The Very Important and of Course Blacklisted BIS Paper About the Crisis

Admittedly, my RSS reader is hardly a definitive check, but it does cover a pretty large number of financial and economics websites, including those of academics. And from what I can tell, an extremely important paper by Claudio Borio and Piti Disyatat of the BIS, “Global imbalances and the financial crisis: Link or no link?” has been relegated to the netherworld. The Economist’s blog (not the magazine) mentioned it in passing, and a VoxEU post on the article then led the WSJ economics blog to take notice. But from the major economics blogs and publications, silence.

Why would that be? One might surmise that this is a case of censorship. Borio has been a long-standing critic of the Greenspan and later Bernanke thesis that central banks should ignore asset and credit bubbles if prices are stable. He and William White went public (as public as you can go in the BIS) in 2003 with their contention that an international housing bubble was underway and action was warranted. Greenspan and virtually all other right-thinking economists ignored the bubble and other signs of trouble (like a sustained near zero consumer savings rate in the US) and drank the Great Moderation Kool-Aid instead.

Despite the overwhelming evidence of their colossal pre-crisis screw-up, most academic economists are unwilling to admit much if any error. And they are generally respectful towards Bernanke (the fact that the Fed is the biggest single source of funding for academic research no doubt contributes to the deference shown to the central bank).

The paper is important for a second reason: it seeks to address the limited and imprecise thinking about the relationship between the financial markets and the real economy. I cover some of this ground in ECONNED. The shortcomings of prevailing macro models include: an equilibrium assumption (by contrast, financial markets, which impact the real economy, have no propensity to equilibrium), no role for credit, banks, or even money (except sometimes in error terms).

In addition to its heretical views, another reason the Borio/Disyatat paper has gotten less attention than it warrants is that it is written densely and defensively, perhaps a response to the way the clear and well documented White/Borio papers on the housing bubble were dismissed as having no theoretical foundation. I read it early in the summer, and have dragged my feet in posting on it because it would be difficult to do it justice in a single piece. It should have occurred to me sooner to write about it over two or three posts.

However, I may simply not have been up to the task of making it accessible. Our Andrew Dittmer (a Harvard Phd in mathematics who among other things, has taught group theory to seventh graders) has converted the paper into Layspeak:

The May 2011 Bank of International Settlements paper by Claudio Borio and Piti
Disyatat is quite important It suffers, however, from one defect: it is not written in English, but in economese. I have therefore taken the liberty of poetically translating it into our language (and adding occasional remarks here and there). All numbers below are references to page numbers in the original paper.

* * * * *

The global financial crisis led to widespread dislocations and misery. However, another set of victims, hitherto overlooked, were central banking authorities and professors of economics who had staked their names on the thesis that the current configuration of the global financial system (which they had helped to engineer) was generally wonderful. These unfortunate souls were forced to come up with an explanation for the crisis on short notice, and it had to be an explanation in which they themselves played no role.

Ben Bernanke et al. rose brilliantly to the challenge. They remembered that many Asian countries had stocked up on foreign currency reserves in the hopes of never again being at the mercy of the IMF (26, note). Obviously, trying to resist the IMF was wrong and deserved criticism. Moreover, saying bad things about the Chinese would inevitably be welcomed in foreign policy circles eager to talk about the coming “bipolar confrontation” between America and China.

This “savings glut” theory argued that savings by Asian (and Middle Eastern) countries had washed like a tidal wave onto US financial markets, effectively forcing US money managers to invest imprudently in the course of their attempts to cope. For instance, these “excess savings” were widely assumed to have reduced long-term interest rates, thereby making credit cheaper.

There were some obvious problems with the global imbalances theory. Before the crisis exploded, many of the same economists had pointed to the same imbalances as a happy coincidence of needs, leading to better results for all (23). According to the sort of economic theory that was used in these explanations, if “global imbalances” were causing long-term interest rates to fall, that was simply a natural market outcome that should be contributing to equilibrium (23).

Consistency is the hobgoblin of little minds, and the “excess savings” theory was duly welcomed. It was even paid the supreme compliment of being accepted by Goldman Sachs’ lobbying division (see Effective Regulation, part 1, page 1).

Despite the consensus of these eminent authorities, we have decided to take a second look at the theory. Unfortunately, we have found further problems.

