Pity Phil Angelides. As head of the Financial Crisis Inquiry Commission (FCIC) this modern-day Sisyphus has been tasked by an act of Congress to uncover the origins of the current financial and economic crisis. At the moment his understaffed office is studying 22 causes of the Great Recession and adds to that number almost weekly (see the recent discussion of Lehman Brothers’ Repo 105 accounting scheme). Like the FCIC, this article will consider the origins of the current crisis. Unlike the hapless Mr. Angelides, this newsletter will focus on the international sources of the US housing price run-up, whose collapse was the proximate cause of the Great Recession.

Figure 1 (from Robert Shiller) shows US housing prices from 1890 to 2006. US housing prices began their unprecedented climb in 1997 and home prices continued to rise until mid-2006 when they collapsed (not shown in figure 1). Figure 1 also displays three other variables – building costs, population and interest rates – that economic theory suggests should be fundamental to housing prices. It is clear from figure 1 that the variation in these economic fundamentals has little hope of explaining the explosion in US housing prices from 1997 to mid-2006. This observation has caused many to conclude that US housing prices experienced a bubble during the period.

Figure 1

While there is no widely-accepted definition of an asset price bubble, the economic historian Charles Kindleberger, in his classic study Mania, Panics and Crashes (Kindleberger 2008), argued that all bubbles pass through the following sequence of stages:

1.      A rapid, pro-cyclical increase in the supply of credit that provides the funds necessary to purchase the asset, after which,

2.      Asset buyers experience “rational exuberance” or “self-confirmation” as their expectations of higher prices are confirmed. This leads to,

3.      A rapid and unprecedented increase in the price of the asset as new buyers enter the market with the hope of realizing large short-term gains; this phenomenon has been called the “bandwagon” effect. At some point,

4.      “Rational exuberance” mutates into “irrational exuberance” as speculators buy the asset despite their belief that it is over-valued because they also believe a “greater fool” will come along after them and pay an even higher price. As a result, “irrationally exuberant” buyers push up the asset price and realize large capital gains in a short period of time. The entry of “irrationally exuberant” buyers means that,

5.      A large and increasing share of asset purchases are made for short-term gain; at this stage many buy the asset merely to “flip” it. At this point,

6.      A large and increasing share of purchases are financed by credit as lenders become convinced that extending credit to speculators who quickly resell the asset represents a nearly risk-free way to realize above-normal short-term returns. In this way, “irrational exuberance” spreads to the financial sector in general.

 Clearly, all six of Kindleberger’s stages operated with full vigor during the US housing price explosion. I will leave unexplained stages two through six as they belong more to psychology, or behavioral economics, except to note the following breath-taking example of irrational exuberance: a 2005 survey in San Francisco reported that on average new homebuyers in that city believed housing prices would rise 9% a year for each of the next 10 years – that is, on average they believed their housing wealth would more than double in a decade. The same survey found that fully one-third of new homebuyers believed housing prices would rise 50% a year for the next 10 years; that is, this group believed their housing wealth would increase 58-fold in a decade!

 With respect to the first stage in Kindleberger’s sequence – the rapid, pro-cyclical, increase in the supply of credit – John Taylor (2009) of Stanford and others, place the blame squarely on the US Federal Reserve. Taylor argues that the Fed fueled the run up in US housing prices by keeping interest rates too low for too long after the recession of 2001. Contra Taylor, the housing price bubble took off in 1997 (see figure 1), an era when the policy rate was relatively high (see figure 2).

Figure 2

Moreover, Taylor, like many, uses the nominal Fed funds rate as the sole measure of the Fed’s monetary policy stance. Alternative measures of monetary policy, such as the growth rate of the monetary base (i.e. currency and reserves), narrow money (M1), or broad money (M2), were well within historic norms (see figure 3) during the period and so were not excessively loose.

Figure 3

If the Fed was not the source of the rapid, pro-cyclical increase in the supply of credit that fueled the housing price bubble, where did this finance come from? A hint is provided by figure 4, which shows the percentage increase in housing prices in the US and other rich countries from 2002 to 2006. Figure 4 suggests that the housing price bubble was a global phenomenon (the US had only the fifth largest housing price bubble in the sample) and a global housing price bubble requires a global cause.

Figure 4

Starting in the late 1990s a large supply of savings, originating primarily in Asia, were sent to financial markets in the US and the West seeking safety and returns. These excess funds provided the unprecedented increase in credit necessary to fuel the global housing bubble. That is, while it is true that there were problems in the US housing market, that financial innovation led to risks that were poorly understood (and even more poorly managed), that mortgage originators were too aggressive, that incentive problems infected rating agencies and financial market regulators, that mistakes were made by government policymakers and private market participants, it must also be conceded that there was an international component to the global housing price bubble whose collapse led to the global downturn.

