The United States is currently engulfed in the most severe financial crisis since the GreatDepression. The crisis was triggered by thecrash in the real estate “bubble” and amplifiedby the extreme concentration of risk in a highlyleveraged financial sector.Conventional wisdom is that both the bubbleand the risk concentration were the result ofmistakes in regulatory policy: an expansionarymonetary policy during the boom period of thebubble, and failure to reign in the practices ofunscrupulous lenders. In this paper we arguethat, while correct in some dimensions, thisstory misses two key structural factors behindthe securitization process that supported thereal estate boom and the corresponding leverage.First, over the last decade, the US hasexperienced large and sustained capital inflowsfrom foreigners seeking US assets to store value(Caballero, Emmanuel Farhi, and Pierre-OlivierGourinchas 2008). Second, especially after theNASDAQ/tech bubble and bust, excess worldsavings have looked predominantly for safedebt investments. This should not be surprisingbecause a large amount of the capital flowinto the US has been from foreign central banksand governments that are not expert investorsand are merely looking for a store of value(Krishnamurthy and Annette Vissing-Jorgenson2008).In this paper we develop a stylized modelthat captures the essence of this environment.The model accounts for three facts observedduring the boom and bust phases of the currentcrisis. First, during a period of good shocks—which we interpret as the period up to the endGlobal Imbalances and Financial FragilityBy Ricardo J. Caballero and Arvind Krishnamurthy*of 2006—the growth in asset demand pushes upasset prices and lowers risk premia and interestrates. It is interesting to observe that the valueof risky assets rises despite the fact that theincrease in demand is for riskless assets. Second,foreign demand for debt instruments increasesthe equilibrium level of leverage of the domesticfinancial sector. In order to accommodate thisdemand, the US financial sector manufacturesdebt claims out of all types of products, which isthe reason for the wave of securitization. Third,if shocks turn negative—which we interpret asthe post-2006 period—the foreign demand nowturns toxic; bad shocks and high leverage lead toan amplified downturn and rising risk premia.In addition to highlighting the role of capitalflows in facilitating the securitization boom, ouranalysis speaks to the broader issue of globalimbalances. Many of the concerns regardingglobal imbalances derive from emerging markets’experiences, where capital flows are oftenspeculative and a source of volatility, as emphasizedin the literature on sudden stops. Ouranalysis shows that somewhat paradoxically, fora core economy such as that of the US, the riskin “excessive” capital inflows derives from theopposite concern: capital flows into the countryare mostly nonspeculative and in search ofsafety. As a result, the US sells riskless assetsto foreigners and in so doing raises the effectiveleverage of its financial institutions. In otherwords, as global imbalances rise, the US increas
