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More details about how the crisis grew--and the argument for a global central bank

Posted by: Michael Mandel on March 20

The big surprise, when Lehman failed, was how fast the disaster spread across the global financial markets and economy. We are gradually understanding more about why that happened. Brad Setser recently identified a crucial piece of the puzzle.

One other point. The fact that several of AIG’s largest counterparties are European financial firms is by now well known. What is I think less well known is that the expansion of the dollar balance sheets of “European” financial firms — the BIS reports that the dollar-denominated balance sheets of major European financial institutions (UK, Swiss and Eurozone) increased from a little over $2 trillion in 2000 to something like $8 trillion …— played a large role in the US credit boom.

As the BIS (Baba, McCauley and Ramaswamy) reports, many European banks were growing their dollar balance sheets so quickly that many started to rely heavily on US money market funds for financing. And if an institution is borrowing from US money market funds to buy securitized US mortgage credit, in a lot of ways it is a US bank, or at least a shadow US bank.

Consequently I think it is possible to think of AIG as the insurer-of-last resort to the United States’ own shadow financial system. That shadow financial system just operated offshore. There was a reason why investors in the UK were buying so many US asset backed securities during the peak years of the credit boom.

Let me explain the implications of what Brad is saying. U.S. households and households boosted their holdings of money market mutual funds by roughly $700 billion between 2004 and 2007 (the inflow continued into the first half of 2008 as well). Everyone thought that money was completely safe…but in fact according to the new report from the BIS that Setser refers to, the U.S. money market funds were investing much of that money in short-term securities issued by non-U.S. banks in order to get higher returns. In fact, the BIS authors calculate that

US money market funds’ investment in non-US banks reached an estimated $1 trillion in mid-2008 out of total assets of over $2 trillion.

Are you with me so far? U.S. money market funds were sending money overseas.

But that’s not where it stopped. Those same non-U.S. banks, in turn, were using this short-term funding from U.S. money markets funds to finance roughly $8 trillion of U.S. dollar assets—-which would include things like subprime mortgage-backed securities, bonds issued by U.S. banks, and all sorts of odd things. That’s up from roughly $5 trillion in 2004.

Yowza. The U.S. money market funds could not get away with investing directly in these risky long-term assets. So instead, they sent the money overseas, where the foreign banks did the dirty work for them of investing in the risky assets.

Meanwhile (and this is just supposition), the savings of German and French households were probably being lent to Eastern Europe.

So when Lehman failed, that triggered a run on money market funds which had bought Lehman paper. That, in turn, squeezed European banks which depended on U.S. money market funds for their dollar funding. And that, in turn, forced European banks to pull back on their funding for Eastern Europe.

To me, this whole crisis flows out of the lack of a global central bank. To evade regulation, financial institutions hopscotched their money across national borders and back again. In the process they gained a bit higher returns, at the cost of greatly expanding the complexity and opacity of the financial system.

If we don’t at least take steps towards better global tracking of financial flows—at least—we are doomed to have this happen time and again.

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Reader Comments


March 21, 2009 07:09 PM

I'm a little frightened by what I'm hearing. Large banks took foolish risks with money because they thought they were operating with a big backstop, and the answer is to keep making the backstop bigger?
Is a huge central bank really the best guarantor of financial transparency and sanity?
My relatively untrained instinct says we should be seeking more transparency and truly distributed risk instead of risk that is quietly centralized. We need more individual responsibility and defense in depth instead of a huge single tacking agency and insurance policy.


March 22, 2009 02:16 AM

Unfortunately, this is a terrible idea.

It will be about as effective at maintaining global fiscal order as the UN is at maintaining human rights.

A UN Global Central Bank - that provides the same rights to Zimbabwe as to Japan and the US. No thanks.


March 22, 2009 02:54 AM

There is talk about a new world currency that might eventually replace the Dollar. This currency will be measured against a basket of currency. I wonder if this has anything to do with the world central of this blog.
By Gleb Bryanski of Reuters

MOSCOW - China and other emerging nations back Russia's call for a discussion on how to replace the US dollar as the world's primary reserve currency, a senior Russian government source said.

Russia has proposed the creation of a new reserve currency, to be issued by international financial institutions, among other measures in the text of its proposals to the April G20 summit published last Monday.

