By Frances Coppola
After the crisis-ridden 1990s, countries whose currencies were not considered safe havens opted to build up substantial reserves of safe haven currencies, particularly U.S. dollars, to help them maintain exchange rate stability. Mostly, they held those reserves not in the form of cash or bank deposits, but as so-called “safe assets”: U.S. government Treasury bonds (USTs) and bonds issued by the federally backed agencies Fannie Mae, Freddie Mac and Ginnie Mae (“agency debt”).
Additionally, from 2002 onwards there was rising private sector demand, particularly in Europe, for dollar-denominated safe assets, which became the principal collateral for transactions in offshore dollar markets. Between 2002 and 2008, demand for dollar-denominated safe assets, both public and private, widened the U.S.’s current account deficit1 and depressed the dollar’s exchange rate.2
The need to generate sufficient safe assets to meet international demand strained the U.S.’s financial system, eventually helping to trigger the 2008 crisis. But now, over a decade after that crisis, the dollar remains world’s primary safe haven currency and the U.S. its primary safe asset provider. This influences the dollar exchange rate in some unexpected ways.
During the early 2000s, there was widespread concern that the U.S.’s widening “twin deficits” could result in a disastrous “sudden stop” like that experienced by developing countries in the 1990s.3 This fear contributed to a falling dollar exchange rate.
The economist Ben Bernanke put forward a theory that the U.S.’s growing current account deficit arose mainly from what he called a “global savings glut.” He argued that towards the end of the 1990s, developing countries started to protect themselves from FX crises by saving far more than they invested. Investment in Asian economies, particularly, fell rapidly after the Asian financial crisis of 1996-8.4
Bernanke observed that China invested more than 80 percent of its current account surpluses in USTs and agency debt. Other Asian developing countries sought safe haven currencies by investing their surpluses in a mixture of U.S. safe assets and European bank deposits. Bernanke explained that these countries invested in U.S. and European assets because their own governments were incapable of producing assets deemed safe.5
Strong demand for government safe assets widened the current account deficits of the countries concerned, particularly the U.S., and depressed the yields on their bonds. Bernanke said that this was why Federal Reserve interest rate rises didn’t raise longer-term interest rates. They simply caused the yield curve to invert.
Bernanke’s hypothesis attributed the U.S.’s widening current account deficit largely to factors beyond the reach of U.S. policy. Bernanke said that the current account would eventually move towards balance as developing countries’ economies improved and they moved towards flexible exchange rates. And he dismissed fears of a sudden stop. “Fundamentally, I see no reason why the whole process should not proceed smoothly,” he said.6
But the global savings glut theory doesn’t fully explain swings in the dollar exchange rate between the late 1990s and the 2008 financial crisis. Two other important factors are U.S. domestic policy and the behavior of international investors.
In the second half of the 1990s, capital flowed into U.S. stock markets thanks to the dotcom boom. As the U.S. economy strengthened, the government ran a budget surplus,7 and eventually the Fed started to raise rates.8 Concurrent monetary and fiscal tightening, coupled with a stock market boom and strong demand from developing countries for USTs and agency debt, caused the dollar’s exchange rate to soar.9
But after the NASDAQ market crash of March 2000, the U.S. economy slowed dramatically, entering recession in March 2001. Then, on September 11, 2001, terrorists destroyed the World Trade Center in New York. The attack sent shock waves around the world. Initially, the dollar crashed, but then soared again as investors fled to safe haven currencies.10
According to the economist Richard J. Caballero, the whole world, not just developing countries, switched from “risk-on” to “risk-off” after the dotcom bust and the 9/11 attacks. “After the crash,” he says, “the world came to realize that there was substantial risk in U.S. assets as well and decided to refocus on the safe tranches of the asset distribution.”11
After 9/11, the principal problem facing international investors and financial markets was finding enough safe haven currency assets, since the supply of USTs and agency debt was being bought up by East Asian countries. Between 2003 and 2007, the value of USTs and agency debt in circulation increased by $1.6 trillion, of which $900 billion was purchased by developing countries and only $200 billion by European countries.12 The global financial industry rose to this challenge by creating new classes of “safe asset,” mainly derived from U.S. property. A large proportion of the new assets were rated as triple-A, effectively making them almost equivalent in safety to USTs and agency debt.
These private safe assets were hugely popular and produced in huge quantities. European banks invested heavily in U.S. mortgage-backed securities and their derivatives—some of the very assets whose unraveling kicked off the Great Recession. The European banks funded their purchases by borrowing dollars on international money markets. Since banks create money when they purchase securities, offshore dollar creation by European banks inflated the global supply of dollars and helped to drive down the dollar exchange rate.13
All of this set the stage for the coming financial crisis and Great Recession.
Global demand for safe haven currencies and safe assets took off after the recession of 2000-2002. Not only developing countries scarred by the FX crises of the 1990s, but also European banks and investors sought out triple-A rated dollar-denominated securities. From 2002 to 2007, the dollar’s exchange rate fell continually, but this did not dampen demand for dollar securities. This period can be regarded as the time when the U.S. truly became the supplier of safe assets for the world and, simultaneously, the mechanisms fell into place for the coming global financial crisis.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “Balance on Current Account, NIPAs,” FRED Economic Data; https://fred.stlouisfed.org/series/NETFI
2. “Trade Weighted U.S. Dollar Index: Broad, Goods,” FRED Economic Data; https://fred.stlouisfed.org/series/TWEXB
3. “Fall of the Dollar,” Global Policy Forum; https://www.globalpolicy.org/component/content/article/214-general/43906-fall-of-the-dollar.html
4. “The Global Saving Glut and the U.S. Current Account Deficit,” U.S. Federal Reserve, Bernanke; https://www.federalreserve.gov/boarddocs/speeches/2005/200503102/
5. “International Capital Flows and the Returns to Safe Assets in the United States,” U.S. Federal Reserve, Bernanke; https://www.federalreserve.gov/PUBS/ifdp/2011/1014/ifdp1014.pdf
6. “The Global Saving Glut and the U.S. Current Account Deficit,” U.S. Federal Reserve, Bernanke; https://www.federalreserve.gov/boarddocs/speeches/2005/200503102/
7. “Federal Surplus or Deficit,” FRED Economic Data; https://fred.stlouisfed.org/series/FYFSD
8. “Effective Federal Funds Rate,” FRED Economic Data; https://fred.stlouisfed.org/series/FEDFUNDS
9. “Trade Weighted U.S. Dollar Index: Broad, Goods,” FRED Economic Data; https://fred.stlouisfed.org/series/TWEXB
11. “The ‘Other’ Imbalance and the Financial Crisis,” National Bureau of Economic Research, Caballero; https://www.nber.org/papers/w15636.pdf
12. “The Global Saving Glut and the U.S. Current Account Deficit,” U.S. Federal Reserve, Bernanke; https://www.federalreserve.gov/boarddocs/speeches/2005/200503102/
13. “European banks and the global banking glut,” Coppola Comment; http://www.coppolacomment.com/2019/06/european-banks-and-global-banking-glut.html