How the Crisis spread around the World
It is amazing that a crisis that began in the US housing market, and apparently resulted from the making of unwise “sub-prime” loans to US mortgagees spread like wild fire around the world. There have actually been three channels through which this has happened.
Firstly, the mortgage-backed securities (MBS) and other “toxic bonds” were bought by banks and investors all around the world. Everywhere they lost value. This was particularly important in Europe. Everywhere owners of such bonds felt unsure about their true value.
Secondly, there is the drying up of the wholesale market. The uncertainty about the value of these “toxic” bonds, and hence uncertainty not just what a bank’s own position was but also about the financial situation of “counterparties” – other banks and institutions – led to the credit crisis, I have already discussed this. Any institution that had been depending on borrowing short term in the wholesale market was affected. This effect was very widespread and was felt even when an institution did not own any of the “toxic bonds”. Two examples are the British mortgage bank Northern Rock, which depended heavily on borrowing short term in the wholesale market, and had very little capital of its own, and also a surprisingly low base of retail deposits. Other examples are the three Icelandic banks that had greatly expanded internationally, financing themselves also by borrowing short term on the international wholesale market.
Thirdly, many countries were affected by the expectation of a severe US recession (and perhaps a European recession) and no doubt will be affected by the actual recession that, at the time of writing, seemed to be on the way. This effect goes mainly through trade, especially the fall in world commodity prices. This expectation no doubt explains both the sharp decline in the value of the Australian dollar and in the Australian stock market. This transmission process can be important, as in the Australian case, even when the other two transmissions, just discussed, are not.
Too much Monetary Expansion? Was Greenspan at fault?
It is common in the US to blame the Fed – and specifically its former chairman, Alan Greenspan – for excessive credit expansion, which then gave rise to the speculative housing boom, leading eventually to a bubble, which ended with disastrous effects. In other words, the argument is that it was excessive US monetary expansion rather than the international savings glut that caused the US housing boom and thus the troubles that followed. This raises a question: what is the relationship between US monetary policy and the international savings glut which I have regarded above as the first step in the process that led to the crisis?
The answer can be put very simply in words, but can also be expounded clearly with the help of a familiar diagram. While one could interpret my analysis as referring purely to the United States, I shall have in mind here a One World story, in effect treating the whole world – tied together by the international capital market – as one country.
An increase in savings would be deflationary if the real interest rate did not change, or did not fall sufficiently. A fall in the real rate of interest is then required to stimulate both investment and dissaving, and in this way employment could be maintained. I shall call the maintenance of the initial employment and inflation rate – assumed to be a desirable combination – “internal balance”. Appropriate monetary expansion can bring this about. In practice the Fed was very successful in maintaining “internal balance” in the United States once the economy had recovered from the “dot com” boom and slump. Hence credit expansion fostered or permitted by the Fed’s monetary policy was required if internal balance was to be maintained while the economy was hit by the deflationary impulse of the savings glut.
The IS-LM Diagram
Figure 1 is the Hicksian IS-LM diagram. The vertical axis shows the real rate of interest (r) and the horizontal axis shows real income and output (Y). The LM curve is drawn for a given real money supply (defined broadly), and the IS curve shows the level of income for any given interest rate.
We start with LM0 and IS0, and equilibrium at point A. Increased net savings shift the IS curve to IS1. If the interest rate stayed constant equilibrium would be at the deflationary equilibrium at B. But, suppose the interest rate is flexible, being determined by monetary (credit) policy. If the money supply stayed constant (Mr Greenspan did nothing) equilibrium would be at C. But if he followed an “internal balance” policy designed to restore income (and output, as well as the inflation rate) at its original level Y0, he would have to increase the money supply, shifting the LM curve to LM1.
The new equilibrium will then be at D. The interest rate will have fallen, and it would appear that this was brought about by central bank monetary policy that had shifted the LM curve to LM1. But it was actually the inevitable by-product of the increase in saving, given the commitment to an “internal balance” policy. It follows that critics of the Greenspan policy are really criticising his “internal balance” policy. Given the international savings glut, this policy made monetary expansion, and hence a decline in the real interest rate, inevitable.
Should Monetary Policy have pierced the Bubble?
There is a related criticism, which is actually more serious and raises a question about the pursuit of an “internal balance” policy. Such a policy ignores asset bubbles provided the bubbles do not affect real income and the inflation rate. Asset prices affect this policy only insofar as they affect the cost-of-living index and thus the rate of inflation as this term is generally understood.
It is possible to have an asset bubble, such as a housing boom, while the inflation rate is unaffected, or perhaps is kept down by some offsetting factor. Indeed, this is what happened initially in the United States. But once the bubble ends – often with a crisis – aggregate demand is likely to be reduced, as indeed has happened recently when the housing market crashed. Thus the Greenspan policy seems to involve no monetary policy concern with the bubble when an asset market bubble starts, or no intervention to prevent the start of such a bubble, but it does call for intervention when the bubble ends if this ending reduces spending and thus aggregate demand.
The problem is that there are potentially two objectives of monetary policy, namely the preservation of “internal balance” as defined here, and the prevention or moderation of asset bubbles. The main examples of such bubbles are in housing and in the stock market. But if there is only one instrument of policy – namely monetary policy – some sacrifice of “internal balance” would be required if there is to be a significant impact on asset prices. This is a genuine dilemma. Increasing the interest rate in order to kill a nascent housing bubble may involve serious effects on output and employment.
One should then consider whether a second policy instrument (or set of instruments) could be found to influence housing and stock market bubbles. I cannot pursue this here, though I suspect the answer involves special taxes or controls. This needs to be explored further.
Is China to blame?
