Views from the World
The Global Response to the U.S. Subprime Crisis
Brad W. Setser, Fellow, Council on Foreign Relations
(Keizai Koho, August 2008 issue)

In August 2007, the United States experienced its most significant financial crisis in recent memory. The price of securities based on repackaged mortgage loans - and securities based on repacking already repackaged mortgage loans - tumbled. Consequently, foreign demand for these securities disappeared. Rather than buying the financial equivalents of a Mercedes or a Lexus, highly engineered luxury cars that trade at a premium, buyers discovered that they had bought the financial equivalent of lemons: dolled-up, poorly engineered cars that sell for a discount. Various onshore and offshore structures that had borrowed in the short-term money market to finance the purchase of long-term asset-backed securities found themselves in severe trouble. As demand for U.S. debt fell, the value of the dollar also fell.

The past year has been defined by policies the United States put in place to respond to this crisis. It also has been shaped by policies other countries adopted in response to both the crisis and the United States' own policies. The next year - at least if the United States avoids slipping into a prolonged slump - is likely to be defined by how policy makers react to now apparent consequences of the policies adopted in the fall of 2007 and early 2008 and, perhaps, by new efforts to try to strengthen the resilience of the financial sector.

The full scope of the policy response to the crisis is worth spelling out in detail. The response includes:
* A series of cuts in U.S. short-term policy interest rates brought the Fed funds rate down to 2%.
* The adoption of a $168 billion fiscal stimulus package looks set to combine with the normal rise in spending and fall in tax revenues associated with a slowdown to increase the FY 2008 deficit to around $500 billion.
* The New York Fed engineered a takeover of Bear Sterns, a troubled broker-dealer, by JP Morgan Chase.
* A series of facilities were created at the Federal Reserve Bank to provide financing to both U.S. banks and broker-dealers, largely through lending the Treasuries on the Fed's balance sheet to financial institutions needing liquid assets. The resulting shift in the composition of the Federal Reserve's balance sheet - the Fed's holdings of U.S. treasuries fell from $785 billion in August 2007 to around $480 billion at the end of June 2008 - has been far more dramatic than the increase in its size. Allowing broker-dealers access to the Fed necessitated a temporary extension of the Fed's supervision to a new set of institutions.
* Financing was provided to banks through the Federal Home Loan Banks, which can lend against mortgage collateral.
* A set of restrictions was lifted on the activities of the government-sponsored agencies active in the mortgage market. This allowed the agencies to make larger loans than in the past and to increase their own lending.
* More recently, there was a series of steps designed to reassure the market that the agencies' debt is safe, including a larger credit line from the Treasury and the possible use of taxpayers' funds to rebuild their equity capital.

These steps produced a significant increase in the quantity of safe collateral circulating in the market, as both the Treasury's new issuance and the Fed's activities have increased the stock of available Treasuries. They also produced a dramatic expansion of the share of lending to households that was backed directly (or indirectly, through the agencies?f perceived implicit government guarantee) by the U.S. government. Saskia Sholtes of the Financial Times reported that at the end of 2007, Fannie Mae, Freddie Mac, and the Federal Home Loan Banks provided 90% of mortgage financing in the United States;[1] Richard Iley of BNP Paribas has called this the de facto nationalization of the U.S. housing market.

The reorientation of U.S. policy was matched by important policy shifts abroad. These include:
* The European Central Bank provided large-scale liquidity to European banks (the Bank of England joined in, belatedly). The ECB believed that lending offered a substitute for rate cuts and, in early July, even increased rates.
* Interest rates in China were kept constant, despite rising inflation, and rates were cut in the Gulf.
* There was a significant increase in reserve accumulation by emerging economies that continued to either peg to the dollar or manage their currencies against the dollar. The dollar?fs slide - together with cuts in US rates - led many market participants (or speculators) to question the wisdom of China?fs ongoing efforts to resist rapid appreciation against the dollar, the Gulf?fs dollar peg and other currency pegs, and managed exchange rates. China?fs decision to shunt some of its reserve growth into the state banking system - and lags in the Gulf?fs reserve reporting - masked the extent of this intervention. But if the $100 billion in foreign exchange that China?fs banks added to their foreign currency holdings in late 2007 and the $90 billion the banks seem to have added in the first six months of 2008, as well as funds shifted to the CIC, are factored in, there is little doubt that the scale of Chinese reserve growth accelerated dramatically. In April alone, China reported a $75 billion increase in its reserves. The total increase in China?fs foreign assets in the first half of 2008 likely exceeded $400 billion.
* The oil exporters, concerned about a fall in demand for oil, didn?ft reverse production cuts that they implemented in early 2007 - back when oil was trading in the $60 range.

