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Read Brender and Pisani’s “Globalised finance and its collapse”

by Brad Setser
June 16, 2009

I highly recommend Anton Brender and Florence Pisani’s recent monograph, “Globalized finance and its collapse.” In a lot of ways, it is something that I wish I could have written. I don’t agree with every detail, but in my view they get the broad story right.

Brender and Pisani both teach at Paris-Dauphine. But Anglo-Saxon chauvinism shouldn’t get in the way of appreciating quality work. And in this case, there is no excuse: the translation (by Francis Wells) is superb.

In some deep sense, Brender and Pisani have updated the core arguments of Martin Wolf’s Fixing Global Finance (also highly recommended) to reflect many of the things what we all have learned in the last nine months of crisis.

Like Martin Wolf, Brender and Pisani recognize that globalization took an unusual turn over the past several years: the globalization of finance resulted in a world where the poor financed the rich, not one where the rich financed the poor. And what’s more, this “uphill” flow was essentially a government flow. Despite the talk of the triumph of private markets over the state a few years back, the capital flow that defined the world’s true financial architecture over the past several years was the result of the enormous accumulation of foreign exchange reserves in the hands of the central banks of key Asian and oil-exporting economies.

Dooley and Garber recognize this. They don’t pretend that private investors in the emerging world drove the uphill flow of capital. But Dooley and Garber also assert that there is no connection between this uphill flow and the current crisis. In a March Vox EU piece they wrote:

“We have argued that the decisions of governments of emerging markets to place an unusually large share of domestic savings in US assets depressed real interest rates in the US and elsewhere in financial markets closely integrated with the US … Low risk-free real interest rates that were expected to persist for a long time, in the absence of a downturn, generated equilibrium asset prices that appeared high by historical standards. These equilibrium prices looked like bubbles to those who expected real interest rates and asset prices to return to historical norms in the near future … Along with our critics, we recognised that if we were wrong about the durability of the Bretton Woods II system and the associated durability of low real interest rates, the decline in asset prices would be spectacular and very negative for financial stability and economic activity … This is not the crisis that actually hit the global system. But the idea that an excessive compression of spreads and increased leverage were directly caused by low real interest rates seems to us entirely without foundation.” Emphasis added.

It actually isn’t that hard to find examples of how low returns on “safe” investments induced more risk-taking throughout the system, especially private intermediaries started to believe in the essential stability of Bretton Woods 2. The Wall Street Journal recently reported that many bond funds underperformed their index in 2008 because their managers had been taking on more risk to juice returns in the good years, and thus went into the crisis underweight the safe assets that central banks typically hold. US money market funds that lend ever-growing sums to European commercial banks were making a similar bet. As were the European banks that relied on wholesale funding to cover their growing portfolios of risky dollar debt. The inverted yield curve forced vehicles that borrow short and lend long to either go out of business or take ever more credit risk — and as volatility fell and spreads compressed, there was a constant temptation to take on more leverage to keep profits up. The pressures to take more risk were there.

Brender and Pisani document clearly how the process ended up working.

They recognize that the current crisis could not have happened in the absence of an accumulation of credit risk by private financial intermediaries (big banks, broker-dealers and the “vehicles” that operated in the shadows) in the US and Europe. But they also recognize that the accumulation of credit risk by private financial intermediaries would not have been possible if emerging market governments hadn’t been so willing to accumulate exchange rate risk.

They consequently highlight the impossibility of assigning blame for the current crisis solely to the financial sector (and their regulators) in the West or the central banks of the East. Both ultimately were responsible, just in slightly different ways.

Brender and Pisani write:

“The emerging region’s savings surplus could not have been built up if there had not been a counterpart in the form of an increased financing requirement in the developed countries. However, it was not sufficient for the latter to import these savings. Since the emerging region’s surplus was for the most part invested risk-free, it was necessary that the developed regions take on the risks that the emerging regions did not. In order that savings invested risk free should finance investments that are risky by nature, someone somewhere had to take on the associated risks. That has probably been the most original, and the least emphasized, contribution of globalization. By considerably facilitating the circulation of financial risks, it enabled the developed world to relieve the emerging countries of a significant part of those related to the investing of their savings surplus – at the cost, obviously, of the accumulation of risks in the globalised financial system.” (Brender and Pisani, p. 59 – by risk free, they mean credit risk free)

I am — no surprise — sympathetic to this argument. I (independently) made a somewhat similar argument back in November:*

“China wasn’t directly making loans to the most risky borrowers in the US – or actually lending to those who were buying Chinese goods. But the inflow from China was still central to the process that allowed the extension of credit in an economy that itself wasn’t saving, and thus wasn’t generating new funds to lend. Think of it this way: when China bought a Treasury bond from an American insurance company or bank, if provided the pension fund or bank with funds to invest in riskier assets that offered a higher yield than Treasury bonds. Wall Street proved more than capable of churning out ever more complex kinds of mortgage backed securities – and securities composed of parts of other mortgage backed securities – to meet this demand.”

Brender and Pisani highlight all the steps in a “global chain of risk taking” that allowed the savings of a Chinese household to be used to finance a US subprime mortgage. But the chain was such that the Chinese household actually never took on all that much risk. The household accepted a low yielding RMB deposit in one of China’s state banks. But the state banks – broadly speaking – didn’t buy many risky US mortgages. Taking exchange rate risk wasn’t their core business.

They did put a lot of RMB on deposit at China’s central bank. And they bought a lot of the “sterilization bills” that China’s central bank issued. No risk there: the state banks were acting like narrow banks, taking in deposits and investing in safe government paper. There is a macroeconomic story here too. The rise in business profits – and business savings – inside China meant that China’s firms weren’t borrowing as much from China’s state banks, freeing up the savings of China’s households to be lent to China’s central bank. The fact that China’s central bank imposed pretty severe limits on bank lending in 2003 no doubt played a role as well; so long as tight lending curbs were in place, the state banks didn’t have much of an incentive to induce Chinese borrowers to borrow more.

