At the Paris G20 meeting on 18 February 2011, Federal Reserve Chairman Ben Bernanke squarely laid the blame for the financial crisis and ensuing economic crisis on global imbalances, or the so-called global saving glut (for a review of the arguments see Suominen 2010). What the Chairman failed to mention is that the Fed’s easy monetary policy in the early 2000s played a crucial role in bringing about the global saving glut.
The loosening of monetary policy
Following the bursting of the dot-com bubble in late 2000 and the subsequent recession in the US, the Federal Open Market Committee (FOMC) began to lower the target for the overnight fed funds rate, the monetary policy rate. Rates fell from 6.5% in late 2000 to 1.75% in December 2001 and to 1% in June 2003. The target rate was left at 1% for a year. At the time, the historically low fed funds rate resulted in a negative real fed funds rate from November 2002 to August 2005. Though the FOMC stuck to a monetary-policy rule similar to the classic Taylor rule using inflation forecasts instead of current values, it changed its preferred measure of inflation twice in the early 2000s (from headline Consumer Price Index (CPI) to headline Personal Consumption Expenditures (PCE) in January 2000 and from headline PCE to core PCE in June 2003) without a countervailing change in the parameters, thereby effectively loosening the monetary-policy rule considerably.
In recent research (Mees 2011), I show that the Fed’s easy monetary policy, rather than the housing boom, as asserted by Taylor (2007), sparked the refinancing boom. While mortgages for purchase do not respond significantly to changes in the fed funds rate but instead to changes in long-term interest rates, I find that mortgages for refinance are significantly responsive to both changes in the fed funds rate and changes in long-term interest rates, especially so in the period 2000 – 2008. Between Q1 2003 and Q2 2004, the time when the FOMC held the fed funds rate steady at 1%, two-thirds of all mortgage originations were for home refinance.
Figure 1. Mortgages for purchase and refinance ($ billions)
Source: Mortgage Bankers Association
Figure 2. Fed funds rate, 10-year treasury and 30-year mortgage rate (%)
Source: Federal Reserve, Freddie Mac
Spending money that had been raised through home equity extraction – or remortgaging – amounted to more than 4% of GDP in 2005. From the FOMC transcripts in 2003 and 2004, it emerges that the FOMC in general looked favourably upon home equity extraction as a source of personal consumption expenditure. In his 2005 Sandridge lecture, Bernanke boasted of the depth and sophistication of the country's financial markets that allowed households easy access to rising housing wealth. The possibility that the housing boom could one day turn to bust, leaving many homeowners in negative equity, seems not to have set off any alarm bells at the Federal Reserve. At the end of 2009 almost 25%, or 11.4 million, of all residential properties with mortgages in the US were in negative equity – or “underwater”. More than half of these mortgages were the result of home refinancing, given the scale of refinancing/home equity extraction in the years preceding the financial crisis.
Figure 3. Spending out of home equity extraction (% GDP)
Source: Federal Reserve
In addition to home equity extraction, consumer credit also rose in the years leading up to the financial crisis – albeit at a more moderate pace of about 1% of GDP per year as many households used home loans to pay off credit card debt. Beyond home equity extraction and consumer credit, the US economy also received stimulus from incremental government spending on the wars in Afghanistan and Iraq, and from the Bush tax cuts, which effectively transformed sovereign debt into consumer credit. Despite all this effort, the benefit US economy was a disappointment. The sum of tax cuts, war spending, consumer credit, and spending out of home equity extraction was in the range of 4% to 8% of GDP from 2002 to 2008. Nominal GDP growth was on average about two percentage points lower than the overall stimulus, even though the economy was operating below potential and experienced an unemployment gap and output gap during most of those years.
As real GDP growth in the US declined from 4.1% in 2004 to 1.3% in 2007, China experienced consecutive years of double-digit economic growth. And while the US saving rate hovered around 15%, China’s saving rate increased from 38% of GDP in 2000 to 54% of GDP in 2006. Rising enterprise savings, instead of household savings, accounts for the increase in China’s saving rate in the 2000s. Chinese household savings actually declined as a percentage of GDP.