In the developing country debt crisis of the eighties the blame was put on the borrowers, who had apparently borrowed unwisely and had used their borrowed funds inefficiently. But now, when the principal borrowers are in the United States, the blame is often put not on the borrowers but on the countries that generated the high savings, and especially China. It is argued that China ought not to have run such high current account surpluses, reaching 11% of GDP in 2007. Here it must be remembered (as I have noted in Part I) that China, while the largest exporter of capital in 2007, only accounted for 21.4% of total capital exports in 2007, and indeed its surplus was only significant from 2005. There were many other capital exporters, notably Japan over a long period, Germany, and since 2003 the oil exporters.
Whether it is in the interest of the various savings-glut countries to run high current account surpluses is a matter for them, for their governments and their various corporations and individuals. A careful study might suggest that China would have been wise to increase its domestic consumption. On the other hand it may be sensible for a fast growing high-investment country like China to temporarily park some of its savings abroad. (I have called this the “parking theory” in Corden, 2007). Each country has its own story. Surely one does not have to agree with Polonius (in Hamlet) “Neither a borrower nor a lender be”, especially internationally. It is the job of the various firms in the international capital market, notably banks, to intermediate capital flows from lenders to borrowers as efficiently as possible.
There will always be savers who want to lend and others who want to borrow, whether within a country or across borders. This is a form of inter-temporal trade, and there are potentially gains from such trade, as from ordinary trade in goods and services. It should also be remembered that in countries with rapidly ageing populations (notably Japan and Germany) it is likely to be thoroughly rational to have a high level of savings relative to income for certain periods, while fruitful investment opportunities may be limited. They are thus likely to have current account surpluses (see Cooper, 2007). We can always expect periods when some countries have high savings levels, perhaps temporary, while others have investment booms leading to current account deficits.
One should plan to achieve an international economic system where there can be global imbalances, usually temporary, but without crises. One can think of important examples in the nineteenth and early twentieth century when there were significant imbalances. But it is certainly desirable that current account deficit countries use their funds for investment rather than consumption, other than during wars and environmental disasters. The fault and the failures in this recent crisis have been not with ultimate lenders or borrowers – other than US sub-prime mortgagees – but with the financial intermediaries, often highly paid .
How is this Crisis related to the often expected Crisis of Global Imbalances?
Until this latest crisis, the crisis that was widely expected was one resulting from the “global imbalances”, and specifically concerning the US dollar. The United States was running a large current account deficit, and from 2002 to 2005 a large fiscal deficit. It was argued that this was unsustainable and would end in a dollar crisis. Such a crisis would be set off by speculation against the dollar, and then a possibly dramatic drop in the dollar, presumably relative to many currencies, but especially the Euro.It was widely argued that something should be done to reduce those imbalances before a crisis resulted.
I argued, by contrast, in Corden (2007) first, that such imbalances were not necessarily undesirable, since they represented inter-temporal trade (and there is no reason to favour home bias in the international capital market), and second, even though they must inevitably end or decline, they need not end in crises. Nevertheless there were various possibilities which I explored, notably the effects of a decline in the surpluses of the savings glut countries – which would lead to a rise in the world interest rate – and a decline or end to the US fiscal deficit which would lead, in contrast, to a fall in the world real interest rate.
As I explained earlier the crisis we have actually had begun with a world-wide credit boom which is explained by the same savings glut – the various current account surpluses – which formed the centrepiece of the global imbalances discussion. But the current crisis was not caused by the imbalances. If the US fiscal deficit had been reduced more, or if private savings in the US had increased substantially, the imbalances might have declined, but the credit boom would have been even greater. If savings had increased in most or all countries that initially had a current account deficit, the imbalances might conceivably have disappeared completely, but the world-wide credit boom would have been huge. Of course, I am assuming that the various countries’ monetary policies would have been expansionary to maintain internal balance in their countries.
It may seem surprising that the US dollar has actually gone up relative to most other currencies, especially the Euro. The explanation is that the initial “search for yield” has been converted by the panic to a “flight to safety”. And US Treasury bills have been seen in the market as the safest asset to hold. Thus there has been a movement away from private sector investments of all kinds, reflected in world -wide declines in stock markets, and also away from government bonds of many countries. Only government dollar and yen bonds seem to have been attractive, so that yields (interest rates) on those two have declined, while required yields on many or almost all private bonds and equities world wide have risen, in many cases very sharply.
The net result is that the value of the dollar in the foreign exchange market has actually gone up relative to almost all floating currencies other than the yen. This is very different from the horror stories of dollar crash envisaged earlier. Thus this crisis is very different from the one that was widely expected.
The Keynesian Situation
In my exploration of possible crises or problems that might arise as a result of the global imbalances (in Corden, 2007) one possibility I discussed was what I called the “Keynesian situation”. If the US fiscal deficit were reduced or eliminated, while the savings glut in various surplus countries continued, the world real interest rate might fall to zero (assuming appropriate monetary expansion). But then monetary policy will have reached its limits, and Keynesian fiscal expansion, perhaps coordinated among major countries, would be needed. This is a situation very similar to the one we have currently, except that the reason for the world-wide decline in demand is not an elimination of the US fiscal deficit, but rather a breakdown in the world’s financial sector, and the consequent panic reaction. But there is actually a desperate need now for a coordinated – or even uncoordinated – fiscal expansion.
This blog as well as the previous one (Part I) is based on a longer Working Paper of the Melbourne Institute of Applied Economic and Social Research, which also discusses “What is to be done”. This 2008 Working Paper is accessible at
Cooper, R. (2007) ‘Understanding Global Imbalances’, Brookings Papers on Economic Activity, No.2.
Corden, W.M. (2007) ‘Those Current Account Imbalances: A Sceptical View’ The World Economy,30, 363-382.
Mankiw, N. G. (1994) Macroeconomics. Second Edition, Worth Publishers.