"The Rest of the World Caused US Subprime Crisis"

There's this TIME article gaining attention that mentions economist Ricardo Caballero making the case that other countries, by deliberately running up large external surpluses to help build reserves, are more responsible for the US subprime crisis than America itself:

Caballero says that [the blame America thesis] is wrong. His story of the financial crisis begins not in the rising condo buildings or growing developments in Miami or Las Vegas, but in investment houses and offices of central bankers in Beijing and Riyadh. Caballero asserts that international investors, particularly those tasked with deploying the reserves of foreign governments, prefer relatively safe investments, which made the normally stable U.S. economy a natural hunting ground. The money might have gone into stocks, but after the Nasdaq and stock market rout of the early 2000s, investors' appetite shifted to bonds.

China, contending with a huge trade surplus with the U.S., bought more and more Treasury bonds, pushing down yields and making Treasuries less attractive to other foreign investors. As a result, the rising demand for higher yielding U.S. debt opened the door for Wall Street investment bankers to spin out new classes of fixed-income securities, most notably collateralized debt obligations or CDOs. Much of the money raised by those investments was funneled in the mortgage market. That gave lenders the ability to make more loans, allowing more people to buy houses and push up real estate prices. Many of those loans, it turns out, were made to people who couldn't afford to pay. What happened next — real estate bust, foreclosures and Wall Street mayhem — is well known.

While those in mainstream (American) media might find this idea novel, IPE Zone readers should know better. Even before the crisis hit, Ben Bernanke was already proffering his highly problematic and self-serving "deficits don't matter because there's a global savings glut" thesis. More recently, the eminence grise of financial reporting, Martin Wolf of the Financial Times, made a similar case in anticipation of the crisis in Fixing Global Finance. As an aside, I recently read this book and was struck by how he didn't offer an explanation of why global finance now needed fixing when he previously wrote a book entitled Why Globalization Works. If it ain't broke, don't fix it, eh? Perhaps he needs to read the Foreign Policy article on Big Idea, Big Title works as well! Anyway, here's Harold James' review of Wolf's more recent book in the pages of Foreign Affairs where he notices this very thing:

In this new work, Wolf expertly relays the debates that followed the Asian financial crisis of 1997-98 and the extraordinary ballooning of the U.S. current account deficit in the first years of this century -- debates that asked whether the global imbalances that had prompted these crises were extraordinary threats or permanent features of the world economy. For Wolf, these imbalances are extraordinary, and it is they, rather than globalization itself, that threaten the stability of both mature and emerging markets.

In a move that may seem odd today, given the current talk about the end of capitalism, Wolf's book casts the American model of financial liberalization as a hero and Chinese mercantilism as a villain. Wolf argues, for instance, that China's "inordinately mercantilist currency policies" have caused dangerous imbalances. In order to maintain its exports' competitiveness on the world market and keep a vast (and potentially restive) work force occupied, Beijing prevented the Chinese currency from appreciating against the dollar and thus from driving up the price of China's exports. The result was a vast trade surplus. A byproduct, largely unintended, was the piling up of reserves of U.S. dollars, which Beijing then placed mostly in U.S. government securities. (It also invested in quasi-state institutions, such as Fannie Mae and Freddie Mac, thereby indirectly enabling their recklessly aggressive lending.) This is Wolf's international spin on Alaskan Governor Sarah Palin's explanation for the crisis -- "Darn right, it was the predatory lenders" -- only his predators are the Chinese.

Which brings me to Ricardo Caballero's latest academic piece on this Bernanke-Wolf theme. While he doesn't absolve Americans of being faultless in the matter, the root cause of the crisis was (yawn) the rest of the world. Here's the abstract:

One of the main economic villains before the crisis was the presence of large “global imbalances.” The concern was that the U.S. would experience a sudden stop of capital flows, which would unavoidably drag the world economy into a deep recession. However, when the crisis finally did come, the mechanism did not at all resemble the feared sudden stop. Quite the opposite, during the crisis net capital inflows to the U.S. were a stabilizing rather than a destabilizing source. I argue instead that the root imbalance was of a different kind: The entire world had an insatiable demand for safe debt instruments that put an enormous pressure on the U.S. financial system and its incentives (and this was facilitated by regulatory mistakes). The crisis itself was the result of the negative feedback loop between the initial tremors in the financial industry created to bridge the safe‐assets gap and the panic associated with the chaotic unraveling of this complex industry. Essentially, the financial sector was able to create “safe” assets from the securitization of lower quality ones, but at the cost of exposing the economy to a systemic panic. This structural problem can be alleviated if governments around the world explicitly absorb a larger share of the systemic risk. The options for doing this range from surplus countries rebalancing their portfolios toward riskier assets, to private‐public solutions where asset‐producer countries preserve the good parts of the securitization industry while removing the systemic risk from the banks’ balance sheets. Such public‐private solutions could be designed with fee structures that could incorporate all kind of too‐big‐ or too‐interconnected-to‐fail considerations.

Really, I have no idea why the journos find Caballero's work unique when it's ground that been very, very well trodden already. You can read the rest of Caballero's article via the link above although I'd be hard-pressed to find something new.

21/1 UPDATE: Add Bank of England Governor "Swervin'" Mervyn King to the echo chamber.