There has been a great deal of debate over the causes of the US housing bubble that preceded the financial meltdown. Ben Bernanke and Hank Paulson attribute it to the glut of Asian savings that swept into US capital markets and depressed interest rates and risk spreads. Axel Leijonhufvud believes the mercantilist polices of Asian nations presented the US with a tradeoff – an asset bubble or deflation- and that the US Fed elected to abet the resulting imbalances by setting interest rates below the ‘Natural Rate’ level –embodied in the Taylor Rule - in order to counter the deflationary forces set in motion by the trade deficit. Others have posited a purely domestic cause: A Minskyian process by which complacency over risk, aided by financial de-regulation and GSE policy to expand home ownership to lower income families , led to an unsustainable explosion in leverage and risk taking, particularly in the housing sector.
The question of causality of the bubble has a direct bearing on the appropriate policy response to prevent future bubbles. If the primary cause was the trade deficit, then rectifying the imbalance is the most important policy goal. If the primary cause was high leverage and risk taking, then reining in the financial sector should be the priority.
The US Trade Deficit was a Necessary Condition for the Housing Bubble
The housing bubble involved both a massive price increase and a massive expansion of housing production. During the boom years, from 2000 – 2007, the Case Shiller HPI more than doubled; a rate very much higher than the prior trend in home price increase, resulting in a significant rise in the home price/median income ratio. During that period annual new home construction also more than doubled, a rate that dramatically exceeded the growth in household formations. Residential investment grew from under 7% of GDP to over 10% of GDP in the decade ending in 2007 .
We show, from the National Income Identity (NII) and the pattern of aggregate expenditure during the period, that the trade deficit was a necessary condition for the homebuilding bubble to have occurred. The NII is
Where Y is the value of domestic output at full employment, (C+I+G) is domestic expenditure, and XM is Net Exports (Exports – Imports). During the Boom, both consumption (C) and government spending (G) increased at a rate greater than domestic income (Y). So, for Investment (I) to increase, from a starting position of full employment, net exports (XM) had to decline by at least as much. That is (holding constant domestic income)
(2) ΔI+ ΔXM≤ 0
The bubble required that total domestic expenditure exceed the value of domestic output, which required, in turn, an increase in the trade deficit. Between 2000 and 2007, the US annual current account deficit grew by nearly $600bn, a threefold increase; as a percentage of GDP, the current account deficit grew from 1.5% to over 6% in the decade ending in 2006 .
The US Trade Deficit was Caused by Asian Mercantilism
Many researchers have documented that Asian nations adopted polices to build up foreign reserves -principally of US dollars – after the Asian financial crisis of 1997/98, in which their lack of reserves contributed to the collapse of the exchange value of their currencies (and thereby to financial and economic devastation). During the past decade, China became the largest exporter to the US and intervened (1) to prevent exchange rate adjustment by pegging the Remnimbi to the dollar and (2) to prevent domestic price inflation by sterilizing the inflow of dollars. As evidence of the effectiveness of these interventionist policies in promoting China's export growth, from 2000 to 2007 China’s foreign reserves increased twelve-fold, from 1,000bn RMB to over 12,000bn RMB while its monetary base increased only three -fold and its average annual inflation rate was below 3%. From 2000 to 2007, China’s annual bi-lateral trade surplus with the US increased ten-fold, from $20bn to $200bn. China’s interventions prevented market adjustments to the currency exchange rate and domestic price level that would have reversed the trade imbalance with the US. These mercantilist policies enabled China to grow its exports to the US throughout the period. It resulted in a huge buildup of Dollar reserves in the Bank of China, which were recycled into US investments.
