Causes of the Global Financial Crisis

14 September 2012

An address at the University of International Business and Economics in Beijing

Ladies and gentlemen,

Thank you very much for making me so welcome here at the University of International Business and Economics.  I am delighted to be here, and greatly appreciate your compliment in making me an honorary professor at this university.  I have heard a lot about this institution in recent months, and very much look forward to the few days I will spend here.

As you may know, I’m to give a total of four lectures during my time here in Beijing.  In this first lecture, I propose to talk about the causes of the Global Financial Crisis; my second lecture will cover some of the challenges facing central banks; my third will deal with the pros and cons of foreign direct investment; and finally I will speak about New Zealand, and New Zealand’s relationship with China.


In many parts of the world, the popular media, and far too many politicians, blame the Global Financial Crisis on the greed of bankers.  The problem is “Wall Street” or the “City of London”.  And when it’s announced that bankers have been paid tens of millions of dollars despite driving the institutions which they’ve run into serious trouble, and that, in the UK, government support for seriously troubled banks at one stage amounted to close to two-thirds of British GDP1, it’s easy to understand why banks make very easy targets.  Even I, for several years myself a director of the largest bank in New Zealand, feel outraged!

I don’t want to excuse the bankers.  It seems undeniable that many bankers, motivated by what motivates most people in a market economy, took enormous gambles using money belonging to other people in the belief that they could make themselves very rich indeed in the process.  Too many of those bankers appear to have paid no penalty for their risk-taking, and indeed too many of them appear to have been generously rewarded when they were forced to leave their positions.

But it’s my conviction that the policy environment within which the banks operated was a major contributor — indeed, probably the major contributor — to the crisis which is still causing an enormous amount of economic and social pain throughout much of the world, and I hope I can show you why I feel this.

There have been many aspects of this policy environment.


To begin with, we had ongoing pressure on US banks to lend to marginally creditworthy borrowers.  This was not a new phenomenon in the US.  As early as 1922, Secretary of Commerce Herbert Hoover was encouraging banks to devote more of their lending to residential property despite an already over-heated housing market.  The subsequent housing market collapse was one of the contributors to the Great Depression. 

Again in the 1960s, the US federal government embarked on a programme designed to encourage home ownership by giving poor families access to federally-insured loans that required minimal deposits.  The end result was an avalanche of foreclosures among ill-prepared owners that some years later cost the taxpayer dearly.2

Stan Liebowitz wrote a fascinating paper in October 2008, in which he concluded that “in an attempt to increase home ownership, particularly by minorities and the less affluent, virtually every branch of the (US) government undertook an attack on (mortgage) underwriting standards starting in the early 1990s.  Regulators, academic specialists, GSEs (the government-sponsored enterprises Fannie Mae, Freddie Mac and Ginnie Mae), and housing activists universally praised the decline in mortgage-underwriting standards as an ‘innovation’ in mortgage lending.  This weakening of underwriting standards succeeded in increasing home ownership and also the price of housing, helping to lead to a housing price bubble.”3

Richard Salsman has argued that the real problem was what he called the “morality of altruism”.  He argued that “altruism has motivated the utter debasement of lending standards in the past decade… Highlighting the legal-coercive backing of Washington’s altruistic credit policies, the Federal Reserve Bank has for years distributed a booklet to mortgage lenders — Closing the Gap: A Guide to Equal Opportunity Lending — which includes sidebar reminders that fines and jail terms await those found to be deficient in fighting ‘discrimination’ by (not) lending to the less-than-creditworthy.  The booklet, still distributed today, derides as ‘arbitrary and unreasonable’ such traditional credit standards as a 20 percent down payment…, an above-par credit score, a history of paying one’s bills on time, and a steady job yielding an income sufficient to make monthly mortgage payments”.4


And secondly we had the curious American habit of non-recourse lending, whereby borrowers engaged in a “heads I win, tails the bank loses” game — knowing that if house prices rose, the borrower stood to make a lot of money, while if they fell, the bank stood to lose a lot of money.  I have been told that this non-recourse lending is in fact mandated by legislation in many American states. 

While non-recourse lending might not in itself be a source of major difficulty if it is priced appropriately, it certainly seems likely to have added some additional risk to the US banking system.


