Causes: Where Did All That Money Come From?

We’ve gotten some comments to the effect that, for all the discussion of the financial crisis and the various bailouts, we haven’t looked hard at the underlying causes of the financial crisis and accompanying recession. The problem, as I think I’ve hinted at various times, is that any macroeconomic event of this magnitude is overdetermined, on two dimensions. First, there are just too many factors at play to identify which are the most important: in this case, we have lax underwriting, lax bond rating, skewed incentives in the financial sector, under-saving in the U.S., over-saving in other parts of the world, insufficient regulation, and so on. How many of these did it take to create the crisis? There is no good way of knowing, because the sample size (one, maybe two if you add the Great Depression) is just not big enough. Second, there is still the conceptual problem of identfying the proximate cause(s). To simplify for a moment, we had high leverage which made a liquidity crisis possible, and then we had the downturn in subprime that made it plausible, and then we had the Lehman bankruptcy that made it a reality. Which of these is the cause? Leverage, subprime, or Lehman?

In any case, we’re not going to resolve these issues. But I want to start an occasional series of posts looking at one of the root causes at a time.

Today’s topic was inspired by this week’s meetings between U.S.-China meeting in Beijing, where, according to the FT, “the US was lectured about its economic fragilities.”

Zhou Xiaochuan, governor of the Chinese central bank, urged the US to rebalance its economy. “Over-consumption and a high reliance on credit is the cause of the US financial crisis,” he said. “As the largest and most important economy in the world, the US should take the initiative to adjust its policies, raise its savings ratio appropriately and reduce its trade and fiscal deficits.”

There has been a lot of tut-tutting, here and especially abroad, about over-consumption and over-indebtedness in the U.S. According to this story, the problem is that U.S. consumers grew addicted to spending, and financed their spending through ever-increasing amounts of debt. Over-consumption fed itself, because it drove up asset prices, which enabled consumers to take on even more debt, which enabled them to spend more, and so on. But, according to this story, the assets were not actually getting more valuable – a house in the suburbs of Las Vegas is the same house it was ten years ago – and the asset price bubble and the debt mountain both had to collapse. (Note that, if you blame the U.S. consumer, then mortgage brokers, investment banks, and bond rating agencies all become mere enablers; if they hadn’t existed, the consumer would have figured out another way to rack up the debt.) The counterfactual “solution” (the historical path that would have avoided this outcome) was for the U.S. consumer to live a more sober life, consume less, and take on less debt.

I am unsatisfied with this story for two reasons. First, I don’t think it’s much of an explanation to say that people were insufficiently virtuous. People are the way they are, and you can only change them slowly, if at all. (The radical stage of the French Revolution, and the Chinese Cultural Revolution, both tried this, and failed miserably.) So maybe Americans are more like grasshoppers than ants. Maybe it’s our popular culture, or our mediocre public education system, or our irrational optimism, or something else. And maybe, at the margins, our leaders could have take a few steps to talk people down from their belief that assets only appreciate in value. But it wouldn’t have changed much.

Second – and this was supposed to be the topic of this post – it takes two to tango. If the U.S., seen as a single unit, borrowed a big pile of money, that’s because someone else lent it to us – and lent it to us cheaply. And while China isn’t the only country that lent us money, it was the major new lender of the last decade.

The U.S., as we all know, has been running a large trade deficit. The flip side of a trade deficit, leaving aside a few details, is foreign capital inflows. Again, looking at the U.S. as one big household, if we consume more than we produce, we have to pay for it somehow; we pay for it by selling assets (foreign direct investment in the U.S., foreign purchases of U.S. stocks, etc.) or borrowing money from overseas (foreign purchases of U.S. bonds).  If we are not saving enough to invest in our economy, then the investment is coming from some other country that is saving more than it needs for its economy.

