Renowned economist John Maynard Keynes explained the crisis of the Great Depression in terms of the “paradox of thrift”: Individual saving is a private virtue, but when many individuals rapidly increase their savings at the same time, the demand for goods and services will drop and the unemployment rate will rise. In the last 30 years, as national financial markets have become increasingly integrated, some countries with exceptionally high savings ­rates—­Singapore, Japan, ­China—­have made an ­end ­run around Keynes’s paradox and exported some of their excess savings to their trading partners, in particular, the United ­States.

The huge global pool of savings that has accumulated in this way over the last few decades, now amounting to trillions of dollars, has been the source of four successive tsunamis that have first uplifted, then flattened, some of the world’s leading economies. The first tsunami struck Mexico, Brazil, and other developing countries in the 1970s; the second hit Japan and three Nordic countries in the late 1980s; another swamped Thailand, Malaysia, Russia, and eventually Argentina in the mid-­1990s. We are now living in the aftermath of the fourth tsunami.

The pattern has been similar each time. The tsunami brings a deluge of money into a country, causing its currency to appreciate and prices of real estate and of stocks to rise. Its economy booms. Rational exuberance morphs into irrational ­exuberance—­a bubble develops. But eventually the inflows decline and the national currency often crashes, with disastrous consequences. The party ends abruptly and painfully. In the Asian financial crisis of the late 1990s, stock market indexes plunged throughout the region and unemployment in Indonesia, the Philippines, South Korea, and Thailand soared. On Wall Street and in other global finance centers, banks and other big institutions trembled, and some collapsed. The crisis in Russia in 1998, for example, delivered the coup de grâce to the U.S. hedge fund ­Long-­Term Capital ­Management.

The tsunamis are an indirect consequence of a dramatic change in international money flows that began around 1980. Until then, the United States had been far and away the world’s largest creditor and source of investment money. American savings began to flow abroad during World War I, initially when the United States helped the British and French finance their war efforts, and then in the 1920s as more dollars poured into private investments and government bonds. By the early 1940s, the United States was the world’s largest foreign investor. By 1980, its net foreign assets (assets minus liabilities) were larger than those of all other creditor countries ­combined.

But the next 20 years brought a reversal of unprecedented proportions. By 2000, America’s net foreign liabilities had become larger than those of all other debtor countries combined, and its liabilities were still growing rapidly as foreign savings surged into Treasury bills and other ­dollar-­denominated securities. The shift was amazingly rapid. Britain was the world’s largest net creditor before the United States took its place nearly 100 years ago, and despite the extraordinary costs of two world wars, the island nation remained an international creditor until just a few years ­ago.

The change in America’s international investment position did not occur because the U.S. Treasury or major American corporations borrowed money in yen or yuan. Foreign savings “crowded in” to the United States, and the U.S. economy adjusted to accommodate the inflow: Interest rates fell, so Americans saved less and consumed ­more.

In the 1980s and ’90s, more of these savings came from Japan than from any other country. As its economy matured and its growth slowed after the post–World War II recovery, Japan’s domestic investment declined, and the excess savings flowed abroad. The Japanese invested most of that money in dollar securities, where it would be safe and liquid. Other Asian ­countries—­Taiwan, South Korea, Sing­apore, Thailand, and most recently ­China—­have followed the same path. As of April, China held $764 billion in U.S. Treasury securities—more than any other country—and many billions more in other dollar investments.

This is not the first time that excess domestic savings have entered the international economy. Countries that grow rapidly almost always generate extra cash as their economies mature and their domestic investment ­declines—­it is as if it takes time for households to realize their good fortune and increase their consumption. In the 17th century, the Dutch generated enormous savings to finance the draining and development of their lowlands, and as that work was completed they continued to save at high levels and began to invest overseas. They were succeeded as the major exporter of savings by the British in the 19th century and the Americans in the ­20th.

Two factors distinguish the savings tsunamis of the past 35 years from earlier experiences. One is that the volume of savings in various Asian countries has been ­extraordinary—­as high as 40 or 50 percent of their gross domestic products. This Herculean thrift is not only the product of personal virtue. A variety of government policies, from low interest rates to mandatory savings laws, keep ordinary people as well as corporations socking large quantities of money ­away.

The second crucial difference lies in how the savings have been invested. In the past, the United States and other creditors acquired ­longer-­term overseas investments, such as foreign companies, stocks, and bonds. But Japan and other creditor countries today keep a very high proportion of their foreign holdings in ­short-­term assets (securities that are essentially liquid or, at most, mature in a few months’ time), such as Treasury bills and bank ­deposits—­potential “hot money” that can be moved quickly to anywhere in the ­world.

