Posted by: Dirk | April 1, 2009

What did (not) cause the financial crisis

There is post by Michael Dooley and Peter Garber on which I would like to comment on. Some weeks ago, I sent a piece to that blog and was rejected just minutes later. That left me with a feeling that is not about discussing economics, but just publishing views of established people, since my piece was arguing against what Dooley and Garber (DG) just published. But since the internet gives me the opportunity, let me use my own blog for a discussion of some important issues regarding the financial crisis. That is exactly what we need, I think. Enjoy the arguments, validate, value and think for yourselves. (Of course, you are free to comment on this, too!)

DG argue that “(t)hree important misconceptions could lead to a disastrous reform agenda:

  1. That the crisis was caused by current account imbalances, particularly by net flows of savings from emerging markets to the US.
  2. That the crisis was caused by easy monetary policy in the US.
  3. That the crisis was caused by financial innovation.

I would argue that these are not misconceptions but exactly the points where our international economic order failed. Let us take up these points one by one and then discuss later what DG see as the root of all evil:

In our view, a far more plausible argument is that the crisis was caused by ineffective supervision and regulation of financial markets in the US and other industrial countries driven by ill-conceived policy choices.

But let us return to trade imbalances. DG argue:

The idea that fraud and reckless lending flourished because US financial markets were unable to honestly and efficiently intermediate a net flow of foreign savings equal to about 5% of GDP, while having no problem with inter-mediating much larger flows of domestic savings, is astonishing to us. If so, would not the much larger gross capital flows into and out of the US also cause an outbreak of bad behaviour even without a net imbalance?

Well, 5% sounds small, so let me rephrase that: after 2001, the US experienced net capital inflows of 200 and up to 700 billion dollars a quarter (see graph by St. Louis Fed). Among these capital inflows a huge amount went to buy up treasury bonds, pushing down its return along the way. The interest rate for risk-less treasury bonds was pushed down (in this DG agree). Investors were crowded out and looking for other ways to invest. It drove them into housing, either directly by buying houses or indirectly by buying mortgage-backed (toxic) assets. Without the capital inflows from abroad, this would certainly not have happened to this extent.

In theory, it might be a win-win situation if one country invests foreign money and then returns it later with interest. Many developing countries and recently, Eastern Europe, have acted that way. Since they are capital scarce, returns to capital there should be higher than say in the old EU-15. So, huge capital inflows into the US does not automatically mean that the capital will be wasted. If they would just have hoarded the capital inflows, the US could repay its debtors now. However, the foreign capital was invested mainly into two things: the Iraq war and real estate. The return to these projects has been disastrous. (I don’t buy into a peace dividend from the Iraq adventure.) The capital was wasted, but the debt is still there.

The second part of the question is why other countries could deal with capital inflows from the US. Well, I think the reason is that their banking systems were healthier than that of the US. Of course, countries like Spain, Ireland and Great Britain also had real estate bubbles, so maybe, yes, there was also an outbreak of bad behaviour. And even in Germany, where the real estate market was quiet, banks behaved bad by buying risky assets they did not understand.

Let me repeat the argument again: trade imbalances cause international capital flows (by accounting identity). The larger the imbalances, the larger the capital flows. Whereas inside countries, debtors can default only with a lot of stress, exchange rate movements make defaults relatively easy. Also, investing in a foreign country is riskier for banks since they might not fully understand what they are doing. Also, in the long run what flows in will flow out, and currency crisis have been with us since the end of Bretton Woods.

Now, let’s face the second issue, that of lax monetary policy on behalf of the Fed. I cannot really see the argument of DG clearly. This is how they end their paragraph:

This pure bubble idea does not provide much guidance for reforming the international monetary system. Clearly we should enforce prudential regulations that discourage people from acting on such expectations. But do we really want to reform away anything that causes real interest rates to fall and asset prices to rise?

If I understand it, they say that if low interest rates caused the crisis, should we then abandon low interest rates? This is clearly missing the core of the problem. With hindsight, it was a bad idea to use inflation targeting and neglect financial market developments. The low nominal and real interest rate in the US caused an explosion in the value of financial assets, but lead to only slight reductions in unemployment. However, the Bush administration was probably fine with that. While rising imports meant that the job market was weak, at least those with financial assets or working in Wall Street firms had a really good time.

