Real Cause of This Financial Crisis? Global Hunger for Savings Instruments

Every sort of idiotic expanation is offered by academic economists for the financial crisis. Explaining the crisis has become a major industry. The academics by and large haven’t a clue. Grass might as well grow where their classrooms now stand. Wall Street greed and absence of risk management was the usual answer. That’s silly. The investors who bought subprime assets in 2006 weren’t any greedier than when they bought prime assets in 2004. The difference is that monstrous demand crushed the returns on prime assets.

During 2006, I tried (in vain) to build up a research department at the second-tier brokerage house Cantor Fitzgerald. No prejudice to Cantor: the business model they used at the time simply didn’t work out. But during 2006, I showed how global flows caused massive distortions in the pricing of American securities, and created demand for highly-levered structured instruments that (temporarily) provided higher returns. I published this story repeatedly through the year. In my first report for Cantor, on Jan. 5, 2006, I wrote:

In C.S. Lewis’s “Screwtape Letters,” an old devil gives practical advice to a novice demon. Diabolical amounts of leverage compressed credit spreads during 2005. Wrong as the market may be about inherent risk, it is likely to stay wrong, as the Fed backs off from aggressive tightening, the threatened curve inversion fails to materialize, absolute yield levels remain low, and investors enhance returns through leverage.

Investors are not piling into levered synthetic BBB structures because they are complacent about credit risk. On the contrary, all the investors I know are scared to death. But as long as the average U.S. pension fund requires returns of 8.75% to meet its long-term obligations, and the aggregate corporate bond index yields just over 5%, institutional investors will continue to pick up nickels on the slope of the volcano. Sponsorship of ever-more-esoteric structures is a failsafe symptom of yield dearth. Investment banks are selling AAA-rated synthetic CDO principal with coupon indexed to the performance of the equity tranche, like the old range accrual notes that brought down Orange County in 1996. Trust Preferreds, REITs, Chinese loans, home equity and a wide variety of other assets have entered the lists of CDO collateral.

The insatiable hunger for savings instruments on the part of the world’s aging savers is responsible, ultimately, for the great financial crisis. Huge foreign demand for US securities pushed the returns of prime securities down to levels that made them useless to most American investors, including pension funds who have fixed return targets averaging 9%, and banks funding at LIBOR. Once prime assets couldn’t meet the requirements of investors, subprime assets were invented to provide higher returns. Wall Street treated cancer with Red Bull, to be sure, and deserves all the opprobrium it has gotten — but it didn’t invent the cancer.

The charts below (click to enlarge) are derived from my 2006 spreadsheets; I published versions of them in early 2006.

First, massive foreign inflows into the dollar drove US interest rates down. The change in custody holdings in the chart below is the Fed’s holdings of Treasury securities on behalf of foreign central banks. The effect was most obvious in 2003 when massive Asian central bank intervention to hold the dollar up ballooned reserves. But the flood of capital that poured into the US through the 2000’s artificially depressed the overall level of rates.

Even more important is that the risk premium for prime assets disappeared. Shown below is the LIBOR Option-Adjusted Spread (that is, the expected excess return over LIBOR after taking into account the value of embedded interest-rate options) for a typical agency pass-through — that’s prime mortgages (guaranteed by a federal agency). This went from 80 basis points to zero between 2003 and 2005, as massive buying by Asian central banks and related agencies pushed down the expected return to levels never before seen. For that matter, the interest on high yield debt, adjusted for “expected loss” (the average loss rate over the preceding twenty years) went to zero.

We can see how foreign inflows caused the collapse of agency spreads during 2003-2007. Below are reported net foreign purchases of securities issued by Federal agencies (Fannie Mae (FNM) and Freddie Mac (FRE) mainly), against the LIBOR spread of these securities. (The LIBOR spread on a fixed rate bond is calculated including the cost of a fixed-to-floating interest rate swap). Foreign central banks were willing to buy these securities at LIBOR -20 basis points, because they had cash burning a hole in their pockets, and didn’t need to worry about funding costs. But every other institution that funded at LIBOR watched spreads fall with dismay. They simply couldn’t buy prime assets, given their own funding costs.

