Paul Krugman, in today’s column at the NY Times, has compared the experiences of the US and Canada in the financial crisis and finds the following:
It wasn’t interest rate policy. Many commentators have blamed the Federal Reserve for the financial crisis, claiming that the Fed created a disastrous bubble by keeping interest rates too low for too long. But Canadian interest rates have tracked U.S. rates quite closely, so it seems that low rates aren’t enough by themselves to produce a financial crisis.
Canada’s experience also seems to refute the view, forcefully pushed by Paul Volcker, the formidable former Fed chairman, that the roots of our crisis lay in the scale and scope of our financial institutions — in the existence of banks that were “too big to fail.” For in Canada essentially all the banks are too big to fail: just five banking groups dominate the financial scene.
Krugman concludes that it is regulation of the Canadian financial system that led to Canada’s better path through the financial crisis. In a joint paper with Finn Körner, I have shown another explanation that fits quite well with the Canada/US comparison: net capital inflows from the rest of the world, invested mostly in government bonds, invested mostly by China.
The logic is the following (read the paper for a longer version): China has large net exports in order to grow. That would lead to currency appreciation, if not for the sterilization of the central bank: Export earnings to a large part are held in US dollar assets. Since the People’s Bank of China is quite risk-averse, the money is invested in US treasury bonds. This drives the price of those bonds up and its yield down. It did so until the yield was below the inflation rate, leaving US savers who have invested in that asset with a negative return (yield minus inflation was below zero). This situation lasted for the years 2002-6 (graph taken from our paper, data source is FRED2):
US savers were crowded out of treasury bonds, which is a very large asset class. As the debt was rolled over, more and more US savers – or better, pension funds, hedge funds and whoever was in charge of investing the savings- went to look for alternatives. They found these in real estate and in the stock market, building up big bubbles there.
The regulation of the US financial markets was not much worse than that in Canada. However, with the pressure building up, the regulation was undone because of endogenous pressure. Net capital inflows increase US asset prices but decrease the yields (at least with bonds), so the players on the financial market were pushed to innovate.
To be clear: yes, the reduction of regulation helped the crisis to develop, but that was not the causa sine qua non. It is the net capital inflows that put pressure on regulation, and these inflows mainly stem from the integration of China into the world economy. China relies on an undervalued exchange rate to expand its exports, and has done quite well. Why it has to rely on this arrangement? Probably this has something to do with New Economic Geography, where industry location depends on trade costs and increasing returns to scale, and where industries can be attracted and locked-in by subsidizing production for a while. Anyways, let’s get back to the issue of where the US and Canada differ.
Using data from CANSIM (which cost me 6 Canadian dollars and will cause problems when I try to put this one on the faculty’s tab) I was wondering whether China had bought into Canadian bonds just as in the US. The answer is: no.
China is part of the “all other countries” group, which is depicted as red in the graph above. Its share in “total, all countries” is low and stable. Therefore, I would suppose that the yield of government debt from Canada did not deliver negative real returns like in the US. Again, the data available confirms this (source: Bank of Canada/ Banque du Canada):
The nominal yield of Canadian government bonds can be approximated by the interest rate. So, if the interest rate minus inflation turns negative, then the real yield of Canadian government bonds is below zero – savers in Canada lose purchasing power. This happens only for about 6 months around January 2003. This is very different from the US situation.
Summing up, the regulation of banking and finance in Canada has been better than in the US. However, the pressure from foreign capital inflows did not exist in Canada as they existed in the US. It is wrong to assume that better regulation is what saved Canada. The US had good regulation, too, but that was dismantled due to domestic pressures (before and during the housing bubble). It is the fall of the US bonds yield and the subsequent crowding out of US savers that led to Wall Street’s search for investment opportunities. Regulation was swept away by the financial sector in an attempt to find higher yields.
Did China cause the crisis then? We don’t think so. There had been other net exporters, like Germany and Japan, which left few choices to China to find markets for its products. While Germany had a flexible exchange rate, Japan piled up foreign reserves just as China. So did many oil-exporting countries. It is these global imbalances together that caused the crisis.
In our paper we conclude:
Regarding the integration of China into the world economy Corden (2007) proposes not to resist the shock but rather to accommodate it. We concur.