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What caused the bubble that led to the crash?

Mark Thoma comes up with this interesting theory on the cause of the housing bubble, the deflation of which has imposed a very nasty economic disaster on just about every nation:

In response to the question of whether the Fed’s low interest rate policy is responsible for the bubble, most respondents point instead to regulatory failures of one type or another. Ben Bernake has also made this argument. However, I don’t think it was one or the other, I think it was both. That is, first you need something to fuel the fire, and low interest rates provided fuel by injecting liquidity into the system. And second, you need a failure of those responsible for preventing fires from starting along with a failure to have systems in place to limit the damage if they do start.

In Professor Thoma’s analogy, low interest rates was the fuel. But, he later expands this to include China and other export surplus nations, who used their excess profits to purchase US financial instruments. US financial firms, took one dollar of their own money and borrowed 29 more dollars of Chinese excess savings in order to make loans to us for our mortgages.

And, if we correctly understand how all this worked, we then took one of our dollars, and borrowed 19 dollars of this already highly leveraged cash to purchase our home.


That means, in the above example, the financial sector could take $6,327 of its own money, borrow another $183,673.33 from the Chinese – loan the sum to us, and reap the return on the entire $190,000, minus interest payments to the Chinese for money borrowed at extraordinarily low interest rates. The down payment on the $200,000 mortgage would have been $10,000 – so Wall Street was already in the black – with a hefty 37 percent profit – before we left the building, after signing our mortgage agreement!

Math isn’t our strong point here, so our numbers are suspect – but, you get the picture:

However, the idea that low interest rates injected liquidity into the system and helped create the bubble is absurd, since it doesn’t explain why China would tolerate such low interest rates for its savings in the first place when Wall Street was making fantastic profits loaning Chinese savings to Americans debtors. How could the United States, a perennial  credit-whore, force China to lend it ever greater sums of money on the easiest of terms, when Wall Street was using those very same easy terms to reap massive profits re-lending it to us?

Indeed, as Bernanke pointed out:

I will only note here that, as more accommodative monetary policies generally reduce capital inflows, this relationship appears to be inconsistent with the existence of a strong link between monetary policy and house price appreciation.

Which is to say, low interest rates on China’s savings in the United States should have encouraged China to look elsewhere for better returns – but, it didn’t. Once the money was there, according to Bernanke, the failure of Washington to prevent China savings from producing an American home bubble allowed the process to run wild.

Thoma continues in much the same vein:

Once the fuel was present, something had to allow the bubble to inflate and then do widespread damage, and that’s where the regulatory failure comes in. But I don’t think the regulatory failure matters much without a large amount of liquidity within the system, and I don’t think the large amount of cash in the system is problematic without the regulatory failures.

“Let’s assume that we have a can-opener…”

So, as is to be expected from economists, they can account for an event once everything is in place for that event to emerge, but they cannot explain how things come to be in place. They can’t explain why China would be lending to the United States on such extraordinarily easy terms when the United States shows no willingness to ever run a sufficient export surplus to repay its creditors.

Hence this joke:

A physicist, a chemist and an economist are stranded on an island, with nothing to eat. A can of soup washes ashore.

The physicist says, “Let’s smash the can open with a rock.”

The chemist says, “Let’s build a fire and heat the can first.”

The economist says, “Let’s assume that we have a can-opener…”

Since they can’t do what you can do – now that you have completed the horribly unfinished theory Paul Krugman offered: namely, that export surpluses being generated from various countries require that the owner of the reserve currency of choice become a net importer – which is to explain why Chinese excess dollar savings must find their way back into the American Dollar Empire (no matter the interest rate offered) they have no explanation for why asset side deleveraging is a constant mortal threat to capital – or, what is the same thing, why every dollar of Chinese savings must lead to a new burst of American debt.

Unlike economists, you know that it was the failure of American debt to keep pace with the inflows of American dollars from China which caused the financial crisis.

But, we won’t tell them.

Nor, will we tell them that the only way to correct this problem is to shorten hours of work.

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