The Trade Deficit Reduced US Interest Rates and Risk Spreads
Now we look at the ‘standard’ New Keynesian (NK) reduced from model to draw out the adjustments required when the trade deficit increases due to mercantilist policies of an offshore economy. The standard frictiionless DSGE model, according to Olivier Blanchard, has three equations “An aggregate demand relation [AD], in which output is determined by demand, and demand depends in turn on anticipations of both future output and future real interest rates. A Phillips-curve like relation, in which inflation depends on both output and anticipations of future inflation. And a monetary policy relation, which embodies the proposition that monetary policy can be used to affect the real interest rate” . The NK model adds frictions that create lags in the adjustment of output to changes in demand. For our purposes, we need only examine the NK AD equation. Following Woodford  the closed economy version of the model is
(3) Yt+1= (1−ρ )Y+ρYt−α(i−πt+1−r)
Where (t) represents the time period, ( i ) is the market interest rate, π is the inflation rate and (π + r ) is the Wicksellian ‘Natural Rate’ of interest. A fundamental condition for the maintenance of full employment ( Yt + 1 =Y), is that the market rate of interest converge to the natural rate of interest. The current theory of monetary policy prescribes the adoption of rules by the central bank to effectuate this convergence. Now let us consider the effect of an exogenous increase in the trade deficit – caused by offshore mercantilist policies – by adding to equation (3) a variable representing net exports (XM).
(4) Yt+1= (1−ρ )Y+ρYt−α(i−πt+1−r)+ XM
If XM is forced down to a negative value (the US runs a trade deficit), then, in order to maintain full employment (Yt + 1 =Y), it must be the case that the market rate of interest is held below the natural rate (i< π +r) so that the stimulative effect of lower interest rates offset the depressive effect on aggregatge demand of reduced net exports. Since the US did maintain full employment throughout the bubble period, the only remaining question is whether the reduced market interest rates were enforced by Fed policy, or whether they were market driven. Evidence for the Fed’s responsibility is that the Fed Funds Rate was reduced from 6.5% to 1% during the period from 2001 to 2004, at that time an historically unprecedented drop, in order to stave off deflationary pressure from the growing deficit. Evidence for the hypothesis that the rate decline was market driven –caused by the inflow of the Asian savings glut that accompanied the trade deficit – is that when the Fed raised its policy rate from 1% to 5.25%, from 2004 to 2006, the ten year treasury rate barely budged. Alan Greenspan notably referred to the Fed’s loss of influence on the yield curve, as a ‘conundrum’. Moreover, during the period of Fed rate increases, from 2004 – 2006, risk spreads remained at historic lows. From 2000 – 2007, foreign official net assets in the US increased from $50bn to nearly $500bn , as China became the largest purchaser of US Treasury notes and GSE (Fannie and Freddie) debt. So, foreign capital inflows significantly increased the supply of funding in US bond markets. Studies have estimated the growth in offshore investment in US government debt during the past decade depressed Treasury yeilds by 50 to 70 basis points.  I think the evidence supports the hypothesis that US interest rates would have been driven down by the influx of foreign capital, regardless of Fed policy. What Caused the US Housing Bubble?
There is little doubt that increased financial sector leverage –from 20x capital to 30x capital from 2000 – 2007 - contributed to, and resulted from, an underestimation of risk that fueled the frenzy of lending, as did all sorts of other contingent circumstances. But the underlying, indispensable factor driving the low rates and increasing the capital available, appears to have been the massive increase in offshore capital inflows. Bernanke and Paulson were correct to identify the Asian savings glut as the locus causes of the bubble. We can go further and assert that it was mercantilist intervention on the part of Asian nations, principally China,that fueled the growth in the US trade deficit that generated the influx of foreign capital. Hence, it should be recognized that the US economy will continue to be plagued by asset bubbles until its trade deficit is permanently reduced.
 Rogoff, Ken and Maurice Obstfeld, (2009) Global Imbalances and the Financial Crisis: Products of Common Causes, Paper submitted to the FRB San Francisco Asia Economic Policy Conference, Oct 18-20, 2009.
 Blanchard, O.J., (2008) The State of Macro MIT WP 08-17.
 Woodford, Michael, (2003) Interest and Prices
 US Dept. of Commerce, BEA.
 Krishnamurthy, Arvind and Annette Vissing-Jorgenson (2008) The Aggregate Demand for Treasury Debt Mimeo, Northwestern University, Evanston IL. And Warnock, Francis E. and Veronica Cacdac Warnock (2009) International Capital Flows and US Interest Rates Journal of international Money and Finance 28 (6): 903-19.
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