Comment on “Global Imbalances and the Financial Crisis: Reassessing the Role of International Finance”

Abstract

Borio and Disyatat (2010) is at the heart of the ongoing debate on the cause(s) of the recent financial crisis. Many agree on the role played by the inability of the prudential authorities to contain the excessive speculation by US and European financial institutions in the credit market. Some of the existing regulations seem to have encouraged it. People disagree on the role played by monetary policy.Low interest rates are normally a precondition for serious imprudent behavior by financial institutions.During the 2004‐ 2007 period, however, the Fed raised its policy rate by more than 400 basis points. Yet, long-term Treasury bond rates responded little to the rise in short-term rates ‐ the so-called conundrum.Thus,Bernanke (2010) asserts that monetary policy played a minor role in the formation of the credit bubble. According to Bernanke, it was financial innovations that encouraged risky investment in securitized assets and capital inflows from current account surplus countries that contributed significantly to the bubble. Capital inflows must have contained the rise in long-term interest rates and added to the binge. Borio and Disyatat start by criticizing the theory of interest inherent in the view that emphasizes the role played by capital inflows.This view,the excess saving (ES) view,holds that saving and investment determine the rate of interest. Borio and Disyatat are skeptical of this approach, and are in favor of a perspective that looks at the role of gross capital flows. Now, there is a long debate on the theory of interest rate determination, for example, the loanable funds theory versus the liquidity preference theory. I do not think it would be useful for me to go into that debate. I would just like to point out that, although it is entirely possible to write down a model where saving and investment determine the rate of interest, in modern developed financial markets it is usually the supply of, and the demand for, the stock of assets that determine asset prices. Flow variables affect asset prices as they slowly change the levels of asset supplies. Such a perspective is, of course, close to looking at gross international capital flows. Borio and Disyatat then turn to the analysis of the pattern of international gross capital movements in the 2000s, and find that banks in the Euro area and the UK dominated in terms of gross capital inflows into, and outflows from, the USA. That is, in addition to US financial institutions, they were the ones most active in the credit market binge, not Asian investors. I must say that very few object to this view of the world.