Ezra Klein - A New Spin on the "Giant Pool of Money" Theory

Ezra Klein - A New Spin on the "Giant Pool of Money" Theory:
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.

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.