In February 2005, the then Chairman of the Federal Reserve Alan Greenspan first raised the spectre of the interest conundrum: “[T]he broadly unanticipated behaviour of world bond markets remains a conundrum.” In a speech to the International Monetary Conference in Beijing (via satellite) on June 6, 2005, Greenspan elaborated further on the interest conundrum: “The pronounced decline in US Treasury long-term interest rates over the past year despite a 200-basis-point increase in our fed funds rate is clearly without recent precedent. (…) The unusual behaviour of long-term rates first became apparent almost a year ago.”
In March 2005 Ben Bernanke, who was Fed governor at the time, in the Sandridge lecture advanced the theory of a global saving glut. He argued that there was an excess of world savings – a global savings glut – and that the US acted as the consumer of last resort. Maurice Obstfeld and Kenneth Rogoff (2010) pointed out that the global saving rate was actually low in the 2002-2004 period. According to Obstfeld and Rogoff the increase in global saving plays out largely after 2004. However, by focusing solely on the global saving rate, Obstfeld and Rogoff overlook the changing composition of world savings. In 2000 advanced economies accounted for 78% of global savings. By 2008 the share of emerging economies in global savings had doubled to 44%, while advanced economies accounted for a much more modest 56% of global savings (see Figure 4).
Figure 4. Advanced, emerging economies and global savings (% world GDP)
Emerging economies’ savings are heavily skewed towards fixed income assets. We see total debt securities outstanding rising at a higher rate from 2002 onward, despite the fact that the global saving rate was relatively low at the time (Figure 5). This coincides with a quickening in China’s savings. It corroborates Greenspan’s statement in June 2005 that “the unusual behaviour of long-term rates first became apparent almost a year ago”.
Figure 5. Total debt securities outstanding ($ billions)
Source: Bank of International Settlements
I perform an OLS-regression identical to the one in Warnock and Warnock (2009), which includes inflation expectations, interest rate risk premium, expected real GDP growth and the structural budget deficit. We find that total debt securities outstanding explain the 10-year Treasury yield considerably better than foreign purchases of US government bonds.
Our study shows that in the early 2000s US long-term interest rates largely delinked from the Fed’s monetary policy. At first, in 2001- 2003, interest rates did not come down as much as was to be expected based on the experience in the past two decades. Subsequently, in 2004-2005, the 200-basis point rise in the fed funds rate failed to lift long-term interest rates. We see a similar outcome in the UK, and to a lesser extent in Germany, where the term structure was not as stable to begin with. We show that total debt securities outstanding, instead of foreign flows into US Treasury and agency bonds, account for the interest conundrum in the US.
The Fed’s easy monetary policy in the early 2000s did not trigger so much the housing boom, as asserted by John Taylor, but rather the refinancing boom and ensuing spending spree that spurred economic growth (and savings) in China (and oil-exporting nations). The most important factor driving housing demand is long-term interest rates. Hence, the prolonged decline in long-term interest rates in the mid-2000s is largely to blame for the housing boom in the U.S. Despite popular belief, the proliferation of exotic mortgage products can hardly be faulted for the housing boom and eventual bust. As a share of total mortgage originations, mortgages with exotic features are less than five percent of total mortgages until and including 2004, and only slightly above five percent of total mortgages in 2005 and 2006 (respectively 5.6 and 7.7 percent of total mortgage originations).
Bernanke, Ben S (2005), “The Global Saving Glut and the US Current Account Deficit” , The Sandridge Lecture.
Bernanke, Ben S (2011), “Global Imbalances: Links to Economic and Financial Stability”.
Greenspan, Alan (2010), “The Crisis”.
Mees, Heleen (2011), “US Monetary Policy and the Interest Conundrum”.
Obstfeld, Maurice and Kenneth S Rogoff (2010), “Global Imbalances and the Financial Crisis: Products of Common Causes”.
Suominen, Kati (2010), “Did global imbalances cause the crisis?”, VoxEU.org, 14 June.
Taylor, John B. (2007), “Housing and Monetary Policy”, NBER Working Paper Series 13682.
Warnock, Francis E and Veronica Cacdac Warnock (2009), “International capital flows and US interest rates”, Journal of International Money and Finance, 28:903-919.