I recently wrote a post on Pieria about the (sizeable) role of the Eurodollar market in the 2007-8 financial crisis, or rather in the credit boom that led to the crisis. In order to explain the vast increase in transatlantic two-way flows (round-trips) from 1997 to 2007, I used this diagram from Hyung Song Shin's 2011 paper on the "global banking glut":
But there's a problem. This diagram appears to show that all money lent by both US and European banks came from US households. Where did they get their money? It wasn't wages. We know that US wages have been stagnating for two decades. No doubt some will suggest it came from Asian savers - the "global saving glut" that is apparently caused by thrifty Chinese households. But how could thrifty Chinese households provide US households with money? Most Chinese households save in yuan. It is Chinese government and corporations that lend to the US, and it is not households they lend to. Mainly, it is the US government. No, the "Asian savers" argument won't wash either. Where US households obtained the extraordinary amounts of money that crossed the Atlantic in the decade before the financial crisis is a mystery. It grew on trees, perhaps?
No it didn't. It came from banks. To show this, I've produced a diagram of my own:
In my diagram the flows can start anywhere. All actors in this diagram should properly be regarded as part of the "pump" that maintained the two-way flow. In my earlier post I suggested that the principal driver of the pump was regulatory arbitrage by banks between the Basel I and Basel II regimes, with the shadow banking sector and money market funds facilitating. But the desire of borrowers for loans and households & corporations (particularly construction companies) for property sales are important too. Without these, the US banks would have lent much less and the European banks would have had much less funding.
However, although this is a circular flow, the quantities of money and property/securities circulating are not constant. As the money flows around this model, it expands: and correspondingly, property and securities also expand.
Money was created by US banks when they lent. The "Loans" arrow at the left hand side is always new money. Similarly, money was created by European banks when they purchased securities. The "Payment" arrow at the top right hand side is also new money.
Lending against property created not only new money, but also new securities. The loans were sold by US banks to securitizers, who pooled them, tranched them and created new securities, which they sold into the capital markets. In the "shadow banking" box is not only the securitization process itself, but also rehypothecation and leveraging of the ensuing RMBS products. The value of the securities that came out of the other side of that box was far higher than the value of the loans that went into it. The "Payment" arrow was enlarged both by the ability of European banks to create new money AND the ability of the shadow banking sector to leverage up property-backed securities.*
So the Eurodollar transatlantic flows grew enormously in the decade before the financial crisis, both money and property-backed securities. US lending against property expanded enormously, and there was as a result a construction bubble - the "Property" arrow at the bottom left-hand side itself expanded. But it expanded less than the other arrows. Most of the expansion of money was absorbed in price rises.
Normally, we would expect such a massive expansion of credit to have caused consumer price inflation to rise significantly. But it didn't. This period is known as the "Great Moderation", when consumer price inflation remained low and stable. For me, this is where the "Asian savers" theory gains traction. But the "savers" were not thrifty Chinese households. They were Asian governments, scarred by the Asian financial crisis of 1997 and anxious to protect themselves from damaging flows of capital by building up foreign exchange reserves. Instead of borrowing from Western countries, as they have done in the past - and suffered for it - they exported to them. I have observed before that the "Great Moderation" in the West is paralleled by the "Great Expansion" in the East. I would go further: I think it was caused by it. The massive expansion of low-cost imports to the West depressed consumer price inflation even though spending was increasing as a result of the credit bubble. I would venture to suggest that had there not been a credit bubble, this would actually have been a period of deflation. The stagnation of wages in many Western countries supports this line of argument.
Having said that, it is also clear that spending didn't increase as much as might have been expected. Spending would be a "leak" from the two-way flow in the diagram, reducing the flow and dampening the leverage. But most of the money seems to have stayed within the flow, driving up house prices to an unsustainable level.
Toxic cross-border feedback loops come in many kinds. This was a property-based one. The yen carry trade was a currency-based one, and once again, when it abruptly reversed the consequences were disastrous - although I don't think it was the sole cause of the financial crisis, it was certainly a significant contributor. Capital flows into Eurozone periphery countries prior to 2012 were a similar leveraging cross-border flow system that failed disastrously. So were the capital flows into Asian economies that reversed abruptly in 1997, causing the Asian crisis: I think QE-driven capital flows into emerging markets exhibit similar characteristics, and policy makers should be on their guard. Nor are these flow systems a new phenomenon: going back further, the Latin American debt crisis of the 1980s was the disastrous consequence of the failure of an enormous oil-based leveraging cross-border flow system.
It is difficult to see how conventional monetary policy could have dampened this leveraging cross-border flow without causing outright deflation in domestic consumer prices. And I would add that attempting to interrupt the flow once the system was fully developed - for example, by imposing capital controls - would have been dangerous. All the players in this game depended on the flow continuing. When it was suddenly interrupted, first in 2007 with the freezing of the ABCP market (top RH corner "Funding" and "Securities (collateral) arrows) and secondly in 2008 with the fall of Lehman (collapse of "shadow banking" box) followed by Reserve Primary breaking the buck (failure of "money market funds") box, the results were disastrous. All the players suffered, and many of them failed.
Cross-border leveraging flow systems of the kind I have illustrated above are the storms and hurricanes of the financial system. We ignore them at our peril.
When the Nile floods fail
European banks and the global banking glut - Pieria
Currency wars and the fall of empires - Pieria
* I should emphasise that this diagram ONLY shows the Eurodollar flow. European banks were not the only purchasers of US RMBS and derivative products.