Alternative causes of the financial crisis

Global savings glut» as a major reason for the latest financial crisis of 2008

Group members:

Anton Remnyov

Maria Misyuk

Sjoerd Ronteltap

Sofia Zubkova

Tiina Ahltorh

Abstract

The issue of reasons of financial crisis 2008 is still highly questionable. There is no agreement between different scholars on one single reason. In this essay we present opposite views on this problem: global savings glut as one of the main arguments in current debates and several alternative causes (housing bubble, excess saving theory and paper money issue), which also deserves closer attention.

Introduction – financial crisis 2008 overview

In 2008 the worst crisis since the Great Depression hit the World. This crisis caused a large economic downturn (Laeven, 2012). For this crisis several origins can be found. The foremost reason for the financial crisis is the collapse of the so called ‘housing bubble’ in the United States. It was the direct trigger of the financial crisis[1].

The ‘housing bubble’ was a consequence of several reasons. There was a common believe in the United States that housing prices would not fall. Due to this common believe a lot of risk was being taken by banks, giving mortgages to people who would never be able to afford these mortgages if the housing prices stopped rising. When the bubble did finally collapse, people were not able to pay their interest payments. The banks then lay claim on their houses and tried to sell them. However, this caused the supply of houses on the housing market to rise, leading to an even steeper decline in housing prices and more foreclosures. During the housing bubble, the Federal reserve raised the interest rates. An effect of this rise was that the adjusted rate mortgages would get higher interest rates and people would have to pay higher interest payments. The rise in interest rates also caused the housing prices to deflate, thereby contributing to the negative spiral of housing price declines that followed[2].

As mentioned before, the optimism of the housing prices went hand in hand with risk taking behavior. People borrowed a lot and banks were keen to lend it to them. However, due to excessive deregulation many of the banks did not have enough capital to withstand possible losses or defaults of the parties they entered into a commitment with. Banks were overleveraged (Bodie et al., 2011). Next to this banks had their compensation packages linked to short term performance of the companies, foregoing the long term and putting an emphasis on risk.

Many of these banks also sold a lot of toxic investments. Investments called CDO’s, MBS’s or CDS’s. The investments were used more and more over the years and got more and more complicated. After a while not even the executives of the banks knew what they exactly did. The products were repackaged so often that the underlying value often was not traceable anymore. The problem was that credit rating agencies often gave these products high credit ratings, causing many investors to invest in these products thinking they were safe. However, the credit rating agencies were paid by the banks to rate their products and there was a lot of pressure within these agencies to give favorable ratings. This contributed to the rapid spread of these toxic investment and to the huge debt pool that was created within the global economy (Bodie et al., 2011).

Another theory for the financial crisis of 2008 is the global saving glut theory by Ben Bernanke. Due to the rise of the Asian economies, that have large trade surpluses, and the very attractive investment climate of the United States after the Asian crisis, large flows of money entered the American economy. The current account balance, which is the difference between the savings and the investments of the domestic agents, showed a large deficit for the United States. Worldwide the financial balances of all countries should sum to zero. Bernanke therefore concludes that, since the US trade deficit worsened, this is due to a growing surplus in the rest of the world. All this new money made it very attractive to borrow against low interest rates and thus greatly increasing debt in the US economy. So economic growth was financed by debt and consequences of it are very well known[3].

Further we discuss in detail two opposite perspectives on whether global savings glut is the major reason for the latest financial crisis of 2008, starting with supporting arguments.

Global savings glut

In order to understand, why global savings glut is regarded as a reason of severe imbalances we should look more deeply at the logic of this phenomenon.

Decades before crisis in emerging markets cheap domestic currency was observed and assumed quite high export orientation. Trade surplus in this perspective was inevitable and it in turn influenced increasing inflow of cash in the economy. However accumulated cash was almost not used on the domestic market due to generally two reasons. First one was the threat of galloping inflation. Second was very limited opportunities of safe investments. As a result there was a need to allocate cash to the markets with relatively low risks that is advanced economies and mainly the USA. Therefore developed markets experienced trade deficits which only grew to unsustainable levels. So global savings glut is reasonably seen as cause of this balance of excessive surpluses and deficits, meaning global imbalances.

Alternative causes of the financial crisis

We identified at least three alternative reasons of the crisis 2008: asset and housing bubble, excess saving theory and paper money issue.

Asset and housing bubble

The pace of mortgage finance boom from 2001 to 2006 was obvious, and it was certain to be unsustainable forever. The rise of prices on housing in advanced economies was sure to end at some point, but even if the first concerns were voiced in 2003 they were dismissed (Ron, 2011).

