Twofish's Blog

January 10, 2009

Why a savings glut didn’t cause the banking crisis

Filed under: china, finance — twofish @ 6:05 pm

bsetser: 2fish — agreed. but w/o those stupid loans financing stupid consumption, there would be a shortfall in aggregate demand in the US (as happened)

No there wouldn’t if the excess credit was directed at investment or public goods. This would have required far, far more government intervention than was fashionable in 2005, but if the government took Chinese money and then encouraged student loans or small business loans rather than mortgages, the US would have been better off.

What you are arguing is that bad lending is a natural result of cheap money, and I’m saying that it took an ideology of governmental indifference to cause all of that cheap money to go into bad lending. There’s no reason a priori that the cheap money had to go into stupid loans. If you want to boost demand, there are better ways of doing it. A crash program to build houses on the moon would have left the US better off than what actually happened.

bsetser: the key thing is that if there isn’t a big household deficit in the US financed with subprime loans absorbing the surplus of savings v investment elsewhere in the world, SOMETHING ELSE has to adjust.

Sure, and there are dozens of other adjustments that would have been more beneficial than what happened. If you had fewer housing loans and more loans to build research parks and universities and then loans to people to attend those research parks and universities.

If the US took trillions of dollars in Chinese money and printed it all in $100 bills and buried it in the Rocky Mountains to dig up later, it would have been better off than loaning to subprime.

If the US government took those trillions of dollars and just *gave* it to subprime borrowers rather than *loaning* it, things would have been better. You would have ended up the same cost to the US government debt, but it would not have resulted in a banking crisis.

The savings glut thesis makes sense only if you believe that the subprime loan was the best way of dealing with Chinese money. I’ve given two ridiculous examples of policies that I think would have given a better out come. That tells you how truly dreadful, US policy was.

If instead of loaning subprime borrowers $50,000, the US government just sent them a check for say $50,000 from the US Treasury. Everyone would be better off today. The cost to the US government would have been the same (since no one is going to pay back that $50,000 now anyhow), and you wouldn’t have had a banking crisis.


One other thing. If people were so willing to lend to people with no income and no hope of paying back loans at 2%, then why should they stop if the interest rate is 6% or 8%.

The people who were making the loans were making money off of fees, so they didn’t care what the interest rate was. The people where getting the loans didn’t care what the interest rate. They just cared about how much cash they could get up front and the monthly payment and you can get them to sign on the dotted line by doing stupid things like cash back rebates or negative amortization.

Also the last major banking crisis in the US happened in the 1980’s when Volcker raised interest rates to 20%, and it is a model for how you can have a banking crisis form in a high interest rate environment.

What happened in 1980 was that savings and loans had decontrolled interest rates and were competing for deposits by promising high interest rates. In order to deliver those high interest rates, they invested in extremely speculative investments that went bad.

So I’d argue that if interest rates *had* been 8-10% and you had lax regulation, that you would had had a banking crises anyway. Banks would have been under pressure to pay huge interest rates on their accounts. Without regulation, they would have been looking for risky and stupid investments (emerging markets, commodities, etc. etc.).

They would have ended up shooting themselves. For example, they could have ended up offering very high yield fixed interest bonds to depositors, and when interest rates went down, they would have gotten crushed.


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