The idea of “national savings” or “current account surplus” refers to the total amount of exports sold minus the total amount of imports sold (more or less). The “excess savings” theory holds that this excess had to have been financed somehow, and so presumably by countries in surplus, like China.

However, for the US in 2010, the total amount of financial flows into the US was at least 60 times the current account deficit (9), counting only securities transactions. If this number were correct, then inflows would be 61 times the current account deficit, and outflows would be 60 times the current account deficit. The current account deficit is a drop in the bucket. Why would anyone assume it had anything to do with the picture at all?

Moreover, if the “savings glut” theory was correct, we would expect there to be certain historical correlations between the following variables: (a) current account deficits of the US, (b) US and world long-term interest rates, (c) value of the US dollar, (d) the global savings rate, (e) world GDP. There aren’t (4-6, see graphs).

You would also expect credit crises to occur mainly in countries with current account deficits. They don’t (6).

Suppose we look at a more reasonable variables: gross capital flows (13-14). What do we learn about the causes of the crisis?

Financial flows exploded from 1998 to 2007, expanding by a factor of four RELATIVE to world GDP (13), and then fell by 75% in 2008 (15). The most important source of financial flows was Europe, dwarfing the contributions of Asia and the Middle East (15). The bulk of inflows originated in the private sector (15).

If we look instead at foreign holdings of US securities (15-16), Europe is still dominant, but China and Japan are a little more prominent due to their large accumulations of foreign exchange reserves (15). Still, the Caribbean financial centers alone account for roughly the same proportion as either China or Japan (16). Other statistics provide a similar picture (17-19).

So what caused the crisis? Clearly, the shadow banking system (mainly based around US and European financial institutions) succeeding in generating huge amounts of leverage and financing all by itself (24, 28). Banks can expand credit independently of their reserve requirements (30) – the central bank’s role is limited to setting short-term interest rates (30). European banks deliberately levered themselves up so they could take advantage of opportunities to use ABS in strategies (11), many of which were ultimately aimed at looting these same banks for the benefit of bank employees. These activities pushed long-term interest rates down. Short-term rates remained low because the Fed didn’t raise them as long as inflation didn’t appear to be an issue (25, 27).

The Asian countries played a small role as well. They didn’t want US/European-driven asset price inflation to spill over into distortions in their economies, and so they protected themselves by accumulating foreign exchange reserves (26 and 26 note). That was mean of them. If they had allowed more spillover, then the costs of the shadow banking system would have been partly borne by them, and that would have made the credit crisis less severe in the advanced countries (26). As things stand, instead, the advanced countries are suffering, while Asian countries have bounced back strongly (26).

What should we do? Well, we have suggestions for theory and practice. Let’s start with the practical suggestions.

Countries should do a better job of restraining their financial sectors (24). However, that will probably not be enough (24). Countries should also work together to share the burden of consequences of further crises (27). Unfortunately, countries are irrational and political and so are often unwilling to cooperate in ways we consider wise (27).

Since we can’t count on other countries doing the right thing, we will have to count on the Fed instead. If there is another boom in asset prices, the Fed should cool it off by raising interest rates and so inducing deflation in the rest of the economy. The balance of views in the international community has been shifting in this direction (27).

As for the theory, maybe you are wondering what was wrong with economics that led people to believe in the “savings glut” theory. We have a few ideas.

First, most present day macroeconomic analysis proceeds by imagining that people only trade physical objects with each other. They don’t use money, and they certainly don’t make loans or go bankrupt. Even though the people that make these analyses know that in the real world money and loans and bankruptcy DO exist, they think that is useful to pretend that they don’t and then arrive at authoritative conclusions. We would like to beg them humbly to reconsider this blind spot (2, 12, 21, 27-31).

Second, current analyses of interest rates make a distinction between the “market” interest rate and the “natural” interest rate. The distinction between these two rates is very subtle, so we’ll explain it carefully.

The “market” interest rate refers to the interest rates people pay on various kinds of loans. The “natural” interest rates is an unobservable variable that is equal to whatever economists decide the interest rate really ought to be for the purpose of some model. Usually, this imaginary interest rate is calculated in such a way that whatever the Fed and banks and hedge funds do, it can never change. It only depends on what physical goods are bought and sold in the economy (1-2, 20-23, 29).

In the past, economists have decided to use the imaginary interest rate instead of the actual interest rate. We don’t want to be disrespectful, but is there any chance they might be willing to change their minds?

This post originally appeared at naked capitalism and is reproduced with permission.