China’s central bank played a key role in the chain of risk-taking. Brender and Pisani:

“The Chinese central bank is an essential link in the chain. It buys dollars in exchange for yuans … its role then is that of the exchange rate risk-taker …. It is its policy of not allowing the exchange rate to appreciate too much under the impact of China’s current account surplus that prompts it to play this role. Its intervention binds together the various links in the chain. The particular way in which the dollars purchases on this occasion are invested risk-free is of little importance. If, instead of a deposit with an American commercial bank, the Chinese central bank … acquires a Treasury bill, the seller of the bill will hold a deposit in its place.”

The process wasn’t all that different in the oil exporters. In fact it was a lot simpler: the Treasury of the oil-exporters government just put the dollars it received from the national oil company’s oil sales on deposit at the central bank.

But the global system – especially after 2004 – couldn’t have functioned as it did without private intermediaries willing to take the risk that China’s central banks (and other central banks) wasn’t willing to take. There were lots of such risks.

To simplify a bit, central banks wanted fairly short-term, liquid claims that didn’t pose much (or any) credit risk. They were willing to take exchange rate risk, but not credit risk – and not too much liquidity risk.**

They wanted fairly short-term Treasury notes, or – if they wanted a bit more yield and were willing to give up a bit of liquidity, a fixed rate, fixed maturity bond that one of the US housing agencies issued to finance its own “retained” portfolio of mortgages.***

That worked when the US was running a big fiscal deficit – say in 2003 and 2004. Or if most US mortgages were “prime” mortgages that the Agencies could easily repackage into the kind of bonds that they long had been willing to guarantee. It didn’t work quite as well when a lot of mortgages were being issued to American households that didn’t quality for a prime mortgage (whether because the mortgage was too big, or because they couldn’t come up with the down payment and documented income needed to qualify for a conforming mortgage).

Households wanted to borrow for long-terms, with funky payment terms — and in a lot of cases they wanted to borrow without putting much money down and even without fully documenting their income. Those little details didn’t matter if home prices only rose; any home could eventually be flipped at a higher price. But such mortgages were intrinsically illiquid. Securitizing their payment streams didn’t really change that fact; securitization ended up turning complex mortgages into illiquid securities. And those securities carried a lot of credit risk if home prices ever stopped appreciating, as we all discovered.

The emerging world’s savings surplus, in theory, could have been used to finance borrowing by US household quite directly. But emerging markets governments generally were not willing to take on the credit risk associated with financing households taking on excessive levels of debt. The system only worked if a private intermediaries – as part of the chain of risk-takers – took on the risks that emerging market central banks didn’t want.

Brender and Pisnani (p. 66):

“In fact, there is nothing to prevent the commercial bank mentioned earlier that receives a deposit from the Chinese central bank from taking on all the other risks related to the mortgage — liquidity risk, interest-rate risk and credit risk. …. It can however arrive at a similar result — taking on, against renumeration, the risks mentioned — without having to have them on its balance sheet. For this purpose, all it has to do is create an ad hoc financial vehicle — a so-called conduit — in which it is the main shareholder. This vehicle will buy mortgage loans, financing itself by borrowing short-term and merely benefiting from a line of credit from the bank. As credit-risk and interest-rate risk taker, the vehicle will generate margin but without being subjected to the same prudential constraints as the bank.”

Brender and Pisani’s example focuses on a conduit, but the basic logic applies to any institution — be it a bank with wholesale funding or a hedge fund — that was willing to borrow short and lend long and take on the credit risk associated with lending to US households. As time went on, the cumulative risk that the private financial intermediaries needed to absorb rose steadily, as Americans could only consume in excess of their income by taking on ever more debt.

Daniel Gros of the Center for European Policy Studies summarized the Brender Pisani argument well in a recent Vox EU column:

“As is well known, the current account deficit of the US arose from an unsustainable increase in consumption (and residential construction). This excess of domestic spending was financed mainly through an increase in the mortgage debt of US households. One key characteristic of mortgages is that they are long-term (often for 30 years). The consumption spree of US households thus led to a large additional supply of long-term (private) assets. However, this supply of longer-term assets was not matched by a corresponding demand for this type of assets. The excess savings from China (and other emerging economies and oil producers) were mostly intermediated by their central bank, which accumulated huge foreign exchange reserves. These reserves were (and still are) almost exclusively invested in short- to medium-term, safe (i.e. government) and liquid securities (mostly in the US). There was thus a need for maturity (and risk) transformation on a very large scale to meet a persistent excess demand for safe and liquid assets.”

As the deficits that offset that the surplus of the emerging world shifted toward the US household sector, the ability of the private financial system to assume a set of risks that central banks (as proxies for the savers of the emerging world) didn’t want to bear became central to the sustainability of the system. This wasn’t widely recognized at the time. Most analysts who worried about the sustainability of the “imbalances” — a group that includes Eichengreen, Rogoff, Wolf and Setser and Roubini — focused on the risk that emerging market central banks might lose their appetite for dollar risk. That fear wasn’t entirely off: just look at the headlines that popped up this spring. China has suddenly woken up to the exchange rate risks associated with the accumulation of unneeded dollar reserves.

But as Brender and Pisani demonstrate, the stability of the system that financed the US household deficit — and a slew of deficits in various European countries with housing booms — hinged both on the willingness of emerging market central banks to take exchange rate risk AND on the willingness of private intermediaries to take the credit and liquidity risk associated with lending at long-terms to ever more-indebted households. And the weak link in the system — as Nouriel realized before most — was the ability of private financial intermediaries to keep on taking credit and liquidity risk.

Bretton Woods 2, it turns out, relied both on the willingness of emerging market central banks to take on exchange rate risk and the willingness of private financial intermediaries to finance the exuberance (or excesses) of American households. Both were integral to the system once the US fiscal deficit started to fall — especially in a world where the Agencies faced limits on their balance sheet growth and fewer and fewer Americans were taking out prime mortgages.

The collapse of private sector intermediation — particularly in the shadow financial system — led to a collapse in lending to households, a collapse in consumer spending, a sharp fall in Asian exports and a global contraction. Rising US household debts no longer support rising Chinese exports (or growing investment in China’s export sector). The system has changed.

