These are perilous times. But history tells us they will pass. This evening I should like to trace a likely future path out of what will surely be the longest and deepest global economic contraction since the 1930s. The disclosure in August 2007 that highly leveraged financial institutions were holding significant quantities of defaulting securitized American subprime mortgages shocked markets and precipitated what became a global solvency crisis. For the year following, weakened banks struggled to respond to investor demands for larger capital cushions. But in the end, bank efforts to fortify their balance sheets fell short, and, in the wake of the Lehman Brothers default in September 2008, the financial system at the heart of our global economy seized up. Banks, fearful of their own solvency, all but stopped lending. Issuance of corporate bonds, commercial paper, and a wide variety of other financial products largely ceased. Credit-financed economic activity was brought to a virtual standstill. If there had been any question that we now live in a fully integrated global economic and financial system, the speed and depth of the contraction in global trade, in a matter of a few short weeks, should have set aside any such doubts. Global manufacturing production in October of last year fell off a cliff, and, at least in the United States, production continued to fall sharply.

For a few months subsequent to the August 2007 disruption, the crisis was wholly financial. The world’s nonfinancial sector balance sheets and cash flows were in as good shape as I can recall. But, the contagion from the crisis in finance took hold in the fall of 2007. Global stock prices peaked at the end of October, and then progressively declined for nearly a year into the Lehman crisis. Global losses in publicly traded corporate equities up to that point totaled $16 trillion, but losses more than doubled in the ten weeks following the Lehman default, bringing cumulative global losses to almost $35 trillion, a decline of more than 50% and an effective doubling of the degree of corporate leverage. Added to that are trillions of dollars of losses of equity in homes ($4 trillion in the U.S. alone) and losses of non-listed corporate and unincorporated businesses that could readily bring the aggregate equity loss to well over $40 trillion, a staggering two thirds of last year’s global GDP. This combined loss has been critically important in the disabling of global finance because equity capital serves as the support for all corporate and mortgage debt and their derivatives. These assets are the collateral that powers global intermediation, the process that directs a nation’s saving into physical productive investment. I find it useful to think of the world economy’s equity capital in the context of the global consolidated balance sheet. All debt and derivatives cancel out leaving intellectual and physical assets at market value on the left hand side of the balance sheet and the market value of equity on the right hand side. Changes in equity values change both sides of the global balance sheet equally. Debt and derivatives are then best seen as a grossing up, reflecting the degree of intermediation or leverage.