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International capital flows and the returns to safe assets in the United States 2003-2007

  • Bernanke, B.S.

A broad array of domestic institutional factors –including problems with the originate-to-distribute model for mortgage loans, deteriorating lending standards, deficiencies in risk management, conflicting incentives for the government-sponsored enterprises (GSEs), and shortcomings of supervision and regulation– were the primary sources of the US housing boom and bust and the associated financial crisis. In addition, the extended rise in US house prices was likely also supported by long-term interest rates (including mortgage rates) that were surprisingly low, given the level of short-term rates and other macro fundamentals –a development that Greenspan (2005) dubbed a “conundrum.” The “global saving glut” (GSG) hypothesis (Bernanke, 2005 and 2007) argues that increased capital inflows to the United States from countries in which desired saving greatly exceeded desired investment –including Asian emerging markets and commodity exporters– were an important reason that US longer-term interest rates during this period were lower than expected. This essay investigates further the effects of capital inflows to the United States on US longer-term interest rates; however, we look beyond the overall size of the inflows emphasised by the GSG hypothesis to examine the implications for US yields of the portfolio preferences of foreign creditors. We present evidence that, in the spirit of Caballero and Krishnamurthy (2009), foreign investors during this period tended to prefer US assets perceived to be safe. In particular, foreign investors –especially the GSG countries–acquired a substantial share of the new issues of US Treasuries, Agency debt, and Agency-sponsored mortgage-backed securities. The downward pressure on yields exerted by inflows from the GSG countries was reinforced by the portfolio preferences of other foreign investors. We focus particularly on the case of Europe: although Europe did not run a large current account surplus as did the GSG countries, we show that it leveraged up its international balance sheet, issuing external liabilities to finance substantial purchases of apparently safe US “private label” mortgage-backed securities and other fixed-income products. The strong demand for apparently safe assets by both domestic and foreign investors not only served to reduce yields on these assets but also provided additional incentives for the US financial services industry to develop structured investment products that “transformed” risky loans into highly-rated securities. Our findings do not challenge the view that domestic factors, including those listed above, were the primary sources of the housing boom and bust in the United States. However, examining how changes in the pattern of international capital flows affected yields on US assets helps provide a deeper understanding of the origins and dynamics of the crisis.

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Article provided by Banque de France in its journal Financial Stability Review.

Volume (Year): (2011)
Issue (Month): 15 (February)
Pages: 13-26

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Handle: RePEc:bfr:fisrev:2011:15:02
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  1. Christopher Mayer & Karen Pence & Shane M. Sherlund, 2009. "The Rise in Mortgage Defaults," Journal of Economic Perspectives, American Economic Association, vol. 23(1), pages 27-50, Winter.
  2. Ricardo J. Caballero & Emmanuel Farhi & Pierre-Olivier Gourinchas, 2006. "An Equilibrium Model of Global Imbalances and Low Interest Rates," 2006 Meeting Papers 894, Society for Economic Dynamics.
  3. Olivier Blanchard & Francesco Giavazzi & Filipa Sa, 2005. "The U.S. Current Account and the Dollar," NBER Working Papers 11137, National Bureau of Economic Research, Inc.
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  5. Patrick McGuire & Goetz von Peter, 2009. "The US dollar shortage in global banking," BIS Quarterly Review, Bank for International Settlements, March.
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  7. Ricardo J. Caballero & Arvind Krishnamurthy, 2009. "Global Imbalances and Financial Fragility," American Economic Review, American Economic Association, vol. 99(2), pages 584-88, May.
  8. Glenn D. Rudebusch & Eric T. Swanson & Tao Wu, 2006. "The bond yield "conundrum" from a macro-finance perspective," Working Paper Series 2006-16, Federal Reserve Bank of San Francisco.
  9. Joshua Coval & Jakub Jurek & Erik Stafford, 2009. "The Economics of Structured Finance," Journal of Economic Perspectives, American Economic Association, vol. 23(1), pages 3-25, Winter.
  10. Ben S. Bernanke & Vincent R. Reinhart & Brian P. Sack, 2004. "Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 35(2), pages 1-100.
  11. Gary B. Gorton, 2009. "Information, Liquidity, and the (Ongoing) Panic of 2007," NBER Working Papers 14649, National Bureau of Economic Research, Inc.
  12. Richard N. Cooper, 2005. "Living with Global Imbalances: A Contrarian View," Policy Briefs PB05-03, Peterson Institute for International Economics.
  13. Joseph Gruber & Steven Kamin, 2009. "Do Differences in Financial Development Explain the Global Pattern of Current Account Imbalances?," Review of International Economics, Wiley Blackwell, vol. 17(4), pages 667-688, 09.
  14. Jane Dokko & Brian Doyle & Michael T. Kiley & Jinill Kim & Shane Sherlund & Jae Sim & Skander Van den Heuvel, 2009. "Monetary policy and the housing bubble," Finance and Economics Discussion Series 2009-49, Board of Governors of the Federal Reserve System (U.S.).
  15. Patrick McGuire & Goetz von Peter, 2009. "The US dollar shortage in global banking and the international policy response," BIS Working Papers 291, Bank for International Settlements.
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