Rather than financing growth, China is financing (unhappily) adjustment. And that is never that much fun.

And here I am using China as shorthand for a host of emerging market central banks that are adding to their reserves even as their exports shrink.

* That piece was initially written at the prodding of a US newspaper, which – alas — subsequently decided not to publish it. Ouch!
** Sovereign funds were willing to take on a broader range of risks. But the flows through sovereign funds were comparatively small (despite the attention they received) And – as Brender and Pisani accurately note – sovereign funds were more willing to invest in real estate and equity markets than to take credit risk.
*** Over time, central banks took a broader set of risks. From mid 2007 to mid 2008, many central banks in Asia were buying “Agency MBS” for their own portfolio. Agency MBS have a rather complicated payments structure, and aren’t necessarily the most liquid of bonds. But they also don’t have much credit risk — at least not so long as the US government stands behind the Agencies. Central banks were never big buyers of CDOs or CDOs squared. Agency MBS was about as racy as most got. And Agency MBS are ultimately backed by a mix of conforming mortgages (no subprime), the Agencies capital (now gone) and the US government.


  • Posted by RodgerRafter

    The notion that the poor were financing the rich is simplistic and misleading. We witnessed the a large scale transfer of wealth.

    While the US has had a high standard of living relative to China, it would be a mistake to call us the rich nation and them the poor nation at this point.

    Which nation has the better infrastructure? After spending 2 1/2 weeks in China recently, I’d say they have it pretty easily.

    Which nation has more productive capacity? Easy, China.

    Which nation has the better workforce? I’d take China’s.

    Which nation has over a $1 trillion in reserves, and which is burdened by a massive debt?

    Which nation has the better educational system? Give the US the edge on quality at the top, but China gets a huge nod for the numbers of graduates and performance at the lower levels.

    Which nation has more efficient housing in a time of increasing resource scarcity? China again gets the nod.

    It’s not hard to see where things are heading and which country is wealthy in the areas that count. The last decade has been about wealth transfer, and the financing issue has only been one small part of that.

  • Posted by bsetser

    the gap between average per capita GDP (and or median per capita GDP) between the US and cHina — and most of the emerging world — remains large. the US has a higher per capita GDP than a country like Saudi arabia — and my guess is that the distribution of income in Saudi is even more skewed than in the US, so averages are more misleading than usual. The gap in living standards as measured by per capita consumption is also large. The same is true for Russia.

    The poor financing the rich short-hand doesn’t work for Qatar and Abu Dhabi, but those are the exceptions not the rule.

    incidentally, any time you run a current account deficit there is a wealth transfer of sorts, as the country with the surplus is accumulating claims (i.e. buying assets) of the country running the deficit. the key question though is whether the returns on those assets will justify the investment, and in the case of china’s investment in the us, Brender and Pisani argue (and i agree) that the government — which borrows in rmb and lends in dollars — will be accumulating losses not accumualting gains. So yes, China’s wealth is rising. But the government of china is taking big losses by using chinese savings to buy us debt.

  • Posted by Glen M

    Brad: “To simplify a bit, central banks wanted fairly short-term, liquid claims that didn’t pose much (or any) credit risk. They were willing to take exchange rate risk, but not credit risk – and not too much liquidity risk.**”

    Except now China seems to want to escape the exchange rate risk (or cost seem it has been realized).

    To my surprise there is more to CFR than Brads blog. One insightful article even addresses this very issue…….

    “So neither the IMF idea nor the scattershot attempts to internationalize the yuan will rescue the Chinese from their dilemma. China has accumulated at least $1.5 trillion in dollar assets, according to my Council on Foreign Relations colleague Brad Setser, so a (highly plausible) 30 percent move in the yuan-dollar rate would cost the country around $450 billion – about a tenth of its economy. And, to make the dilemma even more painful, China’s determination to control the appreciation of its currency forces it to buy billions more in dollar assets every month. Like an addict at a slot machine, China is adding to its hopeless bet, ensuring that its eventual losses will be even heavier.”

  • Posted by Cedric Regula

    I still think in addition to the much talked about BRIC-EM flow to the OECD(mostly US) that the cross currency carry trade had a lot to do with our flat and depressed yield curve(Greenspan conundrum). Here the culprites would be the low cost funding currencies, Japan and the Swiss. And their banks can do it with 30-1 leverage.

    We had a dollar funded long dated treasury carry trade when Greenspan had rates at 1%, and told our banking system that he would hold it there “for a considerable period of time”. But when he finally started raising short rates, thru the magic of international banking, you could still leverage the yield spread between yen or franc and the 10 year bond. The dollar actually rose in 2005 on interest rate differentials, but then headed down again, so getting the currency timing made things a little trickier, but they may hedge that.

    I’ve never seen anyone quantify how many Treasuries and.or GSE paper was funded that way, but Cayman Islands always shows up as somewhere in the top 4 countries in the TIC reports.

  • Posted by sean matthews

    not wanting to lower the tone of the discussion, but the translation is by Francis Wells, not Patricia. Patricia is the restaurant critic and food writer (and a very good one).

  • Posted by Ying

    Minsky argues securitisation resulted from two types of development. One is the globalization of the world’s financial structure. The other is a response to the cost structure of the bank.

    Globlization of finance needs standardlization of financial securities and the free flow of capital. The standarderlization process is carried out by modern financial pricing model such as Monte Carlo method. Model prices has been
    accepted as fundermental value of the securities in large investment
    communities. Financial market liberlization in 80s and 90s also allow
    investors all over the world to purchase securities backed by assets.

    Securitisation allows banks to keep debt of its balance sheet while creating credits out of the banking supervision authority. It is also a huge revenue source for banks in serving as intermediaries between investors and borrowers while carrying little risk on itself( if it can get its loans of the balance sheet quickly).

    The growth of insatiable demand for the instruments from Pension funds, global central banks and mutual funds etc provided banks ample fee based revenue source.

