The Financial Crisis E-Book

Howard Davies

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 322

Veröffentlichungsjahr: 2014

Beschreibung

There is still no consensus on who or what caused the financial crisis which engulfed the world, beginning in the summer of 2007.

A huge number of suspects have been identified, from greedy investment bankers, through feckless borrowers, dilatory regulators and myopic central bankers to violent video games and high levels of testosterone among the denizens of trading floors. There is not even agreement on whether the crisis shows a need for more government intervention in markets, or less: some maintain that government encouragement of home ownership lay at the heart of the problem in the US, in particular.

In The Financial Crisis Howard Davies charts a course through these arguments, and the evidence advanced for each of them. The reader can thereby assess the weight to be attached to each, and the likely effectiveness of the remedies under development.

Leseprobe

THE FINANCIAL CRISIS

THE FINANCIAL CRISIS

Who is to Blame?

Howard Davies

polity

Copyright © Howard Davies 2010

The right of Howard Davies to be identified as Author of this Work has been asserted in accordance with the UK Copyright, Designs and Patents Act 1988.

First published in 2010 by Polity Press

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ISBN-13: 978-0-7456-5163-7

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CONTENTS

Acknowledgements

Introduction

A  The Big Picture

  1  Frankenstein’s Monster: The End of Laissez-Faire Capitalism

  2  The Rich get Richer – the Poor Borrow

  3  The Savings Glut: Global Imbalances

  4  Too Loose for Too Long – US Monetary Policy

B  The Trigger

  5  Minsky’s Moment

  6  The Subprime Collapse: A Failure of Government?

C  The Failures of Regulation

  7  A Capital Shortage

  8  Procyclicality

  9  The Canary in the Coal Mine: Off-Balance Sheet Vehicles

10  The Taxi at the Station – Liquidity

11  The Blind Man and the Elephant: US Regulation

12  SEC – RIP?

13  Financial Weapons of Mass Destruction: Derivatives

14  Federal Mortgage Regulation

15  Casino Banking: The End of Glass-Steagall

16  Too Big to Fail

17  Lighting the Touchpaper: Light Touch Regulation

18  There were Three People in the Marriage – UK Regulation

19  A Failure of Coordination

20  Paradise Lost: Offshore Centres

D  Ac countants, Auditors and Rating Agencies

21  Shoot the Messenger: Fair Value Accounting

22  Tunnel Vision: The Auditors

23  Conflicts of Interest: Credit Rating Agencies

E  Financial Firms and Markets

24  Breaking the Chain: Originate to Distribute

25  Too Complex to Trade: Derivatives

26  Disaster Myopia: Risk Management

27  The Roach Motel: Corporate Governance

28  Blankfein’s Bonus: Pay and Incentives

29  The Vampire Squid: Fraud

30  A Plague of Locusts: Hedge Funds

31  Short-Selling

F  Economics and Finance Theory: Irrational Expectations

32  The Death of Economics

33  Inefficient Markets

34  An Ethics-Free Zone: Business Schools

G  Wild Cards

35  The Watchdog that Didn’t Bark: The Media

36  Greed is Bad

37  Lara Croft: Video Games

38  Hormones

And Finally …

39  A Combustible Mixture

Index

ACKNOWLEDGEMENTS

In preparing this guide I have benefited from discussions with politicians, central bankers, regulators and market participants. Some of them are quoted in the relevant sections; others are not.

I am particularly grateful to Stephanie Morisset for her help in preparing the text and the references, with ready support from Veronique Mizgailo, Kaylee Stewart and Jagoda Sumicka.

INTRODUCTION

The crisis which engulfed the world, beginning in 2007, was the most destructive economic event of the last eighty years.

Triggered by problems in the United States’ subprime mortgage market in the summer of 2007, it soon spread to other related and unrelated financial markets and then into the real economy. The global economy, which had grown by 3.5 per cent per year on average over the previous decade, contracted by over 1 per cent in 2009, with far sharper falls in the advanced industrialized countries. Peak to trough reductions in GDP were around 6 per cent in the main developed economies. By late 2009, growth had begun to recover in some of them, though not all. But the economic costs will continue to be felt for some time. Global unemployment is estimated to be 15 million higher than it was before the crisis. There has been an enormous loss of value in the financial sector also, with estimates suggesting that financial firms will need recapitalization totalling $16.0 trillion.

