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

Author

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  • Ben S. Bernanke
  • Carol C. Bertaut
  • Laurie Pounder Demarco
  • Steven B. Kamin

Abstract

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 GSEs, and shortcomings of supervision and regulation--were the primary sources of the U.S. housing boom and bust and the associated financial crisis. In addition, the extended rise in U.S. 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 U.S. 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 U.S. longer-term interest rates; however, we look beyond the overall size of the inflows emphasized by the GSG hypothesis to examine the implications for U.S. 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 U.S. assets perceived to be safe. In particular, foreign investors--especially the GSG countries--acquired a substantial share of the new issues of U.S. 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 U.S. "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 U.S. 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 U.S. assets helps provide a deeper understanding of the origins and dynamics of the crisis.

Suggested Citation

  • Ben S. Bernanke & Carol C. Bertaut & Laurie Pounder Demarco & Steven B. Kamin, 2011. "International capital flows and the returns to safe assets in the United States, 2003-2007," International Finance Discussion Papers 1014, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgif:1014
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    References listed on IDEAS

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    Cited by:

    1. Barry Eichengreen & Hui Tong, 2011. "The External Impact of China's Exchange Rate Policy: Evidence from Firm Level Data," NBER Working Papers 17593, National Bureau of Economic Research, Inc.
    2. Gourinchas, Pierre-Olivier & Rey, Hélène, 2014. "External Adjustment, Global Imbalances, Valuation Effects," Handbook of International Economics, Elsevier.
    3. Gourinchas, Pierre-Olivier & Rey, Hélène & Truempler, Kai, 2012. "The financial crisis and the geography of wealth transfers," Journal of International Economics, Elsevier, vol. 88(2), pages 266-283.
    4. Dániel Horváth & Róbert Szini, 2015. "The safety trap – the financial market and macroeconomic consequences of the scarcity of safe assets," Financial and Economic Review, Magyar Nemzeti Bank (Central Bank of Hungary), vol. 14(1), pages 111-138.
    5. Kacperczyk, Marcin & Perignon, Christophe & Vuillemey, Guillaume, 2017. "The Private Production of Safe Assets," CEPR Discussion Papers 12086, C.E.P.R. Discussion Papers.
    6. Photis Lysandrou, 2014. "Post-Keynesian stock-flow models after the subprime crisis: the need for micro-foundations," European Journal of Economics and Economic Policies: Intervention, Edward Elgar Publishing, vol. 11(1), pages 113-126, April.
    7. Mary M. Everett, 2015. "International liquidity shocks and the European sovereign debt crisis: Was euro area unconventional monetary policy successful?," FIW Working Paper series 143, FIW.
    8. repec:cbh:journl:v:14:y:2015:i:1:p:111-138 is not listed on IDEAS
    9. Caballero, Ricardo & Farhi, Emmanuel & Gourinchas, Pierre-Olivier, 2015. "Global Imbalances and Currency Wars at the ZLB," CEPR Discussion Papers 10905, C.E.P.R. Discussion Papers.
    10. Byrne, Joseph P. & Fiess, Norbert, 2016. "International capital flows to emerging markets: National and global determinants," Journal of International Money and Finance, Elsevier, vol. 61(C), pages 82-100.
    11. Julian Kozlowski & Laura Veldkamp & Venky Venkateswaran, 2018. "The Tail that Keeps the Riskless Rate Low," NBER Working Papers 24362, National Bureau of Economic Research, Inc.
    12. Siklos, Pierre L., 2011. "Emerging market yield spreads: Domestic, external determinants, and volatility spillovers," Global Finance Journal, Elsevier, vol. 22(2), pages 83-100.
    13. Thomas Goda & Özlem Onaran & Engelbert Stockhammer, 2014. "A case for redistribution? Income inequality and wealth concentration in the recent crisis," DOCUMENTOS DE TRABAJO CIEF 012186, UNIVERSIDAD EAFIT.
    14. Goda, Thomas & Lysandrou, Photis & Stewart, Chris, 2013. "The contribution of US bond demand to the US bond yield conundrum of 2004–2007: An empirical investigation," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 27(C), pages 113-136.
    15. Bank for International Settlements, 2015. "Introduction to BIS statistics," BIS Quarterly Review, Bank for International Settlements, September.
    16. Zoltan Pozsar, 2014. "Shadow Banking: The Money View," Working Papers 14-04, Office of Financial Research, US Department of the Treasury.
    17. Ott, Hervé, 2014. "Will euro area house prices sharply decrease?," Economic Modelling, Elsevier, vol. 42(C), pages 116-127.
    18. Sydney Ludvigson & Stijn Van Nieuwerburgh & Jack Favilukis, 2012. "Foreign Ownership of U.S. Safe Assets: Good or Bad?," 2012 Meeting Papers 297, Society for Economic Dynamics.
    19. Ma, Guonan & McCauley, Robert N., 2013. "Is China or India more financially open?," Journal of International Money and Finance, Elsevier, vol. 39(C), pages 6-27.
    20. Marco Passarella, 2013. "Financial Integration in the European Union: an Analysis of ECB’s role," Working papers wpaper04, Financialisation, Economy, Society & Sustainable Development (FESSUD) Project.

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    Keywords

    Saving and investment ; Investments; Foreign ; Housing - Prices ; Financial crises;

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