    In one word, Minky says:”Securitization and globlization reflect the new technology of communication, computation and record keeping”

    My question is if the major global commercial banks and investment banks can’t predict the risk of over securitization, how can Chinese and other Asia central banks predict currency risk correctly in advance? After all US economy has been the most resilient and predicable one in the world.

    I am not trying to assign blame to any organizations or governments. Just feel that ideas come and go. People who have better picture of reality is always in obscure minority in most cases.

  • Posted by eh

    I’d be pretty irritated if I were a chinese citizen and my government took all of my savings and invested in other countries. That is the ultimate slap in the face to the Chinese people by their own gov’t/central bank. Instead of investing in the future of China, it just perpetuated a quick fix into a festering nightmare.

  • Posted by bsetser

    sean — thanks for catching that. i make the needed edits.

  • Posted by Cedric Regula


    You will have your chance to be irritated. Victor Pandit (Citibank CEO) made a speech yesterday that Citi must seek to grow in international markets, because that’s where the global growth will be going forward.

    Your tax dollars at work. (ditto that for all our banks…)

  • Posted by Michael

    “And the weak link in the system — as Nouriel realized before most — was the ability of private financial intermediaries to keep on taking credit and liquidity risk.”

    Actually, there is no evidence that financial intermediaries would not have continued (and would still be) taking credit and liquidity risk, if the ultimate borrower – the American (and Icelandic, and Irish, and Spanish, etc) consumer had been willing/able to support ever higher and higher levels of personal indebtedness. Nobody cut these consumers’ credit off until said consumers finally petered-out and stopped paying ever-higher prices for houses in 2006, which put a cap on the asset-value rise of their existing housing stock, which left said consumers sitting on mountains of debt (that many, many observers warned about for years) with no way to make the payments. So, the mortgage-defaults gathered steam in 2007 and all the developing-nations’ savers’ money that ended up in excessive consumption and housing in developed nations started to go up in smoke. Fortunately for the developing-nations’ savers, it was the greedy over-leveraged financial intermediaries and the spendthrift people of the developed nations who lost all the money in the crash. In the big picture, I’d say the flow of funds “imbalance” has been very good to the citizen-savers of the developing world.

  • Posted by don

    A very good piece. My own thinking on the issue was less developed. A favorite observation was that leverage could not directly increase the total amount of debt. That is, net borrowing cannot exceed net saving. It is still not clear to me that leverage had much effect on increasing the net amount of borrowing. To do this, one would have to establish exactly how it increased the net amount of saving.

  • Posted by jonathan

    You probably want to clean up this sentence: “The emerging world’s savings surplus could have been used to finance those borrowers in emerging market savers wanted to take on all the risks associated with financing households taking on excessive levels of debt.”

    Love the piece.

    If we imagine the same intro scenario, that China et al accumulate and put tons in the safer dollar investments, then you have a question: how could this have been prevented? I put it this way because we’re now talking about regulatory choices and because we have few ways of regulating what countries choose to do with their money.

    The presentation of history implies inevitability, that x happened and y domino fell, but this build up of risk in the private sector was itself enabled by government’s choices – here and abroad – to avoid regulation, to avoid squashing “innovation,” all in a belief that the markets are benign or at least their destructive powers are limited in consequence.

    I note you said everyone bears responsibility. I’m not arguing with that statement, but we can’t expect various external forces, particularly sovereign nations, to change behavior as we hope. We must, instead, try to protect ourselves – and enable growth, etc. – by regulating that which we can control. I think it’s important to note that our regulators – and those in Britain and elsewhere – utterly failed at that most important task. History can look at the larger picture but we must deal with what we can see and control.

    Thanks for the most excellent post.

  • Posted by ReformerRay

    The U.S. sent a net of 5.7 trillion dollars overseas during the twelve years of 1997 – 2008 to pay for goods imported in excess of goods exported. If that flow of funds had not existed, the other financal flows under discussion by Brad and others would have been much smaller.

  • Posted by Cedric Regula

    don: re: leverage-savings-borrowing.

    They didn’t cover this in econ 101, but I think the short answer on that is financial intermediaries got access to more low cost savings, and worldwide, (ie the typical sucker with a savings account, money market fund, bank CD, etc…) and it was low cost in most of the developed world because of easy money policy of most central banks, and they went looking to leverage the low cost funds in higher return/higher risk assets. So the buyer was there and the market responded with the products.

    In many cases it was the same usual suspect companies fufulling both the role of buyer and producer. Then they short ’em too. Need a scorecard to keep track.

  • Posted by ReformerRay

    The practice of using U.S. dollars acquired in trade to purchase U.S. Treasury notes and securities was began by the Japanese government back in the 1980’s. This use of these monies were ignored by the U.S. public. The public outcry over the proposed purchase of Rockfeller Center by a Japanese businessman led the wily Japanese to this solution as a way to maintain their trade surplus with the U.S.

    China is merely imitating a long established tradition.

    As many other commentators to this blog have noted, the aim of some of our trading partners is to build up their manufacturing sector by maintaining a trade surplus with the U.S. Any other consideration is secondary.

  • Posted by ReformerRay

    Do not think that the dollars sent to the U.S. by Central banks means that these funds are not available to the exporter who received these dollars from the U.S. The exporter from China to the U.S. exchanged these dollars for Yuan. The Yuan can then be used to build up the export ability of that businessman.

    Dollars sent from the U.S. to pay for a trade deficit provide a double service. They enable Central banks to acquire Reserves denominated in dollars and export oriented entities to become more efficient better competitors to U.S. producers.

  • Posted by don

    Cedric Regula:
    Thanks, but I still don’t see clearly how the leveraging increased total net saving. By funneling savings from low-interest rate environments (e.g., Japan and the yen carry trade) the financial intermediaries moved the savings to a place where it could command a better return. This might increase savings in the low-interest rate place, but it should also depress savings in the higher-interest rate place. However, more likely, saving is determined by income rather than by the interest rate, so the arbitrage flows do not directly affect saving in either market.
    But how about a Rube-Goldberg dynamic contraption like the following. Forced saving in China (currency intervention to depress the renminbi) leads to higher asset prices and consumption demand in the U.S., and to increased income and saving in China. China can continue the currency intervention without inflation, because the income increase brings with it an increase in saving. The U.S. can withstand the reduction in aggregate demand from the current account deficit, because the increase in saving abroad supports higher asset prices and higher consumption demand.
    Of course, the reinforcing cycle can’t continue, so eventually it doesn’t ….

