It is All Your Fault

The world is experiencing a financial crisis of historic proportions. It seems only natural to look for the causes. Around the world, including in the United States, many blame America for the financial crisis. Even the UK Prime Minister Gordon Brown, whose economy and financial system share sufficient characteristics with the US as to render meaningful the concept of Anglo-American capitalism, singled out the United States as an important source of what he called “irresponsibility”.

For the Prosecution

Former Fed Chairman Alan Greenspan’s recent mea culpa seemed to many to be a confession, even if personal responsibility was not really acknowledged. The proximate cause of the financial crisis is ostensibly sub-prime mortgages in the US, made possible and encouraged by the overly accommodative monetary policy for an excessive period of time. The demise (failures and gun-shot marriages) of several large US financial institutions--Bear Stearns, Countrywide, Lehman, Merrill, Wachovia, AIG, Washington Mutual--and the magnitude of losses, which the Bank of England's Financial Stability Report estimate to be greater than the losses of the euro-zone and the UK put together, would lend credence to the assessment.

The US is not just the epicenter of the crisis, but many argue that American's penchant for OPM--Other People's Money--credit, the over-development of its financial markets and the light and evaporating regulatory regime was the causa belli. This is the essential narrative that is being told.

Global Forces at Work

There are of course kernels of truth to this assessment. Yet isn’t a good lie, like the truth, able to explain the facts? A major problem with the narrative is that it is based on the wrong level of analysis. There is a global market for capital. Capital has become increasingly globalized ever since the Soviet Union took its dollar deposits out of the US and placed them in UK banks a half a century ago, helping, unintended of course, to start the Eurodollar market. Anything but the most superficial of inquiries arguably reveals the global nature of the forces leading to this crisis. That should be the level of analysis, not a particular country.

One often cited cause of the excesses that are now being violently unwound, with the benefit of hindsight, is being called excessively easy US monetary policy. The Federal Reserve, under the reportedly autocratic hand of Alan Greenspan, did keep short-term rates low for a prolonged period of time. But even countries that did not have such low short-term interest rates, like Spain and the UK, had an appreciation of house prices in excess of the United States. Moreover, the so-called “Greenspan conundrum”, the fact that long-term interest rates remained low despite the gradual tightening policy that did occur prior to the much of excesses, was a global phenomenon. European bond yields also remained lower than expected given the macro-economic conditions.

The most compelling explanation of the “Greenspan conundrum” was provided by none other than Benjamin Bernanke himself. He suggested the source of the problem was surplus savings especially in Asia. Some developing countries were generating saving far in excess of their ability to absorb it in the domestic asset markets and economy. Private saving rates were high and through current account surplus and intervention to ensure the current account remained in surplus, public savings in the form of reserves grew dramatically. These savings were re-cycled into the world economy through the purchase of sovereign bonds (including the paper of government-sponsored enterprises, like Fannie Mae and Freddie Mac) and this served to depress long-term interest rates.

One Fire, Many Matches

It is true that the US had a different and lighter regulatory regime than Europe, and many other countries for that matter. But the different regulatory regimes do not avoid excesses that are built during the protracted credit cycle. The regulatory regime provides the incentives for behaviors that shape and color the specificity of the credit cycle as it is expressed in different countries. The US seemed to go over-board in the de-regulatory push, as Greenspan and many others belatedly recognize. There were some that opposed the continuous push for financial deregulation in real-time. As CEO of Goldman Sachs, Treasury Secretary Paulson sharpened his persuasive skills that he recently put to use to secure a $700 bln line of credit from Congress, helping lobby the pliant Securities Exchange Commission (SEC) to reduce the capital requirements for broker-dealers in 2004.

Without that single “innovation”, the end of the credit crisis would have looked and felt quite a bit different. It may be true that the arsonist is now the fire chief, but he did not start all the fires. In fact, the differences in regulatory regimes were modest compared with their similarities. Many times more than roughly $1.3 trillion in sub-prime mortgages has been lost. Sub-prime lending is not the cause of the crisis. Leveraging is. And this practice knows no nationality, or perhaps, more to the point, it knows all nationalities.