The big international banks that take ­short-­term dollar deposits from the Bank of Japan, the People’s Bank of China, and other central banks are always seeking profitable ways to invest this money. And in many countries where they do business, they can often make loans at interest rates significantly below those offered by their domestic banks. In the 1970s, when the deposits came from Saudi Arabia and other oil exporters, the banks engaged in ­“petro­dollar recycling”—lending generously to governments and ­government-­owned firms in Mexico, Brazil, Argentina, Chile, and other developing countries. Amid surging commodity prices for their products, the Latin American economies were booming, the demand for new roads, bridges, and other infrastructure was high, and it seemed the good times would never end. “Countries don’t go bankrupt,” one of the world’s leading bankers declared. The Latin American debt crisis, which was triggered by the Mexican government’s default in the middle of 1982 and resulted in years of economic and political pain throughout the region, proved him wrong, but the lesson never seems to sink ­in.

Recently, China has begun to question the dollar’s role as the world’s dominant reserve currency. But no one obliged China to buy hundreds of billions of dollars of U.S. Treasury bills and bonds. Its central bank could have bought securities denominated in the Albanian lek or the Zambian kwacha. Beijing buys dollars primarily because the low value of the yuan enables the Chinese to sell vast quantities of goods to the United States. China’s leaders depend on exports to create the tens of millions of manufacturing jobs in Shenzhen, Guangzhou, and Xiamen they need to keep the social peace.

It would be a great boon to American manufacturing firms if China were to end its currency protectionism. The yuan would appreciate sharply, reducing China’s exports. America’s trade deficit would shrink. But Beijing is not likely to let market forces determine the value of its currency. And if it were to begin buying many more yen or euros instead of dollars, as it sometimes suggests it will, politicians from Tokyo to Paris would go ballistic. They would accuse the Chinese of following a classic ­“beggar-­thy-­neighbor” policy, keeping the value of the yuan artificially low and thus increasing China’s exports to their countries. So China’s leaders will continue to buy dollars, even as they complain loudly that the United States’ trade and fiscal deficits are too ­large.

Over the next few years, the global savings glut will become even larger. Sluggish economic growth around the world will expand the pool of global savings, and most of the money will be used to buy ­dollar-­denominated securities, for the simple reason that they remain the most attractive investment. That means that governments in the United States and Europe are likely to find it relatively easy to finance the enormous fiscal deficits that lie before them. It also means that inflation rates in these countries are likely to remain ­low.

But another, less comforting implication of continued growth in global savings is that more money will flow to countries outside the United States and Europe. Some will see their currencies appreciate, and before long they will experience “irrational exuberance.” Then will come the ­collapse—­a shock both to these countries and to the global economic system. We have seen the pattern before. The question is, where will the next tsunami strike: India? Brazil? South ­Korea?

r, a former Wilson Center fellow, is professor emeritus of international economics and finance at the Graduate School of Business of the University of Chicago. He is the author of

 The New International Money Game (rev. ed. 2000), 

and brought out the fifth edition of Charles P. Kindleberger's classic

 Manias, Panics, and Crashes: A History of Financial Crises

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The global economic crisis has some surprising causes, but who
would have guessed that overzealous saving was one of them?

The Global Savings Tsunami

The recession that began in January 2008 was more severe than any of the other 10 recessions the United States has endured since World War II. The decline in the nation’s gross domestic product (GDP) surpassed previous records and the percentage of American workers without jobs nearly did so. And the expansion of the U.S. economy since the recession officially ended in June 2009 has been sluggish, challenging the economists’ adage “The sharper the decline, the quicker the recovery.” The growth rate in 2011 fluctuated around two percent, much too low to make a significant dent in the number of Americans without work, despite the Obama administration’s injection of more than $750 billion into the national economy and the provision of virtually free money to financial institutions by the Federal Reserve.

Most recessions since World War II have come about because the Federal Reserve curbed the growth of credit to restrain inflationary pressures. The Fed sold bonds, the bonds’ prices fell, and individuals, commercial banks, and other financial firms bought the bonds at their attractive new prices. That reduced the reserves of the commercial banks, leaving them less money to lend to property developers and households. As sales of new homes declined, real estate developers produced fewer new homes, increasing unemployment in the building trades and a host of real estate–related businesses. Before long, this process would pitch the nation into recession.

Once the Fed became convinced that the inflation threat had abated, it would reverse its credit policies: The supply of credit would expand, and developers would produce more homes, knowing that the underlying demand was still strong.