And what certainly added very considerable risk to the financial system was the widespread practice of securitizing residential and other loans.  This was not directly a “policy issue” — it was a practice of financial institutions themselves, not in any way mandated by the US authorities.  But it was lauded by at least some of the authorities as a powerful innovation enabling credit risk to be diffused across a multitude of financial institutions, and therefore more readily absorbed.  But securitization turned out to be the source of enormous danger.  Loan originators had little incentive to ensure borrowers were creditworthy because they had no intention of holding onto the risk.  They passed that risk on “down the chain”, with successive financial institutions clipping the ticket as the risk was passed from hand to hand but holding no exposure to the potential default.  There was no transparency or accountability in the credit chain, and significant parts of the process were largely unregulated.


Another major source of the crisis was the practice in many urban areas in the US — and indeed in many other developed countries also, including New Zealand — of tightly regulating the supply of residential land.  As a result, once demand for residential property started to go up there was little or no scope for an increase in supply to meet that demand, and house prices rose strongly.  While house prices hardly rose at all in a large and fast-growing city like Dallas where restrictions on the supply of residential land were almost non-existent, they rose very strongly indeed in places like Los Angeles and San Francisco.  As Thomas Sowell has noted, 60% of all mortgage defaults in the US were concentrated in just five states, primarily those where the supply of residential land was subject to tight restriction.5


I also want to put at least some of the blame for the Global Financial Crisis on banking regulation and supervision.  You may be expecting me to argue that the crisis wouldn’t have happened if bank regulators had been more assertive, or more attentive.  But actually I contend rather that banking regulation itself may have contributed to the crisis by leading depositors and, worse still, bank directors to assume that the regulators had everything under control. 

I have never forgotten a conversation I had in Washington in September 1992, at the time of the World Bank/IMF annual meetings — almost exactly 20 years ago to the day.  I found myself at one of those dinners which make the annual meetings of the World Bank Group so enjoyable sitting beside a man who, after a long and successful career in the British Treasury, had just become a director of one of the major British clearing banks.  I asked him how he found being a director of a bank after a lifetime in the Treasury.  Funny you should ask that he said.  I’ve always thought that banking was all about measuring and pricing risk, and of course I’ve had no experience of that in the Treasury.  But I’m relieved to discover that all I have to worry about is whether we’re complying with the Bank of England’s rules.

In the mid-nineties, we in New Zealand introduced a system of bank regulation involving minimal rules and regulations, but instead imposing a requirement that all bank directors had to sign off a statement every quarter attesting to the fact that, in their opinion, their banks had adequate risk control systems in place, and that those systems were working appropriately.  We’d no sooner announced our intention to introduce this system when the chief executive of the Australian owner of one of the largest banks in New Zealand flew from Australia to tell me in no uncertain terms that what we were proposing to do was totally unrealistic.  Most bank directors, he told me firmly, simply had no understanding of banking.  For that reason, he wanted me, as the head of our central bank (which was then and still is also the banking regulator), to continue laying down a series of rules and regulations by which banks should operate.  In other words, he wanted the banking regulator to make all the key decisions which would minimise his bank’s risks.  I told him, equally firmly, that I had no intention whatsoever of doing that.

Sir Mervyn King has noted that “forty years ago, the clearing banks in London held around 30% of their assets in short-term liquid instruments.  Today that liquid assets ratio is about 1%.  For the major UK banks, almost 25% of customer loans are now funded by short-term borrowing in wholesale markets.  At the turn of the new century it was close to zero.”6

Of course, bank chief executives are under huge competitive pressure.  At monthly board meetings, directors are keen to know whether their bank has won additional market share or lost it.  A CEO who has to report that his bank has lost market share several months in a row is under enormous pressure to “do something about it”.  So if competing banks have won market share by relaxing underwriting standards, the pressure on him to do likewise is very intense, particularly if he can assume with a reasonable degree of confidence that the central bank will be there to help if something goes wrong. 

So I find it hard to avoid the conclusion that part of the reason that banks have felt able to adopt much riskier balance sheets is their belief that, in a crisis, the regulator — which has laid down most of the rules by which banks must operate — would look after them.  And of course, that belief has now been amply justified.


