Many observers in the West have embraced a reading of the financial crisis in which global imbalances and the surge in uphill net capital flows from poor to rich countries play a dominant role. Mervyn King, governor of the Bank of England said in a speech at the University of Exeter in 2010 that “[c]apital flows provided the fuel which the developed world’s inadequately designed and regulated financial system then ignited to produce the firestorm that engulfed us all” (quoted by Merrouche and Nier, 2010). Such explanations conveniently blame events that took place outside of the advanced economies for at least providing the initial impetus for the economic and financial mess Ben Bernanke’s savings glut hypothesis (Bernanke 2005) skillfully argues that a large and sudden rise of desired savings from developing countries – a savings glut – flooded the US economy. The implication is that low American interest rates and, ultimately, the financial crisis were due to the unusual saving behavior elsewhere.
Others disagree with such an imbalance-centered view of the crisis. To name a few: Claudio Borio and Piti Disyatat (2011), Maury Obstfeld (2012) as well as Philip Lane and Peter McQuade (2012) have all questioned the usefulness of current account based approaches to understanding the 2008 crisis and the drivers of financial fragility more generally. In a long-run empirical study, Jorda, Schularick and Taylor (2011) did not find a systematic link between current account imbalances and financial crises, but instead point to close link between credit growth and crises.
This debate suggests that a closer look at the composition and role of imbalances in the run up to the crisis is warranted. What exactly were the imbalances in the American economy and how did they contribute to the financial crisis? Savings and investment patterns in the US economy have changed dramatically over a twenty year period that culminates in the crisis. The uphill capital flows from emerging markets in response to their insatiable hunger for reserve assets (the savings glut) is only one of several dramatic features of American savings behavior that fueled the housing boom and credit expansion.
In our new paper — “The Making of America’s Imbalances” — we examine the evolution of sectoral financial balances in the US economy in the past 50 years using the Flow of Funds accounts. Specifically, we look at the changes in the financing flows among the different sectors of the US economy – households, business, government and the rest of the world. Such a financial balances approach meshes with recent contributions arguing that for a better understanding of global imbalances, we have to look beyond the current account and focus on the underlying gross flows of capital (Shin 2011).
What do we find? We show that the relationships are more nuanced than implied by the savings glut view of the world. America’s imbalances were long in the making. New dynamics in the household and business sectors were already apparent in the 1990s, long before the deterioration in the US government balance or the current account balance and long before the arrival on the international stage of Chinese reserve accumulation.
The financial balance of the American household sector deteriorated in two phases. First, in the 1990s, American households dramatically reduced their acquisition of financial assets. The reduction in active savings was mostly a response to rising equity wealth during the stock market boom of the 1990s. Households’ acquisition of financial assets dropped from about to 10% of GDP in the 1980s to slightly above zero in the late 1990s. The shift in household behavior was offset by the US business sector which ceased being a net borrower as its financial asset acquisitions matched its borrowing. The second phase got underway after 1998 when – against the background of record low active savings – households started to borrow strongly. These shifts are shown in the chart below. The key shift in savings behavior occurred in the 1990s. The 2000s, by contrast, were marked by an increase in borrowing. When record low active savings met the credit boom of the 2000s, the American current account went deep into the red.
Who financed the household borrowing binge of the 2000s? China and other emerging markets played virtually no direct role in the financing flows behind the American credit bubble. In brief, the U.S. financial sector provided the financing for mortgage-hungry America (until it collapsed with the crisis). But where did Wall Street find the savings to fuel to fire?
In the 2000s, the American financial system fed the credit hunger of the American economy mainly by issuing debt liabilities in international financial markets; but it was the foreign private sector, not foreign governments, that provided most of the fuel for the fire. Foreign official inflows went almost exclusively into Treasury securities while private investors bought bonds and other instruments issued by U.S. financial. In other words, those who are looking for international drivers of the American credit bubble, should not look to Beijing and Riyadh, but to international private capital markets. The capital inflow bonanza of the 2000s that enabled the American credit bubble (Chinn and Frieden 2011) was primarily a private sector inflow, as shown in the charts below. Beijing may have financed the war in Iraq at low cost while Wall Street, foreign banks and private investors fueled the housing bubble.
Last but not least, in the paper we point to a potentially important distinction that was lost in previous analyses of household savings behavior. When we delve deeper into the role of capital gains for savings and borrowing decisions, we uncover a close statistical relationship between gains in equity (but not housing) wealth and active savings decisions (i.e., acquisition of financial assets) by American households. Borrowing behavior, by contrast, depends much more closely on fluctuations in housing wealth, both directly because of higher values of the housing stock and indirectly through mortgage equity withdrawals. We think that this result challenges the (conventional) wisdom that non-leveraged equity market bubbles pose a lesser problem for macroeconomic balance than credit-fueled housing bubbles. Our results indicate that equity market bubbles too trigger substantial changes in the financial behavior of households. The economic and financial repercussions of those could be costly to reverse at a later stage.
- Bernanke, Ben. 2005. “The Global Saving Glut and the U.S. Current Account Deficit,” March 10, 2005.
- Borio, Claudio and Piti Disyatat. 2011. “Global imbalances and the financial crisis: Link or no link?” BIS Working Papers No 346.
- Chinn, Menzie and Jeffrey Frieden. 2011. Lost Decades. Norton.
- Jordà, Òscar, Moritz Schularick and Alan M Taylor. 2011. “Financial Crises, Credit Booms, and External Imbalances: 140 Years of Lessons,” IMF Economic Review, 59, 340–378.
- Lane, Philip R. and Peter McQuade. 2012. “Domestic Credit Growth and International Capital Flows,“ Manuscript, Trinity College Dublin, May 2012.
- Merrouche, Ouarda and Erlend Nier, 2010. “What Caused the Global Financial Crisis? Evidence on the Drivers of Financial Imbalances 1999-2007.” IMF Working Paper 10/265.
- Obstfeld, Maurice. 2012. “Does the Current Account Still Matter?” NBER Working Paper No. 17877, March 2012
- Shin, Hyun Song. 2011. “Global Banking Glut and Loan Risk Premium,” Mundell-Fleming Lecture, International Monetary Fund, November 2011.
This post written by Paul Wachtel and Moritz Schularick.