Reserve accumulation and easy money helped to cause the subprime crisis: A conjecture in search of a theory
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Synopsis (Via Vox.Eu)
How did turmoil in the US subprime mortgage market ignite a global crisis? This column explains how emerging markets’ voracious appetite for international reserves coupled with record-low US policy interest rates and lax financial regulation to produce the large-scale creation of quasi-money subject to self-fulfilling-expectations runs. The theory suggests significant changes in Fed and regulatory policy are needed.
Introduction (Via Vox.Eu)
A view that is gaining popularity as one of the fundamental explanations for the current crisis is that emerging markets’ voracious appetite for international reserves coupled with record-low US policy interest rates and lax financial regulation to produce a frantic “search for yield,” the creation of fragile financial instruments, and occasionally outright fraud. For example see Henry Paulson’s discussion quoted in Guta (2009).
This view – particularly, the “financial fragility” component – could help to answer a central question, namely, why minor fireworks in the subprime mortgage market ignited a fearsome powder keg and a local problem became global in a short span of time.
In this column, I will present a framework that provides some conceptual support for the view. The framework stresses fragilities associated with liquid financial instruments that have long been identified in the finance literature.1 For the sake of concreteness, I will focus on the Fed and abstract from international aspects, unless strictly necessary.
Policy Implications: Most Important Part Of Paper (Via Vox.Eu)
1. Financial innovation and bubbles could stem from lax monetary policy and financial regulation.
2. Bubbles are not all the same. Bubbles that involve the banking system are likely the worst kind, because they could bring about a sudden stop of bank credit, seriously draining working capital, for example.
3. With the benefit of hindsight, to prevent price deflation in the first half of the 2000s, the Fed should have resorted to quantitative easing instead of keeping interest rates low for an extended period of time.
4. During financial crises, expansive monetary and fiscal policy may not suffice. An aggressive credit policy may be called for. Since under those circumstances credit markets don’t work properly, the central bank may have to direct credit to strategic sectors, like Brazil has done on several occasions.
5. Crisis time is no time for implementing tighter financial regulation. The latter may exacerbate contraction of credit flows and enhance its deleterious effects.
6. The above observation weakens any tough statement in normal times about policy in crisis times (e.g., a commitment to no-bailout). But, normal times are the time to deactivate financial bombs.
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