As the funding costs of the federal agencies collapsed, they bought more mortgages, and as they bought more mortgages, LIBOR OAS shrank, as per the second chart in the series. The close relationship between the LIBOR funding costs of the federal agencies and mortgage-backed securities is shown below.

That’s why investors went to subprime. Structured securities could be had with an undeserved AAA rating paying LIBOR+20 or LIBOR +25, and the likes of Citigroup (C) vacuumed them up in huge quantities and stuck them in Special Investment Vehicles with a paper-thin margin of capital to cover losses. AAA’s weren’t supposed to have any losses. So the Fed went along with it.

This created egregious mis-pricing of the whole credit market. I wrote on Jan. 27, 2006,:

We do not value pigs by the attractiveness of their physique, nor for the nobility of their character, but for their suitability for sausage. In a credit market dominated by the CDO bid, the most valuable securities are the ones that offer the most yield relative to default rates projected by the models that rating agencies use to rate CDO’s.

The financial crisis may have calmed down, but the sources of the crisis remain unchanged: the industrial world is unable to fund the greatest retirement wave in history at current returns. Everything that seems to offer yield turns almost instantly into a mini-bubble. This time, as I’ve argued, it’s the “troubled assets” that TARP was supposed to take off banks’ books. They have doubled in price during the past three to four months, just as losses are starting to creep up.

It was all obvious, foreseeable, and documentable — and I documented it in 2006.

Comments

[Moon Kil Woong:]

"But as long as the average U.S. pension fund requires returns of 8.75% to meet its long-term obligations, and the aggregate corporate bond index yields just over 5%, institutional investors will continue to pick up nickels on the slope of the volcano."

This is a great statement. Once again institutions are dawdling with risk in commodity and equity speculation and junk paper to book some returns other than the pitifully low manipulated rates the Federal Reserve has set. They seem oblivious to the fact that the asset bubbles asre starting to surface and the lava is churning once again.

Although you can fault them the fundamental reason for all of this is rwally the Fed's punishment of any savers whatsoever. For as long as they can't get decent rates on resonable risk with bonds they will be forced to play the greater fool game in speculative markets to try to get fair value for their money. The only problem is that just like a casino, the risk/reward doesn't balance and the game doesn't pay in the long run (unless you get someone else like the bank depositors or the government to stake you and/ior take the losses). That certainly seems to be the preferred tactic these days.

Oct 22 03:49 AM

[Dave Wrixon:]

So the problem is the channeling of a disproportionate amount of World resources into the US economy. The solution therefore is clearly to channel much of it back out again. Don't worry the markets are already on it. Even Ben cannot hold back this dyke.

Oct 22 04:07 AM

[chap08:]

Like those you criticize, you are only partly right and only describe one part of the picture. You say the cause was "insatiable hunger for savings instruments". That does not describe what was happening - and what is still happening.

Later on you say "The effect was most obvious in 2003 when massive Asian central bank intervention to hold the dollar up ballooned reserves". Now you are getting nearer the truth. This is all about trade and propping up the dollar. Why were these central banks buying up Treasuries? Because they didn't want to sell dollars and drive up their own currencies. There are many things they could have done with these funds, such as invest them in their own countries, or other developed nations. But they didn't - not because Treasuries were such outstanding value (clearly not) - but because they wanted to prop up the dollar and so support their export industries. Why does Japan own 20% of our Treasuries while supporting a massive national debt of their own? The underlying cause is trade.

As for "the average U.S. pension fund " which "requires returns of 8.75% to meet its long-term obligations", well sorry, but these idiots got what they deserved. First off to require 8.75% to meet long term obligations is stupid in the first place. There was no way for them to get returns of 8.75% without taking massive risks. Then to invest in CDOs because otherwise they won't get 8.75% is even more stupid. You said that "all the investors I know are scared to death". Does that say to you that they have responsibly placed pension assets in safe and appropriate investments? Or does it say that these idiots were afraid to think for themselves and heading for a fall?

Oct 22 06:20 AM

[User 353732:]

There is some truth in several explanations because multiple causes and forces converged to create sequential bubbles and frauds. No one explanation contains all the truth.

