A New Meme: Blame It on Beijing (and Seoul, and Riyadh…)

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, 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.

Originally published at Econbrowser and reproduced here with the author’s permission.

2 Responses to "A New Meme: Blame It on Beijing (and Seoul, and Riyadh…)"

  1. MC-Shalom   January 22, 2009 at 11:20 am

    You Bail Them Out, We Opt Out.

    Dear [May Be Too Much? Ok] Expensive Chairman Ben S. Bernanke,

    All of Our Economic Problems Find They Root in the Existence of Credit.Out of the $5,000,000,000,000 bail out money for the banks, that is $1,000 for every inhabitant of this planet, what is it exactly that WE, The People, got?If your bank doesn’t pay back its credits, how come you should pay it back yours?If your bank gets 0% Loans, how come you don’t?At the same time, everyday, some of us are losing our home or even our jobs.Credit discriminates against people of lower economic classes, as such it is unconstitutional, isn’t it? It is a supra national stealth weapon of class struggle.Credit is a predatory practice. When the predator finishes up the preys he dies. What did you expect?Where are you exactly in that food chain?

    Credit is a Stealth Weapon of Mass Destruction.Credit is Mathematically Inept, Morally Unacceptable.You Bail Them Out, We Opt OutOpting Out Is Both Free and Completely Anonymous.The Solution: The Credit Free, Free Market Economy.Is Both Dynamic on the Short Run & Stable on the Long Run, The Only Available Short Run Solution.I Am, Hence, Leading an Exit Out of Credit:

    Let me outline for you my proposed strategy:

    Preserve Your Belongings.The Property Title: Opt Out of Credit.The Credit Free Money: The Dinar-Shekel AKA The DaSh, Symbol: .Asset Transfer: The Right Grant Operation.A Specific Application of Employment, Interest and Money.[A Tract Intended For my Fellows Economists].

    If Risk Free Interest Rates Are at 0.00% Doesn’t That Mean That Credit is Worthless?Since credit based currencies are managed by setting interest rates, on which all control has been lost, are they managed anymore?We Need, Hence, Cancel All Interest Bearing Debt and Abolish Interest Bearing Credit.

    In This Age of Turbulence The People Wants an Exit Out of Credit: An Adventure in a New World Economic Order.

    The other option would be to wait till most of the productive assets of the economy get physically destroyed either by war or by rust.It will be either awfully deadly or dramatically long.A price none of us can afford to pay.

    “The current crisis can be overcome only by developing a sense of common purpose. The alternative to a new international order is chaos.”

    – Henry A. Kissinger

    They Bail Out, Let’s Opt Out!Check Out How Many of Us Are Already on Their Way to Opt Out of Credit.

    Let me provide you with a link to my press release for my open letter to you:

    Chairman Ben S. Bernanke, Quantitative [Ooops! I Meant Credit] Easing Can’t Work!

    I am, Mister Chairman, Yours Sincerely [Do I Have Really Have the Choice?],Shalom P. Hamou AKA ‘MCShalom’Chief Economist – Master Conductor1 7 7 6 – Annuit CœptisTel: +972 54 441-7640

  2. Guest   January 28, 2009 at 3:04 pm

    Please, will some grownup delete the gibberish among the comments?