In June Martin Wolf wrote approvingly of a report on the role of global imbalances in the financial crisis:
The authors conclude that the low bond yields caused by newly emerging savings gluts drove the crazy lending whose results we now see. With better regulation, the mess would have been smaller, as the International Monetary Fund rightly argues in its recent World Economic Outlook. But someone had to borrow this money. If it had not been households, who would have done so – governments, so running larger fiscal deficits, or corporations already flush with profits? This is as much a macroeconomic story as one of folly, greed and mis-regulation.
Since then this view has become common. For example Wolfgang Munchau in Monday’s Financial Times states: “Without excessive imbalances, the demand for products we now refer to as toxic assets would have been smaller.”
It is not clear, however, that this causal story really makes sense when analyzed in a demand and supply framework. Afterall, the “crazy lending” that Martin Wolf references represents an increase in the supply of financial assets over and above what would exist in a world with normal lending. It is far from clear why it is correct for anyone to claim that a shift in the demand for financial assets “causes” a shift in the supply of financial assets. Standard economic analysis would usually claim that a shift in the demand for financial assets results in a movement along an existing supply curve raising the price of the assets and lowering their yield.
While it is true that we observe in the data a decline in the yields of fixed income assets, this phenomenon is consistent with the observed increase in supply of these assets – as long as the shift in demand was sufficient to outweigh the effect of an increase in supply. In other words, while “crazy lending” caused an increase in supply and tended to raise the yields on these assets, this effect was overwhelmed by the increase in demand.
Now in a world with alternate assets, like ownership interests, increasing the supply of fixed income assets and therefore their yields will tend to attract investors to bonds and discourage them from entering more pricey stock markets. Thus, as long as we acknowledge that there was “crazy lending” going on and thus that the supply of fixed income assets was greater than it would have been a world without “crazy lending,” surely we must also acknowledge that this raised fixed income yields above their natural level and reduced the tendency of investors to put their money into equity and alternative assets instead of fixed income assets.
In fact, it is entirely possible that extremely low yields in fixed income markets and a shift by emerging market money into equities would have prompted reconsideration on the part of both developing and developed economies of the wisdom of maintaining massive current account imbalances. That is, it is entirely possible that “crazy lending” actually slowed the current account adjustment process – precisely because “crazy lending” prevented the returns on fixed income assets from falling to derisory levels.
In short, elementary economic analysis allows us to reach a conclusion opposite to Wolfgang Munchau’s: Without toxic assets, the quantity demanded of fixed income assets would have been smaller. We can also conclude that in the absence of toxic assets, foreign capital flows into US equity investments would have been greater. Left with a choice between derisory fixed income returns and riskier investments, foreign investors would have had a strong incentive to reduce their allocation of funds to the US market. In other words, in the absence of toxic assets the “savings glut” might have started to unwind on its own.
Thus, while emerging market demand for fixed income assets made it possible for financiers to produce and sell toxic assets, the fact remains that the supply of toxic assets increased the supply of bonds, raised the yields on bonds relative to an environment without toxic assets and by doing so interfered with the price mechanism that would tend to reduce emerging market demand for fixed income assets. Whether allowing market forces to operate would have been enough to start the unwind of global imbalances is unknowable, but we can be sure of one thing: the production and sale of toxic assets worked to keep the demand for fixed income assets high and by doing so worked against the resolution of global imbalances.