Today we are fortunate to have a Paul Wachtel (NYU) and Moritz Schularick (Free University of Berlin) as guest contributors. This article is based upon their paper of the same title.
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.
Figure 1.
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.
Figure 2.
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.
References
- 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.
So does the narrative read like this?
“Foreign official inflows went almost exclusively into Treasury securities while private investors bought bonds and other instruments issued by U.S. financial. This huge inflow of foreign official funds was entirely contained in government markets and had no effect on other markets. Thus, private sector purchasers of treasuries and other government debt were entirely unmoved by huge Chinese and petrodollar flows into US government paper. There was, as a result, no “search for yield” from private sector investors who would ordinarily have purchased US government securities. These markets remained isolated. Nor did governments seek investments in private securities to maintain yield levels. The experience of seven Norwegian towns who bought subprime securities from Citi remains an anomaly.
In the financial crisis, public and private flows remained distinct. During this period, money was not a fungible commodity.”
Is that the narrative?
In the deep and dark part of my brain, where I store information in disarray, an alarm went off when I read the following:
“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.”
Then the alarm in my head rang even louder when I read:
“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”
So, in an effort to quiet my alarm bell, I read Mr. Bernakes’ paper and I found this:
“From about 1996 to early 2000, equity prices played a key equilibrating role in international financial markets. The development and adoption of new technologies and rising productivity in the United States–together with the country’s long-standing advantages such as low political risk, strong property rights, and a good regulatory environment–made the U.S. economy exceptionally attractive to international investors during that period. Consequently, capital flowed rapidly into the United States, helping to fuel large appreciations in stock prices and in the value of the dollar. Stock indexes rose in other industrial countries as well, although stock-market capitalization per capita is significantly lower in those countries than in the United States.”
“The current account positions of the industrial countries adjusted endogenously to these changes in financial market conditions. I will focus here on the case of the United States, which bore the bulk of the adjustment. From the trade perspective, higher stock-market wealth increased the willingness of U.S. consumers to spend on goods and services, including large quantities of imports, while the strong dollar made U.S. imports cheap (in terms of dollars) and exports expensive (in terms of foreign currencies), creating a rising trade imbalance. From the saving-investment perspective, the U.S. current account deficit rose as capital investment increased (spurred by perceived profit opportunities) at the same time that the rapid increase in household wealth and expectations of future income gains reduced U.S. residents’ perceived need to save. Thus the rapid increase in the U.S. current account deficit between 1996 and 2000 was fueled to a significant extent both by increased global saving and the greater interest on the part of foreigners in investing in the United States.”
Anyway, the alarm is quiet now. It was just that some liberties were taken with what Mr. Bernanke actually said. My alarm went off not because I had stored some errant information, but because some very important information was being undermined by some distortions.
Stephen,
The same thought struck me. Soveriegn demand for treasuries drove the riskless rate toward 0. At the same time, private money managers became desperate for return when risky returns followed the riskless rate lower. The risk premium shrank as money managers found it necessary to take on more risk to maintain historical levels of returns.
Sovereigns’ forcing the riskless rate toward 0 caused the increase in private money managers’ preference for risk. In other words, sovereigns were an enabler of what became the private sector’s addiction to risk.
I find this article and the comments to be a very wordy and sterile analysis of what is, at root, a very simple, ancient and all-too-human tale of greed and hubris. The global pool of capital in the 2000’s, seeking ever higher returns (i.e. greed), found what it thought were risk-free (i.e. hubris) investments in MBS, CDOs and all of their synthetic descendants. This spurred foolish mortgage lending by banks and brokers (i.e. greed) to people who never should have been granted credit, in the foolhardy belief that real estate prices could never come down (i.e. hubris). End of story. Very basic and simple, really.
Chairman Bernankes’ position does not allow him to just come out and say that dollar hegemony caused the asset bubble in the US. But he does not allow the integrity of his analysis to be compromised by concerns about his job security, or by whatever. In the following, note his use of the word “force” in the first sentence. Then, connect that to his mention of “exchange rates” in the second paragraph:
“In response to these crises, emerging-market nations either chose or were forced into new strategies for managing international capital flows. In general, these strategies involved shifting from being net importers of financial capital to being net exporters, in some cases very large net exporters. For example, in response to instability of capital flows and the exchange rate, some East Asian countries, such as Korea and Thailand, began to build up large quantities of foreign-exchange reserves and continued to do so even after the constraints imposed by the halt to capital inflows from global financial markets were relaxed. Increases in foreign-exchange reserves necessarily involve a shift toward surplus in the country’s current account, increases in gross capital inflows, reductions in gross private capital outflows, or some combination of these elements. As table 1 shows, current account surpluses have been an important source of reserve accumulation in East Asia.”