Governments were successful, as they had not been in the 1930s, in using fiscal policy to prevent the world sliding into a full-scale depression. Fiscal stabilizers were allowed to operate, and in many places direct stimuli were introduced. These initiatives were effective, up to a point, but the costs in terms of government deficits and an increase in the stock of government debt have been enormous. The total debt outstanding of major Western economies is expected to rise from 84.1 per cent of GDP in 2007 to 109.9 per cent in 2010, with a number of countries showing debt to GDP ratios well above 100 per cent. These debts will be a serious drag on the economies of the affected countries for many years to come. Future generations will be paying for this crisis for decades.

It is therefore not surprising that there has been a massive outpouring of analysis and commentary, designed to identify the causes of the crisis and the appropriate remedies to reduce the risk of a recurrence. Some of this analysis has become personal – commentators have asked not simply what was to blame for the crisis, but who. The old saying has it that success has a hundred fathers, but failure is an orphan. In this case, that has been turned on its head. As time passed, explanations proliferated and the list of guilty men (and a few women) continued to lengthen. Far from opinion converging on one explanation of the crisis, views tended to diverge, with a range of competing narratives articulated.

A common element was the identification of excess leverage as the key underlying problem. But why was that leverage allowed to develop? Whose leverage was most important in contributing to the crash? And what should be done to prevent the same thing happening again in the future?

One narrative identified a series of macroeconomic trends which led to an unsustainable global economy, which was bound to unwind sooner or later. Massive global imbalances were allowed to build up in the early years of this century, with huge current account surpluses in China and the oil-producing countries, matched by enormous deficits in the US, the UK, and elsewhere. These imbalances created a surplus of liquidity – a savings glut – which went in search of apparently safe assets generating a higher return than government debt. This process was facilitated, indeed positively encouraged, by loose monetary policy in the United States following the dot-com boom and bust and the Twin Towers attack. So, on this analysis, bad macroeconomic policy was the number one culprit.

But why did these imbalances build up? Some argue that China, with its export-led growth model, was the most important contributor. Others prefer to see the fault on the US side. American consumers had become used to levels of consumption, and a standard of living, higher than their income could justify. Why blame the Chinese for feeding this insidious habit?

Still others look behind these global trends and identify growing income inequalities, especially in the United States, as a key factor. While the top deciles of the income distribution were doing well, middle- and lower-income American households were unable to maintain their previous standard of living, or certainly to maintain a rising standard, and used growing indebtedness as an attempt to compensate for falling real incomes. This growing income inequality was reinforced by the Bush administration’s tax policy which further biased the rewards of growth towards the better off.

An alternative strand of thinking, which also sees government policy as a crucial contributory factor, puts the argument very differently. Successive US administrations sought to encourage increasing levels of home ownership, for political reasons. That could only be achieved by making debt available to less creditworthy households. That, in turn, required government intervention in the market through legislation – the Community Reinvestment Act – and through the two government-supported entities, Fannie Mae and Freddie Mac, who guaranteed subprime mortgages. So it was too much government, intervening in financial markets to achieve a certain social outcome, which eventually destabilized the economy.

But there is a strongly held rival view, which suggests a very different role for government in the build-up to the crisis. Governments in the United States and the United Kingdom, in particular, had encouraged the growth of the financial sector, and the growth of financial innovation, by a series of deregulatory measures over a long period. So it was too little, not too much government that was the problem. Congress, in particular, was heavily influenced by costly lobbying by Wall Street firms. Had governments kept a tighter rein on financial markets and financial institutions, then the outcome would have been very different.

Many politicians acknowledge the possibility that macroeconomic conditions may have been a contributory factor, but understandably prefer arguments based on the behaviour of the financial sector. Even governments, like those in Washington and London, which had traditionally maintained close links with financial firms and their leaders, began to adopt a very different style of rhetoric about them as the crisis developed. A narrative which identified fundamental flaws in the operation of financial markets began to be developed. On this argument, it was undisciplined market behaviour which lay at the heart of the financial instability which erupted so damagingly in 2007. Exotic financial innovations, whose social utility was doubtful, were driven by incentive structures which rewarded market participants extravagantly, sometimes for short-term returns which left their firms dangerously exposed to potential longer-term losses.