The recession of 1981–82 was especially severe because the Fed was determined to stamp out the expectations of accelerating inflation that had developed in the second half of the 1970s. An increase of tenfold or more in oil prices during the 1970s had kindled boom conditions in Texas, Louisiana, and other energy-producing states. Sharp increases in the prices of wheat, corn, and other grains had triggered a spike in prices of farmland in the grain-producing states of the Great Plains.

The contractive monetary policy adopted by Fed chairman Paul Volcker in October 1979 led to the highest interest rates since the Fed was created in 1913—short-term rates climbed to more than 20 percent and long-term rates to more than 10 percent. Unemployment rose above 10 percent. As inflationary expectations were reversed, the prices of hard assets people had acquired in the late 1970s as inflation hedges—gold and silver, farmland, real estate, and collectibles—declined, in some cases sharply, as bubbles in these assets burst.The recession brought grain prices down, which caused theprice of farmland to tumble. Ahandful of large banks failed, and the federal government was forced to bail out hundreds of smaller banks and savings and loan associations. But, as had been the case in every previous postwar recession, real estate prices remained stable at the national level, even though there were significant drops in areas that had experienced booms.

The distinctive feature of the most recent recession was the massive failure of leading financial firms, including Countrywide Financial, Washington Mutual, Wachovia, and many small community banks in Georgia and Florida. The U.S. investment banking industry was decimated: Bear Stearns and Lehman Brothers failed, and Merrill Lynch was saved in early 2009 only because Bank of America bought it. But then Bank of America and Citibank needed huge infusions of government money to stave off collapse. AIG, the largest insurance company in the world, would have closed without the tens of billions of dollars pumped into it by the Fed.

Countrywide and Washington Mutual had been extremely aggressive in extending mortgage credit after 2000 as each battled to become the nation’s dominant mortgage lender. They weakened their credit standards and became inventive at developing new kinds of mortgage loans that reduced the interest payments that borrowers were required to pay in the first few years, allowing home buyers to take on debts that were large—much too large—relative to their incomes.

Easy credit contributed to the surge in real estate prices, which climbed by 10 percent annually at the national level between 2002 and 2006 and by 20 percent a year in the nation’s 16 most rapidly growing states, in the South and West. Two government-sponsored lenders, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), which between them indirectly provided half of the nation’s mortgage money, were aggressive buyers of mortgages from Countrywide and Washington Mutual. Fannie Mae and Freddie Mac were able to sell their bonds to investors because some foreign governments and their sovereign wealth funds were of the impression that these bonds were guaranteed by the U.S. Treasury.

Eventually, rational exuberance morphed into irrational exuberance, and Americans started buying homes and apartments simply because prices were increasing and they saw an exceptional opportunity for profit. And prices were increasing mainly because Americans were buying property. The surge in prices led to a boom in construction; the number of new housing units constructed was one-third larger than the number needed to accommodate the growth of the population and fulfill other needs. By the end of 2006 there were more than two million unoccupied homes in the United States, all built with the expectation that prices would continue to increase.

The decline in real estate prices that started at the end of 2006 was not prompted by any Fed action but by a slackening of foreign demand for Fannie Mae and Freddie Mac bonds. Many of the high-risk borrowers who had received mortgage loans from Countrywide and Washington Mutual were unable to make their first payment, often because the mortgage refinancing that had supplied so much easy money suddenly dried up. Borrowers began defaulting on their mortgages. One of the great puzzles of the recession is how the Fed could have been so oblivious to the bubble in home prices and the surge in housing starts.

The decline in real estate prices in the first few months of 2007 was gradual. The true dimensions of the crisis became clearer in August, when Countrywide suddenly experienced a “run”; it was no longer able to roll over the maturing short-term loans it had been using to underwrite its aggressive funding of new mortgages. Other lenders stumbled, too. Countrywide was saved only when Bank of America bought it early in 2008 (much as the giant bank would avert the extinction of Merrill Lynch the following year). Once property prices stopped increasing, the calculus of developers and investors changed radically. Now the interest rate on their debt was higher than the annual increase in prices. Some decided to sell, pushing prices down further. Then millions of people who had recently bought property found themselves with “upside-down” mortgages—the amount they owed on their mortgage was greater than the market value of their property. Others who had taken out home equity loans based on the increase in the value of their property and had slim equity also were underwater. More houses went up for sale, putting additional downward pressure on the housing market. A race to the bottom was on.