Calls for a rethink of the US dollar's status as world's sole benchmark currency come amid concerns about its long-term value as the US Federal Reserve moved to pump more than a trillion dollars of new cash into the ailing economy late Wednesday.

Russia met representatives of China, India and Brazil ahead of the G20 finance ministers meeting last week, as the big emerging powers seek to up their influence on decisionmaking globally. Their first ever joint communique did not mention a new currency but the source said the issue was discussed.

"They (China) did not formally put forward their position for the G20 summit but unofficially they had distributed their paper regarding the same ideas (the need for the new currency)," the source told Reuters, speaking on condition of anonymity.

The source said the Chinese paper envisaged the International Monetary Fund's Special Drawing Rights (SDRs) being first assigned a role of a clearing currency on some transactions and then gradually becoming the main global reserve currency. "They said that the role of reserve currency should be given to SDR," the source said.

A UN panel of experts is also looking at using expanded SDRs, originally created by the International Monetary Fund in 1969, but now used mainly as an accounting unit within similar organisations as a new reserve currency instead of the US dollar.

Currency specialist Avinash Persaud, a member of the UN panel, told a Reuters Funds Summit on Wednesday that the proposal was to create something like the old Ecu, or European currency unit, that was a hard-traded, weighted basket.

The SDR and the old Ecu are essentially combinations of currencies, weighted to a constituent's economic clout, which can be valued against other currencies and against those inside the basket.

The Russian source said Moscow was aware that the emergence of the new global currency would not happen overnight and said its goal was to initiate a discussion about it at the G20 summit in London on April 2.

The source said that India did not object to the discussion but was not prepared to take the lead. The source said South Korea and South Africa backed the idea, while developed nations were not "allergic" to it.

"We are not waiting for everyone to say: 'How beautifully it has all been formulated, let's subscribe to it'," the source said. "The main idea is to start a discussion about it."

Russia holds about half of its reserves, the world's third-largest, in US dollars, with the rest in euros and pounds. Prime Minister Vladimir Putin has called on reserve currency issuers to show more financial discipline.

Finance Minister Alexei Kudrin told reporters on the sidelines of the G20 finance ministers meeting that it would take up to 30 years to create a new super-currency, suggesting there was no unity in Russia on the issue.

President Dmitry Medvedev's top economic aide and G20 sherpa Arkady Dvorkovich is behind the Kremlin's G20 proposals, made public one day after Kudrin returned from England.


March 22, 2009 06:10 AM

Mike seems to have embraced the Obama tactic of using this crisis to pump an unrelated idea that he already wanted for some time. Given the fact that central banks and regulatory agencies were either almost completely AWOL during this crisis, like the SEC during the Madoff scam, or how lots of these securities were deliberately constructed to avoid existing idiotic regulations, I don't see how Mike can credibly call for a global central bank at all. The only way to enforce discipline is for investors to track where their money is going themselves. All the countries whose savings were going into the overheated US housing market, you're telling me they couldn't have put two and two together and pulled out of housing? You cannot legislate away stupidity. By regulating, you often just put straitjackets on the smart people trying to get their jobs done legally and the conmen always find some loophole to worm through. The only palliative is due diligence by investors. You're telling me none of the Madoff investors could have gone to a financial firm and asked them to verify if Bernie's numbers made sense? The whistleblower Markopolos figured out it was a scam in 4 hours, you're telling me not one of them could have done that? If not, the way the market works is that they get burnt for their mistakes, that's what's happening today. When you think you're getting something for nothing and then keep dumping your money in, don't be surprised when you get burnt. That's market discipline and that's the best way for the market to work. I'm not saying we shouldn't make changes. It's great that the financial system burnt down, as they clearly weren't doing much of value. We can now build a better financial system on the ashes of the old one. We need to update bankruptcy laws so that every company isn't only geared towards the upside, so the possible downside of bankruptcy is accounted for (specifically, I've read that there is some ambiguity over how derivatives contracts will be honored under bankruptcy law). The way out of this mess is to get rid of the dumb regulations we have now, put in a few updated laws where necessary (such as in bankruptcy law), and most of all for investors to do their job of due diligence. Many of the Madoff investors were rich idiots from "noble" families in Europe, who cares if these morons lost their shirts? Hoping that some global central bank will somehow magically solve these problems is just delusion, the triumph of hope over experience.


