The short answer is that the Bush administration increased the US Government deficit by spending more (especially on warfare) and cutting taxes (so Americans had more money to spend). This huge expenditure -injection increased production in the US and the rest of the world. Given the -multiplier (the additional spending by producers because of the stronger economy), the world economy lifted and a recession seemed to have been avoided. Or was it only deferred?

Because US dollars are the international medium of exchange, a US public deficit injects cash into the world economy as the US Government pays its bills -without a corresponding revenue inflow. This raises the threat of inflation. To reduce that possibility, the US Government sells bonds (fixed-interest debt securities) to absorb the money. Although bonds can’t be used to pay bills, they can be converted easily back into cash, especially if interest rates are low. So the result of the US deficit is an enormous increase in the world economy’s liquidity.

In effect, the US is the world’s banker. Other countries – China, Japan and the Middle East oil producers – ran large -savings surpluses that they chose to invest in the US, keeping -interest rates low. It might seem unwise to invest in a bank that was spending the proceeds on wars in Afghanistan and Iraq, and on goods and services for Americans. I suppose the -assumption was that the US would honour its debts by taxing its -citizens in the future.

In fact, the -overseas investors in the bank took a slight pounding from the falling US exchange rate. If inflation is the falling value of money, this was a form of inflation.

Flush with this liquidity, the US financial institutions (and their equivalents in Europe and elsewhere) used it as a base to generate all sorts of fancy financial assets, including sub-prime mortgages, many of which are called “toxic assets” today. There’s a lot of talk about the need for better financial regulation. I don’t dis-agree, but given the surplus of liquidity (cash and near cash), I’m sceptical that any regulation could have prevented all the abuses. It was a bit like putting -teenagers into a casino with their pockets full of chips and telling them to restrain themselves.
Artificial profits for the financiers was the result of these toxic investments. One estimate is US$5 trillion over five years. It may not be right, but let’s use it for illustrative -purposes. Double or treble that figure to allow for the -multiplier production that the -artificial profits stimulated. This would add about 3-5% to GDP.

What we are now seeing is the -unwinding of those artificial profits. But the US$5 trillion must be removed from the financial assets of the world first. Hence the balance-sheet crisis.

Unfortunately, the same mechanisms that lifted GDP by the artificial -profits are now working in reverse. That means that the world GDP has to be reduced by about 3-5%. Getting down to the lower level involves a growth slowdown that we call a “recession”. Of course, the international economic managers (many of whom got us into the mess) may cock things up further.

Economies do not mete out justice, especially in a downswing. That means many people will suffer despite not having particularly benefited from the upswing. Meanwhile, some of those who benefited will hardly be touched on the downer. No one said the world was fair.

You may have noticed that many countries, including the US, are trying to get out of this mess with the same sort of deficit spending that got us into it. This is one of the reasons there is some urgency in getting better international financial regulation, so financiers cannot misuse the liquidity being generated.

Even so, some downswing is unavoidable. You might say the Bush measures deferred the millennium recession, rather than prevented it. Pessimists might argue that the deferring will lead to a depression.