Friday, March 4, 2011

They Did It, They Did, They Did It!

Lately, that seems to be the message coming from current and past Fed officials regarding the housing and credit boom in the early-to-mid 2000s.  First Ben Bernanke, then Vincent Reinhart, and now Janet Yellen have come out saying it was excess savings by foreigners and failings in the U.S. private sector that was the root cause of the boom.  No blame is assigned to the Fed.  They ask how could the Fed have created a liquidity glut that drove down world interest rates and sparked off a global housing boom?

The answer is easy: the Fed is a global 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 was exported to much of the emerging world at this time. This means that the other two monetary powers, the ECB and Japan, had to be 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 loose monetary policy also got exported to some degree to Japan and the Euro area.  From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s.  Inevitably, some of this global liquidity glut got recycled back into the U.S. economy and further fueled the housing boom (i.e. the dollar block countries had to buy up more dollars as the Fed loosened policy and these funds got recycled via Treasury purchases back to the U.S. economy). As I showed in a recent post, there is strong evidence that a good portion of the foreign reserve buildup in the global economy during the 2000s can be tied to U.S. monetary policy.

What is amazing is that on one hand these Fed officials will acknowledge the Fed's global monetary power and then completely ignore the implications of this for early-to-mid 2000s.  I wish they wrestle with the four questions I presented to Ben Bernanke after his recent speech.   In case any of these Fed officials are interested, I am about to wrap up a coauthored paper that more fully develops the implications of the Fed's monetary superpower status during the housing boom. I would be glad to share it with them.

Update:  Here is a paper from the ECB that empirically estimates how important the global saving glut was versus monetary policy.  This is the abstract:
 Since the late-1990s, the global economy is characterised by historically low risk premia and an unprecedented widening of external imbalances. This paper explores to what extent these two global trends can be understood as a reaction to three structural shocks in different regions of the global economy: (i) monetary shocks (“excess liquidity” hypothesis), (ii) preference shocks (“savings glut” hypothesis), and (iii) investment shocks (“investment drought” hypothesis). In order to uniquely identify these shocks in an integrated framework, we estimate structural VARs for the two main regions with widening imbalances, the United States and emerging Asia, using sign restrictions that are compatible with standard New Keynesian and Real Business Cycle models. Our results show that monetary shocks potentially explain the largest part of the variation in imbalances and financial market prices. We find that savings shocks and investment shocks explain less of the variation. Hence, a “liquidity glut” may have been a more important driver of real and financial imbalances in the US and emerging Asia than a “savings glut”.


  1. David - you are as guilty of understating the role of foreign (Chinese) oversaving as Janet Yellen is of overstating it. I think you are both missing the point: while there can be no doubt that the Chinese oversaved (i.e. had GINORMOUS piles of Dollars to do something with and chose not to spend them on U.S. goods, but rather to buy Treasuries) and snapped up Treasuries AT ANY PRICE, the reason they had such huge piles was that they intentionally kept their currency too weak. I don't think I have heard any economist suggest that, had the Yuan been allowed to find a market exchange rate, the Chinese would have accumulated as many Dollars as they did. (Do you really think we wouldn't have found substitutes for those cheap plastic party favors we buy for our kid's parties and then immediately throw away?) They did not oversave as a matter of policy, they oversaved as a result of their currency manipulation, done in order to increase exports to more than they otherwise would have been. That given, we'd have been fools to have paid them more in interest than they were willing to take. The U.S. could simply never have borrowed as munch as we borrowed, at the interest rates we paid, had the Chinese not been willing to accept those interest rates.

  2. David, I think that the saving glut doesn´t explain all, but it has its importance. See

  3. GSG adherents seem to focus blame on the BRIC policy of undervalued exchange rates.

    But what are the implications of large BRIC revals? During the brief period of modest Yuan revaluation, in 2008, our inflation rate shot up. The reval helped reverse a decade-long trend of China exporting deflation to us. In fact, U.S. China import inflation rose to an annualized 7%+ rate just before the 2008 crisis intervened.

    To those who argue that the solution is BRIC revals, I say, be careful what you wish for. These revals would arguably continue as long as our monetary policy remains too easy for their economies. In other words, for years. Yes, we would benefit from more exports (or rather, higher export prices), but the impact on our Walmart shoppers could be quite negative.

  4. Pearson, I can not see the effect of revals.
    But perhaps you think the current situation one near of equilibrium? I´d rather preffer a world where no country accumulate so huge volume of reserves, and one where free people choice its level of consumption.
    In fact, we have two world, one ruled by free choice, the other by government.