But what about interest rates?  What about monetary policy?  To what extent did excessively loose monetary policy prior to the Global Financial Crisis contribute to that crisis?

Not surprisingly, there has been a lot of discussion around this issue.  Some US economists have blamed Alan Greenspan for holding short-term policy interest rates too low for too long, thus fuelling the property bubble and leading directly to the subsequent crash.  Alan Greenspan has replied, noting that it is not the short-term interest rates which the Federal Reserve Bank controls which most directly influence the interest rates on home mortgages.  And in any case, consumer price inflation in the US was well-behaved during most of the last decade.

But in my view one of the factors underlying the whole Global Financial Crisis was a profound imbalance in the global economy, between China and the US, that caused interest rates to be far too low for far too long in the US and some other developed economies. 

What appears to have happened is that China kept its exchange rate at an artificially low level for years in order to encourage exports.  This had the direct effect of providing an abundant supply of cheap imports to the United States, helping to keep inflation in check there and justifying low policy interest rates.  It also had the effect of generating very large balance of payments surpluses in China, which China invested in US Treasuries, thus tending to depress yields on longer-term securities in the US as well.

There was what in Europe would be called a Faustian bargain, which in many ways suited both the US and China in the short-term, but which would have serious long-term costs: the US got low consumer price inflation, low interest rates, rising asset prices, and inexpensive funding of its growing fiscal and current account deficits.  China got open access to the world’s largest market for its rapidly growing export industries, industries which were able to employ the hundreds of millions of people moving from the countryside into China’s rapidly burgeoning cities.  The arrangement suited both countries.

But there was a cost, as there is in every Faustian bargain.

The bubble has long since popped in the US, and American homeowners and state and federal governments suddenly find themselves grappling with the consequences of bingeing on credit.  There’s resentment rather than gratitude for the flow of inexpensive imports from China, and frustration that China refuses to let its currency appreciate to reflect its vast foreign exchange reserves and large balance of payments surplus.  Chinese policy is seen as being mercantilist, and aimed at generating employment in China at the expense of American workers.

On the Chinese side, there’s irritation at the criticism which US politicians express about their currency regime, and anger that the vast US dollar assets built up over many years are drifting down in value against other major currencies — with the Federal Reserve Board not only doing nothing to prevent that but appearing to actively encourage the trend with repeated quantitative easings.

In my view, this imbalance between the US and China caused by the undervaluation of the yuan is damaging China, damaging the US, and seriously damaging prospects for international trade and economic growth.

It’s damaging China because, by keeping the cost of capital artificially low, it’s leading to all sorts of wasteful investment.  By keeping the cost of consumption artificially high — in other words, by keeping real wages artificially low — it’s keeping domestic consumption well below what might be expected in a more normal situation.  (I understand that private consumption makes up only about one-third of Chinese GDP, compared with over 60% in most developed economies.)  And of course, it’s channeling vast sums of Chinese savings into low-yielding US Treasuries.

A country at China’s stage of development might normally be expected to run a balance of payments deficit, with resources flowing into the country to add to its stock of investment capital.  This was Singapore’s experience in the early stages of its development, and of course also that of many other now developed countries, such as Canada, the US, Australia, and New Zealand.  It’s extraordinary to see a country which, despite very rapid growth, is still one of the poorest countries in the world exporting vast amounts of capital to the US. 

Undervaluation of the yuan is also damaging the US and other countries by dragging a great deal of manufacturing production out of those other countries towards China.

And the risk is that in the current environment of high unemployment, very low growth and fiscal austerity in many developed economies there will be strong political pressures to “compensate” for the undervaluation of the Chinese currency by some form of protection against Chinese exports.  As you know, there’s intense pressure for the US Congress to impose duties on Chinese exports to the US, and Mitt Romney, the Republican candidate for the US presidency, has promised to take measures to offset what he regards as the manipulation of the Chinese currency if he is elected.

And we all know how extremely dangerous such moves would be. 