March 22, 2009 11:15 AM

I do think the EU are going to need the functions of a lender of last resort that the ECB doesn't really provide, and there is nothing wrong with the IMF and World Bank intervening in a crisis, and financial multinationals like Citi really do need some effective regulatory oversight, and some control over currency manipulation is necessary. That said, I don't see how such an institution could work or be accountable to anyone.

One thing people keep saying is interest rates were too low too long. I would dispute this. They were in fact too high. Our financial ponzi scheme was keeping rates at levels that couldn't be sustained. If only good lending had occurred, there would have vast sums that had no investment opportunity and rates would have fallen far below what they were. It was not that rates were too low but too high for the investment opportunities available and it was this lack of opportunities that is the core of the problem.


March 23, 2009 03:35 PM

It is a pursuasive argument, but I'm with CompEng here -- distributed systems and transparency are called for, not putting all the hens under the control of a few distant, all-powerful wolves with the keys to the henhouse. Where would I turn if I suspected that global bankers were engineering the bankruptcy of my too-rich industry or region with the same thoughtless, egotistical, and brutal coolness to which bankers seem particularly prone? After all, journalists and others had some recourse when local watchdogs revealed that the government and AT&T had conspired to spy -- they just needed to move their communications elsewhere rather than trusting the good intentions of a small group answering to no-one. There is a reason why the controller must not report to the operations manager -- it is to eliminate temptation, and that is the type of approach that I feel is needed going forward (easier said than done).


March 23, 2009 06:00 PM

can't possibly work.
let the market be a market. more diverse interests, fighting each other, that's how balance will be maintained.

Joe Cushing

March 24, 2009 08:41 AM

Giving any one organization a monopoly on money sounds frightening to me. Why not have a few major central banks. We are already moving that way with the Euro. Maybe there can be one in South America, one in Africa and one in Asia.


March 24, 2009 05:08 PM

US banks were collecting the globe's wealth (american, arab, chinese, european) and used their overseas shadow banks to keep pumping money into the US housing bubble. I will not call it a fraud, I will not call it stupidity, I will assume that US Banks were acting under pressure from their clients for a bit higher returns. AIG took on thoughtlessly almost all the risk of this endeavor, perhaps under the same pressures.
What could a global central bank do to prevent this from happening? If people want to invest in bubbles or trust heavy names like Citi blindly, what can a global central bank possibly do? I think it can do a lot. It can track global financial flows and periodically issue reports and implicitly warn investors. The Fed, an institution serving the interests of the US (just like any other national central bank), had no incentive to tell the world "stop shipping your money, we have currently no idea what to do with it apart from the fast and easy way of crediting our citizens to buy houses they cannot really afford". It is hard to believe that the Fed didn't know what was going on, I think it just had no motive to stop it. A global central bank could help identify opportunities for investors and bankers around the globe through research and related announcements as well as incentives. The third world needs desperately some of the wealth that has been accumulated and has been struggling for a few more additional decimal points in higher returns. It can be done in a way that both capitalists and poor countries will benefit.
I believe our problem is that we really are not thinking "global", we are still in the era of nationalism, we love our countries in the same sickly way we loved them before financial globalization began.


March 27, 2009 12:26 AM

Regulatory hodge podge is one on the key ingredients creating the price differentials (aka arbitrage opportunities) that global investment banks find so attractive. We all know that the idea of a global systemic regulator crossing national boundaries is a farce. The next best enforcer is the market grim reaper who punishes financial stupidity with failure. Unfortunately, Mr. Reaper has had his sickle confiscated by Father Moral Hazard.


March 28, 2009 04:31 PM

I tried twice to post a comment under your article about the stock market rally. They don't come through. Am I doing something wrong?

Mike Mandel

March 29, 2009 06:16 PM

We had a temporary glitch which I think is fixed now...did your comments go through?

Thank you for your interest. This blog is no longer active.



Michael Mandel, BW's award-winning chief economist, provides his unique perspective on the hot economic issues of the day. From globalization to the future of work to the ups and downs of the financial markets, Mandel-named 2006 economic journalist of the year by the World Leadership Forum-offers cutting edge analysis and commentary.

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