For some time, earnings in the financial sector had been outpacing those in other parts of the economy. These trends were tolerated, perhaps even encouraged, by politicians who looked to wealthy financiers for support, whether for their own election campaigns or for favoured projects in the arts and charities. Those high earnings began to look very different in the light of the crisis. How was it that a small number of individuals could have extracted such high rents from their position in the markets? In particular, after almost all major financial institutions had to be rescued by governments in late 2008, how could it be that individuals could earn huge bonuses in one year, when losses in the following year were ‘socialized’ and in effect underwritten by taxpayers? It was argued that we had allowed a situation to develop in which there was a fundamental asymmetry – heads the financial firms won, tails the taxpayer lost.

This became a widely held view about the financial sector generally. But some specific villains were identified, too, whose actions were thought to have contributed significantly to the problems with which governments were wrestling. Unregulated hedge funds and private equity firms were highlighted. Credit rating agencies, whose actions had undoubtedly been a part of the subprime bubble problem, were similarly seen as institutions with a strong case to answer and to be riddled with conflicts of interest and dangerous perverse incentives. Among the investment banks, Goldman Sachs became the favoured target.

And what of the institutions put in place to regulate these markets? Another strand of argument identified their failings as being central to the problem. Auditors facilitated accounting tricks which concealed leverage. Regulators had the power to require banks to hold more capital and larger reserves, yet did not use them. They allowed new instruments of speculation to be introduced, without adequate risk management controls around them. To these general criticisms were added some specifics – the Federal Reserve could have had some regulated mortgage lending but chose not to do so, for example. In the UK, the structure of regulation put in place by the Labour government after 1997 was seen to have misfired, especially at the beginning of the crisis in 2007.

Why did regulators maintain a weak, hands-off approach? They were influenced by economists and financial theorists who had developed a set of flawed theories about efficient markets. But the field is not left to economists, politicians and regulators. Others advanced more fundamental societal explanations for the instabilities. Religious leaders entered the fray with homilies on human wickedness and greed.

It is perhaps not surprising that such a plethora of explanations should have been articulated. We are all infl uenced by our perceptions, prejudices and interests. Central bankers are not likely to volunteer that weak monetary policy was at the heart of the problem. Alan Greenspan’s celebrated apology was very limited in its scope and did not speak to the monetary policy decisions which he himself had made. Politicians are not likely to say that they were guilty of fuelling the fire with ill-considered social interventions. Regulators rarely confess to having been asleep at the wheel. Bankers are unlikely to put their hands up and acknowledge that it was their short-term greed and recklessness which was to blame.

But there is a problem in simply observing that a wide range of explanations have been advanced. The problem is that policy responses are being proposed, and even implemented, based on narratives which may not be well supported by the evidence. Some policy changes have perhaps been advanced in the category of ‘it is important never to waste a good crisis’. The measures taken to constrain offshore centres, for example, one of the least plausible sets of potential culprits, refl ect the desire some Western politicians have had for some time to close off tax loopholes.

It may not matter much that the crisis allowed that to happen, but in other cases, policies implemented on the back of flawed and very partial analysis may be damaging. There is a risk that measures taken will impose long-term costs on the economy for little ultimate gain. There is also a risk that we convince ourselves that the problem has been solved through the implementation of tighter regulations here or there, and ignore some of the more difficult underlying issues.

The aim of this short book is to survey these different explanations, which are sometimes complementary, but sometimes conflicting. Thirty-eight strands are identified. In each case, the charge sheet is summarized and some of the key protagonists who have advanced the argument are identified. I briefl y describe the facts that may be deduced to support the argument, and the counterarguments where there are specific points to make. There is a short list of references in each case, which allows the reader to go further. Finally, as the 39th step, there is a short consolidated assessment of the arguments which seem to me to be the most persuasive. Readers may disagree, and I acknowledge that other combinations of causes could plausibly be put together.

The book was originally devised as an aid to teaching an LSE course module on the financial crisis and the responses to it. I hope it may be useful in other similar teaching contexts, and to the general reader also. Since the economic and social costs of the crisis will be with us for some time, the debate on its origins, and the appropriate responses to them, undoubtedly still has some road to travel.