So far, this may sound like ants and grasshoppers, one being more virtuous than the other. (Although, in the current situation, both are equally responsible for the degree of economic imbalance in the world.) But it’s a little more complicated. Because while Americans were over-consuming, the Chinese government was consciously and explicitly suppressing domestic consumption. It did this by intervening on foreign currency markets to keep its currency, the renminbi, artificially low. Having a cheap currency made Chinese goods cheaper in the U.S., increasing our imports. It also reduced the purchasing power of people in China, making it harder for them to buy imported goods and reducing their standard of living. So to the extent that the U.S. over-consumed, it was aided and abetted by other countries under-consuming, China most prominently.

I don’t know the specific mechanism used to control the exchange rate, but in general the most direct means would be some combination of printing more renminbi and using it to buy U.S. dollars. In order to be able to control its currency, and as a result of keeping it low against the dollar, the Chinese government has amassed roughly $2 trillion in foreign currency reserves, which are believed to be largely in U.S. dollar-denominated assets, such as Treasury bonds and the bonds of government agencies such as Fannie Mae and Freddie Mac.

Now, China wasn’t the only country building up foreign exchange reserves, largely in dollars. Since the emerging markets crisis of 1997-98, the conventional wisdom has been that large currency reserves are necessary to protect yourself against an attack on your own currency, and as a result countries like Russia, South Korea, and Brazil (all victims in 1997-98) amassed hundreds of billions of dollars’ worth of reserves on their own.

All of the U.S. dollar reserves held by all of these countries were effectively loans to the U.S. Treasury bonds were loans to our government; agency bonds were loans to our housing sector. This large appetite for U.S. bonds pushed up prices and pushed down yields, lowering interest rates and thereby fueling the U.S. bubble. Even though the money didn’t go directly into subprime lending, it lowered the costs for all the investors who were investing in subprime. so at the same time that irrational beliefs about asset prices were driving those prices up, the increased availability of money looking for things to buy also drove prices up. Looking at it counterfactually, if there had not been so much global demand for U.S. assets, it’s unlikely that even the once-divine Alan Greenspan could have kept 30-year mortgage rates as low as they were, since the only lever he had control over, the Fed funds target rate, is an overnight rate. And if mortgage rates hadn’t been so low, the bubble couldn’t have been as big.

Which brings us back to the present. Does China really want us to mend our ways, “raise [our] savings ratio appropriately and reduce [our] trade and fiscal deficits,” or do they just enjoy hearing themselves say it? If the U.S. does start saving and reduces its trade deficit, the impact on China’s export-led economy could be devastating. On paper, China could switch toward promoting domestic consumption, thereby reducing its reliance on exports, but at a minimum this is likely to cause significant internal dislocation for a period of years. In any case, they are likely to get what the wish for: the U.S. savings rate is likely to increase significantly simply due to the rush of panic that many Americans have felt for the last two months, and the trade deficit is likely to improve both due to a reduction in consumption and due to the fall in commodity prices.  Countries that want someone else to do their consumption for them may have to start looking elsewhere.

19 thoughts on “Causes: Where Did All That Money Come From?

  1. Good post, I totally agree with you. US was getting cheap loans and so did US consumers, which caused bubble in various assets and consumers got addicted to spending. It was fun while it lasted. In our schools, we definitely need to focus on teaching fiscal responsibilities and importance of savings.

    Also treasury needs to learn the lessons from this crisis, it looks like it is again creating new bubbles by providing super cheap loans (4.5% 30yr fixed) for buying homes. It is against US principles of free markets. This is artificially increasing buying power today. But when rates eventually rise then people won’t be able to sell these same houses at the prices they bought. Also, there should be strict enforcement of minimum 20% down (this will also promote savings), and will keep speculators who put nothing down away.

  2. So the U.S. can start printing more money to “ease” it’s problems .. and China can print more money to buy up the newly minted money, etc etc .. until eventually hyperinflation has completely eliminated my law school loans?

  3. From a reader, via email:

    I am always surprised by the view that the Chinese are somewhat at fault for the financial crisis because they financed US consumption.