The dramatic declines of the Mexican peso, Brazilian real and the South Korean won in recent weeks, for example appear to have largely been driven by unwinding of the foreign (largely dollar) borrowing by domestic businesses and banks themselves. Similarly Mr. and Mrs. Watanabe in Japan have lost significant chunks of their savings and pension money, not, to be sure, because they engaged in sub-prime lending. Rather, the large losses being realized are the result of unwinding leveraged short-yen carry trades that for years helped Japanese households earn somewhat higher returns than were available in low yielding Japanese government bonds, poor performing stock market or sluggish real estate market. Consider over the past month, the Australian dollar has lost around 21% against the yen, while the New Zealand dollar has lost 19%. The euro itself, which many Japanese institutional investors bought to buy euro-denominated sovereign bonds has seen a 16% decline against the yen in the past month, sufficient, if unhedged, to offset several years of carry (interest rate pick-up).

Surely the US regulation-lite and the sub-prime lending cannot account for the collapse of Iceland’s banking system and economy, perhaps one of the most spectacular implosions of modern times or the fact that several medium- and low-income countries like Hungary, the Ukraine, and Pakistan are being forced into the waiting arms of the IMF, like long lost lovers. Japanese banks have little sub-prime exposure, but the Topix index of Japanese bank shares has lost nearly 75% of its value in the last 30 months.

Up in Smoke

Europe’s conceit is that it had a stronger regulatory regime than the Anglo-Americans. So what? The crisis will result in important and significant changes in Europe’s regulatory regime. Hyman Minski’s insight that excess risk taking and balance sheet engineering is the “natural” result of prolonged stability and prosperity remains valid. In terms of equity to asset ratios, which are one measure of leverage, European banks were more leveraged than US banks. German banks appeared to have been the most leveraged, according to some studies, with a gearing ratio of equity to assets of more than fifty times. Households may not be leveraged. Revolving credit may be shunned. Mortgages are harder to come by, and the variety of related products is quite limited. But the excesses are found not on the household level but the institutional level.

The specificity of the euro-zone’s excesses lie not in loans to poor and weak households. The path of least resistance for capital risk taking, given the regulatory regime and other institutional practices in Europe, was lending to business and sovereigns. Of the 784.6 bln euro losses that the Bank of England’s October Financial Stability Report estimates on a mark-to-market basis among selected financial assets in the euro-zone, some 719 bln, or more than 90%, is traced to corporate bonds.

Sovereign lending also seems to be another potential Achilles Heel. According to some reports, German lenders will absorb almost 30% of the $74 bln worth of bank loans to Iceland. But Iceland is just the tip of the proverbial iceberg. The rest lies in emerging markets. The Bank of International Settlements estimates that Europe accounts for a full three quarters of the $4.7 trillion cross-border bank loans to eastern and central Europe, Latin America, and emerging Asia. Austria has reported lending the equivalent of 85% of its GDP to emerging markets, but concentrated in the Hungary, Ukraine and Serbia. Conservative Swiss bankers have lent 50% of their GDP to emerging markets. Sweden, the UK and Spain have lent around 25% of their respective GDP to lower-income countries. The comparable figure for the US is a modest 4%.

In some ways, Europe’s lending to emerging markets is similar to a company offering credit to its customers so they can afford to buy the company’s products. Germany and the Netherlands, for example, each export about 3.5% of their GDP to central and eastern Europe. The dozen central and east European countries that joined the EU since 2004 account for 15.3% of the euro zone’s exports compared with about 10% at the start of the decade. Euro-zone exports to low-income countries amounted to 6% of the euro-zone’s GDP in 2006, up from 4.5% in 2000. Exports to China and Russia have doubled in the same period and three-quarters of the loans to China and India originate in Europe.

European banks gamed their regulatory regime just as much it appears, even if differently, as US banks. The extensive use of credit default swaps to reduce the regulatory capital requirements was a major way the European financial institutions were able to leverage their balance sheets. They also appear to have fueled the dramatic expansion of their balance sheets in recent years by borrowing cheap dollars (that have suddenly become quite dear). They have engaged in carry trade writ large that is biting them in much the same way as the Hungarian who took out a mortgage denominated in Swiss francs, of a Japanese pensioner who bought an Australian dollar samurai bond.

Besides perhaps offering outlet for some frustrations, blaming the Anglo-American capitalism for the financial crisis does little good and a great deal of harm. It prevents an appreciation of the global character of the crisis. It personalizes what is essentially a systemic issue a la Minsky. It encourages the externalization of one’s domestic problems. It discourages the recognition of the real dangers of unchecked leverage. It fans the flames of an exclusionary type of nationalism. The spark may very well have emanated from the United States, but many countries had plenty of dry kindling, which, if not the sub-prime, another spark would have arisen to ignite the conflagration.