Working Paper: NBER ID: w14688
Authors: Ricardo J. Caballero; Arvind Krishnamurthy
Abstract: The U.S. is currently engulfed in the most severe financial crisis since the Great Depression. A key structural factor behind this crisis is the large demand for riskless assets from the rest of the world. In this paper we present a model to show how such demand not only triggered a sharp rise in U.S. asset prices, but also exposed the U.S. financial sector to a downturn by concentrating risk onto its balance sheet. In addition to highlighting the role of capital flows in facilitating the securitization boom, our analysis speaks to the broader issue of global imbalances. While in emerging markets the concern with capital flows is in their speculative nature, in the U.S. the risk in capital inflows derives from the opposite concern: capital flows into the U.S. are mostly non-speculative and in search of safety. As a result, the U.S. sells riskless assets to foreigners, and in so doing, it raises the effective leverage of its financial institutions. In other words, as global imbalances rise, the U.S. increasingly specializes in holding its "toxic waste."
Keywords: Global imbalances; Financial crisis; Riskless assets; Securitization; Leverage
JEL Codes: E44; F32; F37; G12; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| foreign demand for riskless assets (xtf) (G15) | value of risky domestic assets (vt) (G32) |
| foreign demand for riskless assets (xtf) (G15) | domestic financial wealth (wt) (G59) |
| foreign capital inflows (xtf) (F21) | interest rates (rt) (E43) |
| foreign demand for riskless assets (xtf) (G15) | risk premium on domestic assets (G19) |
| increase in foreign leverage (F65) | risk premium on domestic assets (G19) |