  • Posted by ReformerRay

    My point is simple – to understand international financial flows of the last decade we should begin with the source of the dollars, which is the U.S. trade deficit.

    I realize that the other things discussed above are realities and that other choices could have been made. But the magnitude of the problem would have been much less without the dollars flow from the U.S.

    Bernanke got it backward when he discussed a global savings glut. His data showed a flow of dollars from the U.S. to developing countries between 2000 and 2004. His labelling that reality “a savings glut” has misled much thinking on this topic.

  • Posted by Cedric Regula


    Right, I think. I was just pointing to just one elephant body part, my point there, I guess, is that there was more ACCESS to low cost savings (of the unsophisticated) by the old IBs, commercial banks, shadow banks, and insurance company investment arms. They embarked on leveraging that into questionable higher return “investments”, but the smarter ones were satisfied with the fees, origionation costs, and commisions and the risk was passed off elsewhere. For instance, Lehman was basically a hedge fund funded by short term repos in the money markets.

    But you touched on another part of the monster. We don’t need domestic savings to get this to happen. We just need a Twin Deficit. That’s good for a bunch of savings when the consumer doesn’t have to pay the current amount of fiscal spending and also benefits from low financing cost.

    And houses were income! Spend you equity income with a HEW. Much of the money went to chinese products, but it will be back.

    This does want to end. Good news, bad news story there.

  • Posted by MakeMeTreasurySecretary

    It is a good article and you add some valuable comments.
    At the same time, I must say that RodgerRafter has made a very good point in his comment. I have lived a little in Asia and a lot in Europe and I am a big believer that per capita GDP is not a good way to evaluate the wealth of the people of a country. I am sure that the US still has a wealthier population than China. But the difference is much less than what the per capita GDP indicates.

    Indeed, and please correct me if I am wrong, the per capita GDP is not a measure of wealth but a measure at which wealth changes hands. Higher rate does not necessarily indicate higher accumulation. An analogy from the animal world may help. Pound per pound, a hummingbird has a hundred times the metabolism rate of an elephant but I would not call the elephant starving and the hummingbird full. In fact, it is the hummingbird that easily starves itself to death and not the elephant.

  • Posted by FollowTheMoney

    the world is witnessing the largest transfer of wealth in global history.

    it is the transfer from west to east, and with it, sadly the “Fall of the Washington Wall”.


  • Posted by ee43

    Wake up people to the corruption. As long as Geithner and bernanke are running the show,
    don’t short. Wait for the bulls to exhaust themselves which may not be for awhile.

    good articles found this site

  • Posted by Jesse

    Thanks for the great post Brad!

    jonathan wrote:
    “If we imagine the same intro scenario, that China et al accumulate and put tons in the safer dollar investments, then you have a question: how could this have been prevented? I put it this way because we’re now talking about regulatory choices and because we have few ways of regulating what countries choose to do with their money.”

    A few possible strategies.

    1. The US could have taxed the income earned on these dollar investments by China et. al. I don’t think this would prevent accumulation of such investments but it might help. Ditto private savings flows (e.g. restore the witholding tax).

    2. The US could have restricted the imports that resulted from and supported the savings flows from BRIC and OPEC either through tariffs or through import certificates.

    3. In cases where comparable markets exist, the FED could have counter-invested in securities from these countries, this balancing the flow of funds. Unfortunately, this might have made the bubbles bigger.

    4. I’d be interested in hearing what others think about how to regulate the intermediaries. I’m not convinced that this would be effective though. If there is a lot of profitable intermediation to be done, I suspect that it will be done by someone. If not banks then hedge funds… Limiting the leverage these entities are allowed to take on seems like an important aspect. Eliminating the ability to hide risk through off balance sheet vehicles makes sense but it is probably hard to do. Changing corporate culture to focus on long term value rather than short term fraud is essential but difficult. The business schools often have an extremely high incidence of cheating and academic misconduct. Perhaps the culture of cheating and short-sightedness begins there, or maybe the B-schools merely reflect the culture they are preparing their students to enter.

    5. Educate Americans so that more will recognize that ‘living richly’ through excessive home equity borrowing isn’t the same thing as being rich.

  • Posted by FollowTheMoney

    @ Jesse,

    The best thing for this country in my view:

    people swapped being rich and owning materials to being wealthy and owning knowledge.

    However this will take time, we’re going to see structural changes over the next 10 years. This recession is going to very different than what most of us are used to. We’re going to look at the way we live, work, and consume very differently before the next election. This is the big one, this will change peoples perception of savings vs. spending. mark it.

  • Posted by MakeMeTreasurySecretary

    On the lighter side: Bob, who is penniless, explains to his buddies that he has partnered with Joe, who is very wealthy. “I contribute the smarts and he invests the money’, he explains to his friends. “But this does not seem fair to Joe,” observes one of his friends. “It is fair’, says Bob, “because Joe will soon have the smarts and I the money.”

    I guess many of us are getting smarter every day.

  • Posted by HZ

    When the rich finance the poor — financiers can be fickle — if the rich change their mind the poor suffer greatly. The reverse is not true. The financiers from the poor countries can be just as fickle, but they are not able to inflict much pain on the rich because the rich borrow in their own currencies. In the end that is how we end up with our current financing arrangement.

  • Posted by bsetser

    HZ — though it now seems like poor creditors want to act like rich creditors and start lending in their own currencies … which would change the dynamic a bit. and the us has shown that just borrowing in your own currency isn’t quite enough to assure that you won’t get into trouble.

  • Posted by Dale

    I thought that Nouriel Roubini’s salient contribution was to recognize that house prices couldn’t keep going up forever, and indeed would fall substantially. Everything else he was able to predict flowed from that one basic observation, I thought.

