Symbiotic twin killings

What caused the crisis?  It seems like most of the plausible answers I’ve heard come down to one of two basic explanations:

(1) “We were living beyond our means” — Congressman Dan Maffei (D-NY), in a WRVO Community Forum in Syracuse last week that included, um, me.  Sounded very reasonable coming from Congressman Maffei, less so coming from stockbroker/ investment advisor/ author Peter Schiff on the other night’s “Daily Show”, probably because of the diametrically opposite policy prescriptions the two draw.  Maffei backs the stimulus bill and wants to see the economy recover as soon as possible; Schiff is an adherent of the Austrian school and thinks a good old bloodletting (oops, “liquidation” or “correction”) is just what the doctor ordered.  Either way, this explanation has a lot going for it, as it explains the rash of subprime mortgage borrowing, home equity loans, maxed-out credit cards, etc.

(2) A “global savings glut” led to stock and housing bubbles, which finally burst — Fed Chairman Ben Bernanke, Nobel economist / NYT columnist Paul Krugman.  The idea here is that while we spendthrift Americans were running up huge debts, people in other countries, notably China and Japan, as well as the minority of wealthy Americans with high savings rates, had large pools of savings seeking a good risk-adjusted return.   And they invested much of it here, in Treasury bonds, thereby keeping U.S. interest rates low; in the stock market, reinflating the late 1990s bubble; in the corporate bond market, lowering rates on all bonds, even junk bonds; and in real estate, largely through securitized collections of other people’s mortgages.  (By some accounts, demand created its own supply of mortgage-backed securities — after the 2001 stock debacle, investors were looking for an alternative to stocks and thought real estate looked promising.)  A particular problem here seems to be that many investors opted for wildly risky investment vehicles, like investing in “diverse” portfolios of dodgy mortgages or blindly handing their money over to a Bernie Madoff or a Robert Allen Stanford, without realizing they were risky.

These aren’t the whole story — there’s also the late 1990s deregulation, the rise of credit default swaps, the lack of financial oversight, the “too big to fail” precedent of the Long Term Capital Management hedge fund bailout, low federal funds rates, greed, incompetence, etc. — but they probably are most of it.

What prompted this post was the realization that (1) and (2) are opposite sides of the same coin.  We can’t live beyond our means unless someone lends us money; that someone was those foreign savers.  While nobody forced Americans to take out home equity loans they could not afford, those loans would not have been offered in the first place unless money was flowing into the banks from somewhere and unless those investors hadn’t somehow been deluded (perhaps by themselves) that the loans were sound investments.  And that global savings glut would probably not have existed if the U.S. did not have such a large and persistent trade deficit, which itself would not exist if we consumed no more than we produced.  (This also goes hand in hand with the national income accounting identity that the current account deficit and the capital account surplus must be equal.)

The symbiotic nature of the U.S. consumer credit bubble and the globally-driven asset bubble  is not exactly a new idea and has been noted by numerous other commentators, but it deserves more emphasis.

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One Response to “Symbiotic twin killings”

  1. What the #$*! do we know!? « Blogging Through the Wreckage Says:

    […] A few weeks ago I noted that there were two basic explanations of the crisis that were both plausible and consistent with each other:  (1) overindebted Americans and (2) a global savings glut. Money inflows from abroad helped fuel the housing and stock-market bubbles, and also made U.S. interest rates cheaper, thus making it easier for spendthrift Americans to keep on borrowing. Americans have been living beyond their means since 1981 (we know this because the trade balance has been negative during that time, meaning that imports have made up the gap between what we purchase and what we produce), and foreigners have been our eager enablers by purchasing U.S. stocks, bonds, property, and other assets. Aggregate statistics show that American indebtedness increased greatly in the past decade — to the highest levels since 1929! — and of course the housing market (and to a lesser extent the stock market) became a historic bubble in this decade. The usual story is that the runups in stock and housing prices encouraged Americans to spend more and more, even to the point of going further into debt, as their equity was rising and in many cases, like home equity loans, they could even borrow against it. Then the housing bubble burst, and the stock bubble followed suit, and suddenly Americans were a lot less wealthy and therefore cut back their spending, causing GDP to fall. […]

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