Global Imbalances and Financial Fragility

The U.S. is currently engulfed in the most severe financial crisis since the Great Depression. A key structural factor behind this crisis is the large demand for riskless assets from the rest of the world. In this paper we present a model to show how such demand not only triggered a sharp rise in U.S. asset prices, but also exposed the U.S. financial sector to a downturn by concentrating risk onto its balance sheet. In addition to highlighting the role of capital flows in facilitating the securitization boom, our analysis speaks to the broader issue of global imbalances. While in emerging markets the concern with capital flows is in their speculative nature, in the U.S. the risk in capital inflows derives from the opposite concern: capital flows into the U.S. are mostly non-speculative and in search of safety. As a result, the U.S. sells riskless assets to foreigners, and in so doing, it raises the effective leverage of its financial institutions. In other words, as global imbalances rise, the U.S. increasingly specializes in holding its "toxic waste."(This abstract was borrowed from another version of this item.)