  • Posted by guest

    It would be interesting to plot the last ten years aggregated incomes and cash flows in the western emisphere as opposed to aggregated capital gains.
    The 10 years yields (euro, dollars)
    Most of the wealth created was money illusion.

  • Posted by Qingdao

    Every day I meet people like Roger Rafter who spend 2 weeks in “China“ – Shanghai and Beijing -, then return to where-ever they came from spouting nonsense. Maybe one statistic will help (from memory- so approximate): % of people in China living on less than $1/day: 7 %. This is what you hear from the Roger Rabbits’s of this world; % of people living on less that $2/day: 42%

  • Posted by Minzu


    You cover a lot of ground here. I thought the Brender & Pisani book was most interesting for indicating how difficult it will be to fix the system”.

    It requires levels of cooperation and coordination that are irrational from the point of view of the self-interested politicians we all rely on.

    Financial systems that occasionally collapse provide (a) an opportunity for financial operators with the ability to exploit systemic risk to ride the wave up (and even down) with generous bail out possibilities for the more defensively inclined and (b) an opportunity for politicians to enjoy soft budget constraints themselves for uneralistically hedonistic policies or create the illusion to their constituents that they do (3) since regulation will always lag behind technology and international coordination is impossible without international governance (with coercive powers) that encompasses also the Londons, Zurichs and Bermuda’ of this world (to name a few) of this world, politicians just have to show effort in being prudent and can put the blame for crises on the financial sector. Dealing with a crisis may actually bring political advantage.

    Remedies are easy to design (sound financial regulation, international rules regarding cooperative rather than competitive exchange rates, etc) but impossible to execute, especially since significant countries like China (but there are many others) have governments that (in my opinion) rely on development-driven legitimacy for their tenure, rather than, simplistically, popularity, like mainstream democracies.

    These two regime types cannot agree on stable arrangements between each other when the legitimacy seekers (democracies have inherent legitimacy) would then become dependent on the soundness (or rather the risk policy becomes sound) of policy making in democracies, while democratic politicians (contrary to the rational expectations hypothesis) need a capacity for hedonistic policy making to remain popular. Informal arrangements like BWII are in fact faustian bargains for both legitimacy seekers and hedonists. They cannot last but may be sticky, and are hence an excellent temporary compromise. They are a useful and typical device of international relations

  • Posted by Sergei

    The accumulation of risks by private financial intermediaries sounds a lot like the minsky process, where during periods of declining perceived volatility, risks are built up in the system as economic agents increase leverage to achieve desired return on equity in the face of declining risk spreads. Even if emerging market central banks did not artificially depress the yields on risk-free assets, the minsky process could have still played out if private agents were convinced that central banks have made economic cycles less frequent and severe…

  • Posted by Brick

    While I agree largely with most of what is being suggested claiming that the poor financed the rich seems flawed in some intuitive way to me. Stepping slightly away from the flows of money I am not sure it was entirely Chinese households that financed the US lending but rather Chinese business. This is something MIT professor Yasheng Huang contends and points to a problem with income suppression in both china and the developed world. Rather we could point to currency exchange rates not reflecting purchasing power parity (PPP) creating an environment where the average worker (neither rich nor poor) tends to finance the rich and the poor due to income suppression. This environment could be seen as the breeding ground for the credit expansion as workers either save or scrabble for credit to try to maintain a standard of living.
    Back on topic if we do suggest that banks as intermediaries took on more and more risk, it seems reasonable to suggest that those risks must have been obfuscated, which points back to weak regulation. Your conclusion that China is unhappily financing adjustment highlights is something that I think China will be attempting to address, with all its consequences ultimately for the dollar.

  • Posted by q

    great piece, brad.

  • Posted by Cedric Regula


    I know some people reading Brad’s blog here mentioned the very quiet news story about Italian authorites arresting two Japanese nationals with $134 Billion of t-bonds in a briefcase and that they were headed to switzerland for some strange reason.

    I’ve been curious about that too, since this amount equals the combined net worth of Warren Buffet, Bill Gates and Carlos Slim. I thought that would be very news worthy, but my googles on the subject haven’t found much news coverage.

    I finally found a story at Debtors Prision on this and they raised some questions I had, like are these real or counterfiet, what is the USG doing issuing $500,000,000 bearer bonds that don’t need to be registered?…etc..

    But I still haven’t seen any comments from US offficials. Waiting on that…

  • Posted by q

    cedric —
    i think these are ‘helicopter bonds’, no?

  • Posted by MPO

    “Which nation has the better infrastructure? After spending 2 1/2 weeks in China recently, I’d say they have it pretty easily.”

    Try spending more time and traveling further. You’ll change your tune. The rest of your data points are cherry-picked in order to make a subjective argument which would often at best not be upheld by relevant data and comparisons, and at worst would be refuted. China is not “poor” in many respects, that much I have argued for some time. That does not mean, however, that they are exactly the opposite of it and sitting atop the totem pole.

  • Posted by IronMan

    It’s time to step out of the box Mr. Setser and take a different perspective. Rich is suppose to finance the poor?? Keeping the status quo? Maybe that’s why economists like you never caught the real world trend before they happen. GIGO.

  • Posted by ee43

    # Advertising by the National Association of Realtors in 2005 and 2006 after home prices had doubled in five years telling all Americans it was the best time to buy and that buying a house is always a great investment.
    # Both liberal and conservative ideologue pundits skewing every issue in order to prove their pre-ordained position.
    # Corporate titans like GE own TV networks and slanting the reporting of the news in a way that aligns with their corporate interests.

    good articles for low news day…

  • Posted by gillies

    q suggests : i think these are ‘helicopter bonds’, no?

    from a news item about the financing of kurdish factions in the iraq war, it is possible to calculate that $100 dollar bills weigh one ton per $100 million. thus the italian bag contained the equivalent of 1,340 tons of $100 bills which would amount to 268 helicopters carrying 5 tons each.

    cedric regula : two questions to ask before getting carried away – 1 does this story make any sense ? 2 who released this story, and why ? if we cannot get beyond that point, the actual detail of the story is more or less useless to us.

