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 [1]. 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
mortgage losses.- 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. [2], [3], [4], [5] [6] [7].
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: [8] [9]). 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: [10]), 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.
People blame pushers for their addictions, too. That’s why we lock up drug dealers in this country instead of treating addicts.
Same logic.
Thank you for this. Such bogus pseud-o-causes need to be slayed once and for all to insure guilty partisans cannot re-employ revisionist history in the future for parochial gain. Such explanations would have us believe that the glutted savings were somehow miraculuously conceived in Asia, despite the footprints back to poor USA fiscal policy, fertilized by absurdly low real rates (given the lame fiscal policy), coincidental to extended asset prices. Oh, sorry , we anglo-saxons don’t look at asset prices…unless they are too low, or until it’s too late, or both.
Thank you, Menzie. I saw those passages in the ERP in a similar light, but wondered if that was just me being me. You’ve given me some reference material off which to bounce.
Menzie:
First, the Wright article you mention points to a declining term premium for the conundrum. I thought that interpretation no longer had merit. The conundrum–or the flattening of the yield curve–simply was the bond market expecting a recession and thus lowering its expectations of future short term interest rates. (See here )
Second, I am glad to see you raising questions about the saving glut story. Your story, however, appears to rely heavily on tax cuts as the exogenous shock the drove down the U.S. saving rate. What the about Fed’s low interest rates in early-to-mid 200s? Surely there was something exogenous here in that no one expected the interest rates to drop as low and long as they did during this time. Not only did the Fed’s unexpected loose monetary policy affect domestic consumption/savings, but it got exported to the dollar block countries and to some extent to non-dollar block countries (e.g. ECB had to keep watchful eye on dollar lest the Euro got too expensive). I am not saying it was the only enabler, but it certainly seems important. What are your thoughts on this global liquidity glut perspective?
BTW, here is an abstract from a ECB working paper that does find empirical support for this view:
I think both sides are true, there is a borrowers side and a lenders side to the story. It took two to tango.
FWIW I don’t entirely blame China/Japan for the final blowout. A soaring part of the current account deficit after 2005 say, was accounted for by the oil trade-deficit. So recycling petrodollars became a big part of the demand for bonds.
The loose money policy of the Fed during this period played into the ‘savings glut’ in that it increased the need of all the central banks involved to create Yuan, Yen, et al (only some of it sterilized) with which to buy US debt to prevent their currencies from appreciating against the US$.
All the central bankers of the world deserve blame but our own Fed in effect exported our easy money policy. They would have created less “savings” if we had created fewer US$s.
Menzie —
Four points:
A) i haven’t gone back and looked at all the references questioning the “glut to low rates” link, so i speak with some trepidation. certainly the argument only works with an intermediate step, one Bernanke left out: the glut fueled central bank reserve growth and thus demand for CB reserve assets. and there i would note that many of the studies i have seen on the question make use of the unrevised TIC data, and that makes them suspect as the scale of the revisions to CB demand for Treasuries and Agencies after 04 has been enormous. The Warnock and Warnock methodology of looking at private and official purchases together b/c lots of private purchases are official purchases is the only one that really works.
B)The loose fiscal and loose money explanations strike me as better explanations for the 02-04 rise in the deficit than for the persistence of deficits from 05 through 07. The fiscal deficit came down. Rates rose (short-term rates, not long-term rates). I would be interested in a bit more detail on your explanation for this period — as it is a period when the deficit in the us economy shifted from the government to the household sector. (it is a problematic period for my preferred explanation as well, as it is a period when CBs aren’t directly financing the sector of the US economy that actually has the big and growing borrowing need).
