Perhaps I’m overstating it, but I think this is the abridged version of the Bush Administration’s perspective on how we got into the financial mess we find ourselves in. You might ask why I focus on the ideas of the outgoing government. Well, it’s because I’m confident that this will be a thesis pushed by some commentators eager to absolve previous policymakers of blame . And indeed (as Mish points out), this view has apparently adherents in high places.
But let me let the the Economic Report of the President [large pdf] (Chapter 2) speak for itself:
- The roots of the current global financial crisis began in the late 1990s.
A rapid increase in saving by developing countries (sometimes called the
“global saving glut”) resulted in a large influx of capital to the United
States and other industrialized countries, driving down the return on
safe assets. The relatively low yield on safe assets likely encouraged investors
to look for higher yields from riskier assets, whose yields also went
down. What turned out to be an underpricing of risk across a number of
markets (housing, commercial real estate, and leveraged buyouts, among others) in the United States and abroad, and an uncertainty about how
this risk was distributed throughout the global financial system, set the
stage for subsequent financial distress.
- The influx of inexpensive capital helped finance a housing boom. House
prices appreciated rapidly earlier in this decade, and building increased
to well-above historic levels. Eventually, house prices began to decline
with this glut in housing supply.
- Considerable innovations in housing finance—the growth of subprime
mortgages and the expansion of the market for assets backed by
mortgages—helped fuel the housing boom. Those innovations were
often beneficial, helping to make home ownership more affordable and
accessible, but excesses set the stage for later losses.
- The declining value of mortgage-related assets has had a disproportionate
effect on the financial sector because a large fraction of mortgage-related
assets are held by banks, investment banks, and other highly levered
financial institutions. The combination of leverage (the use of borrowed
funds) and, in particular, a reliance on short-term funding made these
institutions (both in the United States and abroad) vulnerable to large
- Vulnerable institutions failed, and others nearly failed. The remaining
institutions pulled back from extending credit to each other, and interbank
lending rates increased to unprecedented levels. The effects of
the crisis were most visible in the financial sector, but the impact and
consequences of the crisis are being felt by households, businesses, and
governments throughout the world.
There is greater detail in the section titled: “Origins of the Crisis”, subheading “The Global Saving Glut”:
As this influx of capital became available to fund investments, interest rates
fell broadly. The return on safe assets was notably low: the 10-year Treasury
rate ranged from only 3.1 percent to 5.3 percent from 2003 to 2007, whereas
the average rate over the preceding 40 years was 7.5 percent. While to some
extent the low rates reflected relatively benign inflation risk, the rate on risky
assets was even lower relative to its historical average: the rate on a 10-year
BAA investment-grade (medium-quality) bond ranged from only 5.6 percent
to 7.5 percent from 2003 to 2007, whereas the average over the preceding
40 years was 9.3 percent. The net effect was a dramatic narrowing of credit
spreads. A credit spread measures the difference between the yield on a risky
asset, such as a corporate bond, and the yield on a riskless asset, such as a
Treasury bond, with a similar maturity. Risky assets pay a premium for a
number of reasons, including liquidity risk (the risk that it will be difficult to
sell at an expected price in a timely manner) and default risk (the risk that a
borrower will be unable to make timely principal and interest payments).
Thinking in terms of systems of supply and demand is a very useful disciplining device. And here I think resorting to this framework, even allowing for distortions in the markets, can be useful, for it reminds one that the outcome (current account balances or the mirror image, financial account balances, and interest rates) are the equilibrium outcome of supply and demand for saving. (A related, but distinct, perspective is Brad Setser’s creditors/debtors story.)
I’ll admit that it’s plausible to think of an exogenous shift in excess saving (decrease in investment demand in East Asia, increase in corporate and household saving in China, etc.) as resulting in increased US borrowing from abroad. This is indeed a variant of the Bernanke “saving glut” thesis. The Bernanke focus is on the “depth and sophistication” of the US capital markets.
Well, I think this last point leads us to my critique. Was it really sophisticated capital markets in the US, or a mania in which either agents made implausible assessments of future risk/return tradeoffs, or were engaged in “looting” the system by exploiting implicit guarantees and building up contingent liabilities for the taxpayers, that sucked in capital from the rest of the world.
Three years ago, I’d surely have a difficult time convincing people that US capital markets weren’t completely self-regulating and self-correcting. Maybe it’s time to revisit the “saving glut” hypothesis, and say that perhaps capital “sucked” into America, rather than “pushed” into America.
Even if one were to say that the excess saving from East Asia — and the oil exporters as we enter 2005-08 — drove the bubble (and I’m willing to admit that there is something to the argument that global imbalances exacerbated domestic imbalances, especially related to the housing sector), I have two big caveats.
The argument that the saving glut led to low interest rates is not unambiguously accepted. , , ,   .
Consider Wright’s work [pdf] on how the conundrum can be explained without resort to a central role for international factors (although he allows for some; see also this post). Also consider the correlation between low interest rates and the US current account. Below is a graph from a post two years ago.
Figure 1: The Net Export to GDP ratio and the ten year constant maturity yield (end of quarter) yield minus the ten year ahead (median) expected CPI inflation rate. Source: FRED II and Philadelphia Fed.
But, thinking again about exogeneity, why were funds flowing to the US. Some of it was low national saving. And why was that saving low? Because we were piling tax cuts upon tax cuts (admittedly I’m sounding like a broken record here:  ). But then add to this question why did the oil exporters start building up current account surpluses of enormous magnitudes? Because demand for oil rose in China, and the US (some observers conveniently ignore the US and focus on China, but it was adding substantial amounts of incremental demand up to 2005 or so). But some of that Chinese demand for oil was “derived demand”, driven by US consumption of Chinese made goods.
So, while I won’t say that the idea of saving flows coming from East Asia had some role in the financial crisis we’re now undergoing [is completely without content grammar corrected 11:15 Pacific 1/22]], I’d say one has to think about how those flows came about, as much as how big they are. We don’t usually think of the rest-of-the-world driving macroeconomic events in the US (here’s my take: ), and I still don’t think it’s time to start.
Figure 2: Trade balance to GDP ratio (blue) and trade balance ex. oil imports to GDP ratio (red). NBER defined recessions shaded gray. Sources: BEA/Census trade release for November, Macroeconomic Advisers [xls] (release of 15 January 2009), NBER, and author’s calculations.
By the way, I am disagreeing slightly with Brad Setser’s take on this subject, although I think it is more a point of emphasis than substance. My reading of his post is that excess saving from East Asia and oil exporters enabled (my phrase, not his) the US housing boom, and the search for yield. I think that’s somewhat different from the ERP thesis.