A   THE BIG PICTURE

The first four explanations focus on the political and economic background. They divide into two pairs, the first largely political, the second macroeconomic.

Does the crisis reveal fundamental flaws in the particular version of laissez-faire capitalism operated in the US and the UK in recent years? Is it the end of the line for the Reagan-Thatcher model? (Section 1)

What drove the rapid growth in borrowing – and can that be attributed to the growing income inequality which has been a feature of the last two decades? (2)

Were there features of the global macroeconomic background which generated instability, in particular the growing surplus in China and the oil-producing nations, which were reinvested in the West, driving down return on risky assets? (3) Should monetary policy have done more to offset these pressures, and to tighten financial conditions as asset prices boomed? (4)

1

FRANKENSTEIN’S MONSTER: THE END OF LAISSEZ-FAIRECAPITALISM

Most of the arguments in this book relate to features of the management of the global economy and the international financial system which have been identified as key contributors to the crisis. But there is a broader political context. There are many who have seen the crisis as more than a ‘Minsky moment’ (Section 5) or a 100-year flood, and rather as a sign that the capitalist system is fundamentally flawed. There has been something of a revival of far left groups (and also of far right parties exploiting populist discontent). Marxist economic historians see the crisis as grist to their particular mill. Billy Bragg, the genial singer-songwriter and political activist, sees the crisis as a vindication of popular resistance to Thatcherite free market dogma: ‘like Frankenstein’s monster, Thatcherism has turned on its creators’.1

In using this rhetoric, Bragg finds himself quite close to mainstream opinion among centrist continental European politicians. President Sarkozy of France told supporters in 2008 that ‘the idea of the all powerful market that must not be constrained by any rules, by any political intervention, was mad … the present crisis must incite us to refound capitalism on the basis of ethics and work … laissez-faire is finished’.2 Peer Steinbrück, then German finance minister, saw even broader changes in prospect: ‘the US will lose its status as the super power of the world financial system. This world will become multi-polar … the world will never be as it was before the crisis.’3 George Soros has used similar language. He criticizes politicians and central bankers on both sides of the Atlantic as being ‘in the thrall of a market fundamentalist fallacy’.4 In an earlier book, ‘The Crisis of Global Capitalism’5 Soros pinpointed the dominance of this fallacy as beginning in the early 1980s: ‘it was only when Thatcher and Reagan came to power around 1980 that market fundamentalism became the dominant ideology’. Soros has consistently argued for re-regulation and for a reversal of the growing ‘financialization’ of western economies. Paul Krugman has advanced similar arguments, declaring in the summer of 2009 that ‘deregulation bred bloated finance, which bred more deregulation, which bred this monster that ate the world economy’.6

The critique of laissez-faire finds a cousin in an attack on unfettered globalization. Katsuhito Iwai puts the case succinctly in a paper called ‘The Second End of Laissez-faire’. ‘Globalization,’ he argues, ‘can be understood as a grand experiment to test the laissez-faire doctrine of neo-classical economics, which claims that a capitalist economy will become more efficient and stable as markets spread deeper and wider around the world. The “once a century” global economic crisis of 2007–9 stands as a testament to the failure of this grand experiment.’7 Globalization did bring about a high level of average growth for the world as a whole, but at the same time it produced massive instability ‘because capitalism is a system that is built essentially on speculation’. Others have gone back to the Brandt Commission report in 1980 which anticipated that unless governments corrected global monetary balances through coordinated global action, there would be a series of sovereign debt crises. The Commission’s calls for reform of the world’s monetary system look prescient today. As the crisis has evolved into a sovereign debt problem in many countries (notably Ireland, Greece and the UK) these arguments may look increasingly persuasive.8

Another strand of this critique has a more explicitly environmentalist flavour. Jacques Attali argues that ‘the acute cause of the crisis is the growing difficulty the West has in compensating for its domestic depletion by attracting enough resources from elsewhere … the West instituted the globalization of markets in order to attract resources from the rest of the world, which made it possible for it to maintain its standard of living by creating a worldwide financial bubble.’9 Jonathan Porritt, a British environmentalist, sees no difference between Tony Blair and Gordon Brown and Margaret Thatcher in this respect: ‘they remain convinced to this day that economic success for any single nation depends entirely on the speed with which the global economy as a whole can be opened up to the full rigour of deregulated neo-liberalism.’10 In his view, the original sin here is the pursuit of higher economic growth at all costs. Those arguments go beyond the scope of this book.