There was and is towering deceit and criminal greed on Wall St. That is part of the explanation. This deceit and criminality was actively facilitated by political corruption in WashDc, leveraged by irresponsible amounts of credit, scaled by the internet and made opaque by complex and deeply flawed algorithms.

There was and is howling incompetence, insatiable lust for power and repulsive vanity in WashDc which found in a servile and intellectually bankrupt Big Media a willing propaganda machine and in Wall St an enthusiastic financier. That is part of the explanation.

There was and is a monumental sense of entitlements amongst money and pension fund managers and many individual investors that high return and low risk could be attained systematically with little effort, no insight and negligible merit.That is part of the explanation.

Something for nothing, the inequitable allocation of risk to the ignorant, lazy and powerless and the illicit garnering of rewards by the powerful and the corrupt, the pathology of borrowing to consume and taking without deserving, of expanding rights and compressing responsibilities all created a milieu where financial engineering for its own sake replaced true capitalism and where the worship of money and power as an ends unto itself became the prevailing idolatry of both a tiny elite and scores of millions of ordinary people. It was and is the triumph of anti-capitalism over capitalism, of lies over truth.

Oct 22 07:01 AM

[tripleblack:]

[quote] The insatiable hunger for savings instruments on the part of the world’s aging savers is responsible, ultimately, for the great financial crisis. Huge foreign demand for US securities pushed the returns of prime securities down to levels that made them useless to most American investors, including pension funds who have fixed return targets averaging 9%, and banks funding at LIBOR. Once prime assets couldn’t meet the requirements of investors, subprime assets were invented to provide higher returns. Wall Street treated cancer with Red Bull, to be sure, and deserves all the opprobrium it has gotten — but it didn’t invent the cancer. [quote]

Right on the money, and a viewpoint I have been searching to find, couched in easy-to-comprehend language!

I wonder if it has occurred to anyone that this chain of events was enabled by the dollar's role as the world's "reserve currency", too.

Oct 22 07:27 AM

[a fat panda:]

Great. We have an article about how many how many explanations there are, and we get 3 more.

Guys, It is consumer debt that caused the problems. Consumer debt enable people to pull demand forward creating the revenues that made the whole thing look reasonable. The low interest rates let people consume hamburgers today for 2 on Friday. Only it wasn't hamburgers. It was cars, and houses, and TVs.

That is layer one. In the next layer, the TV manufacturers became 'rich' selling future demand today. The workers wanted more pay so we set pensions at 8.5% discount rates so that we wouldn't have to fund them. At one point, America had something like 9% of the population was millionaires, all selling tomorrows demand today.

It wasn't just housing that had a bubble. American expectations were in the greatest bubble in history.

Oct 22 07:34 AM

[VK9141:]

Nice article, good use of some striking data to illustrate.

Not sure it's sufficient to offer such a bold headline (although you need to stop somewhere before getting trapped in circular arguments...and it got my attention). But I like the opener which is true and the points you raise along the way make a lot of sense.

In particular the point about shifting demographics in the west.

All at the same time as China's emergence and the other themes mentioned in the above comments (and more).

Looking back now, given such strong geopolitcal forces, it seems the crisis was bound to happen.

Oct 22 07:35 AM

[Keithdt:]

After attacking "idiotic explanations" he contributes another.

Oct 22 07:58 AM

[prudentinve...:]

Your opening sentence is great, ".. Every sort of idiotic expanation is offered by academic economists for the financial crisis ...", but I would also extend it to the vast majority of MSM commentators.

It is obvious to anyone with any intelligence that artificially low interest rates promote bubbles and mis-allocate capital and resources, and this is indeed the single root cause of this crisis. Every other explanation has this simple, obvious fact as its underlying root.

It is unbelieveable that "educated" policymakers and professors should be oblivious of such a basic fact, so perhaps they are aware of it, but choose to pretend otherwise since the politicians, the vocal elements of the MSM, and the underproducing but overconsuming sections of the populace all loves bubbles.