  5. I still say that those who blame the Fed for a housing boom (actually commercial property boom-busted too) are like alcoholics who blame the bartender for getting them drunk.

    BTW, Anthony Downs (Brookings) wrote a perceptive book "Niagara" about this topic.

    The fact is, global savings rates are high. We have Far East Asia, an aging Europe, and in the US a super-rich lightly-taxed top 5 percent (high savings), and savings by pension funds and insurance companies,the latter not always counted as savings).

    "Too much money chasing too few deals" is a mantra heard over and over again--I just heard the class A office space in downtown Los Angeles attracts dozens of buyers (!--at a Bisnow real estate conference).

    VC guys are looking to place their hoards, or give back to investors. Private equity guys say they have to do deals, but where are the good deals. Mutual funds say they need good public stocks. This problem will only get worse. Fed sales are oversubscribed.

    The reality does raise a question: What if global savings rates are "too high" due to cultural reasons, or because people save regardless of interest rates as they need money for retirement, possible medical expenses, college for kids etc.

    Or the pension funds and insurance companies, which save more hundreds of billions every year, regardless of interest rates or economic conditions.

    What if the lowering of the top tax rate in the U.S. from 90 percent to 37 percent has created an enormous pool of capital that grows every year?

    Of course, having lots of capital is a great thing.

    But, I don't think Bernanke, or Anthony Downs, is deluded. There are gluts of capital. Then capital starts looking for yield.

    It may be that QE has to become a chronic feature of monetary policy. We may see zero bound over and over again in years ahead. Japan never sees anything but zero bound, so this is not an exotic scenario.

    It is hard for some people to think of capital as being cheap, or glutted out. There was a time, only decades ago, when capital was scarce. But as societies become richer, obviously, the ratio of savings can increase, even as the overall economy increases.

    So instead of 5 percent of $100, you get 10 percent of $200--a fourfold increase.

    Some people hate this idea, as they love saying things like. "He who has the gold rules." I expect the equation will be, "He who has the great, fundable business idea rules."

    You got capital? So what. There are piles of capital everywhere.

  6. In the immortal words of David Hendry, "the economy is a complicated dynamic, nonlinear, high dimensional evolving entity (Dynamic Econometrics, OUP, 1995).

    So good luck to you in establishing for definite who "caused" the financial crisis - be it the Fed or the Chinese or Bernie Madoff. Like everyone else, you pick your favorite whipping boy and select your evidence to support your preconception.
    Its not just you...all economists do it, but we should be honest about what we are doing.

  7. All:

    I am not saying it was only the Fed's fault. Rather, the Fed played a meaningful role in creating the global liquidity glut and this role has been either downplayed or ignored.

    Yes, the Fed's contribution to the boom depended on the dollar block countries recycling the U.S. monetary policy and yes, there were other contributing factors like structured finance turning risky assets into safe ones. But given these things, the Fed's outsized role in the global economy meant it was a major contributor to the boom.

    I am adding an update that cites a paper that empirically shows this.

  8. It certainly is hard to tell a story about the crisis without mentioning the role of monetary policy. But after reading Rajan's Fault Lines, one can argue that competition from China and India had caused a stagnation in incomes for a significant swathe of the American population. Faced with the jobless recovery after the dotcom crash, and worried about deflation, the Fed has to over-react to negative demand shocks (says Rajan) because the US has such a feeble safety net. So, where is the genetic cause of the bad monetary policy: China's phenomenal rise to power, or America's (to me morally repulsive) lack of a decent safety net for its citizens ?

  9. ECB:

    Probably both, though I doubt Fed officials saw it as them making up for the lack of a good social safety net. My reading of the Fed's minutes is they were genuinely trying to maintain full employment.

    By the way, I listened to an interesting interview of Daron Acemoglu where he questions Rajan's theory. There is still an inequality story, but its the Johnson-Kwak one where the financial sector uses its political clout to ensure it gets a disproportionate share of national income.

  10. "I am adding an update that cites a paper that empirically shows this."

    Do you really think a study, of any type, can definitively "show" this?

    And have not the central banks of China and India been revving up their money supplies for years?

    Investors and lenders need to exercise caution. If you want to lend on property, demand only a 5 percent down payment, and things look boomy--that is the Fed's fault?

    We also have the problem that we need good growth in aggregate demand ever year. And I still see no sensible answer to the problem to too-high savings rates.

    Anyway, give unto me five percent real growth and five percent inflation, rather than one percent real growth and one percent inflation.