Of course, there are some signs that China may be willing to allow the yuan to appreciate somewhat.  Two years ago, Hu Xiaolian, vice governor of the People’s Bank of China, gave a series of speeches in which she argued that a freer exchange rate liberates China’s monetary policy, spurs innovation in China’s export industries, and channels investment to its service sector, where many of China’s new jobs will be found.  “Adopting a more flexible exchange rate regime serves China’s long-term interests as the benefits… far exceed the cost in reorganizing industries and removing outdated capacities” she said.7  That is certainly true, and I hope that China does adopt a more flexible regime before highly damaging protectionist moves are taken in other countries.


And what about the economic turmoil in Europe?  Several of the factors which drove the property bubble in the US were relevant in Europe as well — the tight restrictions on the availability of residential land (certainly true in both Ireland and the UK) as one example.

It seems to me that banking regulation also played a part.  Under Basel I, the sovereign bonds of most developed countries were regarded as riskless, with no bank capital needing to be held against them.  So why not buy the bonds of any sovereign — Greece, Italy, Spain, Portugal, Ireland — which were yielding a little more than the bonds of, say, the UK or Germany?  Basel II changed those rules, and related risk weights to credit ratings, but Basel II was only just beginning to apply when the Global Financial Crisis broke.  In other words, it is likely, in my view, that the very low risk weights which the collective wisdom of the international community of bank regulators assigned to the bonds of European governments had an influence on bank decisions to load up on the bonds of some of the weaker European governments in the years immediately prior to the Global Financial Crisis.

And there can be little doubt that the currency arrangements put in place when the Euro was created also played a major part in the bubble, the bursting of which has contributed so much to the Global Financial Crisis.

By definition, the countries belonging to the Eurozone have had a common monetary policy for more than a decade, and the European Central Bank has correctly operated that monetary policy in order to keep inflation in the Eurozone at a low level. 

When the Eurozone was first established, there was a hope, and indeed an expectation, that the creation of the Eurozone would drive responsible fiscal policy and much-need flexibility in labour market arrangements throughout the currency zone.

And that was in many respects a sensible expectation.  When a country gives up the ability to have an independent monetary policy, and its own exchange rate, it absolutely must use other policy instruments to maintain internal economic equilibrium.

The reality has been different.  Countries such as Ireland and Spain, suddenly enjoying the benefits of the low interest rates which the ECB judged appropriate for the Eurozone as a whole, saw a substantial increase in credit and a huge increase in property prices.  There was no attempt to moderate that boom and both countries enjoyed the prosperity that the boom engendered — until the boom ended, and at that point they found that their banks were over-extended and full of loans of doubtful quality, their fiscal positions were not nearly as robust as they had thought, and incomes had risen to the point where many of their industries were no longer competitive on the international market.


So I believe it is very clear that, while many banks in both North America and Europe behaved in ways which were, with the wisdom of hindsight, most imprudent, they were operating in an environment which almost guaranteed that imprudent behavior would occur.

Where to from here?  If the world is to have any chance of avoiding a similarly catastrophic economic disaster in the future — and I use strong language because it’s clear that the Global Financial Crisis has had enormous cost in terms of lost output and high unemployment — there will need to be change at both the micro and the macro level.

At the micro level, we need much simpler rules for banking regulation, as Andy Haldane argued in his excellent paper at the end of August in Jackson Hole.8  Dr Haldane noted that, whereas the Basel I rules were set out in just 30 pages, the Basel II rules required 347 pages, and the Basel III rules 616 pages.  He also noted that, whereas the Glass-Steagall Act of 1933 in the US ran to a mere 37 pages, the Dodd-Frank Act runs to 848 pages and requires many thousands of pages of supplementary rules and regulations.  He was convinced that this additional complexity does nothing to reduce risk in the banking sector, and arguably increases it.

The simple rules which I favour would cover the maximum amount of leverage a bank can have; a limit on dependence on short-term wholesale funding; a limit on the extent of any open foreign currency exposure; and a limit on loans made to or from related parties.  I would then want to see simple public disclosure of all of those metrics, as well as the extent of risk concentration, by counter-party and by industry. That risk concentration would have to reflect not just credit risk but also settlement risk arising from the bank’s off-balance-sheet operations.  I would insist also that any bank with assets of more than some threshold have a credit rating from one of a specified list of credit rating agencies, with that rating being publicly displayed in all bank branches and on all bank literature.  And I would insist on all bank directors personally signing bank disclosure statements, and attesting at quarterly intervals that their bank has appropriate risk control systems in place.