And it is partly understandable: the prices for real estate grew everywhere in the US, but not at the same speed, and even when the bubble started to collapse – it was a local bubbles, that gave aggregated bubble, that, in turn, affected the state of economy.

Figure 1. The house price bubble across selected US states (quarterly), 1980-2008

But what exactly happened and how it turned out that mortgages became the reason of the worldwide crises?

When somebody goes to a bank and gets a mortgage, the lender can hold it, but more often sells it to government-sponsored enterprise such as Fannie Mae or Freddie Mac. It is done because nowadays banks cannot tie their funds for 20 or 30 years.

The government-sponsored enterprises (GSE) buy all this mortgages, using money they raise by selling bonds. As GSE are linked with the federal government, the investors got the safest bonds on small interest rate, that is smaller than any interest rate anyone who gets mortgage pay.

Therefore GSE raise money at low rates and purchase mortgages that pay higher rates. Assuming everybody pay their mortgage payment in time, GSEs generate more and more money by buying more and more mortgages. But not everyone do that and at some point it stops working: buying new mortgages doesn’t guarantee profit for such enterprise as Fannie Mae.

But again, nobody wanted to believe, that prices for housing can go down, and when it happened, mortgage-backed securities went down and, as mortgage was not only between a lander and a borrower, but also a lot of sides were involved, including government, it led to losses not only for banks but also for other financial institutions. These losses soon spread to other asset classes, fueling a crisis of confidence in the health of many of the world's largest banks. Events reached their climax with the bankruptcy of Lehman Brothers in September 2008.

Excess elasticity theory

Excess saving theory adds together the determinants of the market and the natural rate of interest rate. Therefore, global savings glut is not informative about the potential risks to financial stability. Borio and Disyatat (2011) argue that as a result, the global savings glut view has little to say about the underlying patterns of global intermediation that contributed to the credit boom and the transmission of the turmoil, and diverts attention away from the monetary and financial factors that sowed the seeds of the crisis.

Elasticity in the monetary and financial policies is the degree to which the monetary and financial regimes constrain the credit creation process, and the availability of external funding more generally. According to Borio and Disyatat (2011) fundamental weaknesses in the international monetary and financial system arise from the problem of “excess elasticity”, which means, that the system lacks sufficiently strong constraints to prevent the build-up of unsustainable booms in credit and asset prices, that is, financial imbalances, which can eventually lead to serious financial consequences and shake the world economy. The roots of the recent financial crisis can be traced to a global credit and asset price boom on the back of aggressive risk-taking, which was enabled by the excess elasticity in the policies of the US.
A high elasticity can also accommodate the build-up of financial imbalances, whenever economic agents are not perfectly informed and their incentives are not aligned with the public good, witch was the case with mortgage securities in the United States before the crisis. Therefore, to reduce the likelihood and severity of financial crises, the main policy issue should be that how to address the “excess elasticity” of the overall system, not “excess saving” (that is, global savings glut) in some countries. Noticing this after the 2008 crisis, the US government began to reduce elasticity by regulating financial institutions and securities markets more strictly.

Paper money issue

There is some evidence against global savings glut being a major reason of financial crisis 2008. The main problem causing global savings glut was massive current account deficit in the United States and massive current account surplus in China, Japan, Korea, Taiwan etc. Bernanke has often used this reasoning to explain the United States massive current account deficit. Some countries like China save more than they invest, causing them to have a current account surplus and a glut of savings that they need to lend abroad to savings deficient countries like the United States.

However, one fact is missing in this theory. Most of money that were invested in the United States by Asian countries were not derived from savings but newly issued fiat money. In 2007 People’s Bank of China created $460 billion worth of Yuan to keep currency value and to hold low wage trade advantage. This makes difference it changes to the equation of savings and investment: CA = S – I → CA = (S + Paper money issue) – I.

China’s economy had been growing 10% yearly for 2 decades and it had the highest level of investment relative to GDP (46% in 2009). China printed large amount of Yuan and this money pumped into the United States. Chinese funds drove up the prices of assets and decrease interest rates. It made funds available for investment, particularly in housing. This lead up to this crisis, fuelling a credit bubble.

So, the imbalance was created not by the savings but by the paper money being created by central banks that destabilized the world.

Conclusion

There are different perspectives on origins of the crisis 2008. We believe that reasons of the financial crisis are complex and should be considered systemically as a set of interconnected elements. All of them: global savings glut, housing bubble, excess saving theory and paper money issue contributed to negative global consequences. Thus there is no single answer in trying to find the one reason. One-sided view is very biased however the system of concepts helps to grasp the real origins of financial crisis 2008.

Literature

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[1] www.online.wsj.com

[2] www.nationalreview.com

[3] www.federalreserve.gov

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