Global Imbalances and Financial Fragility

Abstract

The U.S. 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 U.S. has experienced large and sustained capital inflows from foreigners seeking U.S. assets to store value (Ricardo J. Caballero et al 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 U.S. has been from foreign central banks and governments who are not expert investors and are merely looking for a store of value (Arvind 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 of 2006 – the growth in asset demand pushes up asset prices and lowers risk premia

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