The response of those who might be expected to defend the set of beliefs which has informed their policies for some decades has been somewhat muted during the crisis. Gordon Brown, who in the past was loud in his praise of the City of London as a wealth creating engine for the UK economy as a whole, has switched to a language which emphasizes the role of technology and science-based innovation in promoting growth. Peter Mandelson, who in 1998, speaking of New Labour’s attitudes, said ‘we are intensely relaxed about people getting filthy rich, as long as they pay their taxes’,11 had changed tack by the time of the election campaign in 2010. Then he described Bob Diamond, the president of Barclays, as ‘the unacceptable face of banking’.12

Others have stood their ground. In December 2009, Martin Feldstein rearticulated the defence of Reagan and Thatcher. In his view, even in the finance area ‘financial deregulation made London a global financial centre. Some of those regulatory changes may be reversed but Britain is unlikely to jeopardize an important component of its economy by returning to pre-Thatcher financial rules … policies do evolve as conditions change and as we learn from experience. But the dramatic policy changes in the US and Britain under Ronald Reagan and Margaret Thatcher brought about such profound improvements that there is no going back.’13 Niall Ferguson has similarly cautioned against overreaction, and drawing the wrong lessons. In a robust response to Paul Krugman’s critique he argued that ‘we’re going to get the 1970s for fear of the 1930s’.14

In the summer of 2010 these arguments continued to ebb and flow, though the leaders of the advanced industrialized countries had toned down their rhetoric in favour of more practical reform measures on the one hand, and denunciation of the greed and fecklessness of bankers on the other. But some of the underlying tensions in the global economy remained – imbalances being one very visible element. The policy responses of 2007–2010, which helped to prevent the recession turning into a depression, left many governments with huge fiscal deficits. The consequences of necessary efforts to reduce those deficits in the coming years will be severe for the public sectors of those countries, and are likely to constrain real wage growth elsewhere, too. So popular criticism of financialization and globalization may continue to be a prominent feature of politics for some time, with unpredictable consequences for economic policy.

References

  1.  How we all lost when Thatcher won. Billy Bragg. 5 March 2009. www.guardian.co.uk

  2.  ‘Laissez-faire’ capitalism is finished, says France. Elitsa Vucheva. EUObserver. 26 September 2008. http://euobserver.com

  3.  Ibid.

  4.  The false belief at the heart of the financial turmoil. George Soros. 3 April 2008. The Financial Times. www.ft.com

  5.  The Crisis of Global Capitalism. George Soros. Public Affairs. 1998.

  6.  The Crisis and How to Deal with It. The New York Review of Books. 11 June 2009. www.nybooks.com

  7.  The Second End of Laissez-Faire: The Bootstrapping Nature of Money and the Inherent Instability of Capitalism. Katsuhito Iwai. October 2009. CIRJE Discussion Paper No. 646. www.e.u-tokyo.ac.jp

  8.  How the Brandt Report Foresaw Today’s Global Economic Crisis. James Quilligan. Integral Review, Vol. 6, No. 1. March 2010.

  9.  Jacques Attali in The Future of Money, ed. Oliver Chittenden. Virgin Books. 2010.

10.  Jonathon Porritt, in the above.

11.  Peter Mandelson. The Financial Times. 23 October 1998. www.ft.com

12.  Lord Mandelson attacks Barclays head. 3 April 2010. www.news.bbc.co.uk

13.  Is the Reagan-Thatcher Revolution Over? Martin Feldstein. Project Syndicate. 9 December 2009. www.project-syndicate.org

14.  Crisis of Global Capitalism, Soros.

2

THE RICH GET RICHER –THE POOR BORROW

The growth of leverage in American households, in particular, is universally accepted as one of the underlying causes of the crisis. But why did this leverage grow? Why were US households so willing to take on additional debt, when the long-term risks to their economic welfare should have been apparent?

