Barry Eichengreen got it right, I think. His account of the financial crisis was published in mid-September on voxeu.org. Here are the three main points:
- At the domestic level, the key decisions in the United States were to deregulate commissions for stock trading in the 1970s and then to eliminate the Glass-Steagall restrictions on mixing commercial and investment banking in the 1990s.
- The other key element in the crisis was the set of policies giving rise to global imbalances. The Bush Administration cut taxes, causing government dissaving. The Federal Reserve cut interest rates in response to the 2001 recession. All the while the financial innovations described above worked to make credit even cheaper and more widely available to households.
- Of equal importance were the rise of China and the decline of investment in much of Asia following the 1997-8 crisis. With China saving nearly 50 per cent of its GNP, all that money had to go somewhere. Much of it went into U.S. Treasuries and the obligations of Fannie Mae and Freddie Mac. This propped up the dollar. It reduced the cost of borrowing for U.S. households by, on some estimates, 100 basis points, encouraging them to live beyond their means.
My account is very close to this. But let us start from the beginning of the story: the bust of the real estate and asset bubbles in Japan in the 90s. In December 1989, the Japanese twin-bubbles reached their peaks. (How it got their is an interesting story itself, featuring negative nominal interest rates!) What followed were harsh corrections. The stock market lost 30% back to back in 1990 and 1991. The real estate market went down as well. There was no bank run because of (over)confidence in the government, however. So many banks and firms lived on as zombies.
Much capital fled the country. Newly deliberalized financial markets in Scandinavia let to big capital inflows there, destabilizing the economies and leading to a financial crisis there. More capital went to the East Asian economies of Thailand, Malaysia and Indonesia. After these economies also imploded when investors lost confidence and pulled out their money, much of the capital went to the US.
Here is an excerpt from Charles Kindleberger’s book Manias, Panics, and Crashes (5th ed., 2005, p. 164), whose ch.8 Bubble contagion: Tokyo to Bangkok to New York describes more extensively what I wrote above:
Japan, Thailand, and the other Asian countries, and then the United States experienced remarkable economic booms. Growth rates increased and yet inflation rates remained modest, perhaps because the currencies were appreciating and the declines in the prices of imported goods dampened upward pressure on the domestic price levels. The pattern of cash-flows of each of these episodes was Ponzi-like – thus the real estate investors in Japan in the 1980s obtained all the money they needed to pay the interest to the bank lenders from these banks in the form of new loans. This pattern of cash flows wasn’t sustainable and it wasn’t sustained.
This verbal exposition seems to be very close to reality. We have experienced low inflation in the US and worldwide, US growth rates have been higher than average in both stock market and the economy. Also, the share of the financial sector in total private sector gains has increased to 40%. Last week, I visited my colleague Ronny Mazzocchi in Milan and we came up with an idea of how to model this. Here is how it goes. First, you take a financial market which clears savings and investment. But, instead of setting investment equal to saving, we have a situation where inflows of foreign capital fill in the gap whenever savings fall short of the private sectors appetite for capital. Much of the private sector plans to invest the capital in other financial assets, so that the real economy grows above average but without inflation. Also, this explains the low saving rate of US consumers, who feel richer and richer when asset prices increase. Here is the diagram:
After 9/11, the Fed set the interest rate at a very low level. It was doing this complying with inflation-targeting: if the economy threatens to slide down to a recession, a decrease in the interest rate will stimulate economic activity. Back then, not many economists critisized this policy. (Maybe commentators were afraid to question offical US/Fed policy.) The graph shows that at the low interest rate, savings were scarce and investment demand large. Capital inflows from China, Saudi-Arabia and the rest of the world filled the gap. China did this to stabilize its exchange rate vis-a-vis the dollar, and other countries invested in the US as before: either they had no domestic market to invest in, or they wanted to profit from the expected stock market frenzy in the US, or they wanted to diversify their risk.
The capital inflows were also encouraged by US policy: deregulation of the financial market, inflation-targeting monetary policy without concern for financial bubbles, weak performance of the regulatory environment (self-imposed, like rating agencies, and government sponsored, like the Fed, which did not regulate sub-prime mortagages) and political mismanagement (like increasing home-ownership through Freddie and Fannie). The above graph has a theoretical flaw, which should be mentioned here. Savings are a stock, while investments are a flow. However, this should not stop us from using the graph to conclude that we have a positive supply and demand shock each period, which we will draw into the familiar AD/AS model:
So, this is it. Each period, the capital inflows cause a shift of aggregate supply (AS) to the right and also of aggregate demand (AD). AS is shifted since the inflow of capital causes extra investments, which translate into higher capital stock and higher production capacity. AD is shifted since a) net investment increases b) actual consumption increases (because of less saving). The (unstable) equilibrium shifts to the right, output is higher than before. This is repeated as long as the gap between savings and investment is filled by capital inflows. Finally, when it becomes obvious that the new investments in real estate and also firms listed in the stock market is not sustainable, capital flows out and triggers some kind of adjustment process. If the interest rate is above the equilibrium level, demand for investment is lower than supply of savings. The difference constitutes a capital outflow. We have seen this type of crisis in East Asia in 1997: capital flight sets in, and the currency depreciates quickly.
So the relevant policy question is: can the Fed do something to stop the capital flight from happening? Should it try to do so, or will it only delay adjustment? Stopping capital outflows by political intervention is harder than in the past. Instead of friendly European nations, negotiations this time include China, Saudi-Arabia and other oil-rich countries.
UPDATE: I have just read Paul Krugman’s piece on how the international finance multiplier turned a global financial system into a global financial crisis. It is an international variation of the theme of debt deflation and captures the story nicely.