Global Imbalances and Financial Fragility

Abstract

The United States is currently engulfed in the most severe financial crisis since the Great Depression. The crisis was triggered by the crash in the real estate “bubble” and amplified by the extreme concentration of risk in a highly leveraged financial sector. Conventional wisdom is that both the bubble and the risk concentration were the result of mistakes in regulatory policy: an expansionary monetary policy during the boom period of the bubble, and failure to reign in the practices of unscrupulous lenders. In this paper we argue that, while correct in some dimensions, this story misses two key structural factors behind the securitization process that supported the real estate boom and the corresponding leverage. First, over the last decade, the US has experienced large and sustained capital inflows from foreigners seeking US assets to store value (Caballero, Emmanuel Farhi, and Pierre-Olivier Gourinchas 2008). Second, especially after the NASDAQ/tech bubble and bust, excess world savings have looked predominantly for safe debt investments. This should not be surprising because a large amount of the capital flow into the US has been from foreign central banks and governments that are not expert investors and are merely looking for a store of value (Krishnamurthy and Annette Vissing-Jorgenson 2008). In this paper we develop a stylized model that captures the essence of this environment. The model accounts for three facts observed during the boom and bust phases of the current crisis. First, during a period of good shocks— which we interpret as the period up to the end Global Imbalances and Financial Fragility By Ricardo J. Caballero and Arvind Krishnamurthy* of 2006—the growth in asset demand pushes up asset prices and lowers risk premia and interest rates. It is interesting to observe that the value of risky assets rises despite the fact that the increase in demand is for riskless assets. Second, foreign demand for debt instruments increases the equilibrium level of leverage of the domestic financial sector. In order to accommodate this demand, the US financial sector manufactures debt claims out of all types of products, which is the reason for the wave of securitization. Third, if shocks turn negative—which we interpret as the post-2006 period—the foreign demand now turns toxic; bad shocks and high leverage lead to an amplified downturn and rising risk premia. In addition to highlighting the role of capital flows in facilitating the securitization boom, our analysis speaks to the broader issue of global imbalances. Many of the concerns regarding global imbalances derive from emerging markets’ experiences, where capital flows are often speculative and a source of volatility, as emphasized in the literature on sudden stops. Our analysis shows that somewhat paradoxically, for a core economy such as that of the US, the risk in “excessive” capital inflows derives from the opposite concern: capital flows into the country are mostly nonspeculative and in search of safety. As a result, the US sells riskless assets to foreigners and in so doing raises the effective leverage of its financial institutions. In other words, as global imbalances rise, the US increas