The financial crisis was driven by the interaction of the US and European financial systems and the behaviour of Europe’s banks and not by the Asian savings glut, a paper from the Bank for International Settlements (BIS) concludes.
The paper entitled The 2008 crisis: trans-Atlantic or trans-Pacific by Robert McCauley a senior adviser in the monetary and economic department at BIS, was published in late December, and compares two hypotheses about the financial crisis.
· The Asian savings glut hypothesis which suggests that net inflows into high-grade US public bonds from countries running current account surpluses led to the housing boom and bust. An excess of savings over investment abroad led to an excess of US investment over savings.
· The European banking glut hypothesis holds that gross inflows into private bonds led to the boom. Leveraging up by European banks enabled the leveraging-up of US households.
McCauley, surveying previous academic work, has come down in favour of the second hypothesis suggesting that ten years ago at least, globalisation, economic integration and famed global imbalances were not the most significant factor in driving financial contagion.
The analysis suggests that it was behaviour and financial flows between the US and Europe that better match up, adding that “gross flows from Europe better matched US mortgage market trends towards private credit risk, floating interest rates and narrow spreads”.
“What is more, European banks produced, not just invested in, US mortgage-backed securities. Their US securities affiliates held huge exposures to such securities that deserve recognition.
Spain and Ireland are key examples
The report adds: “European banks’ leveraging-up also provided credit that enabled housing booms in Ireland and Spain. These findings favour the European banking glut hypothesis.
“The banking glut better accounts for the parallel real estate booms and busts in Spain and Ireland. True, official reserve managers did invest in euro-denominated government bonds. But the Irish and Spanish mortgage markets work on floating rates closely tied to the policy rates set by the ECB.
“Again, expansion-minded European banks provide a more compelling account of these banking systems’ remarkable ease of external financing. In fact, the Irish and Spanish banking systems experienced capital inflows that were huge in relation to the inflows into the United States in the same years.”
The paper does not wholly discount the impact of the Asian savings.
“It would be wrong to argue the banking glut to the exclusion of the savings glut. The huge inflow into safe assets compressed the term premium on safe assets (lowering the return to taking duration risk), and thereby induced a search for yield in credit. But it would also be wrong to claim that US and European investors responded to this incentive in the same manner. European investors shifted their US bond portfolio in the direction of credit risk markedly more than US investors did.”