world investors viewed other countries as even riskier than the United States and bought Treasury securities copiously.³³ But buyer beware! Over the longer run, the U.S. exchange rate and interest rates could well revert to form, especially if policies are not made to re-establish a firm base for long-term fiscal sustainability.