“Countries in the region that had escaped the worst effects of the crisis but remained concerned about future crises, notably China, also built up reserves. These “war chests” of foreign reserves have been used as a buffer against potential capital outflows. Additionally, reserves were accumulated in the context of foreign exchange interventions intended to promote export-led growth by preventing exchange-rate appreciation. Countries typically pursue export-led growth because domestic demand is thought to be insufficient to employ fully domestic resources. Following the 1997-98 financial crisis, many of the East Asian countries seeking to stimulate their exports had high domestic rates of saving and, relative to historical norms, depressed levels of domestic capital investment–also consistent, of course, with strengthened current accounts.” (2005 Bernanke paper)
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So yes, Sovereigns were increasing t-bill purchases, but… so were ‘foreigners’, and these combined to increase foreign inflows which then caused excess liquidity. That liquidity then found its way to the predictable investments as dictated by perceived ROI. So, as tj put it, “sovereigns were an enabler”. The actual enabler though is the US because of its reserve currency status. This is why Cheney said “debt doesn’t matter any more”. He and his crew found that their wars could be financed by foreign inflows. This is also, in part, why the Bush/Cheney/MIC bunch felt that 2 tax cuts with 2 wars in the making–were doable.
Bush was of course… the Governor of the ‘git-er-done State.
Stephen Kriz: excellent, succinct analysis. Well done. There might be details here and there, but your version captures at least 90% of the story.
It is much, much too simplistic to make the statements and draw the conclusion re foreign official flows that is made:
“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.”
To pretend that rates and prices for private assets and in private markets are somehow completely separable and independent of Treasuries can’t possibly be taken seriously.
I wonder if the authors are aware of a new paper by Loukas Karabarbounis and Brent Neiman, “Declining Labor Shares and the Global Rise of Corporate Savings,” June 2012. The authors develop a Constant Elasticity of Substitution (CES) production model with financial market imperfections. They found a large shift of the share of global savings from labor to corporations. From page 10 of their paper:
“…labor shares in the corporate sector have been declining throughout the world over the last 30 years. This has been true in the world’s largest economies such as the United States, China, Japan and Germany, but also holds true for most developing countries for which we have data. We provide evidence that declining labor shares are related to declines in the relative price of investment using both time series and cross-sectional variation.”
And then on page 12:
“…corporate labor shares around the world declined over the last three decades. The scale of the corporate sector relative to GDP has not changed, other payments to capital have declined as a share of corporate value added, and there has only been a moderate increase in dividends relative to profits. As a result, there has been a significant increase in corporate savings relative to GDP and relative to total savings. Both trends were strongest in countries with larger declines in the relative price of investment goods.”
In general the two papers tend to support one another.
The conclusions of the captioned paper are consistent with the facts and demonstrations of the man made, extensive “financialization” of the world. The credits and loans made the savings and the transformation in financial investments remained the exclusivity of the financial private sector. It does not withhold the responsibilities of the government administrations and public functions as they were the key drivers of the economic artifacts and artificial buoyancy. Reservations may arise as to the distribution of the capital inflows alleged to be distributed between the cost of the Irak war and sundries . At a much more modest scale (except the UK) the European economies have embarked in to the same patterns, as led by all the political circles. It therefore goes beyond the private sector scope of responsibilities and it is not restricted to the USA.
B Friedman is providing for a reminder of the deviation to trends, primary deficits and current accounts deficits are anterior phenomena to the 90s.This warning is not only addressing the trends but asking for explanations and drawing the requirements for a better awareness. France was going the same trend with no awareness at the same time and even less after.
“B Friedman NEW DIRECTIONS IN THE RELATIONSHIP BETWEEN PUBLIC AND PRIVATE DEBT”
The most widely discussed issue at the policy level has been the concern that so large a federal deficit, persisting even a near—full employment, is impairing the economy’s long—run growth and competitiveness by absorbing so much saving as to “crowd out” investment in productive new plant and equipment”
“An Equilibrium Model of “Global Imbalances” and Low Interest Rate” Ricardo J. Caballero, Emmanuel Farhi, and Pierre-Olivier Gourinchas, provide if not for a solution, since the theory by itself does not rectify the imbalances but accommodates those imbalances under few sets of assumptions, where low interest rates, GDP growth differential, assets growth become the feasible sets of the linear programming. It is not and cannot be an open ended solution as it offers no exit strategy. It may have supplied the stepping stone for the requirements of assets growth that is the housing capital gains multiples, the equities multiples and valuations, commodities prices. The assets appropriation is domestic in profits and loss but requires an international pricing and a large money supply support from the Central Bank(s). The model is limited by an homogeneous linear function which will be driven through “fortuitous” events as a non homogeneous, non linear function.
The constraints involve the manufacturing of low interest rates, by ways of derivatives, interest rates swaps, the retention by the primary dealers of the bonds primary issuances. The world of finance is drawn as a riskless world, liquidity abundant markets and a thirst for yields as they are made to evaporate.
The public functions have been operating as a party in complete neglect of their ascribed and constitutional fiduciaries duties. It is not an exclusive private markets matter.
10-Year Treasury Constant Maturity Rate (DGS10)
http://research.stlouisfed.org/fred2/series/DGS10
In short the current accounts imbalances are the causes and the credit and loans the causations.
