Bernanke Blames the Global Financial Crisis on China

They must put something in the water at the Fed, certainly the Board of Governors and the New York Fed. Everyone there, or at least pretty much everyone who gets presented to the media, seems to have an advanced form of mental illness, namely, an pronounced inability to admit error. While many in public life suffer from this particular affliction, it appears pervasive at the Fed. Examples abound including an overt ones like an article attempting to bolster the party line that no one, and hence certainly not the central bank, could have seen the housing bubble coming, or subtler ones, like a long paper on the shadow banking system that I did not bother to shred because doing it right would have tried reader patience Among other things, it endeavored to present the shadow banking system as virtuous (a necessary position since the Fed bailed it out) because it was all tied to securtization and hence credit intermediation. That framing conveniently omits the role of credit default swaps and how they multiplied the worst credit risks well beyond real economy exposure levels and concentrated them in highly geared financial firms.

Another example of the “it is never the Fed’s fault” disease reared its ugly head in the context of the G20 meetings. The big row is over global imbalances with the US mad at China for not doing enough to rebalance its economy (code for consume more, export less). China is admittedly trying to take the barmy position that its huge reserves really don’t count (huh?) so I suppose the Fed thinks it can trot out some whoppers of its own.

Actually, this is an old whopper, since the Fed has maintained for some time that the “savings glut,” meaning emerging markets and in particular China saving too much, had a lot to do with the crisis. From the Financial Times:

Foreign investors’ hunger for safe US assets helped to cause the 2007-2009 crisis by encouraging banks to turn risky mortgages into AAA rated bonds, Ben Bernanke, US Federal Reserve chairman, argued in Paris on Friday.

“The preference by so many investors for perceived safety created strong incentives for US financial engineers to develop investment products that ‘transformed’ risky loans into highly rated securities,” said Mr Bernanke, presenting a new research paper that he co-wrote with other Fed economists.

Mr Bernanke has previously argued that a “global savings glut” led emerging markets to send large amounts of capital to the US in the 2000s, pushing down US interest rates. His new paper says that those emerging markets wanted safe assets – and US regulators failed to keep the financial system from creating them.

“In analogy to the Asian crisis, the primary cause of the breakdown was the poor performance of the financial system and financial regulation in the country receiving the capital inflows, not the inflows themselves,” Mr Bernanke said, adding that the US crisis had given him new sympathy for developing countries that have to manage large capital inflows.

This argument supports Mr Bernanke’s view that low Fed interest rates did not make an important contribution to the financial crisis and the main errors were in regulation.

According to the paper, more than 75 per cent of investment from “savings glut” countries was in AAA rated US assets in 2007, whereas such assets accounted for only 36 per cent of total US securities.

Help me. If this really passes for analysis at the Fed, as opposed to a mere cynical effort to create a talking point, no wonder we had a global crisis.

First, correlation is not causation.

Second, how material was that 75% in terms of the total market for AAA securities of all types?

Third and most important, the savings glut countries liked Treasuries and Agencies. They did not buy the AAA securities that were at the heart of the crisis, namely AAA rated CDOs (far and away the most important driver of the toxic phase which turned a mere housing bubble into a global financial crisis) or AAA RMBS. Without a convincing explanation of a transmission channel between for Treasuries and Agencies, and the seeming free lunch of higher yield AAA paper that these foreign buyers for the most part shunned, this story remains unconvincing. And notice the Fed has been telling the global savings glut story for nearly three years now and still has not found a way to make a causal connection.

In addition, as we’ve pointed out repeatedly, when the Fed started increasing interest rates, demand for prime mortgages fell yet demand for subprime was supercharged. That is an unheard of pattern. When the Fed tightens rates, the outcome usually is for spread of risky credits to rise first and most and safer borrowers to rise less. Unless you can explain this deviation, you have again failed to explain the crisis, and this savings glut twattle does not cut it.

We debunked this thesis in ECONNED:

Now let’s take this one step further: where did the lending boom come from, exactly? As you may recall from the last chapter, the Fed and Treasury would have us believe that the “savings glut,” a.k.a., the Chinese, was the culprit. And the Chinese, along with other central banks in trade surplus countries, did play a role in this drama, through their continued appetite for AAA securities, along with others predisposed toward AAA paper (recall that starting in 2001, foreign central banks became the major actors in buying U.S. Treasury and agency paper).

The average global savings rate over the last 24 years has been 23%. It rose in 2004 to 24.9%. and fell to 23% the following year. It seems a bit of a stretch to call a one-year blip a “global savings glut,” but that view has a following. Similarly, if you look at the level of global savings and try deduce from it the level of worldwide securities issuance in 2006, the two are difficult to reconcile, again suggesting that the explanation does not lie in the level of savings per se, but in changes within securities markets.

At the same time, other data do lend support to the notion that the shadow banking system was the main culprit in the meltdown. Bank lending has contracted far less than its murky twin. Although global corporate lending did fall from its peak of $2 trillion in 2007 to $1.5 trillion in 2008, that level was on par with 2006. Between the second and third quarter of 2008, U.S. bank credit increased 1%, and between the third and fourth quarter, banking industry consultants Oliver Wyman estimated that it contracted by 0.5%.

By contrast, while $1.8 trillion of asset-backed bonds were issued in 2006, only $200 billion were floated in 2008, and issuance through mid-2009 was “minimal.” Similarly, Credit Suisse pegs the contraction in “shadow money” in private debt securities since 2007 at $3.6 trillion, or 38%, due primarily to the substantial increase in repo haircuts, plus a dearth of new issues and a fall in prices.

But of course, the Fed has to continue to assert that its super low rates really have no distorting effect on the wider world. The learned blindness is truly astonishing. Anyone with an operating brain cell can see that the object of Fed policy is to blow a new asset bubble to create a wealth effect to stimulate demand (or more accurately to prop up asset prices, and since the Fed has said it does not believe in asset bubbles, it won’t recognize it has created one till after the fact). And as we have also said repeatedly, the Japanese demonstrated in the late 1980s when they explicitly tried to create a bubble to stimulate domestic spending, that the end result is a financial crisis and a bad economic hangover.

So it does not take much in the way of imagination to see that goosing assets prices in thing you’d like to stabilize, like US housing and stocks, is going to leak into all sorts of other markets, like commodities. But the Fed is insistent on dodging responsibility for its past mistakes as well as its current actions.