ABSTRACT. Geopolitical changes following the end of the Cold War induced a worldwide decline in real long-term interest rates that, in turn, produced home price bubbles across more than a dozen countries. However, it was the heavy securitization of the U.S. subprime mortgage market from 2003 to 2006 that spawned the toxic assets that triggered the disruptive collapse of the global bubble in 2007–08. Private counterparty risk management and official regulation failed to set levels of capital and liquidity that would have thwarted financial contagion and assuaged the impact of the crisis. This woeful record has energized regulatory reform but also suggests that regulations that require a forecast are likely to fail. Instead, the primary imperative has to be increased regulatory capital, liquidity, and collateral requirements for banks and shadow banks alike. Policies that presume that some institutions are “too big to fail” cannot be allowed to stand. Finally, a range of evidence suggests that monetary policy was not the source of the bubble
II. Causes of the Crisis
II.A. The Arbitraged Global Bond Market and the Housing Crisis
The global proliferation of securitized, toxic U.S. subprime mortgages was the immediate trigger of the crisis. But the origins of the crisis reach back, as best I can judge, to the aftermath of the Cold War.1 The fall of the Berlin Wall exposed the economic ruin produced by the Soviet bloc’s economic system. In response, competitive markets quietly, but rapidly, displaced much of the discredited central planning so prevalent in the Soviet bloc and the then Third World.
A large segment of the erstwhile Third World nations, especially China, replicated the successful export-oriented economic model of the so-called Asian Tigers (Hong Kong, Singapore, South Korea, and Taiwan): fairly well educated, low-cost workforces, joined with developed-world technology and protected by increasingly widespread adherence to the rule of law, unleashed explosive economic growth.2 The International Monetary Fund (IMF) estimated that in 2005 more than 800 million members of the world’s labor force were engaged in export-oriented and therefore competitive markets, an increase of 500 million since the fall of the Berlin Wall.3 Additional hundreds of millions became subject to domestic competitive forces, especially in the former Soviet Union.
As a consequence, between 2000 and 2007 the real GDP growth rate of the developing world was almost double that of the developed world. Consumption in the developing world, however, restrained by culture
and inadequate consumer finance, could not keep up with the surge of income, and consequently the saving rate of the developing world soared from 24 percent of nominal GDP in 1999 to 34 percent by 2007, far out stripping its investment rate. With investment elsewhere in the world slow to take up the slack, the result was a pronounced fall from 2000 to 2005 in global long-term interest rates, both nominal (figure 1) and real.
Although the decline in global interest rates indicated, of necessity, that global saving intentions were chronically exceeding global intentions to invest, ex post global saving and investment rates in 2007, overall, were only modestly higher than in 1999, suggesting that the uptrend in the saving intentions of developing economies tempered declining investment intentions in the developed world.4 Of course, whether it was a glut of intended saving or a shortfall of investment intentions, the conclusion is the same: real long-term interest rates had to fall. Inflation and long-term interest rates in all developed economies and the major developing economies had by 2006 converged to single digits, I believe for the first time ever. The path of the convergence is evident in the unweighted average variance of interest rates on 10-year sovereign debt of 15 countries: that average declined markedly from 2000 to 2005 (figure 2)
Equity and real estate capitalization rates were inevitably arbitraged lower by the fall in global long-term real interest rates. Asset prices, particularly home prices, accordingly moved dramatically higher.
The Economist’s surveys document the remarkable convergence of nearly 20 individual nations’ home price rises during the past decade.6
Japan, Germany, and Switzerland (for differing reasons) were the only important exceptions. U.S. home price gains, at their peak, were no more than the global peak average.7 In short, geopolitical events ultimately led to a fall in long-term mortgage interest rates that in turn led, with a lag, to the boom in home prices globally.