The hangover from the property price bubble is one major cause of the sluggishness of the economic expansion over the last several years. New housing starts and completions have remained at low levels as the economy absorbs the excess homes built during the bubble years. The process has moved slowly, despite low interest rates, because of high unemployment and the continuing decline in home prices. Annual housing starts have averaged much less than half their average level in the 1980s and ’90s. If starts were running at the old rate of 1.5 million annually rather than in the current range of 500,000 to 600,000, the nation’s GDP growth rate would be two percentage points higher and the unemployment rate two percentage points lower than they are today.

Unlike recoveries from typical Fed-induced recessions, postbubble economic expansions typically are slow because people are intent on rebuilding their wealth by increasing their saving relative to their spending. At the same time, banks and other financial institutions become more cautious lenders, so that while interest rates are low, credit is relatively scarce.

The current recovery has also been slowed by the $300 billion increase in the nation’s trade deficit since 2008. Each increase of $1 billion in the trade deficit—either because Americans are spending more on foreign goods or foreigners are spending less on U.S. goods—represents a loss of 12,500 American manufacturing jobs. If the trade deficit in 2011 had been in the same ballpark as in 2008, the United States would have had two to three million more manufacturing jobs than it did.

What remains distinctive about the recession of 2008–09 and its continuing aftermath is the decline in home prices. The last time such a drop occurred at the national level was during the Great Depression. That calamity, however, was marked by a much more severe decline in stock prices—which dropped more than 90 percent between 1929 and 1933. Several thousand banks failed, consumer prices fell by more than 30 percent, and exports declined as many countries in Latin America and Europe abandoned the gold standard and devalued their currency. Unemployment in the United States at one point reached 25 percent.

The conditions in the 1920s and mid-2000s in the run-up to economic collapse were surprisingly similar. The American economy grew strongly in the ’20s, with surges in the production of automobiles and the construction of highways, and the introduction of electricity and the telephone in millions of households. Home prices increased, but far less dramatically than they did in the 2000s. Stock prices tripled from the beginning of 1927 to the autumn of 1929, when the crash occurred. Irrational exuberance took hold. Investors were buying stocks because stock prices were increasing, and prices were increasing because investors were buying stocks. Stock market wealth was a smaller component of household wealth than it is today, but higher stock prices helped reduce the cost of capital and increase business investment.

In both the 1920s and the mid-2000s, economic euphoria was pervasive as bubbles in asset prices led to surges in spending—and those spending increases further inflated the bubbles that had fostered them in the first place. Then asset prices imploded, household wealth shrank, and banks suffered large losses when borrowers were unable to repay their loans.

The recession of 2008–09 and its aftermath more closely resemble the Great Depression than any of the other post–World War II recessions. Indeed, this episode might aptly be called the Mini-Depression of 2008–09. Both economic declines involved the interplay among the collapse of real estate values, the decline of banks’ capital and their willingness to lend, and the desire of households to rebuild financial wealth. By contrast, the standard postwar recessions did not involve significant declines in either stock or real estate values or large loan losses by lenders (apart from the localized failures of banks and thrift institutions in the oil- and grain-producing states as a result of the 1980–81 recession). The decline in the capital of banks and other financial institutions between 2007 and 2009 was much greater than the combined declines during the previous 10 recessions.

The 2008 recession did not cascade into another depression because the U.S. Treasury and the Federal Reserve provided abundant funds to recapitalize the banks and limit their distress selling of assets. This intervention—which began in September 2008—sharply reduced the likelihood that a liquidity crisis would morph into a solvency crisis. Had the Treasury and Fed intervened several weeks earlier, however, the bankruptcy of Lehman Brothers would have been prevented, the 2008 recession would have been significantly less severe, and the postrecession expansion would have been more robust.

Even this intervention would have been unnecessary had the Fed and government bank regulators recognized the emerging bubble in property prices in 2004 and 2005 and used their authority to curtail the risky and pernicious credit practices of Countrywide, Washington Mutual, Fannie Mae, Freddie Mac, and other financial institutions. There was abundant evidence, based on the growth rate of the American population, that housing starts far exceeded demand, and the decline in the credit standards of some of the most aggressive mortgage lenders was no secret. Yet when real estate prices began to fall and the tightening of credit led to the collapse of big lenders, it became clear that neither the Federal Reserve nor the U.S. Treasury had contingency plans to deal with runs on banks and other financial firms. A few ounces of prevention would have yielded a ton of cure.

, a former Wilson Center fellow, is a professor emeritus of international economics and finance at the University of Chicago's Booth School of Business. His latest book (with Charles P. Kindleberger) is 

Manias, Panics, and Crashes: A History of Financial Crises

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Words may be failing economists and others who characterize the economic downturn that began in 2008 as "the Great Recession." "Mini-Depression" may be more like it. 

Robert Z. Aliber