Two graphs may illustrate the inflexion point occurring as of 1980, it is interesting to look at all the series supplied by Fred
Total Credit Market Debt Owed (TCMDO) 54,584.05 Billions of Dollars
http://research.stlouisfed.org/fred2/series/TCMDO
Total Savings Deposits at all Depository Institutions (SAVINGS) 2012-07-23: 6,378.1 Billions of Dollars
http://research.stlouisfed.org/fred2/series/SAVINGS
Stephen –
I personally take exactly the opposite view. Greed and hubris are ever-present here on Wall Street. To make your case, you must argue some sort of cyclicality in greed and hubris (which is actually an interesting thought).
Notwithstanding, these questions remain for your thesis:
– Why did greed and hubris manifest themselves in the post 2000s? Why not earlier? Why not now? If it wasn’t a surfeit of capital, are you arguing lax regulation? If so, then the next question is:
– Why did the financial crisis affect only the advanced economies? Why was financial governance better in Argentina better than Athens; Lima than London; the Phillippines than Philadephia; Mauritania than Madrid; Nigeria than Nevada; Shanghai than San Francisco? Are you arguing that governance improved in the emerging markets simultaneously across the board, and that’s why they were spared? Are you arguing that governance collapsed at the same time across the board in the OECD? That’s a very challenging thesis to support. (It is, however, the received wisdom.)
The authors of the post have argued a structural case, that it’s not “Blame it on Beijing”. Personally, I am not convinced, but they’ve taken a crack at the issue and at least tracked down some flows of funds, which is helpful in itself, even if the thesis seems a bit stretched to me.
I strongly suspect, however, had they run their analysis on GDP versus oil consumption, they would have found that the donor countries’ (the OECD) consumers are providing the vast increment of oil to the emerging markets (the recipient countries), and that this–combined with massive liquidity from China and the petrostates–is the defining element in understanding the evolution of the fiscal crisis.
Also plays well against the backdrop of what we know about income inequality, workforce participation, and stagnant wages. In the 1970s and early 80s, the initial response to stagnating wages was to send more household members into the labor market to maintain household income so labor force participation swelled. When that reached high levels in the late 80s, households began to reduce savings again maintaining spendable income levels. When that strategy was exhausted, borrowing began to escalate in the late 1990s, similar to previous borrowing periods, but with the difference that a large part of the borrowing went to residential real estate with substantial amounts of equity withdrawals used for current consumption purposes. There are probably a LOT of problems with this train of thought, but I kind of like how the narrative holds together.
WOW!
I am constantly amazed that I rarely hear any discussion of the lack of administration, public accounting, or regulation in the over-the-counter derivatives markets; the relentless erosion of funding for financial regulation and enforcement; and the migration of capital to offshore tax havens.
While I agree that the increase in demand for petroleum has been a contributing factor to the severity of the current banking crisis, I believe that Steven Kopits overstates its importance. The “defining element” in the evolution of the “fiscal crisis” is, in my opinion, the accumulation of too much debt. The BIS, and most western central banks
abrogated their most fundamental responsibility, and allowed credit instruments to wildly proliferate while they simultaneously allowed bank leverage to balloon.
The petrodollar recycling that was credited with US “prosperity” since 1970, was only an illusion. Eventually, those dollars will buy something tangible: US industrial assets. The same can be said of the Chimerica trade… The constant leak of assets and profits from the US economy has undermined the world’s premier reserve currency and allowed the inevitable reckoning of credit imbalances to occur more easily.
Thanks for the interesting article.
Even though it is important discussion on how and who is responsible for the housing boom and bust, this topic has been getting significant attention. What has NOT been getting nearly as much attention from politicians, media and economists is: what is happening now and what might happen in the future with the housing market?
It appears that currently with massive mortgage ownership between Fannie/Freddie and the Feds, Federal government is on the path of nationalizing private housing industry. With ultimate advantage in the cost of funding government entities can provide incredibly low interest on mortgage loans (btw, with tax deductible interests) and have largely monopolized new mortgage issuance.
Apart from the question of how wise for Federal government to channel and continue to channel such vast resources to the private housing industry, what is the end game here? Does no one see any problem with Federal government owning majority of private housing in this country?
It is interesting to see increasing equity values decrease savings, but is that because feeling wealthier leads to lower desired savings or savings are being invested in equities?
The other question I have is how much of those international private flows were foreign assets of domestic corporations since so much is offshored?
Steven Kopits, thanks for your persuasive, logical comments.
Have we learned much from the housing crisis?
Here is an interesting recent (8/8/2012) article from nytimes.com:
With Rates Low, Banks Increase Mortgage Profit
“After they [banks] bundle the mortgages into bonds, the banks transfer nearly all of the loans to government-controlled entities like Fannie Mae or Freddie Mac. The entities, in turn, guarantee the bond investors a steady stream of payments.”
More risk free profits for the previously bailed-out banks while government/taxpayers take on the risk?
Also, Wells Fargo, one of the Warren Buffet’s favorites, “made 31 percent of all mortgages in the 12 months through June, according to data from Inside Mortgage Finance.”