The Role of Global Imbalances in the Global Housing Bubble

To simplify greatly, think of Asia as the world’s (marginal) producer of goods and the US and the West as the world’s (marginal) consumers of goods. Exports to the US and the West generated vast export revenues for China, Japan and many other Asian economies and these were used to buy safe US and Western assets, primarily US government bonds. Since Asian economies ended up with US government bonds and the US and the West ended up with Asian goods ultimately the US and the West imported Asian goods and paid for them by borrowing from Asia. That is, the US and the West were importers and borrowers while Asian countries were exporters and lenders or savers. This flow of goods to the US and the West, and bonds and other assets to Asia has been termed “global imbalances,” as the West gets Asian goods and Asia accumulates Western debt. It is important to note that Asian countries did not lend directly to risky borrowers in the US housing market or elsewhere. Rather, China and other Asian countries bought safe US government assets from US and Western financial firms who then turned around and used these new funds to invest in riskier, higher return assets such as mortgages and the mortgage-backed securities that financed the housing price bubble.

There are three useful and interrelated ways to think about the rise of global imbalances: the first view stresses the role Asian institutions; the second focuses on the exchange rate and development strategy adopted by many Asian countries since the late 1990s; the third focuses on macroeconomic events in the US and the West. As for the first, since the 1990s the growth of output in Asia has far outstripped the growth in domestic demand. The result has been a dramatic increase in national saving; for example, since 1997 China’s national saving has averaged about 40% of GDP per year. Several explanations based on the role of Asian institutions have been offered for the compression of domestic demand and the rise of saving: under-developed social safety nets in many Asian countries (unemployment insurance, old-age pensions, health care and welfare programs) forced households to increase precautionary saving for these contingencies; weak banking and financial systems throughout the region prompted households and businesses to send their savings to US and Western financial institutions which were seen as safer than their Asian counterparts; political uncertainty caused households and firms to move much of their financial wealth offshore to the US and the West; finally, Japan has repeatedly failed to restart aggregate demand after a decade of economic stagnation meaning its excess output had to be exported to the US and the West.

 A second view of the rise of global imbalances emphasizes the dramatic demographic changes taking place in many Asian countries. According to the UN, almost 700 million people have moved from rural to urban Asia since 1990 (300 million people have moved from the countryside into cities in China alone). This massive internal migration – easily the largest in human history – has dramatically increased productive capacity in developing Asia. Since urban workers in Asia are typically employed in the manufacturing sector, and since workers in the region are relatively poor, policymakers have sought international markets for their manufacturing output. Most Asian countries have accomplished this by keeping their currencies weak relative to the dollar. This so-called export-driven development strategy was perfected by Japan in the post-World War II period and has been widely adopted across Asia since the Asian currency crisis of 1997. In a sense, exchange rate policy is an important part of internal economic development in Asia as weak currencies, cheap labor, and inexpensive goods enabled Asian economies to manage unprecedented internal labor flows by maintaining high urban manufacturing employment. This joint exchange rate – development strategy generated large trade surpluses with the US and the West and these export revenues were then “recycled” back to US and Western financial markets providing the funds necessary to finance the Western housing price bubble.

A third way to think about global imbalances is to examine macroeconomic events in the US and the West. From the national income accounts we have,

NX = Sp + (T – G)  – I

where NX = Net Exports = Exports – Imports (NX is the trade balance), Sp = private savings, G = government spending, T = taxes (T – G is government savings which is negative when the government runs a budget deficit), and I = aggregate investment. Over the past 30 years in the US, and to a lesser extent in the rest of the West, private saving, government saving and national saving have all fallen while investment has been (relatively) stable. This is, of course, the mirror image of the Asian experience and in a global equilibrium Asian goods satisfied this spending binge by Western households, businesses and governments while Asian savings provided the finance for Western borrowing.

 In sum, starting in the late 1990s a symbiotic relationship arose between Asian economies trying to manage dramatic demographic change together with compressed domestic demand and Western countries whose consumers, businesses and governments were eager to spend. The new financial resources flowing out of Asia into Western markets proved to be a double-edged sword. The rise of Asian savings was a boon for the West as it helped fund the “new economy” and the revolution in telecommunications and consumer electronics, while also providing Western consumers, students, businesses and governments with unprecedented access to credit. This has clearly benefited Western countries. On the other hand, Western economies grossly misallocated some of this vast supply of new credit by inflating two asset price bubbles: the dot.com stock bubble of the late 1990s and the US and Western housing price bubble. The collapse of the former led to a mild recession in 2001, while the collapse of the latter led to the current global downturn.

Looking ahead, if global imbalances continue after the Great Recession ends – and there is every indication they will continue as even the most severe recession since the Great Depression has only made a small dent in financial flows between Asia and the West and both regions will face most of the same incentives they faced before the crisis – then Asian, US and Western policymakers will have to develop policies to encourage more productive allocation of this new finance to avoid a more “bubbly” future with frequent asset price run-ups followed by devastating collapses like what we are living through today.

Besides being the source of much of the global finance that has been the subject of this newsletter, China is also the source of many insightful aphorisms. One ancient Chinese saying that seems appropriate to the challenges and opportunities presented by global imbalances is the old chestnut, “May you live in interesting times.” Phil Angelides surely appreciates the double-edged nature of this adage; after reading this, I hope you do too.

Thank you for reading this far and remember it is always a good day to do (international) macroeconomics. If you have any comments or suggestions, please feel free to send me an email at mcintyre@oxy.edu