Nevertheless, I would argue that global imbalances were to blame first. Monetary policy probably helped to increase the bubble, but it did not create it in the first place. However, central bank policies need reforms badly after the crisis is over. Disregarding debt has proved to be fatal.

Now to the last point of financial innovation. Here are DG:

The problem was not financial innovation but the failure of regulators to recognise that innovation generated new ways to exploit moral hazard. Even more, it was the wilful ignorance of policymakers in often overriding the instincts of regulators and financial institutions in order to implement a desired flow of funds to untrustworthy borrowers.

I agree with this. However, financial innovation exists to exploit holes in the regulation. These days, a financial innovation by definition takes advantage of loopholes in regulation. Think of off-shore finance, taxation of hedgefunds, securitization, the carry trade, and the list goes on. Regulation that could have reigned in these innovations was subsequently blocked by lobbying from the same financial firms that exploited them. How this is a failure of regulation is not clear to me.

Let me state my alternative explanation very shortly to conclude this article. I think that imbalances in the global economy caused capital flows from poor to rich countries (against what Heckscher-Ohlin would predict). Investing capital in a capital-rich economy is a bad idea. Struggling to put the capital to use that did not go to the administrations coffers, it finally went into real estate. If we wouldn’t have had an IT bubble in 2000-01, it would have probably gone there. When buyers for houses ran out, banks lowered standards and lent to the NINJAs. with implicit approval from Greenspan’s Fed. Greenspan believed in free unregulated markets, so this was a decision he made on purpose. That’s it.

And for reforms? DG write:

When markets recover, the key lesson is that the industrial countries need to focus on moral hazard, public and private, as the source of the problem and apply the prudential regulations they already have to financial entities that are too large to fail. It is not sensible to try to limit international trade and capital flows, to ask central banks to abandon inflation targeting, to stifle financial innovation, or to regulate entities such as hedge funds1 that do not generate systemic risks.

I agree with this and then I do not. DG want us to “apply the prudential regulations they already have to financial entities that are too large to fail”. Sorry, but this is just wrong. Lehman as an investment banks was too large to fail, but the Fed had to bend the rules to help it and others. Regulation of investment banks? The Glass-Steagall act was repealed in the 90s, and we are left without huge parts of the regulation that were enacted after the Great Depression. Reason: we could now manage risk in better ways. Yeah, right.

I also disagree with the way they present those that want to reform the international economic order. These people are not against trade or capital flows in general. Every economics students knows that you can play beggar-thy-neighbour with an undervalued currency, and this can cause major problems if it is done by a big player (like China). DG always argue pro-market, but why should then the value of the Yuan not be determined on the free market? This is inconsistent, in my view.

Also, why should inflation targeting not be abandoned? Monetary policy was the only tool available to soften the blow, and it did only help to increase the bubble that subsequently imploded. What’s the use of monetary policy if it is pro-cyclical, that it increases growth in good times and makes matters worse in bad times? Economic policy for stabilization is needed. (We already know that free markets bring with them efficiency.)

Last but not least how can DG call for more regulation but then without stifling innovation? There is a trade-off involved in this. You cannot have more regulation and more innovation at the same time. Also, if you do not regulate hedge funds, how can you the determine whether they pose a systemic risk? Was LTCM judged a systemic risk before it had its troubles? This is impossible to judge from the outside, and we have just seen how markets regulating themselves actually do not.

What is also interesting is those things that DG do not write about, like the failure of monetary policy. Monetary policy has hit the zero bound, traditional use is not possible anymore. Ben Bernanke has to open his tool kit and take a deep look inside to find some instrument with which to influence things. In DG, there is also nothing about how we get out of this mess we are in. Supposedly, some regulation could solve all our problems. The last time monetary policy failed was during the Great Depression, and it took more than just better regulation to get out of that one. On one hand I wish DG were right, but on the other hand my economist’s education tells me it won’t happen that way.



  1. I agree that Bernake needs to open up his playbook

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