  • Posted by Cedric Regula


    It’s a real story released by Italian authorities over AP wire, and also published in a Tokyo newspaper. I google “Italy Italian Switzerland treasury bond Japanese” and get the original stories.

    It needs making sense of, and more facts like the unknown identities of the “Japanese nationals”. Like do they work for the Japanese gov, Japanese Mafia, or are they just couriers for some other entity, like the Pope?

    I’ve been looking for more news, since I don’t like speculating that much, at least after getting some initial thoughts out of the way.

  • Posted by GanBeiSiDiao

    Is there any truth regarding what some naysayers maintain regarding the extreme water crisis which continues to impinge upon Beijing? Even while the city population continues to increase?

    Or, is there plenty of water available to draw up from deep aquifers, for generations to come?

    Tell me the truth now. Can we have plenty of swimming pools in Beijing, for the common man, just as in most other countries?

    Or, is there a VERY DIRE SHORTAGE of water resources, as some people say, with deep aquifers being continually and almost finally depleted?

    Does anyone know the truth about the true water situation in Beijing? Now, and in the near future?

  • Posted by FollowTheMoney


    Will you comment on the 134B Japan-Italy-Switzerland Bond mystery?

    Many thanks and keep up the solid work!

    @ Cedric,

    i conquer, counterfeit or not, 134B in T-bills is certainly newsworthy for U.S. Homeland & National Security.

  • Posted by Cedric Regula


    Also the briefcase contained 247 $500,000,000 pre 1982 bearer bonds, perfect fakes if faked, and also some $1,000,000,000,000 “Kennedy Bonds”. These I think would have expired by now.

    See my curiosity?

  • Posted by bsetser

    follow the money — I don’t really have much to add. I would assume that the bonds are counterfeits, but i don’t know that for sure.

    to me today’s current account data is more interesting.

  • Posted by bsetser

    Iron man —

    for most of the 19th century, the (rich) uk financed its fast growing colonies, dominions and ex colonies (including the US).

    after ww1 the us briefly financed war ravaged germany. after ww2 the us (rich) financed europe (poor). and from 1992 to 1997 the net flow of capital was to the emerging world, financing deficits their. after the 97-02 wave of crises, private capital flowed from rich to poor — only an unprecedented build up of reserves led to a net outflow toward the us and europe.

    I am pretty sure that i have been living in the real world when it comes to understanding the direction and magnitude of capital flows.

  • Posted by Cedric Regula


    Hear, hear. I am a supporter of population control. I tell all my girlfriends that I don’t think we should have babies.

    And we have the technology. In fact I have proposed making The Trojan the new reserve currency.

  • Posted by HZ

    We may get into trouble but it matters to what degrees the troubles will become. The poor get into the 1929 style depression or riots (like Argentina and Indonesia), while we are more likely to get into the 1970s style stagflation if the trend reverses. Yes the poor would like to lend in their own currencies but only political failure on the rich side (giving in to the entitled retirees, e.g.) will enable that. Otherwise as you said they will have to reverse the trade balances to stop lending in the rich’s currencies.
    BTW I think Martin Wolf’s diagnosis sounds right (likelihood of Japan style stagnation) but his prescription (bank nationalization) is worse than the disease. More important than a robust economy is to play by the rules. If by the current rule the banks are solvent (as pronounced by the Fed) forced nationalization will just destroy confidence in property rights and rule of law. Yes it will be stimulating but it is not a price worth paying. If we simply take from the rich to give to the poor that will be stimulating (even more stimulating than recapitalizing the banks). Heck if we take from the rich countries and give to the poor countries that will be extremely stimulating.

  • Posted by FollowTheMoney


    In my view, the problem is the banks are still not solvent. That’s a big problem and one the Obama administration will, in my view have to have to deal with very soon.

    The best thing to do is let the banks

    A) total nationalization


    B) allow them to fail (bankruptcy)

    All is certainly NOT well, in my view the Green Shoot hysteria from March-End of May was orchestrated so the banks could re-capitalize.
    Think about it, had there not been “Green Shoots” you think the banks could have raised 100B?

    The media, government, banks, etc had to orchestrate this because i’m opinionated to think that it was the only way the banks could extend there life lines.

    In my view, the truth is they only bought band aids that may fall off. In my opinion what the big banks did, or were forced to do was:

    1. Go out and get PRIVATE capital


    2. in March the banks were very UNPOPULAR by public image, and CONGRESS at the time would not give the funds necessary.

    3. To sum it up the banks had a LOW public opinion level and more taxpayer $$$ funneled to the banks at the time would create public outrage.

    So it’s my opinion that the Green Shoots were orchestrated to perfection. Collaborate on with buyside programs, work the media and recapitalize, and recapitilize QUICKLY. The illusioned Green Shoot hysteria was a quick set up so the banks could raise $$$.

    The problem is the FUNDAMENTALS are deteriorating at a rapid rate, the REAL ECONOMY is declining, and soon the numbers of the CURRENT ACCOUNT and UNEMPLOYMENT will prove just this. Furthermore, i’m of the opinion the banks have hundreds of billions more in undisclosed TOXIC assets. Despite even the latest capital raise amounts, how will the banks look with 14% year end unemployment???

    We have not treated the ROOT of the CRISIS. We have simply given more tylenols to terminal patients.

    In my opinion, you will see what i’m talking about later in the year. There’s just no way this prescription will work. “Everything will be beautiful” is hope, and hope is NOT A STRATEGY.

    In my view, one bad apple will spoil the whole bunch…GET READY!

    *All thoughts on this note are solely of my independent opinion and no third party.

  • Posted by HZ

    Your view may be a reasonable possibility but that does not matter. Finance is a zero sum game and solvency is in the eyes of the beholders. What the regulators say is what counts. The regulators can’t afford to support the banks raise over 100B in private capital and then turn around and say “sorry folks, you were all tricked”.
    If banks are unwilling or unable to expand their balance sheet that is a sign of insolvency. But that is not the technical definition that the regulators use. Creating uncertainty here will just drive capital away. Instead the rule of the play has already been set in the CAP (capital assistance program): Treasury will backstop bank capital raising and force them to raise capital to be above a threshold. It was a successful play (banks actually raised capital at above CAP price). And more capital can and will be raised so long as the rule is clear as was set out in the CAP.

