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A New Spin on the "Giant Pool of Money" Theory

We've talked before about the "giant pool of money" hypothesis. This is the idea that the actual trigger for the financial crisis was that emerging economies were running huge trade surpluses because a series of currency crises had convinced them that they couldn't sustain trade deficits. All that money, however, needed somewhere to go. And it went to developed countries. In particular, it went to America, and more specifically than that, to treasuries.

Problem was, those huge inflows of cash pushed interest rates on Treasurys pretty far down, which made them an abnormally low-performing investment. Martin Wolf had a nice graph expressing some of this last week:


With Treasury bond yields falling through the floor, there was considerable demand for safe assets with better yields. The financial sector, sensing a market opportunity, jumped into the breach with securitized loans and AAA tranches and all the rest. Meanwhile, the strangely low interest rates fed a housing and credit bubble. In this telling, the key culprit behind the financial crisis was not the doings on Wall Street, but the giant hose of money the rest of the world pointed at us. If this is true, then fixing the financial system is like taking medicine to cure your symptoms. The disease still exists.

That, at least, is how I've understood the argument. But I just had a conversation with Steve Pearlstein that's making me somewhat reconsider the point. The causality, he argued, isn't as clear as all that. It may be that we developed these exotic financial instruments as a response to the river of money being pumped into our system. Or it may go the opposite way: That money was pumped into our system because we concocted abnormally attractive investments that caught the eye of foreign investors.

This is a slightly different spin on the same argument: In this telling, the current account deficit was still the problem. But it grew so large not because of foreign investors but because of Wall Street's decisions. Without the development of seemingly safe, high-return assets, that money would have been left to low-yield treasuries, and because those wouldn't have delivered sufficient returns, the money would have ended up going elsewhere. If that's true, then it may be that sufficient regulation of the financial sector actually could do quite a bit to ease our current account problems.

By Ezra Klein  |  June 15, 2009; 3:11 PM ET
Categories:  Financial Crisis , Financial Regulation , Solutions  
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Another thing that people have been saying is that the popping of the housing bubble, in and of itself, is enough to explain our current economic predicament.

But it seems to me that the exotic financial instruments of this decade had a clear role in pumping up the bubble in the first place, as these 'safe' but relatively high-yielding investments greatly increased the demand for securitized packages of loans, which in turn greatly increased the demand for something whose supply is normally fairly inflexible: homeowners to lend money to.

Posted by: rt42 | June 15, 2009 3:54 PM | Report abuse

Yes, there was money and low interest rates, yes yes yes. I get all that - I heard the This American Life story about the giant pool of money, which I believe aired nearly a year ago - well before Paulson yelled fire in the crowded theater last fall.

But I can't begin to understand how this "giant pool of money" persuaded mortgage brokers to lend to anyone who showed up at the table - regardless of ability to pay back the loan.

I can't see how the giant pool forced financial firms to develop "innovative tools" that hid the risk of the securitized debt.

I can't logically link this pool of money to the failure of ratings agencies to properly rate the risk of "innovative" investments.

I don't see how this pool forced people into thinking that terrible risks should be taken with other people's money "because everyone else was doing it."

There was money there. What people did with it was something they should be held accountable for.

Posted by: anne3 | June 15, 2009 4:55 PM | Report abuse

We still need to account for a giant pool of money being recklessly invested. Much of that is due to inequality.

Rather than being directed toward concrete projects that would satisfy real human needs, the money went round and round in speculative games. Why would anyone invest in, say, renewable energy here, or infrastructure in Africa, or heating equipment for China, when they could make a quick buck on the US housing bubble?

The lack of buying power among those with real human needs, combined with the wealthy's willingness to gamble and trust in financial alchemists (because they didn't really need the money they were investing), were the deadly combination. When the haves want to "get richer more quickly," and the have-nots have so little buying power that they can't even pay for life-saving drugs they need, why are we surprised that investment degenerates into a speculative game of musical chairs?


Posted by: pasqualefrank | June 15, 2009 10:32 PM | Report abuse

The problem with the view that securitised assets caused the low interest rates is two fold: securitisation was already happening, and foreign purchases drove down Treasury yields to the point where private investors in the USA would still have purchased other debt instruments.

Posted by: albamus | June 16, 2009 12:11 PM | Report abuse

This stuff is all side issues. The core issue is still the fact that work doesn't pay adequately.

The first step in this disaster was the repudiation of the progressive income tax structure under the Reagan administration (God, I still can't believe we elected a stupid, jingoistic B-movie actor as President). The progressive tax structure was useful in that it made it effectively much cheaper to distribute profits broadly than to concentrate those funds into hundred million dollar comp packages.

The true core of the disaster happened when American businesses went overseas to circumvent American law for the purpose of exploiting the labor of the world's poorest people. This replacement of well-paid, economically productive jobs with bare subsistence labor eliminated the source of funding for economic demand in America. The credit bubble resulted from the desire to maintain economic activity in the face of the ensuing combination of overproduction and diminishing incomes.

You just can't run an economy without funding the demand side of the equation. In the presence of the massive demand deficit, we kept the GDP numbers up through borrowing and housing inflation, creating a sham prosperity, an economic time bomb. There is no regulation that could have prevented us from exhausting our creditworthiness under those conditions.

The ONLY fix for this is to make work pay again. A revival of demand can come only at the expense of distributing profits more broadly through raising wages. In a globally competitive environment, we have to find ways of raising wages globally. All aspects of the financial crisis are symptoms of the consequences of inflating profits at the expense of working people.

Regulatory reform is all very well, but the need to make work pay better is the vital core issue upon which our fate truly rests.

Posted by: lonquest | June 17, 2009 12:11 PM | Report abuse

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