Oct 22 08:13 AM

[Andrew Butter:]

You are absolutely right, I remember having the game explained to me in 2000 by someone from CSFB when I started to work on a toxic asset assembly line, he said:

"Demand for AAA is hugely more than supply".

What went wrong though was a quality issue, there was no quality control on what AAA was, notwithstanding that the US regulators insisted that pension funds and insurance companies held a proportion of their assets in AAA.

Oct 22 08:16 AM

[Econ 1:]

In a nutshell are we saying the Derivative Cowboys are responsible for the meltdown? Or the Fed? Oh no wait it's those Chi-Coms. No, it's the artificially driven saving's killing 0 % interest rates that did us in. Hmmm... I think interest rates should be discovered by the market's supply and demand of available credit (supplied by the nation's saving's holdings) and then the business people could have a clear gauge (the amount of savings in the nation) as to where we are in the business cycle. I guess thats just the Austrian in me;)~ Hell, I think the Glass-Steagall Act was a good idea. I mean a really, really wise and good idea and am I the only person concerned they haven't reinstated the up-tick rule? what were we talking about?sorry

Oct 22 08:19 AM

[Graham and ...:]

Keynes taught us (wrongly) to shun savings and glorify spending. But ultimately, what drives an economy forward is savings (and investment). The WHOLE IDEA is one unit less today means two units tomorrows.

No, it's not global savings, but global greed that caused this crisis. Savings is good, greed is bad (to stand Gordon Gekko on his head).

Put another way, too many Baby Boomers were counting on the stock market to manufacture "savings," without actually saving themselves.

Oct 22 08:57 AM

[Dave Wrixon:]

AAA is simple. It simply means Made in the USA. Everything else was regarded as sub-prime.


On Oct 22 08:16 AM Andrew Butter wrote:

> You are absolutely right, I remember having the game explained to
> me in 2000 by someone from CSFB when I started to work on a toxic
> asset assembly line, he said:
>
> "Demand for AAA is hugely more than supply".
>
> What went wrong though was a quality issue, there was no quality
> control on what AAA was, notwithstanding that the US regulators insisted
> that pension funds and insurance companies held a proportion of their
> assets in AAA.

Oct 22 09:02 AM

[john s. gordon:]

talk about treating gangrene with aspirin pills.
nickels on the slope of the (rumbling) volcano - good simile.
thanks to the author for explaining all this.
> jack

Oct 22 09:07 AM

[sheople:]

What you say is true, but didn't the moving of manufacturing out (with government help) and the exporting of cheap labor (with government help) precipitate the whole mess?


On Oct 22 07:34 AM a fat panda wrote:

> Great. We have an article about how many how many explanations there
> are, and we get 3 more.
>
> Guys, It is consumer debt that caused the problems. Consumer debt
> enable people to pull demand forward creating the revenues that made
> the whole thing look reasonable. The low interest rates let people
> consume hamburgers today for 2 on Friday. Only it wasn't hamburgers.
> It was cars, and houses, and TVs.
>
> That is layer one. In the next layer, the TV manufacturers became
> 'rich' selling future demand today. The workers wanted more pay so
> we set pensions at 8.5% discount rates so that we wouldn't have to
> fund them. At one point, America had something like 9% of the population
> was millionaires, all selling tomorrows demand today.
>
> It wasn't just housing that had a bubble. American expectations were
> in the greatest bubble in history.

Oct 22 09:27 AM

[Vuke:]

Mr. Goldman makes a very good argument. The global hunger for savings has long been fueled by the global rush to print paper. All that paper is now looking for a return.

Sadly, the mountains of "profits" booked on smoke and mirror economies have nothing immediate to rush into except more of the same.

Oct 22 09:35 AM

[Commercial ...:]

Of course investors want AAA securities at high yields; who doesn’t?

The problem was not, and is not the huge demand for safe investments with good returns; that demand is universal and constant.

The problem was that bonds rated AAA were not actually AAA, they turned out to be BB- or worse.

The problem is not the fact that every one wants gold; the problem is that all that glitters is not gold.

Oct 22 09:43 AM

[Tom E.:]

A value added tax is needed and seniors can help to fund their own retirement.