  • Posted by HZ

    BTW, the stimulus money is only 5% disbursed for the current year (and it is a 2 year program). Washington is very bureaucratic. That is why typically fiscal stimulus does not work since it so significantly lags. But this time the drop is so deep the stimulus will actually provide a floor. I don’t think even Prof. Roubini is projecting 14% unemployment (that is politically unworkable for Obama). Everything points to a very sluggish recovery and Wolf is right that a big reason is that deleveraging is incomplete and banks will be risk averse.

  • Posted by FollowTheMoney

    @ HZ-

    i’m aware that 14% year end unemployment is a grim forecast. however we have had such a bubble, we have created so many excesses. we also have imbalances that just can’t be repaired this year or next.

    we’re going to have shut down alot of retailers, resorts, things that traditionally were norm, however in the future will be justified as ‘far above means’…

    as i’ve said several times in the past, this is a very unfortunate situation. this is not going to easy. you will structural changes. of course Obama is trying to do the right thing. But this one giant mess, it wasn’t created over night, and the more debt we issue, the longer the crisis will entail.

    HZ, good chap, i wish you well, but the current framework has no real structure. we need to readjust to LESS SPENDING, BIG READJUSTMENT.

    Yes, 14% unemployment will be very very difficult and I won’t comment on individual companies but in my opinion expect more layoffs as the earnings get ‘weak weak weak’.

  • Posted by anon1

    The B/P paper describes the risk outcome of the “dark matter” issue.

  • Posted by Cedric Regula


    I just found someone gloomier than Roubini. It’s King McCully of Pimco. He says the Fed won’t raise interest rate policy until sometime in 2011.

    If we back that up using normal Fed behavior, they don’t raise rates until they see a trend of rising employment. And it takes 3 months of data to establish a trend.

    So that means no turn for a year and a half yet.

    I believe it, because the last two recessions we’ve had were because certain industries got way overheated, then busted, and going forward the jobs never came back.

    So we need new industries to replace the lost jobs. Hard to tell what they may be…webcamgirls looks like it’s a growing field. Some of them even claim to be finance majors from Vassar. But I’m afraid that Pixar may enter the market and the poor lasses will lose their jobs to automation.

    So I really don’t know what the answer is.

  • Posted by Glen M


    Nassim Taleb the author of “The Black Swan: The Impact of the Highly Improbable”, has a simple proposal to as he puts it, “save capitalism and free markets from the banks.”

    Nationalise the banks, limit the rewards to those who work in what he calls the “utility” part of the system and have a completely uninsured second leg that can take all the risks it wants and lose its shirt, he said in an interview in Davos at the World Economic Forum.

    “They rigged the game. We pay them for their profits, there is no clawback so their incentive is to hide the risk they are taking.”

    “Which is why eventually as someone who loves free markets, a total nationalisation of the part of the business that requires insurance and does clearing and payments needs to happen.”

  • Posted by bsetser

    anon1 – intriguing observation; care to flesh it out further? the obvious notion is that the us exported low risk assets (or so it was thought) and imported higher risk assets, so it was functioning as an intermediary. but B/P seem to suggest something a bit different: US investors sold treasuries and agencies to foreign central banks and used the proceeds not to invest abroad to but invest in riskier securitized us mortgages.

  • Posted by anon1

    The balance sheet on page 74 of the paper looks like the dark matter idea – at least the part with net non-risky liabilities and net risky assets. It’s part of the risk mismatch that creates the dark matter income.

    The paper labels the difference between these two pieces the net investment position of the US. The terminology seems unusual, but the net result is additional income to the US. In a sense, it’s the domestic gravy on top of international dark matter.

    The dark matter theory focused on the return part of the risk/return trade-off. The crisis pointed out the risk part – at least in terms of credit risk – although mostly in terms of the marked to market impact on US assets.

  • Posted by Rien Huizer

    Glen M

    “Nassim Taleb the author of “The Black Swan: The Impact of the Highly Improbable”, has a simple proposal to as he puts it, “save capitalism and free markets from the banks.”

    What he proposes is simply he standard public policy solution to the problem of financial sector regulation. It minimizes taxpayer risk. I like it, but it may not be optimal.

    First, such a scheme would have to be global (although if the US did something like this the other democratic market economies could hardly differ.

    Second, it would pose a serious problem for politicians. Our, inherently ambiguous financial system provides lots of opportunities for interest groups that are always better at collective action than “the taxpayer”. Politicians feed off unfinished business and imperfect solutions and will tinker endlessly but rarely improve.

    The latest coming out of Washington is that ambiguity will remain the dominant feature. Lots of oversight, gaps will be filled etc. But no mention of ending the government’s contingent liabilities. We have no real solution for F&F and the new systemic oversight body will have to invent its own wheels. If it does its job well, the industry will wither, no one would like to be one of those systemic firms. If it shirks (as it probably will, from a future ex post perspective) the industry will start writing options again against a free taxpayer hedge.

    Like Taleb, I have a brilliant solution: move the government to financial reporting as if it were a private, listed corporation. Exit ambiguity..

  • Posted by anon1

    Page 64 of the paper describes two necessary conditions:

    a) The US must spend more; i.e. run a current account deficit

    b) The credit risk is “transformed”

    The second point is mischaracterized. The risk is not really transformed. What is happening is that China et al have purchased a disproportionate share of risk free assets. It’s an alternative to vendor financing, not a transformation per se. Financing has already been provided within the US. SIVs transform risk. Treasury financing doesn’t do that explicitly.

  • Posted by Francis Wells

    I very much appreciated Brad Setser’s reference to the quality of the translation. Leaving aside the question of whether the word ‘superb’ is merited, mentioning the translation is rare enough and mentioning the name of the translator rarer still.
    And, of course, a good translation needs a well-written original text, which is always true of Anton and Florence’s work.
    Thank you very much.