C) I am to be honest not convinced by the pull agrument. I fully accept that financial institutions exploited implicit guarantees to gear up to maintain profits as the yield curve flattened — that is actually essential to the mechanism that financed a big us household deficit. and no doubt foreign demand for US corp. bonds rose substantially from 04 to mid 07 (before collapsing). the only question is whether any of this demand really came form foreign investors willing to take $ risk. i am not sure. demand for corp bonds collapsed after aug 07 and the us external deficit remained large. the easiest explanation for this is that the foreigners buying the bonds (most of the demand came from the uk) were financing their corp bond book with short-term dollar borrowing from us institutions/ money market funds. the growth of the fed’s swap lines post lehman provides indirect evidence that this was the case. if that’s true, there was lots of roundtripping but no net flows — during the 06 to mid 08 period incidentally, foreign central bank demand for us bonds reached incredible levels. watch my blog for some new estimates — and watch the survey data. my strong sense is that the majority of the investors willing to take $ risk and hold $ bonds (as opposed to borrow $ and invest in higher yielding assets to pocket the spread) were CBs, and it is hard to find a “pull” story. arguments about the depth of us markets don’t really hold up; CBs have a ton of illiquid off the run treasuries and a lot of agencies that aren’t very liquid any more.
D) While i have some analytical sympathy for the outgoing administration’s arguments (a bad thing to admit, i know), I never realized that they had any sympathy for my arguments warning of the risks in the system back when they were in a position to do something about it, as opposed to trying to explain why we are in this mess. They generally argued that the biggest risk we faced was disrupting the system and thus there was no need to do much of anything even as deficits persisted. My point of view was quite different — namely that the longer a system where EM surpluses financed large external deficits (whether from a big fiscal deficit or a big household deficit), the bigger the eventual problem.
Finally, yes, i do think the inflow enabled the housing boom (good choice of words) and that the chain could have been broken either by less central bank intermediation/ less surplus savings in the emerging world (which would have tended to push up treasury and agency rates in a low savings economy and muted the housing boom) or by breaking the chain of intermediation inside the us that created demand for the riskiest mortgage assets by private players looking for yield (which would have reduced us and global demand and thus pushed down global savings, as we are seeing now … ). neither happened. vulnerabilities built.
Having worked on numerous debt financings firsthand and sat down with other MDs in the banking industry, i feel that most certainly Bernanke’s savings glut thesis is accurate, though it’s clear the federal reserve didn’t do much to counter it.
I don’t understand how any credible economist can look at the 2nd largest economy on the planet (China), using a fixed rate regime, a centrally planned export-driven economy, cycling most of their export earned $$ into their customer’s pockets (US), and think there is no impact to their customer’s cost of capital.
Sure Bush was bad. Sure Iraq was a debacle in terms of cost and bloodshed. Yes Americans chased rising home values and there was a bit of an orgy of speculation. But it does take 2 to tango, and if yields had risen in some fashion and China acted more rationally we would not be in the same place.
even if the bushmen had nothing to do with the mess, why didn’t they try anything to rectify the situation? did they just usurp power to inflict pain?
Yes, meanwhile we have switched from the africanized bee to the chinese hornet…
memes?
I thought it all the low-income “predator borrowers” that got us in this mess? And Fannie Mae? (who sounds like a low-income, ‘predator borrower’ sort of person of color).
And if Obama hadn’t spent so much money on his inauguration? It’s his fault as well.
You can’t deny that both China and Japan have mercantilist economic policies, using currency manipulation to drive their export oriented economies. Whatever else, this is the reason we have a GLOBAL recession right now. Huge new drivers of the global economy are oriented towards nothing more than satisfying the American consumer. It’s not a optimal economic strategy, as we are now seeing.
If Japan and China (and others) were not mercantalists and did not manipulate their currencies, the value of their currency would rise over time, and the trade deficit would take care of itself.
To whatever extent that tax cuts lead to deficits, and provide more T-bills for the mercantalists to recylce their trade dollars, there is the link that Menzie mentions, the “capital pull”. But the mercantalists could recycle their trade dollars in other ways, and have. Remember when the Japanese were buying Manhattan real estate in the ’80’s? Look at all the petrodollar investment in the US more recently.
The mercantalists need to do exactly what the US has done: using tax policy, retool their export oriented economies towards domestic consumers, especially in the real of services and creative endevors.
Buzzcut wrote:
You can’t deny that both China and Japan have mercantilist economic policies, using currency manipulation to drive their export oriented economies.
