As the Obama Administration continues to roll out its proposed legislation (click here for the most recent update) to overhaul regulation of the financial industry, it is important to understand the root causes of the financial crisis.  Regulators had difficulty foreseeing much of what we now refer to as “systemic risk” because such risk, in the form of new and untested financial instruments like credit default swaps and other securities and derivatives, was largely undisclosed and unregulated.  Further, those instruments would not exist but for the money available to invest in them.  And there is where this analysis begins.  The Federal Reserve was responsible for creating the conditions whereby enormous sums of money flowed into the U.S.  The same Federal Reserve that, under the administration’s plan will receive additional powers to oversee systemic risk, thus further distracting it from its mission to implement monetary policy.

This author drafted the following analysis for, and it will become part of, a report on the causes of the financial crisis issued by the American Bar Association.

Causes of the financial crisis did not only originate in changes in legislation, regulation and regulatory oversight, but also in lax monetary and fiscal policy.  The Federal Reserve, seeking to end the technology equity bubble recession of 2000-2002, quickly dropped its federal funds rate to historic lows and held the rate at a low level for an extended period of time.  Simultaneously, “global imbalances,” the large and persistent current account deficit in the United States and, to a lesser extent, the United Kingdom and other wealthy nations, financed by large surpluses in emerging markets, like China, kept long-term interest rates low even when the Fed began raising the federal funds rate.  Both low interest rates and the current account deficit are to blame for creating an unwarranted expansion of the monetary supply.  This excess credit was invested heavily and narrowly in the United States through purchases of Treasury securities and investment in the financial derivatives market, leading to a bubble in housing prices and commodities. 

Low Interest Rates

 In the aftermath of the collapse of the technology equity bubble and the terrorist attacks on September 11, 2001, then Fed Chairman Alan Greenspan injected an enormous amount of liquidity into the U.S. monetary system, which lowered short-term lending rates to 1 percent by 2003.  That target interest rate, representing a 50-year low, was held in place until June 2004.  Economists have argued that the Fed’s interest rate policy, especially the period between 2003 and 2005, held the target interest rate well below guidelines that would indicate “good policy” based on historical experience.[i]

 The low interest rate environment had two significant consequences: (1) an explosion in credit, which is discussed later in this section; and (2) low returns on traditional investments, which likely fueled the boom in hedge funds and private equity.  Generally, low interest rates are beneficial, as the low cost of capital encourages business borrowing for research and development, capital investment or expansion initiatives.  In addition, all of these activities create jobs.

 However, the downside of low interest rates is a reduced return on risk-free assets, such as U.S. Treasuries.  Financial managers, seeking to achieve a minimum yield for their clients (many of whom were retired or soon-to-be-retired), and individual investors acting in their own interests reallocated their portfolios towards more lucrative but riskier assets.  Another method to generate higher returns in a low interest rate environment required an extreme use of leverage.  For example, buying an asset that produces a cash-flow yield of 6.5 percent by leveraging the purchase at 9:1 with a borrowing cost of 5 percent achieves a 20 percent yield.  According to one economist, “Leverage can create the mirage of investment acumen in a rising market that is only unmasked as recklessness in a declining one.”[ii]  In short, low interest rates not only facilitated excessive borrowing, but, in conjunction with raised expectations for return-on-investment and a need for financial managers to show “investment acumen,” the environment likely encouraged mass leveraging as well.

 Current Account Deficit

 With its citizens and corporations borrowing heavily, the United States ran a current account deficit that, beginning in 1992, deepened each year.  The current account measures the balance of investment and savings. The deficit was not due an increase in investment; rather, Americans switched habits from being net savers to net debtors.