    During the Asian Financial crisis, China did not devalue the RMB and, as a result, avoided countries in the region getting into a series of devaluations and also helped other economies recover sooner as their exports to China were less expensive in RMB terms. The Chinese government, while probably acting to some extent in its own self-interest, also behaved responsibly in the circumstances.

    Now the Chinese government is being criticized for being cautious and frugal in having built up a “safety net” to protect the country from external economic shocks. I don’t recall anyone “forcing” the US to accept foreign currency financing of their debt, nor forcing people to expand household debt to 140% of their assets, so is this criticism not backwards? Would we not be in better economic shape globally if the US had tightened its monetary policy a lot more in the late 1990s and early 2000’s as that should have reduced consumption and increased savings in the US while at the same time ‘encouraging” China to focus even more on ways to encourage domestic consumption? Could China take the view had the US been more restrictive in the last 10 or so years, then China would not have been as impacted by the financial and economic crisis from the US?

  4. To the above comment that I just pasted in: I take the point that insofar as any governments bear the fault of the crisis, the U.S. is first in line. We certainly could have had tighter monetary policy, which might have inhibited the growth of the asset bubble. That said, it’s not clear that increasing the Fed funds rate would have had that big an impact on mortgage rates: see <a href=””>this chart</a> for example. Mortgage rates are also dependent on the supply of money looking for long-term, dollar-denominated assets.

    But in my opinion, the fact that the U.S. bears more blame than everyone else does not preclude the possibility that other countries made unwise choices as well. If it was so evident that Americans were over-consuming and the U.S. economy was one big bubble, why did China continue pouring hundreds of billions of dollars – a currency that, relative to the renminbi, everyone knew to be overvalued – into that bubble? One explanation is that, once the first few hundred billion were invested in U.S. government bonds, China could not afford to let the value of those bonds fall – or their underlying currency – fall. (This is sometimes referred to as the financial equivalent of mutual assured destruction.) But isn’t that the equivalent of inflating a bubble because you don’t want it to collapse?

    This analogy isn’t quite right, but anyway: Most people, I think, recognize that there is blame to be shared both by subprime borrowers who took out mortgages they had no chance of affording, and subprime lenders who made credit available on excessively easy terms. I don’t think it’s an adequate defense on the lender’s part to say, “The borrower made a stupid decision; I just made it possible.” I think something of the same sort is going on here.

  5. _caustic: I’m not sure you wanted a serious response, but here’s a quick one anyway. Printing money and issuing new debt are actually the opposite of each other. If the Fed prints money, it doesn’t need anyone to buy anything. If Treasury issues debt, then it does need someone to buy it. But precisely because U.S. saving is going up, most of the money to buy that debt can come from domestic sources. We needed foreigners to buy our debt in the past precisely because we weren’t saving.

  6. It is could be certainly true that China is intervening on foreign currency markets to keep its currency low. But it could be true that these actions are mere complement of China competitive advantage of low prices due to the low cost of labor. GDP / person is roughly $5,000 (adjusted PPP). This huge difference (China GDP / person is 10% of USA GDP /person) could be more significant than the difference on their currency. In addition China core competences are fuel by International corporations that have established operations in China. We can speculate these corporations are teaching Chinese how to work better and how to improve the quality of products so they can do it by themselves later. So, the exports from China may continue and even may grow uncontrollable especially if we enter into a deflationary period. To further establish a better trade balance with China we may need to focus and invest in more research to improve the productivity of our people that will increase our competitive advantage. This could create more jobs, save more works, and eventually competitive more fairly with China.


    Can you explain how the dollar value gains or loses against other currency? Is it that simple other countries try to buy more dollar and keep it as reserve? In this case US economy is in recession and why there is a demand for dollar now? Or do other countries buy US treasury bonds now that put the dollar on demand now? How does dollar vaues get affected in respect to oil price?

  8. Forget the over-determination argument. It is not applicable here. Causation of any single event can rarely be determined by statistical analysis. The determination of causation in a financial crisis is a deductive process.