Oct 22 11:06 AM

[john s. gordon:]

of course the offshoring of manufacturing was a disaster.
of course the fraud of the rating agencies was a disaster.
anything else?
> jack

Oct 22 11:47 AM

[Skjellifetti:]

>Every sort of idiotic expanation is offered by academic economists for the financial crisis. Explaining the crisis has become a major industry. The academics by and large haven’t a clue. Grass might as well grow where their classrooms now stand.

I call shenanigans. Warning about the probable consequences of the structural imbalances caused by Asian's high savings rate has been a cottage industry in academia for years. As Herbert Stein once said: "If something cannot go on forever, it will stop." Too bad that the financial industry refused to listen.

Oct 22 12:13 PM

[Fabien Hug:]

The point is well mentioned; we have a demographic problem. Few people stand behind the baby boomers in our Western societies.
That's the cause of the crisis, nothing else. If interest rates would be kept high, we would face a growth problem and there would be no savings to be fed with these high interest rates anyway. What should we do? Less growth, higher interest rates? That would profit the retired generation. Do they need it? Certainly, but they have the baby boomers to back them up for the moment (Soc Sec). Low interest rates, higher growth? That profits the workforce and the biggest demographic mass (it worked so far but the machine seems to be rusted). Is there a way to balance this out? Certainly, but that will involve a lot of politics and government interference so forget about for the moment. The solution for baby boomers? Profit from growth when you can and save. In Switzerland, the actuarial pension rate is 6.5% down from 7.5% earlier in the decade. This rate is an official rate that includes life expectancy and return on investment. It is used to compute the reserve level of pension funds. Many say that it's still too high (pension funds have real a problem to get returns that allow to reach this technical rate). What it means, is that if you have $ 1 mil in savings at retirement, you get $ 65,000/year in pension money. $ 1 mil is still a lot of money but $ 65,000 doesn't bring you far in a big US or European city. As far as I can see, baby boomers have nobody to cover their backs.

Oct 22 12:24 PM

[pacalis:]

I think this is a nice re-framing of the problem. A big question in all of this is why did people buy all this mortgage backed s$#t. If there was no demand, these mortgage products wouldn't have sold and banks would have been forced to hold the debt of the mortgages they made rather than skimming fees of the transactions. If the banks held the debt, like the did in Canada, you can be damned sure that (1) less mortgages would be given out, and (2) that the quality of the average mortgage would be much much higher.


On Oct 22 07:34 AM a fat panda wrote:

> Great. We have an article about how many how many explanations there
> are, and we get 3 more.
>
> Guys, It is consumer debt that caused the problems. Consumer debt
> enable people to pull demand forward creating the revenues that made
> the whole thing look reasonable. The low interest rates let people
> consume hamburgers today for 2 on Friday. Only it wasn't hamburgers.
> It was cars, and houses, and TVs.
>
> That is layer one. In the next layer, the TV manufacturers became
> 'rich' selling future demand today. The workers wanted more pay
> so we set pensions at 8.5% discount rates so that we wouldn't have
> to fund them. At one point, America had something like 9% of the
> population was millionaires, all selling tomorrows demand today.
>
>
> It wasn't just housing that had a bubble. American expectations
> were in the greatest bubble in history.

Oct 22 01:08 PM

[TxTim:]

Follow Chap08...he get's it. It's all on the doorstep of trading with foreign countries who won't truly float their currency people.... Everyone wants the cheap goods but nobody enforces fair trade. The imbalance will always and without exception end in problems.