I believe a framework of that kind would materially reduce the risk of bank failure, and would incentivize banks to operate prudently.

There is also a need to wind back the recently reinforced perception that, whenever a large bank gets into difficulty, the government or the central bank will automatically bail it out.  This perception is a very dangerous one in that it allows bank creditors to pay little or no attention to the creditworthiness of the bank, and encourages bank directors and management to behave in ways which are undesirably risky, safe in the knowledge that, if things go well, they can make a lot of money, and if things go badly, the government is there to protect bank creditors.

Various proposals have been made to remove this perception and I don’t propose to describe those here, but it is obviously a very important objective.

Also under the heading of changes at the micro level, I believe it is vitally important that the rules around access to land for residential development are liberalized.  As I’ve already mentioned, one of the factors which drove the enormous increase in house prices in many developed countries in the years prior to the Global Financial Crisis — I can’t speak for China in this regard — was the policy of many city governments to restrict the availability of land for residential development.  This artificial restraint played a major role in driving up the price of housing in some parts of the US, and indeed in many other countries also, including my own.  If we are to avoid price bubbles in the housing market in future, that policy of constricting the supply of land will need to change.


At the macro level, there are several changes needed also.  The first is in the area of macro-prudential rules, where bank regulators and/or central banks seek to moderate the growth of credit where that appears to be inconsistent with longer-term financial stability.  Yes, monetary policy as usually understood, using changes in short-term interest rates to influence monetary conditions, has an important role to play, but the Global Financial Crisis has reminded us that the animal spirits of which Keynes spoke can be largely impervious to changes in short-term interest rates.

In New Zealand, the central bank raised its policy interest rate to 8.25% immediately prior to the Crisis, and had been raising that rate gradually throughout the preceding few years.  That was not sufficient to prevent a very large increase in credit, and a very large increase in the price of assets, especially of housing.  The bubble may well have been avoided had the central bank also had a limit on the use of short-term wholesale funding during the boom — such a limit has been introduced only recently.  But there may also have been a need to place a restriction on, for example, the maximum loan to valuation ratio which banks could use in making their lending decisions.  At very least, there should be no pressure on banks to relax their credit standards to accommodate essentially political goals.

In addition, the Global Financial Crisis highlights the importance of understanding the implications of currency arrangements. 

The experience of the Eurozone countries has illustrated the consequences of adopting a single monetary policy for widely different economies, with different rates of productivity growth, different fiscal policies and rigid labour laws.  There must be serious doubts about whether the Eurozone can survive in its current form unless there are radical changes in the labour laws which currently prevent the adjustments in competitiveness which were once achieved by changes in exchange rates. 

And what about the currency relationship between the US and China?  Tomorrow I will be giving a lecture on the challenges facing central banking, and will be touching on the challenges created by “the impossible trinity”, the impossibility of simultaneously maintaining an independent monetary policy, a fixed exchange rate, and freedom from capital controls.  In the short-term, and assuming that the US does not take any precipitate action following its presidential election, I suspect that the problem caused by any under-valuation of the yuan will gradually disappear, as China’s real, or inflation-adjusted, exchange rate appreciates against the US dollar.  In the longer term, China will need to decide whether maintaining a close relationship to the US dollar really is in its best interests.  A great deal depends on how China decides to answer that question. 


1 Speech by Sir Mervyn King to Scottish business organisations, Edinburgh, 20 October 2009.

2 “How did a few dodgy housing loans precipitate the biggest financial crisis since the Great Depression?”, in Competition and Regulation Times, November 2009.

3Anatomy of a Train Wreck: Causes of the Mortgage Meltdown, Stan J. Liebowitz, The Independent Institute, 3 October 2008.

4Altruism: The Moral Root of the Financial Crisis, The Objective Standard, Spring 2009.

5The Housing Boom and Bust: Thomas Sowell on how government policies made the housing crisis possible, by Brian Doherty, on, 20 May 2009.

6Finance: A Return from Risk, a speech at the Mansion House by Sir Mervyn King, 17 March 2009.

7 Quoted in The Economist, 21 August 2010.

8 Andrew G Haldane, “The dog and the Frisbee”, Jackson Hole, 31 August 2012.

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