Explanations for the global financial crisis tend to focus on two themes: (1) subprime mortgages; and (2) global imbalances. More sophisticated explanations generally link these two themes directly. In 2005, then-Governor Ben Bernanke gave a speech entitled the “Global Savings Glut,” that did precisely that. Bernanke argued that large U.S. trade deficits and unusually low long-run interest rates were caused by an excess of savings in China, developing Asia, and oil exporting states.
In balance of payments accounting, the current account balance is equal to a nation’s domestic savings minus its domestic investment. Nations that are excessive savers generate large current account surpluses that must be matched with current account deficits elsewhere in the world. Bernanke speculated that the increase in saving was motivated by a desire to build foreign currency reserves and avoid a replay of the 1998 financial crisis, when a sudden reversal of fund flows caused several Asia economies to collapse. Since the desire to accumulate foreign claims was understood to be primarily motivated by a desire to “insure” against macro instability, it made sense that the lending was directed disproportionately to the U.S. since the U.S. dollar is the world’s reserve currency and U.S. Treasury securities the world’s benchmark asset.
At its peak, the savings glut pushed the U.S. current account deficit to more than 6% of GDP (equivalent to $927 billion in 2012). This net savings inflow was primarily invested by central banks and foreign currency reserve managers in ultra-conservative Treasury and Agency debt portfolios. The lower interest rates on these securities fed directly to new investment in interest rate-sensitive areas like residential housing construction:
Bernanke (2005): In particular, during the past few years, the key asset-price effects of the global saving glut appear to have occurred in the market for residential investment, as low mortgage rates have supported record levels of home construction and strong gains in housing prices. Indeed, increases in home values, together with a stock-market recovery that began in 2003, have recently returned the wealth-to-income ratio of U.S. households to 5.4, not far from its peak value of 6.2 in 1999 and above its long-run (1960-2003) average of 4.8. The expansion of U.S. housing wealth, much of it easily accessible to households through cash-out refinancing and home equity lines of credit, has kept the U.S. national saving rate low – and indeed, together with the significant worsening of the federal budget outlook, helped to drive it lower.
The accumulation of foreign exchange reserves thus directly contributed to the housing bubble by increasing house prices, spurring new construction, and allowing for cash-out refinancing that made home ownership more attractive. Taken a step further, the expectation of continued house price increases reduced the perceived credit risk on riskier loans. Since houses are used as collateral for the mortgage loan, house price appreciation makes default less likely since a delinquent borrower has an incentive to sell the house to extract the remaining equity rather than allow it to go into foreclosure. In the process, the household repays the loan at par and the lender suffers no loss. If investment continued to flow in from abroad, the increase in house prices could persist and mortgage lending could become more lax.
While this makes logical sense at first, the global savings glut thesis suffers from two obvious defects: (1) the collapse of the housing bubble preceded the reduction in the U.S. current account deficit. Generally, when unsustainable booms are caused by foreign capital flows the collapse occurs after the foreign capital is withdrawn, not before. Yet, China and other surplus nations continued to build huge dollar reserves well into 2011. Moreover, the house market and current account deficit were not particularly well synchronized in that house prices cooled as deficits were at their apex – precisely the time when one would expect foreign capital to be exerting the greatest upward pressure on prices.
(2) Secondly, the focus on “net” capital flows completely abstracts from gross capital flows. A current account deficit of $200 billion, for example, could be produced by $10.2 trillion of capital inflows net of $10 trillion of outflows or by $200 billion of inflows and zero gross outflows. According to Treasury data, the most important source of foreign capital for the U.S. was European banks, not Asia. The United Kingdom accounted for 25% of all foreign capital inflows in 2007 despite running a current account deficit of its own. In 2008, net capital flows to the U.S. fell by just $33 billion even as gross inflows fell by nearly $2 trillion. The issue was that U.S. financial outflows to the rest of the world declined by $1.7 trillion, causing the current account deficit to remain roughly the same in 2008 and 2007 despite dramatically different gross fund flows those two years.
As the Bank for International Settlements (BIS) argues in its 2012 annual report, the “savings glut” narrative may have cause and effect backwards. In 2003-2004, the Federal Reserve took interest rates below levels consistent with policy norms, as measured by rules of thumb like the Taylor Rule. By holding interest rates too low for too long, the Fed set off a search for yield that caused domestic investors to search abroad for returns. These fund flows can generate bubbles in the less well-developed financing markets of emerging economies and generated unwanted increases in the foreign exchange value of their currencies. To address these problems, foreign central banks responded by keeping their interest rates too low and accumulating foreign exchange reserves to maintain currency pegs or limit appreciation. Low interest rates make a country less attractive destination for foreign capital, but they also can result in too much domestic production, much of which had to be sold in export markets.
At the same time, European banking regulations reduced the capital charge for holding AAA-rated securitized assets, which made subprime-backed bonds and collateralized debt obligations (CDOs) extremely attractive to European banks. Further, the search for yield in money markets led many U.S.-based money market mutual fund managers to lend dollars to European banks to fund these purchases. As Professor Hyun Shin of Princeton explains in a recent paper, the “savings glut” argument is focused on net lending and that seems misplaced given that changes in the volume of gross capital flows appear to be the defining feature of the period just before the crisis.
The BIS view has important consequences for the near term because it suggests both the housing bubble and current account deficit were the natural consequence of excessive low interest rates. Artificially low interest rates encourage savers to spend more now and save less, which reduces the pool of savings and forces more investment to be financed from abroad. At the same time, bad regulation can generate bad outcomes by creating perverse incentives for European banks to hold “safe assets” or make money market mutual funds’ wholesale lending to those banks seem less risky than it is. As with subprime loans, the debate over the causes and consequences of global imbalances will rage for some time, but it is clear that the BIS alternative narrative deserves much closer attention that it has received to-date.