On Oct 22 06:20 AM chap08 wrote:

> Like those you criticize, you are only partly right and only describe
> one part of the picture. You say the cause was "insatiable hunger
> for savings instruments". That does not describe what was happening
> - and what is still happening.
>
> Later on you say "The effect was most obvious in 2003 when massive
> Asian central bank intervention to hold the dollar up ballooned reserves".
> Now you are getting nearer the truth. This is all about trade and
> propping up the dollar. Why were these central banks buying up Treasuries?
> Because they didn't want to sell dollars and drive up their own currencies.
> There are many things they could have done with these funds, such
> as invest them in their own countries, or other developed nations.
> But they didn't - not because Treasuries were such outstanding value
> (clearly not) - but because they wanted to prop up the dollar and
> so support their export industries. Why does Japan own 20% of our
> Treasuries while supporting a massive national debt of their own?
> The underlying cause is trade.
>
> As for "the average U.S. pension fund " which "requires returns of
> 8.75% to meet its long-term obligations", well sorry, but these idiots
> got what they deserved. First off to require 8.75% to meet long term
> obligations is stupid in the first place. There was no way for them
> to get returns of 8.75% without taking massive risks. Then to invest
> in CDOs because otherwise they won't get 8.75% is even more stupid.
> You said that "all the investors I know are scared to death". Does
> that say to you that they have responsibly placed pension assets
> in safe and appropriate investments? Or does it say that these idiots
> were afraid to think for themselves and heading for a fall?

Oct 22 01:17 PM

[Mr. Big:]

Real cause of the financial crisis?

Ooohhh....where do we start? Some may argue that the seeds of the crisis were planted when the gold standard was abandoned and replaced by fiat money. Recall, in the not so distant past, the days that a family of 5 can be supported by a single income earner? Well....that's long gone now. It was replaced by the dual income family of 5 with dual income, but this family can live a very comfortable and high standard of living and still have plenty of savings for home equity and retirement. Well, guess what? Those days are gone too. Now, the typical family of 5 has dual income earners and can barely make ends meet. Worse, they relied on debt to make up for short-comings.

The rape and pillage of the people, right before the very eyes of the people themselves, all under the illusion that life has advanced for the better for all.

Well....this is just the seed for the crisis. But it set the stage of what was required to happen. But what actually directly contributed to the crisis was a series of events that culminated to the current crisis. These events being:

1) Baby boomer generation being born.
2) Corporate profits outpacing wage increases
3) China joining the Global Trade Organization and the pegging of its currency to the USD
4) The USD being the sole world reserve currency
5) 9/11
6) Bush's tax cuts
7) Greenspans accommodative policies
8) Relaxation of financial regulatory standards
9) The boom in financial engineering
10) Failure of ratings agencies to provide true picture of risk.

Each one of these events, by themselves, would not cause a crisis, but the specific sequence of events had a reinforcing effect that literally blew up in our faces.

Oct 22 01:30 PM

[goldbug101:]

Cheap money is as cheap money does.

Oct 22 03:38 PM

[debtacid:]

A naïve and overly simplistic “expanation” that excludes any mention of the systemic fraud and corruption of 2B2F banks like BA and CS that this guy worked for.

Oct 22 03:58 PM

[Shonkypom:]

Its partly true. But like most baby boomers, this one thinks he invented everything, and that the world revolves around his peer group. He might be chastened to think of the billions of people being born in the developing world. The baby boomer generations retirement problem is just a wart on the face of an ugly pig.
The real issue is that the financial wealth of the world was generated in the 20th century by the pillaging of all natural resources as if they would last forever. Theres precious little left to pillage now. The next wave of economic growth must come from tailoring our economies to enjoy a high standard of living whilst leaving the lightest footprint on our environment.
I'm a capitalist, and I like being rich, but I know its a house of cards, and I'm ready for the reckoning.

Oct 22 04:27 PM

[Jaysan:]

On Oct 22 06:20 AM chap08 wrote:

> Later on you say "The effect was most obvious in 2003 when massive
> Asian central bank intervention to hold the dollar up ballooned reserves".
> Now you are getting nearer the truth. This is all about trade and
> propping up the dollar. Why were these central banks buying up Treasuries?
> Because they didn't want to sell dollars and drive up their own currencies.
> There are many things they could have done with these funds, such
> as invest them in their own countries, or other developed nations.
> But they didn't - not because Treasuries were such outstanding value
> (clearly not) - but because they wanted to prop up the dollar and
> so support their export industries. Why does Japan own 20% of our
> Treasuries while supporting a massive national debt of their own?
> The underlying cause is trade.