One explanation has come from economists on the left of the political spectrum. A report for the president of the UN General Assembly, prepared by a group chaired by Joseph Stiglitz, put the point starkly. Their answer is that growing income inequality is the underlying cause. Globalization has been associated with increasing inequality of income, not only within developing countries, but also among developing countries and between developed and developing countries.1 In the advanced countries, ‘median wages stagnated during the last quarter century, while income inequalities surged in favour of the upper quintiles of the income distribution … The negative impact of stagnant real incomes and rising income inequality on aggregate demand was largely offset by financial innovation and lax monetary policy that increased the ability of households to finance consumption by borrowing.’ In countries where income inequality increased less, which was the case in parts of continental Europe, ‘social protection systems … provided partial compensation for stagnating income’ and ‘were financed through increased public deficits and public debt’.

The report argued, for good measure, that the Iraq war played a part in pushing up the price of oil which brought further reduction in purchase power in many countries.

Others have developed this line further. Branko Milanovic of the Carnegie Endowment for International Peace notes that middle-class income stagnation became a recurrent theme in American political life, and ‘an insoluble political problem for both Democrats and Republicans … A way to make it seem that the middle class was earning more than it did was to increase its purchasing power through broader and more accessible credit … High net-worth individuals and the financial sector were … keen to find new lending opportunities … The middle class and those poorer than them were happy to see their tight budget constraint removed … and partake in the longest US post World War II economic expansion.’2

Thomas Palley of the New America Foundation broadens the critique to one of the entire neo-liberal growth model which has underpinned American economic policy for decades.3 Debt and asset price inflation drove demand, in place of wage growth. ‘A second flaw was the model of US engagement with the global economy that created a triple economic haemorrhage of spending on imports, manufacturing job losses, and off-shoring of investment.’ Deregulation and financial excess are not the ultimate cause of the crisis. Instead, the US needs a new economic paradigm and a new growth model which involves rethinking its commitment to unfettered globalization.

These arguments are strongly contested by others. While Chairman Bernanke of the Fed has himself recognized the growth in income inequality as an important economic phenomenon, his view is that ‘the influence of globalization on inequality has been moderate and almost surely less important than the effects of skill-based technological change’.4 Others also challenge the data on rising income inequality. Kruger and Perry note that ‘consumption inequality … has remained substantially stable’.5 Steven Levitt in ‘Freakonomics’6 argues that ‘the prices of goods that poor people tend to consume have fallen sharply relative to the prices of goods that rich people consume. Consequently, when you measure the true buying power of the rich and the poor, inequality grew only one-third as fast as economists previously thought it did — or maybe didn’t grow at all.’ Furthermore, there is evidence that higher-income households are particularly vulnerable to fluctuation in aggregate consumption. Their vulnerability has increased in recent years and high-income households currently ‘bear an inordinately large share of aggregate fluctuations’.7 So the crisis may well have a significant impact on smoothing consumption inequality.

But these analyses do not challenge the broad picture of rising income inequality, as measured by the Gini index. And the data shows that incomes of the top 5 per cent and top 1 per cent of households have risen much more sharply than those in the bottom half of the distribution, for many years. The top 5 per cent of US households earned 15 per cent of total household income in 1980; by 2006 that share had risen to 21.5 per cent. In the UK household borrowing similarly rose rapidly, and income inequality has also increased dramatically over the last three decades. Very big increases in the pay of the top 1 per cent of the income distribution have been driven largely by bankers’ bonuses.8

In addition to the possible effect on households’ propensity to borrow, Lorenzo Bini Smaghi of the European Central Bank points to an impact on political attitudes to the financial sector, and particularly to government policy towards failing institutions. He sees growing income inequality as one of the reasons why the US authorities were not prepared to rescue Lehman Brothers, noting that ‘the emergence of stark inequalities entails the risk that decision-making mechanisms will be blocked, in particular in crisis situations, with negative repercussions for the collective good and social cohesion’.9

References

  1.  Report of the Commission of Experts of the President of the United Nations General Assembly on Reforms of the International Monetary and Financial System. New York. September 2009. www.un.org

  2.  The True Origins of the Financial Crisis. Branko Milanovic. Yale Global Online. 12 May 2009. http://yaleglobal.yale.edu

