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Look East, not West, to find roots of a global meltdown

The global financial crisis, which developed in 2007 and sent shock waves across the world, is often seen as stemming from reckless mortgage lending and borrowing in the United States. But one professor thinks the real cause came from the other side of the world, Daniel Bardsley writes.

A home for sale in Las Vegas, Nevada. Ronda Churchill / Bloomberg News
A home for sale in Las Vegas, Nevada. Ronda Churchill / Bloomberg News

The global financial crisis, which developed in 2007 and sent shock waves across the world, is often seen as stemming from reckless mortgage lending and borrowing in the United States.

When the US housing bubble burst and the bottom fell out of the subprime mortgage industry, so the narrative goes, the worst financial crisis for more than seven decades enveloped much of the western world and beyond.

But Heleen Mees, an adjunct associate professor at New York University, believesthe real cause of the crisis lies elsewhere, on the other side of the world: it was the high savings rate in China that was to blame.

Ms Mees thinks the problem in the US was not a lack of regulation in terms of lending but an inability on the part of the authorities to prevent long-term interest rates from remaining at low levels.

She says these encouraged homebuyers to borrow too much, ultimately precipitating the housing crash that led to the crisis.

"The demand for houses, the price of houses, responds to 10-year treasury rates, not short-term treasury rates," she said during a presentation in Beijing.

"If you have low interest rates, people will buy houses. Because of rising house prices, people will feel wealthy and spend a lot of money. A lot of Americans took out money from their houses. They were [encouraged] by low interest rates."

The US Federal Reserve, said Ms Mees, "lost control" of long-term interest rates. After "aggressive" rate cuts in the early 2000s, from June 2004 it began to increase the federal funds rate, putting it up from 1 per cent to more than 5 per cent by 2007, yet there was very little effect on 10-year treasury rates, a break from the previous pattern. This allowed the formation of asset bubbles.

The reason long-term interest rates failed to respond to rises in the federal funds rate, says Ms Mees, was the huge current account surplus in China that resulted from its export-driven economic model. This vast surplus led to large purchases of US government bonds.

"The housing bubble was caused by the low interest rates and low interest rates have been caused by China's boom and the enormous savings," she said.

"There was such a build-up of debt securities, which drove down interest rates, which led to huge housing demand. If interest rates had been higher, households in Europe and the United States would not have taken on so much debt.

"Low interest rates were the real cause of the housing bubble in the US and, you can say, in Europe … The build-up of debt securities nicely explains the 10-year treasury rates."

Much of the blame for the bursting of the bubble has been levelled at "exotic mortgages" allowing people to buy more expensive properties by, for example, deferring interest payments. In fact, Ms Mees says these were a small enough proportion of total mortgages, less than 10 per cent, for their impact to be limited.

"More regulation would've been helpful [but] I don't want to say low regulation was the cause of the crisis. Low interest rates were the cause of the crisis," Ms Mees said.

China's saving rate is above 50 per cent and is largely a consequence of corporate, rather than individual, savings. The savings rate for individuals is about 27 per cent of disposable income, five percentage points lower than in India.

Particular characteristics of the Chinese economy, especially a huge labour supply, explain how the country's companies accumulated vast profits.

"Chinese companies have benefited in the 2000s from being able to sell their products for first-world prices, while having to pay only third-world wages. They have huge profits," Ms Mees said.

"In advanced economies, if there's a gain in productivity, employees are able to capture the gain and transfer it to higher wages.

"While there wasn't a labour shortage, workers could not monetise their gains [in productivity], so it was a gain for the companies."

She also notes many of China's large state-owned companies do not distribute profits to shareholders at the same rate as corporations elsewhere.

Despite saying the crisis has its roots in China, Ms Mees believes there is no need for finger-pointing.

"You can be the cause of something without being to blame. You can be the culprit without doing it on purpose," she said.

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