    There are valuable lessons to be learned (or more accurately relearned)from a careful analysis of events that lead up to the current financial crisis. If we don’t analyze what went wrong and take corrective action, we will soon be confronted by another similar crisis (the old lessons of history argument).

    The principal economic view of the Republican party since Reagan was elected President has been that unfettered, unregulated markets are efficient in allocating resources and lead to stable equilibria in markets. Acting on this belief, Bush allowed the opaque unregulated shadow global banking system to evolve into a behemoth(on the order of $10 trillion in assets) large enough to challenge the regulated banking system and take significant market share. In the end, this shadow banking system came to pose enormous systematic risks to the global economy (see: for a discussion by Geithner of the nature of this risk) and proved to be unstable in the face of a series of relatively small shocks (the sub-prime crisis). The Lehman bankruptcy caused a massive run on the then teetering shadow banking system that required a massive government intervention in capital markets to prevent the total collapse of the global financial system.

    The are a lot of lessons that needed to be relearned here. The process begins by analyzing what went wrong and isolating the primary causes of the crisis.

  9. Which came first, the chicken or the egg?

    If the US didn’t start the Greenspan credit expansion in the first place, China wouldn’t be able to accumulate such large Forex reserves in the first place. Japan also contributed with the carry trade.

  10. I reread this post and I sound like a grouchy old man. Although I’m not that old…..LOL

    But no one seems to understand the difference between investing and speculating. And how this crisis has has its seeds in 30 years of forgotten, web-like, interconnected history. There is some kind of amnesia afoot and it’s very strange indeed.

    To refresh all you young whippersnappers:

    The recycled petrodollars of the late 70’s energy crisis helped feed the Japanesse bubble/burst economy which simulatiniously scared the hell out of China and started them down a path of economic changes that damn bubble and burst feed dollars back into the US and abetted the asian currency crisis of the late 90s which is connected to that dislocation that fed more fleeing wealth back to the US for diminishing returns on bonds, which gave a good mojo to jack up the dot com bubble that almost but not quite got a chance to bust and beal before it was rescued by greenspan’s reckless, mindless, vacuuous response to 9/11 and the half decade of free money that forced everyone to take that dough, swallow that dough, choke on that dough. It was Free Money as Patti Smith says.

    But back to the forgotten definition of investor and speculator. An investor makes a return on cash flow. A speculator makes a return on capital gain. It’s a simple distinction. An easy one really.

    But this last 15 years has been hell on an investor trying to make a real cash flow living. Impossible in fact.

    Investors, and I lump my self in this class, could only speculate. We could not invest. There needs to be adequate cash flow returns to investors in order for there to be saving. Why save if money is free and there are no rewards for saving? Everyone has to become a speculator. It’s not so crazy. It’s not so mysterious. It’s not so amoral. Think it through. Bank savings account — 0.00125% return or 2% mortgage bet on a house price appreciation. I’d still take the 2% mortgage. So would you.

    You guys are overthinking it. Over the last 20 years you were burned if you saved and rewarded if you speculated.

    No one seems to know the difference anymore. How sad.

    Oh, and China still remembers the Opium Wars like they were yesterday. If I were Chinesse, I would want to get even…… but that’s another post.

  11. Would we not be in better economic shape globally if the US had tightened its monetary policy a lot more in the late 1990s and early 2000’s as that should have reduced consumption and increased savings in the US while at the same time ‘encouraging” China to focus even more on ways to encourage domestic consumption?

    We don’t make anything in the US – we consume. Tightening the belt doesn’t work when it’s wrapped around our throats, as we’re seeing now. And yet you’ve got people rooting for the demise of the US auto industry b/c they hate unions. I don’t get it.

    As for boosting China’s domestic demand, of course, that’s China’s plan. It will also mean the destruction of the US if we haven’t brought back a manufacturing base by then. Tick tock.

