Monday, 1 December 2008

Non-Fed central banks and the financial crisis

Commentators on the financial crisis often bring up the role of the US Federal Reserve. By holding the Federal Funds rate so low for so long, it is argued, the Fed fuelled the massive increase in subprime mortgage lending that has been at the heart of the crisis. The Mises Institute guys like to go on about this a lot.

Brad Setser, whom I just had the pleasure of hearing speak at Exeter College, has another story. What follows is a very simplified version of it, but I think it retains the essential features of Brad's argument. In recent years, China and the oil-exporting countries have both had very large current account surpluses. The offsetting deficit has overwhelmingly been in the US current account, but there has been no great depreciation of the dollar. The reason for this is that the central banks of the surplus countries have been pegging their exchange rates to the dollar by buying up huge quantities of dollar-denominated assets. Central banks were mainly interested in safe assets like Treasuries (US government debt) and Agencies (debt issued by Fannie Mae, Freddie Mac and Ginnie Mae). They bought lots of these from private financial institutions, who then used the cash to invest in riskier assets like mortgage-backed securities. The rest, of course, is (recent) history.

A good summary of the argument can be found on Brad's blog, where he writes:

[T]he origins of the credit crisis cannot be entirely separated from the Bretton Woods 2 system — a system where many emerging markets pegged (or managed) their exchange rates at levels that implied large ongoing current account surpluses and the resulting reserve growth financed large external deficits in the US and to a lesser degree in Europe…[I]f central banks hadn’t provided so much financing to the US for so long — and kept lending to the US in dollars at low rates even as the United States (gross) external debt rose — the US wouldn’t have built up the same kind of vulnerabilities either. Remember, private investors, by and large, weren’t willing to lend to the US on anything like the same terms as central banks."

So it seems the monetary policies of developing countries' central banks had perhaps as much to do with the US housing bubble as the Federal Reserve itself.

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