While this may be true in that every country in the world is mercantilist today neither China nor Japan are more mercantilist than the US. What do you think all that congressional chest beating was about when China was threatened because they pegged the yuan to the dollar? Doesnt’ everyone in the world know that the US can use monetary tricks in an attempt to favorably alter trade in one direction but let another country fix to the dollar so the US can’t gain an advantage and the mercantilists scream like stuck pigs.
In truth China is much less mercantilist than the US and because of this they will be much stronger when when the world economic disaster finally runs its course.
DickF:
Your comments are total BS. Yes, everyone expects China to have a higher GDP rate when the dust settles. But that is due to the underlying growth in goods/services in China. They are going through a boom which the US already experienced in the last 80 years. It will not be surprising to see their consumer consumption grow faster than the US in the next 20 years.
But it’s ridiculous to say their centrally planned economy, which has obviously created overcapacity in many areas was a good thing. It’s absurd to say that the US (with a floating rate currency) is more mercantilist than China.
your arguments are worthless.
I said this before but an important point very few commentators indeed take into account is the fact that one should not mix up savings with liquidity i.e. real savings vs. “paper” money -liquidity created by the banking system and central banks in particular.
Dick, the US is not specifically targeting a certain range for the dollar. We’re not intervening in currency markets, or implying that we will (as the Japanese do).
If anything, our politicians talk about a strong dollar.
The only bright side I see to all this is that the yen is currently at 88 to the dollar, near all time highs. Export oriented companies like Sony are getting killed. It looks like a wave of Japanese consumer electronics mergers are in the cards.
I am reading Menzie’s piece with interest because it is easy to understand and has lots of interesting references.
In returning to my old thesis of the role of Greenspan I am not playing the role of the man with a hammer that sees only nails. I bring it up because Menzie did not provide me an answer in my last two forays that satisfied my nagging doubts.
I think we all agree that it is important to correctly diagnose the problem so as to avoid a repeat of the same crisis. While it is possible that Menzie is right and Bush wrong or vice versa, it is also possible that both are wrong and the diagnosis is altogether different.
I cannot help but see both the Bush Administration and Menzie as playing two blind men touching the elephant. I readily accept that I could be a third blind man, but that is why I am asking this question. Someone please help me see a different big picture.
To restate the issue, speculative money flows require the money with which to flow. My analogy about the relative causes was to flood control, in which we built levees on the Mississippi and Missouri to protect towns upstream but that only increased the water flow so that the floods increased downstream. In the financial system, the flood of excess money creation bounced up against the existing and newly created fragilities in the regulatory system, but the basic problem was the amount of money.
The only non-duplicative source of dollar creation is the Fed (except in the occasional time when regular banks are allowed to reduce their capital requirements). Even the bad investments that investment banks made started somewhere as bank loans that originated from the creation of bank reserves by the Fed.
The famous saying that when the party is in full swing the Fed’s job is to take away the punch bowl gets pricisely to the point. The Fed kept the punch flowing long after the party had been in full swing with its negative interest rates. In reply to my question about this, the most I heard was that the Fed was indeed part of the problem, but not the major part of the problem.
This to me is like saying that, yes we agree that the excessive rains are part of the problem but the lack of levees and the lack of maintenance of the levees was the main cause. But for this to be true one would have to assume that it is possible for levee systems to protect against any amount of rain. This is of course a fallacy.
The BIS report I keep referring back to stated that the particular nature and intensity of this event was shaped by the regulatory misfires. But it said that at most they were the trigger for, and not the cause of the problem.
My simplistic idea is that, when money is easy, speculative lending makes more money than prudent schemes and risk tolerance increases. The simple way of looking at things is that savers become chumps. The holders of money are increasingly drawn toward overpaying for assets, as in banks lending to Teck Cominco to buy Canada’s Fording Coal, paying 80% cash, or as in European banks lending trillions (not coincidentally in Eurodollars rather than Euros) to emerging countries with most of their income stream from commodities.
I could understand that this could be due primarily to reckless regulatory malfeasance if in fact banks denied credit to good borrowers to invest in speculative investments. But there was plenty of money to go around, which points to the Fed keeping the punch bowl filled.
