Deficits, banking crisis, rising prices, falling U.S. Dollar, recession. These are the main events that have shaped the world economy in 2007.

Deficits: U.S. consumers have spent their money instead of saving it. It has been spent on low cost goods from China and fuel from the Middle East. Both China and the OPEC countries in the Middle East have tried to keep their advantage by controlling the value of their currency or not increasing supply. At the same time, due to the wars it is waging, the U.S. government has been spending more than it can actually afford. The consequent deficit has been funded by foreign capital. Both developments combined have led to a current account deficit and capital account surplus, the latter being used to finance the budget deficit.

Banking crisis: also known as ‘subprime mortgage lending crisis’. Banks have granted mortgages to those who were unlikely to pay (i.e. subprime customers). In order to spread the risks the institutions have ‘repackaged’ their loans into new ones and sold them in pieces to investors. The investors, unaware of what the underlying of the loan actually consisted of, have gotten into trouble when the subprime customers could not fulfil their obligations. In our global world, the loans were sold to institutions all over the world. Therefore, a British bank (called Northern Rock) has steered into trouble. Other U.S. and European institution also had to write down on debt.

As the crisis unfolded, financial institution became reluctant to lend money to each other. This has led to upwards pressure on the short term (interbank) interest rate. In order to prevent a ‘credit crunch’ central banks have intervened and have supplied emergency credit to banks. This action has two negative side effects: 1.) moral hazard: financial institutions were not punished for their mistakes, i.e. buying credit with knowing the actual risks, but gotten cheap emergency credit instead. It creates a precedent…

Rising prices: 2.) prices have been on the rise as we are approaching another high of the business cycle. Without the subprime lending crisis central banks (most likely) would have preferred to raise the interest rates. The European Central Bank aims to keep the inflation at 2%. The rate inflation in Europe was 2,6% in October and 3% in November. The rise in energy prices does not help to contain the inflation rate. Pro-cyclical economic policy in France does neither.

Falling U.S. Dollar: as a result of the events the U.S. Dollar has continued its decline. Due to the subprime crisis confidence in U.S. financial system has diminished, making foreign investors withdraw investments. Also, the lowered interest rate makes it less attractive to invest in short term money market funds. The positive side effect: the U.S. has become cheaper and probably will see a rise in demand for export goods. It will help to unwind the current account deficit.

Recession: this is the question mark. Although U.S. export might increase and provide new fuel for economic growth, confidence will be shaky. As long as the banking crisis keeps flaming up, investors might feel put off to invest. In the end sustainable economic growth finds its roots in investment. Even though this might sound contradictory, when the interest rate starts to rise, investments will come back. For, the banking crisis will then be over, confidence restored, and the business cycle heading for its next peak.