The Effects of U.S. and International Responses to the Subprime Crisis

These policies combined to achieve one key goal of U.S. policy makers. The fall in U.S. domestic demand that accompanied the collapse of the securitized housing credit market has been smaller than many feared last August. Rising central bank demand for U.S. assets offset falling private demand, helping to keep the dollar?fs slide orderly - and slowing the contraction of the U.S. current account deficit. The U.S. data, which tends to understate official purchases, indicates that official investors bought $170 billion in Treasury and agency bonds in the first quarter, an amount roughly equal to the U.S. current account deficit. The purchases of safe U.S. assets by central banks still far exceed the purchases of U.S. equities by sovereign funds ($20 billion in Q1 2008 according to the U.S. balance of payments data, which likely fails to capture all sovereign purchases), but there is little doubt that pressure is building for emerging market governments to invest more aggressively to try to produce higher returns.

However, not all of the effects of the crisis have been benign. The surge in central bank reserve growth in the emerging world, which was only partially sterilized, led to significant monetary easing in many of the world?fs fastest growing emerging economies. Rising inflation rates combined in some cases with falling nominal rates to produce negative real interest rates in much of the emerging world. The ongoing boom in investment contributed, in turn, to a significant rise in oil prices. U.S. oil imports are falling and European imports are stable, so neither was a major source of pressure on supply. The rise in oil prices, in turn, has generated inflationary pressures in the United States even as the U.S. economy slows - an uncomfortable combination. The pattern of adjustment in the global current account also leaves much to be desired. European currencies appreciated not just against the dollar but against the Gulf currencies and China, even though the Gulf and China are in surplus and the European Union countries run a deficit. As a result, China has shifted from relying on the United States to Europe to propel its export growth. The latest data suggests that the enormous surge in oil prices in 2008 will not bring China?fs surplus down in dollar terms. The combination of a constant Chinese surplus and a rising surplus in the oil exporting economies implies a rise in the aggregate current account deficit of the United States and Europe. The imbalances that have marked the global economy haven?ft really started to correct. Private capital is flowing to countries that have surpluses, not to the countries that need financing.

Prospects for Recovery and Implications for Future Economic Policy

It is still unclear whether these steps will be sufficient to avert a US recession. Economic activity in the U.S. may have peaked in January - but growth over the course of Q4 2007 and in January meant that average GDP in Q1 2008 was higher than in Q4. Employment and industrial production are down. The stimulus package should help support consumption over the summer, but there are still doubts that the U.S. economy will have regained enough momentum to resume sustained growth after the stimulus wears off. Growing difficulties in the U.S. financial sector, the slide in U.S. home prices, the slide in the U.S. equity market, and the contractionary impulse from the rise in oil prices suggest caution rather than unbridled optimism.

But at some stage, the most acute phase of the financial crisis will end. This hope has combined with growing evidence that, at least globally, inflation could be a bigger risk than the collapse of growth, to generate a new set of policy debates. Three stand out:

First, is the U.S. economy strong enough to be weaned off fiscal stimulus, or is a second round of stimulus needed?

Second, what regulatory regime changes are needed for U.S. financial institutions? Calls have been made to force banks to hold more capital in good times to build a better cushion against bad times, to extend the scope of regulation to cover the broker-dealers now that they have access to the Fed, to consolidate U.S. regulation, and to make the system safe enough for big institutions to fail by, among other things, moving certain over-the-counter derivative markets onto organized exchanges. Those calls have yet to translate into concrete actions.

Third, who bears responsibility for the uptick in global inflation? And who should adjust their policies to guard against a further rise in inflationary pressures? Emerging markets that peg to the dollar or manage their exchange rates against the dollar blame loose U.S. policy, and argue that the United States needs to raise rates and do more to defend the dollar. Fed Vice Chair Donald Kohn, along with many economists, argues that many booming emerging economies shouldn?ft peg to the dollar and tie their monetary policy to that of the United States. If they don?ft believe U.S. policy is right for their economies they should allow their currencies to appreciate and create the conditions that allow them to adopt monetary policies suited for their own conditions.

The final question has implications that go beyond monetary policy. The willingness of many emerging economies to shadow the dollar and build up their foreign assets - global reserve growth accelerated dramatically after 2002 - contributed to the buildup of vulnerabilities that led to the August 2007 subprime crisis. So far the global response to the crisis largely has been defined by the ongoing interaction between dollar pegs and U.S. weakness. But the costs of dollar pegs that link the currencies of countries with strong economies to the dollar during a U.S. downturn are now more apparent. There is a possibility, though at this stage not yet a probability, that the next stage of the subprime crisis will be marked by the difficulties associated with a real transition away from a world where key emerging markets manage their currencies against the dollar - and the opportunities that such a transition might create.

[1] Saskia Sholtes, ?gFannie and Freddie Drive Home Loans,?h Financial Times, April 2, 2008.

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