Monday, March 2, 2009

A Note to Paul Krugman: There is More to the Story than Just a Saving Glut

In his column today, Paul Krugman pushes the saving glut theory as the reason for the current global economic crisis. At the expense of sounding like a broken record, let me remake the case that the saving glut alone does not explain the entire crisis. Rather, it was number of factors (including the saving glut) that came together to create a perfect financial storm.

One important factor was the emergence of an unexpected global liquidity glut created by the Federal Reserve (Fed) in the early-to-mid 2000s. The Fed is a is a monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. (See this post on evidence for U.S. monetary policy being exported to ECB.) The global liquidity glut story seems most compelling for the 2002-2004 period when the Fed's policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate). Thus, its monetary policy was highly accomodative during this time and was exported to the world.

While the global liquidity glut was important early on in the decade, the saving glut became more important starting in 2005--a view shared by Brad Sester (See also his comments in this Econbrowser post). However, other factors throughout the entire 2000s were important to this process as well : the securitization of finance, underestimating aggregate risk, the lowering of lending standards, rating agency failures, etc. All of these developments in conjunction with the global liquidity glut early on and later the saving glut came together to create the witches brew of excessive credit, asset bubbles, and unsustainable aggregate demand across the globe. That, in short, is my view of how this once-in-a-lifetime perfect financial storm was created.

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