  12. I don’t recall anyone “forcing” the US to accept foreign currency financing of their debt, nor forcing people to expand household debt to 140% of their assets, so is this criticism not backwards?

    Nobody forced American’s because it was forced on us. You see, China never lent American’s foreign money. China lent American’s American dollars. Let me explain exactly how this worked…

    American’s buy Chinese goods with US dollars and US dollars go to China. In China, no business or person is allowed to keep US dollars, they are forced to hand them over to the Chinese government at a fixed exchange rate. Now the Chinese government has a couple options: they can buy US goods with their dollars; they can buy dollar denominated products like oil; or they can unload their dollars in the foreign currency markets. Because we have a trade deficit with China, they always end up with left over dollars so they need to put them somewhere. Well since they don’t want their renminbi to appreciate in value they can’t or wont exchange them on the foreign currency market which is exactly what would happen if they did. SO, what does China do with all those US dollars, they ship them over to the US to buy into US investment and treasury markets. So, yes China did force those dollars on us because they choose NOT to allow the renminbi to appreciate by dumping them on the foreign currency market which is what true capitalism calls for. It does take two to tango!!!

  13. The interesting thing is that China’s decision to invest the US Dollars it acquires via its fixed e.r. policy shrinks the US money supply. This raises domestic interest rates and thus domestic returns, which lowers our exchange rate, which China has to correct for by lowering their money supply. Seems like the net effect of the policy is null, or at least much weaker than intended.

  14. Regarding the “cause” of the crisis, James Kwak confused the issue in a fundamental way. The Chinese purchase of US treasuries have artificially kept US treasury rates low. However, that does not translate into over-borrowing by US consumers. First of all, we all know there is something called the “credit spread”. The fact that US governments can borrow at low rates from China does not imply banks should lend to deadbeat subprime borrowers at a low rate. Secondly, bank lending standards are the main cause of the subprime problem, not that the rates are too low. It is issues such as “liar loans”, 0% down, adjustable rate mortgages, fake appraisals, etc. If the subprime lending rates were 2% higher, would that have stopped the industry meltdown? I don’t think so. Now, Mr. Zhou’s comments are not quite right in getting to the cause of the financial crisis, but the blog here has followed the same stray path down to the wrong conclusion as well. As for the Chinese oversaving and investing in US treasuries, I agree that it’s China’s own choice. However, I don’t think that is necessarily a rational decision by an informed market participant. The decision is unilaterally made by the central government, which means it is set to achieve policy goals (namely fully employment). If we were talking about private sector players, the person who produces goods to sell it cheaply and then turn around to finance the consumer with cheap loans won’t be doing it for long. There is a Chinese saying called “drinking poison to stop the thirst.” Unfortunately, that is what the Chinese government is doing. At some point, the US money printing press will wipe out the value of US treasuries held by the Chinese government. Well, that simply constitutes the biggest wealth transfer in the history of world. As a Chinese, I feel sad to see that happen. Unfortunately, I don’t see anyway out of it now.

  15. The cost of money throughout the U.S. economy is a function of two things: the cost of money for the U.S. government (Treasury yields), and the perceived risk of whatever you are lending to relative to the U.S. government. The housing bubble was fueled by the fact that both of these were low: both the Treasury yields were low, and the perceived risk spreads were low. Lower Treasury yields translate into lower yields for everyone.

    The question is still valid: if mortgage rates were 2% higher, would people have paid so much for houses? But I don’t think you can answer the question that quickly. If you believe that the housing bubble was caused solely by option ARM loans with artificially low payments for the first year, then maybe. But a lot of the buying was being done by people with prime mortgages who were actually looking at their cash flow to decide how much house they could buy. When 30-year rates are around 6%, an increase of 2 percentage points means roughly 33% higher payments; put another way, instead of a $400,000 house, you can only buy a $300,000 house. (I know these figures are off because you have to look at the principal as well, but I don’t feel like looking up a mortgage calculator at this hour.) That seems like a big difference to me.

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