As the European credit crisis deepens, several foreign leaders are blaming the crisis on the United States. German finance minister Peer Steinbrück says, “The origin and the center of gravity of the problem is clearly in the U.S.,” whose system is less “robust” than its German counterpart. Russian Prime Minister Vladimir Putin says, “Everything happening now in the economic and financial sphere began in the United States.” Is the European credit crisis America’s fault?
No. The current financial crisis began with the collapse of the subprime mortgage market, which was certainly largest in the United States. But that market depended on a vast network of international investors, all of whom bear some responsibility for what’s happened.
Assigning blame—an essential part of any grieving process—requires some history. During the Great Depression, the U.S. government decided it should be easier for people with low incomes to buy houses. Fannie Mae was created to buy mortgages from banks so that smaller banks didn’t have to carry the entire debt burden on their own. Eventually, two things happened: Fannie Mae started buying riskier “subprime” mortgages, which were still rated AAA or “safe” by ratings agencies. It also started packaging these mortgages as securities, chopping them up, and selling them to other investors, who resold them to other investors, and so on—a process called securitization. Many of these investors were foreign companies, banks, and governments. (The United States’ current account deficit is about 6 percent of the GDP, which means the country gets about $1 trillion in foreign loans every year.) Risky practices like credit default swaps, in which investors promise to support each other in case someone goes bankrupt, started in the United States but soon became the norm across the world. Mortgage-backed securities were dangerous and people knew it, but American housing prices continued to climb, so investors bought them, anyway. The result was an international, interdependent system in which all markets leaned on other markets for stability. So when the U.S. mortgage market collapsed, everyone else’s followed.
That doesn’t mean Europe would have survived had it not been for us irresponsible Yanks. Several European countries, particularly England, Ireland, and Spain, had their own housing bubbles that burst around the same time as ours. (Others, such as Germany, had stable housing markets.) These bubbles were exacerbated by Europe-specific factors. For example, even as housing prices increased by as much as 10 percent a year in Spain, the European Central Bank set interest rates appropriate for the entire European Union, where prices were increasing much more slowly. As a result, local bubbles expanded faster than usual. Another example: A state-owned German bank held billions in mortgage-backed securities, even though they weren’t safe. The risk was therefore endorsed at home—not the result of an American knife held to European throats. Other structural problems have led to recent collapses: The failure of several Icelandic banks can be traced in part to their size—their assets were 10 times the country’s GDP. Total U.S.-bank assets, by comparison, are far less than our GDP.
So why did the bubble burst here first? For one thing, we’ve got the biggest subprime housing market in the world. Also, the riskiest mortgages were always bought and sold in the United States; high-wire investment tactics like “toggle bonds” and “covenant light” loans have been common in recent years. So you might blame American investors for taking bigger risks than their foreign counterparts. But the difference is comparable to playing Russian roulette with a six-chamber versus a seven-chamber revolver.
Other scapegoats include ratings agencies, which knowingly gave subprime mortgages AAA ratings. The biggest ones—Moody’s, Standard and Poor’s, and Fitch—are all based in the United States. The problem with blaming them is that most investors knew their ratings were bunk but bought the securities, anyway. You could blame Congress, too, for insufficient regulation. But, in fact, many European housing markets are just as loosely governed as the U.S. market.
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Explainer thanks Andrew Caplin of New York University and Jonathan Wright of Johns Hopkins University.