Had the Fed raised interest rates to withdraw money and restrict bank lending to economically sound levels after the 2001 crisis, banks would have had a choice between lending to sound borrowers and lending to speculative borrowers. If they had chosen to lend to NINJA borrowers and their corporate equivalents at attractive rates, they would have had to raise interest rates to punitive levels on good credit risks. The fact that they did not is clearly evidence of too much money sloshing around.
If people grant that this is true (as Menzie did in recognizing that the Fed’s interest rate policy had some responsibility for the crisis), then the only other stance they can take besides mine is that good regulation could have kept the excess money from doing so much damage or perhaps would have forced it into headline inflation rather than simply asset inflation.
I am willing to be persuaded if someone can make the case that the absence of headline inflation was the result of poor financial regulation. But assuming that no one can make this case, we are back to looking at what happens when there is too much money for the real economy and there is no headline inflation.
The answer as near as I can tell is that good borrowers get all the money they need at low rates and are able to expand their operations or increase their assets as fast as they wish to. The leftover money goes to borrowers that are not going to return all of the principal and interest, meaning that the banks are going to experience increased loan defaults.
Of course at the time the Fed was creating all of this money, no one knew exactly how much more money was being created than prudent banking practice would warrant. We only discover this when the loans go sour, which will be the inevitable result once the Fed finally gets around to raising interest rates and thus tilting the playing field away from leverage and speculation on increases in asset prices.
I don’t see anything unreasonable in stating that there is a fixed amount of money that can be prudently lent out at any one time. We have no direct way of measuring prudence, but certainly the Fed can look at certain indirect indicators to figure out when it needs to start taking away the punch bowl. Numerous people have looked at proxies for speculative excess such as a basket of asset indexes and the like.
The key part of the BIS opinion is that it stated that the Fed’s actions were highly unusual, that it is central banking 101 not to hold interest rates negative in real terms after a recovery is in full swing. As I stated before, the last time the Fed did this was in the Nixon Administration. This created the same result of pyramid investment schemes that came crashing down under Volker’s punishing interest rate increases.
I continue to be amazed at how the elephant in the room is ignored by policy makers and the economic literati… Increased liquidity and obscured yield risk were primarily caused by the exponential growth of securitization and derivatives as well as loosened reserve requirements. Indeed, because no reserve requirements were enforced on international trade expansion, the money supply was essentially taken out of the control of central bankers. The entire system was “gamed” by investment bankers and enabled by politicians eager for a painless “fix” to structural imbalances.
You can’t blame China for holding US treasury debt. The dollar is the default international reserve currency and the British/American investment banking cartel controlled more than half of global international trade finance. In order for China to get a seat at the table, they needed to support the existing international banking system.
I suppose the most interesting recent development, has been the rise of multinational corporations that move their assets and profits to minimize tax liability. The shift of governmental/administrative expense from assets/production to household income has increased central governmental deficits, inflation, and credit market debt throughout the developed world.
Menzie and folks around, warren Buffet has an answer worth to consider, also related to professionals in economy :
—
SUSIE GHARIB, ANCHOR, NIGHTLY BUSINESS REPORT: Are we overly optimistic about what President Obama can do?
WARREN BUFFETT, CHAIRMAN, BERKSHIRE HATHAWAY: Well I think if you think that he can turn things around in a month or three months or six months and theres going to be some magical transformation since he took office on the 20th, that cant happen and wouldnt happen. So you dont want to get into Superman-type expectations. On the other hand, I dont think theres anybody better than you could have had; have in the presidency than Barack Obama at this time. He understands economics. Hes a very smart guy. Hes a cool rational-type thinker. He will work with the right kind of people. So youve got the right person in the operating room, but it doesnt mean the patient is going to leave the hospital tomorrow.
…
SG: But I know that during the election that you were one of his economic advisors, what were you telling him?
WB: I was telling him business was going to be awful during the election period and that we were coming up in November to a terrible economic scene which would be even worse probably when he got inaugurated. So far Ive been either lucky or right on that. But hes got the right ideas. He believes in the same things I believe in. America s best days are ahead and that weve got a great economic machine, its sputtering now. And he believes there could be a more equitable job done in distributing the rewards of this great machine. But he doesnt need my advice on anything.
