Don't Blame Trade Imbalances for the Financial Mess

by: The Baseline Scenario

By Simon Johnson and James Kwak

We’ve been at first amused but more recently alarmed at how “global imbalances” are becoming many people’s preferred explanation of the financial crisis.

At first you could brush it off this way: “global imbalances (read: ‘blame China’) . . .”

But this explanation is going mainstream, not least because it is always more convenient for policymakers and bad actors to blame someone far away. For example, The New York Times' Dealbook kicked off a roundtable discussion on the causes of the financial crisis this way:

“There is a conventional view developing on the financial crisis. The Federal Reserve’s policy of historically low interest rates spurred a worldwide search for higher risk and return. Concurrently, the entrenched United States trade imbalance led to a huge transfer of dollar wealth to Asian and commodity-based countries. The unwillingness of Asian economies, particularly China, to stimulate their own domestic consumption led these countries to reinvest the proceeds into the United States. This further contributed to lower American interest rates and further fueled the search for return.”

(Mortgage securitization gets mentioned, but only in the fourth paragraph!)

We took this on in our Washington Post online column this week, but thought it was interesting enough to repost here in full, below.


The time is here for our nation to actually do something about the recent financial crisis — that is, do something to prevent it from happening again. But instead, many people are finding it easier to pass the buck than to, say, regulate the financial sector effectively.

The recent Group of 20 conference in Pittsburgh was replete with talk about “global imbalances,” which means — in the spirit of the South Park movie — “blame China!”

According to this story, the global financial crisis was caused by hardworking Chinese factory workers who committed the sin of over-saving, which created a glut of money that needed to be invested, conceptualized in a great episode of public radio’s “This American Life” as the “giant pool of money.” (Japan and the oil exporters also had large surpluses, but for political reasons, the finger generally gets pointed at China.)

This beast from the East, seeking higher yields than it could find in Treasury bonds, flooded into the housing market, pushing down interest rates and pushing up housing prices, and creating a bubble that finally collapsed, with the results we all know. (More nuanced proponents of this theory hold, in a “fair and balanced” sort of way, that over-savers in China and under-savers in the United States — and other countries, like Spain, Britain and Ireland — are equally to blame. In any case, it’s the imbalance that’s the problem.) This is a convenient story because it absolves us of any need to put our own house in order through better regulation.

Like most errors, this story contains an element of truth. In general, it is not a good thing for a country to consume more than it produces indefinitely because to pay for its excess consumption it must borrow money from the rest of the world, and that country can consume more than it produces only if some other country produces more than it consumes. In particular, the U.S.-China imbalance is due in part to the Chinese policy of keeping its the value of its currency artificially low — encouraging Americans (and other foreigners) to buy Chinese exports and discouraging its citizens from buying imported goods.

But the “blame China” story (or the “half-blame China” variant) suffers from serious problems. First, it takes two to tango. No one put a gun to the American consumer’s head and forced him to buy a new flat-screen TV or to do so by taking out more debt. (Nor are the Chinese somehow morally superior to us; one reason why they save so much more than Americans is that, with no social safety net to speak of, they have to.)

Second, the Chinese government did not lend to American home buyers directly. China bought U.S. Treasury and agency (Fannie Mae, Freddie Mac, etc.) bonds, which put more money into housing and also crowded other people’s money into housing. But the vast majority of Chinese money went into the safer bits of the U.S. financial system; the speculative money came largely from European banks. And all the actual lending decisions were made by financial intermediaries (banks, mortgage lenders, etc.), which made plenty of bad decisions along the way while regulators, from Alan Greenspan on down, looked the other way.

Third, there is no particular reason why a “giant pool of money” should produce a bubble. A savings glut should lower interest rates, which should increase the value of housing; a bubble occurs when prices go up more than dictated by fundamentals like interest rates. If the run-up in housing prices was a direct result of over-saving in China, then housing prices should have fallen only if China stopped over-saving — which has not happened.

While Chinese over-saving was a contributing factor to the recent crisis, it was neither necessary nor sufficient. Cheap money is not bad in and of itself — all other things being equal, it’s better to have people lending to you at low rates than at high rates. The problem is what we did with the cheap money.

For the long-term health of the economy, we want that money to flow into capital investment by the business sector because that is the best thing we know of to boost long-term productivity growth. Instead, though, Tim Duy has a great chart, showing that the rate of growth of investment in equipment and software in the 2000s was far below the rate in the 1990s, even with all the cheap money of this decade.

This may seem like an obscure point, but basically it means that even with the low rates of the Greenspan Fed, and even with all that cheap money from overseas, we couldn’t get it where we needed it to go because it was being sucked up by the housing sector. And it was being sucked up by the housing sector because lenders earned fees for making loans that could not be paid back, and banks earned fees for packaging those loans into securities, and credit rating agencies earned fees for stamping “AAA” on those securities, and all sorts of financial institutions — including those same banks — loaded up on these securities because they offered high yield and low capital requirements. In short, we had a dysfunctional financial system that failed at its most fundamental job — allocating capital to where it benefits the economy the most.

Encouraging productive investment by businesses and preventing the next bubble go hand in hand — both require fixing the financial system. Blaming global imbalances — a consequence bereft of either a subject (an actor) or a verb (an action) — is only a way of avoiding our real problems.