Chap08 is on the right track but not yet there. The underlying cause is certainly not trade! The underlying cause of the anomaly he and Goldman describe is that currencies do not automatically adjust to trade imbalances the way they would do if all countries involved were on a gold standard (or other hard standard like a basket of commodities or whatever).

As my hedge fund manager pal wrote about this issue:

"In a free market gold standard when one country imports more than it exports, it must export gold. That means the importer's money supply declines, and in response, so do its prices. The exporter must import gold which makes its money supply and prices both rise. As the importer's prices fall and the exporter's prices rise a new equilibrium is reached that BALANCES TRADE between the two nations. The mix of goods and amounts may change but eventually prices fall enough in the importing country and rise enough in the exporting country that a sustainable BALANCE in trade develops. That is how a free market allocates trade and is the very basis of the theory of gains for trade to both countries that David Ricardo argued in response to Mercantilism and then proved mathematically.

The problem is that a fractional reserve fiat currency reserve-based system DOES NOT BALANCE TRADE. Instead the US (importer) buys more than it consumes and US dollars leave the country electronically. But the Fed simply prints more so that the US does not face a lower money supply or lower prices - it is not forced to make an adjustment. Conversely China (the exporter) faces an inflow of dollars but it does not face an increase in money supply and prices. Instead it accumulates Reserves which it then has to recycle into dollar-based assets to prevent its currency from rising which would cut off its export advantage. Thus instead of trade being balanced to a sustainable level, you get artificial excess imports and chronic trade deficits in the importing country. In the exporter you get excess production beyond the free-market sustainable level, which are furthered by huge reserves which go toward buying Tbonds which then create artificially low interest rates, which in turn allow consumption to remain excessive for longer, and produce all the problems Goldman wrote about, including the reach for higher yield in an artificially low yield world.

The problem is that the distortion of a fiat currency is interfering with the mechanism through which sustainable trade is established, and excess production and artificially low rates develop, leading to bubbles and poor decision making and yield reach."

Oct 22 07:55 PM

[User 377624:]

Very interesting point you're making. I blame it on the central banks' policy of low rates through increased money supplies.
Low interest rates mean only lower returns are achievable at reasonable risk.
Inflation concerns mean higher returns are desired.
That's why lower rates encourage higher risk. It's all fine until eventually someone trips and then the whole system collapses with them.

Oct 22 08:18 PM

[derryl:]

Jaysan,
That is the most concise and elegant presentation I have seen of the gold standard trade balancing mechanism. The mechanism's virtuous discipline is utterly thwarted by the ability and eagerness of the post-gold fiat reserve currency issuer to solve all domestic problems by creating more money.

But Mr. Goldman is right. All this created money ends up as somebody's savings, seeking yield. The simple fact of our present state is that there is way too much money in the world chasing way too few productive places to put it to work. So excessive demand for financial investments led to a declining interest rate and the invention of 'innovative' financial products to absorb the money by promising yield.

It must be remembered that investment in "financial products" is investment in somebody's debt. Savers have money, borrowers need it, so savers "invest in" borrowers' debt. It is ultimately the borrowers' payments of interest on their debts that provides "yield" on MBS and other CDOs.

And Keynes was also right about the "paradox of thrift" in a fiat money, debt-money monetary system. Savings is money that is removed from the circulating money supply, the producing and consuming economy. So if borrowers have collectively borrowed $1 trillion and spent it into the economy, and savers have collectively saved $300 billion, there is only $700 billion left in the economy for those borrowers to earn back and repay their loans. Musical chairs. There are $300 billion too few chairs in this equation if the money supply expansion music stops.

When money supply is growing new borrowers get new bank loans and spend new money into the economy fast enough to replace the money lost to savings. But we are entering a new normal where borrowers have collectively reached their debt ceiling so nonexistent new loans will not solve this problem. Money supply is actually shrinking as debts are repaid or bank capital is extinguished covering loan losses.

So savers have been relending money to the borrowers and borrowers have been using ever increasing debt just to stay liquid. Like Treasury borrowing money to pay interest on its old debt. This arithmetic obviously cannot go on forever, so it didn't.

Oct 23 03:45 AM