The Greenspan-Bernanke explanation on the cause of the financial bubble rests on the theory of the saving glut. According to this explanation, the problem was not that the Fed mismanaged the monetary policy, but that a saving glut that took place outside the scope of the Fed’s jurisdiction was the cause of the financial boom and bust. More specifically, increased savings from countries like China and India came to the US lowering the interest rates and finally giving rise to the housing bubble through financial instruments like mortgages. Even though there are some differences between Greenspan and Bernanke’s explanation of the saving glut, this hypothesis finds broad consensus. This, however, still begs the question of why the Fed couldn’t do nothing about it.
Albeit there is some truth in this line of reasoning, closer inspection of some economic indicators seem to suggest that the savings glut hypothesis is not so robust. If there was an increase in savings important enough to generate a saving glut, then we should, in principle, see a fall in consumption. The following graph shows the percent change in consumption for the US, China and India; the graph indicates that consumption was still growing.
This means that consumption was not decreasing. However, consumption and saving can both increase if there is an increase in production. If, for example, we produce $100 from which we consume $70 and save $30, the only way to increase savings in $5 to $35 is by reducing consumption from $70 to $65. But if production goes from $100 to $110, then consumption and savings can both increase $5 each to $75 and $35 respectively. The following chart shows consumption and GDP growth rates for China and India. The biggest difference between consumption and growth rates of GDP is around 3%; is that enough to explain a saving glut with the power to cause an international financial crisis?
We can also see what happened with savings to GDP before the crisis. If there was an increase in global savings then we should see an increase in the ratio of savings/GDP. The following chart shows the evolution of savings to GDP for the world, US, China and India.
It is true, of course, that savings in India and China grew during this time. But world savings did not. This can imply two things. The savings from China and India had a small participation in the world economy or the saving glut from Asia was compensated by a de-saving glut in other parts of the world. In either case, the graph does not show strong symptoms of a saving glut. Why was the localized saving glut in Asia going to the US and not to to compensate the de-saving glut in other countries?
The bubble and the crisis, however, did happen. But savings to GDP did not rise globally and commodity prices in all currencies were also increasing. Add to this low interest rates and the result is not a saving glut but a credit expansion glut.
Still, there is some truth in the saving glut explanation. Liquidity from other countries like India and China got into the US economy and provoked the housing market bubble. But it is not so straightforward that the main source of this incoming liquidity was an increase in savings as it was from credit expansion. Furthermore, even if it were true that the main driver was an increase in savings, that doesn’t explain why they were so highly allocated in the housing market in the United States rather than diversified through the world economy. Or is that the housing market in the US was so weak? And why was the rest of the US economy so highly exposed to the housing market? Increase in savings are not enough to explain a crisis. People increase production, savings and the result is a crisis? This is like arguing that getting healthier can make us sick! To blame foreign savings is to overlook the role played by domestic regulations in the housing and financial markets.To explain why so many funds were allocated to the housing market a regulatory framework is required.
The saving glut explanation is not so straightforward, and a monetary policy aimed to expand credit, not only in the US, but in other countries as well, plus financial and housing market regulation seems to be the cause of the financial crisis.
Nicolas Cachanosky is a doctoral student in economics at Suffolk University, as well as a previous Sound Money Essay Contest winner.
Image by Simon Howden / FreeDigitalPhotos.net.