To pay for the deficit as Americans became more leveraged, U.S. had to borrow from foreign sources, usually by issuing treasury debt. Countries with emerging markets that had enjoyed surpluses were happy to oblige.  For instance, the income of oil-exporting countries had ballooned since 2004 because of higher prices for crude.  It would have been neither feasible nor wise for oil-rich nations to spend this windfall within their own borders, and so, much of it was saved and sent abroad. Economists who have sought a unifying reason to explain the saving behavior of a disparate group of countries have converged on one important motive: the need to invest in reliable assets that may be easily converted to cash in the event of an emergency.  Because U.S. assets were considered to be of high quality and the U.S. financial markets were well developed, and thus liquid, the U.S. attracted more investment in its debt than it needed. 

As foreign investment bought up large amounts of U.S. Treasuries, the yield on those investments dropped to a level where foreign investors sought out riskier assets to improve their return.  Those investors then looked to another U.S. asset: real estate.  Owning a mortgage on a single property represented too much risk for a foreign investor, but securities and derivative financial products provided an avenue to diversify both systematic and credit risk in a liquid (or what seemed to be liquid) asset.  Thus the explosion in mortgage-backed securities and derivatives, and the hedge funds that traded them, may find an explanation, at least in part, in the current account deficit. 

Surplus of Credit 

The low interest rate monetary policy caused an increase in leveraging, which, in part, boosted the current account deficit, requiring more foreign investment, which was attracted by the liquidity and relative safety of U.S. markets.  These conditions also caused the U.S. dollar to decline in value, beginning in 2002, which encouraged foreign savers to borrow dollars and invest more in the U.S.  The combined effect was a massive increase in the money supply. 

A central bank’s general purpose is to calibrate the money supply to the genuine needs of an economy—to purchase goods and services and to fund productive investment—with the aim of achieving maximum sustainable long-term growth.  Since price stability is a key factor toward that end, central bankers attempt to make timely adjustments to the amount of money and credit in the system in response to signs of inflation, disinflation, or deflation.  However, if interest rates are kept too low too long, such action causes an unwarranted expansion of credit.  As the money supply increases relative to real economic production, the extra purchasing power results in higher prices for goods and services. 

The increase in the money supply following the 2000-2002 recession caused general price inflation, but the excess credit seemed to spill over especially into certain narrow channels of the economy: housing and commodities.  Even when the Fed began to raise rates, mortgage rates remained relatively low.  Longer-term 10- and 30-year Treasury bond rates remained depressed as foreign savers continued to buy the bonds, driving the prices higher.[i]  Because mortgage rates are generally determined in relation to the yield on the 10-year Treasury bond, mortgage interest rates did not follow along with the Fed’s rate increases.  Thus, the bubble in housing prices ballooned as mortgage rates held at historic lows and credit remained easily available.[ii] 

Conclusion

 In sum, the combination of U.S. monetary and fiscal policy caused, in part, and compounded the financial crisis by maintaining low interest rates for too long and allowing the current account deficit to grow seemingly unchecked.  The low interest rate environment sparked extreme leveraging as U.S. investors sought to improve on lowered yields.  The current account deficit was matched by surpluses in poorer countries.  Those surpluses, having no better investment, found their way back into the U.S. in narrow channels such as government debt and mortgage-backed securities.  Both of these caused and exacerbated the housing bubble, by fueling the easy availability of credit and suppressing mortgage interest rates. 

 

 

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[i] As Treasury Bond prices rise, yields decline.

[ii] The securitization of mortgages allowed lenders to constantly replenish their capital and continue lending.

 

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[i] The Taylor Rule (named for its originator, John B. Taylor, professor of economics at Stanford University) provides important guidance on how the federal funds rate should change in response to changes in the two mandated goals of policy. First, it should move up or down by more than any change in inflation. Second, the Fed should respond to changes in resource slack. See John B. Taylor, The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong(November 2008), http://www.stanford.edu/~johntayl/FCPR.pdf.

[ii]Benn Steil, Lessons of the Financial Crisis, Council on Foreign Relations (March 2009, http://www.cfr.org/content/publications/attachments/Financial_Regulation_CSR45.pdf