…
SG: Whats the most important thing you think he needs to fix?
WB: Well the most important thing to fix right now is the economy. We have a business slowdown particularly after October 1st it was sort of on a glide path downward up til roughly October 1st and then it went into a real nosedive. In fact in September I said we were in an economic Pearl Harbor and Ive never used that phrase before. So he really has a tough economic situation and thats his number one job. Now his number one job always is to keep America safe that goes without saying.
SG: But when you look at the economy, what do you think is the most important thing he needs to fix in the economy?
WB: Well weve had to get the credit system partially fixed in order for the economy to have a chance of starting to turn around. But theres no magic bullet on this. Theyre going to throw everything from the government they can in. As I said, the Treasury is going all in, the Fed and they have to and that isnt necessarily going to produce anything dramatic in the short term at all. Over time the American economy is going to work fine.
SG: There is considerable debate as you know about whether President Obama is taking the right steps so we dont get in this kind of economic mess again, where do you stand on that debate?
WB: Well I dont think the worry right now should be about the next one, the worry should be about the present one. Lets get this fire out and then well figure out fire prevention for the future. But really the important thing to do now is to figure out how we get the American economy restarted and thats not going to be easy and its not going to be soon, but its going to get done.
SG: But there is debate about whether there should be fiscal stimulus, whether tax cuts work or not. There is all of this academic debate among economists. What do you think? Is that the right way to go with stimulus and tax cuts?
WB: The answer is nobody knows. The economists dont know. All you know is you throw everything at it and whether its more effective if youre fighting a fire to be concentrating the water flow on this part or that part. Youre going to use every weapon you have in fighting it. And people, they do not know exactly what the effects are. Economists like to talk about it, but in the end theyve been very, very wrong and most of them in recent years on this. We dont know the perfect answers on it. What we do know is to stand by and do nothing is a terrible mistake or to follow Hoover-like policies would be a mistake and we dont know how effective in the short run we dont know how effective this will be and how quickly things will right themselves. We do know over time the American machine works wonderfully and it will work wonderfully again.
SG: But are we creating new problems?
WB: Always
—
Menzie, that do you think about that ?
Menzie
I think the economic adjustment mechanism following the 1997 Asian crisis worked well. The growing economy, the US, increased its current account deficit while the asian countries decreased theirs(increased their srpluses). Chinas acceptence in the WTO was a landmak event that pushed the adjustment further. But adjustments are temporary processes and this one was pushed too far under the Bretton Woods II banner. Now we have to live with the consequences and undergo the “adjustment to the adjustment”.
David Beckworth: Sorry, because the ERP didn’t mention monetary policy, I didn’t — that was an oversight. I did link to my “causes” of the crisis in note [10] in the post, and overly lax monetary policy is one of them (so this is for colonelmoore as well). I’ll add for his/her benefit that lax monetary policy can lead to manias and hence banking system crises — but it’s not required; consider the backdrop of the S&L crisis.
On the separate issue about the conundrum, well, I haven’t followed the literature as diligently as I should, but I think the econometric literature for its occurrence and disappearance has yet to form a consensus. I have a high regard for Wright’s work, so it seemed to me as good a work to reference as any other (see in particular his last section where he considers the other explanations).
bsetser: I can’t do justice to your comprehensive critique, but I’ll try to address a couple points.
Point (A): I agree that it’s possible that capital inflows caused a reduction in interest rates — the issue is the share. Warnock and Warnock — as well as my work (referenced in the blogpost) calculate the effect as a residual from a standard bond pricing equation. Well, that’s a black box which includes everything omitted…
Point (B): I think there’s a lag between fiscal impulses and trade deficits of about two years — as shown in Figure 4 of Last throes of PoMo Macro”.
Point (C): Maybe I wasn’t clear on my push/pull argument — my “pull” is US consumers on a borrowing binge caused by abdication of a prudential regulatory role by the US government and the Fed.
Point (D): I think we’re in agreement here. There are some elements of truth in the ERP analysis, but I think there are also some big errors of omission. I suspect there were many people in the Administration who have been worried for a long time about those things you and I worry about — but those voices were not allowed to be heard. Not the first time such a thing has happened, but in this event, perhaps the outcome is more tragic because those voices were stifled by those adhering to a particular ideological perspective.
