Our own home grown Third World debt crisis

When you boil away all the febrile rhetoric, the financial crisis the U.S. is experiencing right now is, simply put, a classic Third World debt crisis. The pattern is all too familiar: for years national elites engorge themselves, feasting on the public purse and corrupting politicians; these elites cover up the rot by allowing the masses also to themselves go on a spending and import binge, financed by cheap credit and foreign capital; these factors result in a huge current account and a massive asset-price bubble; finally, the markets wise up as to unsustainability of the situation and the house of cards comes crashing down.

Only two things are novel about the current situation in the U.S. First, it's happening not in some Third World country, but rather in the center of global capitalism. Second, the mechanisms by which the rich engineered all of this entailed somewhat byzantine mathemetical algorithms (albeit utterly banal moral and political algorithms).

For the last twenty five years, when other (poor) countries have gone through this sort of thing, the U.S. has insisted they go through a structural adjustment program -- a euphemism for a radical slashing of government spending, the bankrupting of champion local companies (and subsequent seizure of control by foreign capital), and a radical reduction in spending and income for the middle class. It happened in Mexico in '83, in Argentina repeatedly, in Asia in '98.

But now, when the shoe's on the our foot, we are (so far) refusing to take the medicine we've for a generation insisted that others who behave this way take. The inevitable result of this, you've got to expect, is that the U.S.'s credibility as an avatar of the free market is shot for a generation at least. Here's how the Koreans put it:

In parts of Asia, the bailouts stirred bitter memories of the different approach the United States and the International Monetary Fund adopted during the economic crises there a decade ago.

When the I.M.F. pledged $20 billion to help South Korea survive the Asian financial crisis of the late 1990s, one of the conditions it imposed was that the Korean government allow ailing banks and other companies to collapse rather than bail them out, recalled Yung Chul Park, a professor of economics at Korea University in Seoul, who was deeply involved in the negotiations with the I.M.F.

While Mr. Park says the current crisis is different — it is global rather than limited to one region — "Washington is following a different script this time."

"I understand why they do it," he added. "But they've lost credibility to some extent in pushing for opening up overseas markets to foreign competition and liberalizing economies."

Even if Bernanke and Paulson's interventions manage to save our economic and financial bacon (no sure thing yet), the impact of these events will reverberate for years in terms of U.S. financial authority.

Update: Predicting that the "U.S. political system" will force the taxpayers to pick up the tab for Wall Street's f-up, to the tune of $1-2 trillion (yes, with a T), Kenneth Rogoff adds the following:

A large expansion in debt will impose enormous fiscal costs on the US, ultimately hitting growth through a combination of higher taxes and lower spending. It will certainly make it harder for the US to maintain its military dominance, which has been one of the linchpins of the dollar.

The shrinking financial system will also undermine another central foundation of the strength of the US economy. And it is hard to see how the central bank will be able to resist a period of allowing elevated levels of inflation, as this offers a convenient way for the US to deflate the mounting cost of its private and public debts.

It is a very good thing that the rest of the world retains such confidence in America's ability to manage its problems, otherwise the financial crisis would be far worse.

Let us hope the US political and regulatory response continues to inspire this optimism. Otherwise, sharply rising interest rates and a rapidly declining dollar could put the US in a bind that many emerging markets are all too familiar with.