A backlash against perceived Washington excesses precluding the federal government from providing as much fiscal stimulus as the economy needed, which meant the baton passed to the U.S. Federal Reserve. Having exhausted all other options, the Fed pumped trillions of fresh dollars into the economy. But because the dollar is the world's primary reserve and commercial currency, this flood of money did little to help the U.S. economy because much of it simply escaped offshore in search of higher returns in commodity markets and Asian real estate. China was especially affected by this. With its currency pegged to the dollar, it meant that China effectively imported inflation from the U.S.
Europe took a different but equally damaging course. There, the imbalances were internal - Germany and other Northern nations saved and lent; Greece, Ireland, Portugal and Spain spent and borrowed. Once the savings glut-fueled bubble burst, the underlying lack of competitiveness in the peripheral nations, which underpinned the imbalances, was exposed. As private creditors fled these less competitive nations' debt markets, their governments turned to the Northerners for help. But Germany and co. would only provide aid on the strict condition that fiscal spending be drastically cut back, the results of which were the recent social meltdowns and voter rebellions in places like Greece.
The tensions have turned a breakup of the euro zone into a distinct possibility. If it comes to that it would be a global catastrophe. The international banking system that developed out of the pre-crisis global savings glut is too interconnected to withstand such an event without profound losses and extreme capital flight. But at least financial institutions have had time to prepare for Europe's crisis. What they are not ready for is for a euro breakdown to occur simultaneously with economic downturns in China and the U.S. Therein lies the great risk of a synchronized contraction, as highlighted by Friday's weak U.S. jobs report and Chinese manufacturing data.
WHAT DO WE DO NOW?
Having used up ammunition in the last go-round, governments have little fiscal or monetary firepower left. They should instead set aside their domestic agendas and engage in truly coordinated actions. To restore global investor confidence, they need to free up trade, coordinate fiscal and social policies that help rectify savings and spending imbalances, write enforceable rules requiring free-floating exchange rates and uniformly regulated financial sectors, and develop a centralized system for storing currency reserves so that the dollar loses its distorting dominance.
The trauma of the 1930s reminds us of the risks to world economic and political cohesion when nations respond to global problems with self-serving national solutions. We must resist that outcome. We must make global solution the top priority.
Adapted from The Unfair Trade: How Our Broken Global Financial System Destroys the Middle Class, by Michael Casey, published by Crown Business.