MarkS: Securitization is definitely one of the issues, insofar as it exacerbates agency problems. This is cited as a cause of the crisis in note [10] in the post.
Richman: I don’t usually read what Buffet says, but this particular exchange doesn’t seem wildly crazy, although it overstates somewhat our ignorance. The important point is to have people in place who have expertise, can think analytically, and are not beholden to dogma. Those people will typically also know the limits of our knowledge, and that the words of some long dead economist should not be taken as the final word on what should be done today.
I would view their statements more favorably if our policy makers were not touting this situation all along as the greatest free lunch ever to come along and gorging themselves at the banquet to the point of bulimia.
To the extent the savings glut has any validity, why does no one blame this on the refusal of governments to allow markets to work? Would external surpluses ever become as large as they did if countries like China, Russia, and the middle east oil exporters allowed their currency values to be set in a free exchange market rather than controlling them tightly. Granted a rise in demand would have pushed oil prices higher, but I suspect freely floating exchange rates would have limited the glut to a moderate bulge.
I don’t see how you can blame this on “Tax cuts.” by tax cuts do you mean, we spent an insane amount and didn’t tax enough to cover this insane amount. Yes, tax cuts occured, buts not like they are so low as to be ridiculous. In fact they are quite high. It’s insane spending, not tax cuts. its insane monetary policy. there are no amount of taxes to cover this spending.
I agree with much of what the CEA said. I tend to blame artifically induced savings, created by intervention in currency markets by China and Japan (the latter both overtly and implicitly, by giving the impression that large cureency adjustments would not be tolerated, which encouraged the yen carry trade) for a large part of the problem. Certainly, the Administration shares in the blame. Its tax and war policies greatly exacerbated the budget deficit. The U.S. Treasury refused to brand China as a currency manipulator. And the Treasury stopped putting pressure on Japans to reduce currency interventions when Koizumi put 300 non-combat troops in Iraq.
We had another similar episode in the early 1980’s. Then, OPEC oil exporters with large surpluses deposited their funds in U.S. banks, which made massive loans to LDCs. Then came the LDC debt crisis and bank bailouts.
Bryce: “All the central bankers of the world deserve blame but our own Fed in effect exported our easy money policy. They would have created less ‘savings’ if we had created fewer US$s.”
You seem to assume that currency intervention was passive – set by an arbitrarily set exchange rate, rather than by a goal of an amount of trade surplus. I would argue that, at last in the case of Japan, the opposite is much closer to the truth.
Menzie: “Point (C): Maybe I wasn’t clear on my push/pull argument — my “pull” is US consumers on a borrowing binge caused by abdication of a prudential regulatory role by the US government and the Fed.”
An increase in U.S. borrowing demand would raise the real interest rate, but would increase the overall level of real U.S. indebtedness only to the extent that the increase in interest rates raised net savings abroad (foreign saving less foreign investment) by more than it raised U.S. saving. If I am not mistaken, empirical evidence on the response of saving and investment to the interest rate is mixed. In any event, the net foreign saving appears to have been largely driven by artificial exchange rate policies, not by high real rates of interest. So I think push was more important than pull. More a case of stuffing the goose (to produce pate de fois gras) than the goose being hungry.
Maybe this is a stupid question, but if there was a massive amount of savings being directed to the US why did the dollar fall? Doesn’t a falling dollar imply either excess supply or insufficient demand? How can that be squared with the savings glut explanation?