  3.  America’s Exhausted Paradigm: Macroeconomic Causes of the Financial Crisis and Great Recession. Thomas Palley. New America Foundation. June 2009. www.newamerica.net

  4.  The Level and Distribution of Economic Well-Being. Ben Bernanke. Speech before the Greater Omaha Chamber of Commerce. 6 February 2007. www.federalreserve.gov

  5.  Inequality in what? Dirk Krueger and Fabrizio Perri. 16 February 2007. www.cato-unbound.org

  6.  Shattering the Conventional Wisdom on Growing Inequality. Steven Levitt. Freakonomics Blog. 19 May 2008. http://freakonomics.blogs.nytimes.com

  7.  Who Bears Aggregate Fluctuations and How? Jonathan Parker and Annette Vissing-Jorgensen. NBER Working Paper No. 14665. January 2009. www.nber.org

  8.  Centre of Economic Performance Analysis. May 2010. www.cep.lse.ac.uk

  9.  Some Thoughts on the International Financial Crisis. Lorenzo Bini Smaghi. Speech at the Unione Cristiana Imprenditori e Dirigenti. Milan. 20 October 2008. www.ecb.eu

3

THE SAVINGS GLUT GLOBAL IMBALANCES

A striking feature of the world economy in the years before the crisis was the build-up of huge current account imbalances. In 2006 the combined current account deficit of the US and some other advanced economies was around $800 billion, while the surplus run by the oil-exporters, China and Japan was slightly larger. These imbalances had persisted for some years but expanded rapidly from 2002 onwards. There continues to be a chicken and egg style controversy about who is most responsible for the generation of these imbalances. Was it chronic over-consumption on the part of the United States, or chronic over-production, facilitated by a manipulated exchange rate, on the part of China? This controversy continues to divide opinion among economists, but it is rather the consequences of the imbalances that concern us here.

Richard Portes maintains that ‘global macroeconomic imbalances are the underlying cause of the crisis’.1 Ben Bernanke of the Federal Reserve has said ‘in my view … it is impossible to understand the crisis without reference to the global imbalances in trade and capital flows that began in the la tter half of the 1990s’.2 In his statement before the G20 summit in Washington in November 2008, Hank Paulson, then US Treasury Secretary, referred to ‘global imbalances that fuelled recent excesses’. While the G20 leaders did not agree on the origins of the imbalances, they nonetheless noted that ‘inconsistent and insufficiently coordinated macroeconomic policies’ had led to ‘unsustainable global macroeconomic outcomes. These developments, together, contributed to excesses and ultimately resulted in severe market disruptions.’3 The unusual term ‘unsustainable global macroeconomic outcomes’ refl ected Chinese opposition to an explicit reference to imbalances.4

What is the mechanism through which these imbalances are thought to have led to the crisis?

Essentially, the United States was able to increase its debt dramatically without suffering from an inability to finance it. Surplus countries continued to buy US government securities, driving down long-term rates. The Chinese have now accumulated some $2.5 trillion of US treasuries. The imbalances gave rise to what has been called a ‘savings glut’ in developing countries which held interest rates low. That, in turn, caused investors to look for higher returns on other assets. Investors sought bond-like instruments offering a spread above the risk-free rate, in an attempt to offset the declines in that rate. That demand for yield was met by a wave of financial innovation, centred on the creation of securitized debt instruments, offering apparent security but nonetheless at a somewhat higher yield. This process drove up the capital values of risky instruments across the board. The risk premium on high yield bonds fell, in the years immediately before the crisis, to around half its long-term average.

The impact of this excess liquidity was not offset by monetary policy (Section 4). Central Banks focusing on retail price inflation took comfort from the fact that it remained low, held down by competitive imports from China and elsewhere (their competitiveness assisted, some would say, by an artificially low exchange rate).

How could these imbalances have persisted for so long? One thesis is that weaknesses in the Bretton Woods system allowed it. A country that issues assets which have reserve status around the world (as is the case with the United States) can finance current account deficits for an extended period. A second flaw is that a country facing upward pressure on the value of its currency can manage its exchange rate to resist such pressure and delay adjustment in its balance of payments. These two features of the system mean that apparently unsus tainable imbalances can continue for far longer than might seem possible. But, on the principle that if a thing cannot go on forever it will probably end one day, there was bound to be a reckoning. That reckoning took a more dramatic form than even those who had warned about these imbalances, which included several Central Banks, the BIS, and the IMF, had suspected.