Don, I think you have to differentiate the behavior of the trade-weighted dollar (broad US trade weighted dollar) from the financial dollar (the dollar index, which is about 75% European currncies, of which 57.6% is the Euro). The remarkable thing about the period after 2002 is that the movement of the dollar was very substantially vs. the financial dollar, not the broad trade weighted dollar (which is about 50% Asia and Mexico). The financial dollar collapsed, the trade weighted dollar much less so (a reflection of the fact that China pegged, and the Mexican peso, uniquely, depreciated against USD). I think broadly speaking, after 2002, the US got into a competitive devaluation battle with the Asians which it lost, because it wasn’t willing to go all the way–i.e., intervene in USDCNY to counter their intervention. Of course, the people who really got the short end of that one were people like the UK, the Baltics, Spain, Ireland and Iceland above all–even more housing and finance-centric economies that entered this downturn with monetary conditions that were way tighter than even we faced. I also think the savings glut hypothesis works only up to a certain point. I can see how one can posit a global s/i gap for the period from 1997-2002, let’s say, when you had Asia, Russia, Latin America and global technology blow up serially. But the real takeoff in global reserves is a post 2002 phenomenon, and after 2003,that period that period coincided with massive increases in housing investment in Anglo-Saxonia, Baltia, Antipodia and Iberia as well as a major rampup in German and Chinese export-oriented capex. So I think rather than a rise in the global savings rate, we have to be looking at a massive increase in the global money multipier, i.e., leverage.
Karsan: I don’t follow much of what you said. But I agree with the following “But the real takeoff in global reserves is a post 2002 phenomenon”
Prior to the dotcom bust, U.S. trade deficits were the result of ‘pull’ – high investment and excess aggregate domestic demand. The ‘goose was hungry.’ After the bust, Asian countries used currency manipulation to maintain exports and local demand – the U.S. trade deficit was maintained owing to forced saving abroad. The ‘goose’ was being force-fed.
The degree of the over-valuation of housing around the world was reviewed by the Economist, and found to be much less in the US than in other nations around the world ranging from Britain and France to Australia.
The NY Times had a major story yesterday about how everything is worse in Britain than the US: housing prices were more over-valued and are falling further, the banking sector was more over-leveraged and now is falling faster and harder, GDP is falling faster in a deeper recession. Etc. Then there’s Iceland, Ireland, Russia, etc. etc.
I find it hard to see how when the same problems arose in markets all around the world at the same time, and in many cases worse than in the US, the primary cause is likely to be the Bush Administration’s domestic policies and/or Alan Greenspan’s domestic US monetary policy.
Frankly, some world-wide phenomonon keeping long-term interest rates at historically low levels for an extended period of time, causing markets to underestimate risk (especially of leverage) and overstimulate investments in things like housing, the value of which is leveraged and very sensitive to long rates, seems more likely to me than such world-wide syncrhonization of events by coincidence.
But that’s just one person’s uneducated opinion. Or uneducated person’s opinion. Whatever. FWIW.
Don
You responded to “All the central bankers of the world deserve blame but our own Fed in effect exported our easy money policy. They would have created less ‘savings’ if we had created fewer US$s.” with
“You seem to assume that currency intervention was passive”
I’m not assuming anything but that Asian & petro-state central banks were determined to keep their currencies cheap with respect to the US$. We caused them to work harder–to ‘print’ more of their respective currencies than they otherwise would have–because we were cheapening ours in the name of a 1% Fed funds rate. Because of the attitudes of PBoC et al, we in effect exported our easy money policy
With Timothy Geithner’s recent declaration that China is “manipulating its currency,” it appears that the Obama administration may not be averse to blaming it on China. Since China pegs its currency to the US dollar, by definition it “manipulates its currency.” But is this what the soon-to-be Treasury Secretary had in mind?
Menzi-
Your line of reasoning is pure bull … Stop the Bush bashing and look at what Obama is proposing … focus on real issues.
sally: Thank you for your carefully reasoned insights. Your definition of “real issues” would be welcome.
Bryce: “I’m not assuming anything but that Asian & petro-state central banks were determined to keep their currencies cheap with respect to the US$. We caused them to work harder–to ‘print’ more of their respective currencies than they otherwise would have–because we were cheapening ours in the name of a 1% Fed funds rate. Because of the attitudes of PBoC et al, we in effect exported our easy money policy”
Re-read your statement, and mine. So, the amount of China’s foreign exchange purchases was endogenous? I suspect the trade surplus was closer to exogenous. That is why the renminbi was allowed to appreciate against the dollar (albeit much too little), but is now being forced down against the dollar.
The blame game is like saying your neighbor’s saving is causing your own economic and financial problems and you are therefore not responsible for the problems.