Considerable support for this line of argument has emerged in the last three years. Obstfeld and Rogoff, in a thorough exploration of the relationship between imbalances and the crisis, argue that the two are intimately connected.5 They note that the US ability to finance macroeconomic imbalances through easy foreign borrowing allowed it to postpone tough policy choices. Foreign banks provided a ready source of external funding for the US deficit. So they see the imbalances as a symptom of flawed macroeconomic policy, rather than the cause of the crisis. But they conclude ‘in effect, the global imbalances posed stress tests for weaknesses in the United States, British, and other advanced country financial and political systems – tests that those countries did not pass’. As a result, Greenspan’s forecast that while the deficit could not widen for ever, the ‘flexibility of the American economy will likely facilitate any adjustment without significant consequences to aggregate economic activity’6 turned out to be well wide of the mark.

Not everyone agrees. Ricardo Caballero of MIT and Arvind Krishnamurthy, for example, argue that ‘the root imbalance was not the global imbalance but a safe assets imbalance: The entire world … had an insatiable demand for safe debt instruments which put an enormous pressure on the US financial system.’7 It was this demand for safe assets that stimulated the securitization boom, and the creation of synthetic AAA instruments.

Whatever the precise order of causation between flawed macroeconomic policies, large current account imbalances and investor demand for apparently low risk assets nonetheless yielding an attractive return, it seems clear that this combination played a significant part in the build-up to the crisis. It allowed the creation of leverage on a massive scale. But it was the interaction between the excess liquidity and financial innovation on the one hand, and monetary policy on the other, which produced a highly combustible mixture.

References

1.  Global Imbalances. Richard Portes. In Macroeconomic Stability and Financial Regulation: Key Issues for the G20, ed. Mathias Dewatripoint, Xavier Freixas and Richard Portes. Centre for Economic and Policy Research. London. 2009.

2.  A Conversation with Ben Bernanke. Conference at the Council on Foreign Relations. 10 March 2009. www.cfr.org

3.  Statement from the G-20 Summit on Financial Markets and the World Economy. 15 November 2008. www.g20.org

4.  Global Imbalances and the Financial Crisis. Steven Dunaway. Council of Foreign Relations Special Report No. 44. March 2009. www.cfr.org

5.  Global Imbalances and the Financial Crisis: Products of Common Causes. Maurice Obstfeld and Kenneth Rogoff. CEPR Discussion Paper No. 7606. December 2009. www.cepr.org

6.  Remarks by Chairman Alan Greenspan at Advancing Enterprise Conference. 4 February 2005. www.federalreserve.gov

7.  Global Imbalances and Financial Fragility. Ricardo Caballero and Arvind Krishnamurthy. American Economic Review. May 2009.

4

TOO LOOSE FOR TOO LONG – US MONETARY POLICY

The second leg of the argument that macroeconomic conditions were crucial contributors to the crisis centres on the role of monetary policy, especially in the United States. Those who attach some blame to the Federal Reserve do not necessarily think that other factors – greedy bankers, reckless innovation, sleepy regulators – were unimportant. They believe, however, that monetary policy effectively creates the climatic conditions within which financial markets operate. When the weather is foggy, or there is much ice and snow on the road, driving behaviour which might otherwise reflect a reasonable balance between speed and prudence leads to more accidents and sometimes to an unpleasant pile-up.

There are many who believe that the Fed’s interest rate policy in the early years of the century was too loose. They may give Alan Greenspan credit for relaxing policy aggressively after the dot-com bust and the Twin Towers attack, but they believe he was subsequently too slow to tighten. Between 2000 and 2003 the Fed lowered the Federal Funds target rate from 6.5 per cent to 1 per cent and did not begin to tighten until July 2004, and even then very cautiously. This long period of low short-term rates created very loose credit conditions, especially when seen in conjunction with the large infl ow of savings from overseas. It was not therefore a surprise that house prices rose consistently throughout that period. By 2006