This is the first in a four-part series excerpted from the Political Economy Research Institute (University of Massachusetts-Amherst) working paper “The Endogenous Finance of Global Dollar-Based Financial Fragility in the 2000s: A Minskian Approach,” by Junji Tokunaga and Gerald Epstein. Tokunaga is an Associate Professor in the Department of Economics and Management, Wako University, Tokyo. Gerald Epstein is a Professor in the Department of Economics, University of Massachusetts-Amherst, and Co-Director of the Political Economy Research Institute (PERI). The full paper is available here.
The Endogenous Finance of Global Dollar-Based Financial Fragility in the 2000s: A Minskian Approach
Junji Tokunaga and Gerald Epstein
Global financing patterns have been at the center of debates on the global financial crisis in recent years. The global imbalance view, a prominent hypothesis, attributes the financial crisis to excess saving over investment in emerging market countries which have run current account surplus since the end of the 1990s. The excess saving flowed into advanced countries running current account deficits, particularly the U.S., thus depressing long-term interest rates and fueling a credit boom there in the 2000s.
According to this view, the financial crisis was triggered by an external and exogenous shock that resulted from excess saving in emerging market countries, not the shadow banking system in advanced countries which was the epicenter of the financial crisis. Instead, we argue that a key cause of the global financial crisis was the dynamic expansion of balance sheets at large complex financial institutions (LCFIs) (Borio and Disyatat  and Shin ), driven by the endogenously elastic finance of global dollar funding in the global shadow banking system.
The endogenously elastic finance of the global dollar contributed to the buildup of global financial fragility that led to the global financial crisis. Importantly, the supreme position of U.S. dollar as debt-financing currency, underpinned by the dominant role of the dollar in the development of new financial innovations and instruments, and was a driving force in this endogenously dynamic and ultimately destructive process.
Part 1: Global financing patterns in the 2000s
The Growth of Global Imbalances
In the wake of the global financial crisis, many economists and policymakers have drawn attention to the role of global capital flows as a key factor contributing to the global financial crisis. A prominent view is the global imbalances hypothesis, which focuses on the growing imbalance in world current account position. Since the end of the 1990s, emerging market countries, predominantly in emerging Asian and oil-exporting countries, had run account surpluses, while some advanced countries, such as the U.S., had expanded current account deficits. A growing imbalance in world current account positions emerged in which emerging market countries were consistent providers of net capital flows, and the U.S. was a primary net consistent recipient. Figure 1 demonstrates the absolute value of net capital flows, which mirrors the imbalances in world current accounts, as a percentage of world GDP since the 1980s. A sustained increase in net flows started in the second half of the 1990s, particularly the 2000s, and peaked to around 6.0 percent in 2006 before the start of the financial crisis.
The global imbalances view attributes the global financial crisis to a substantial excess of savings over investment in emerging market countries that mirrors their current account surplus. According to this view, these “excess saving” flowed into advanced countries that ran current account deficits, particularly the U.S., thus depressing long-term interest rates and fuelling the credit boom there. Accordingly, this global imbalances view conjectures that the main macroeconomic cause of the global financial crisis is an external and exogenous shock that resulted from excess savings in emerging market countries, not the shadow banking system in advanced countries that was the epicenter of the financial crisis.
The Expansion of Gross Capital Flows
Recently, some mainstream economists and policymakers suggest that net capital flows, which mirrors the global imbalance, are much less important than gross capital flows (inflows and outflows) for understanding global financial instability in the 2000s, as emphasized by Borio and Disyatat , Dorrucci and McKay , Obstd  and Shin . Figure 2 plots gross capital flows as a percentage of world GDP since the last half of the 1990s. Gross capital flows, most of which consist of flows among advanced economies, rose from about 10 percent in 2002 to over 30 percent in 2007 prior to the financial crisis, and collapsed during the financial crisis, while net capital flows increased from 3.1% in 2001 to 5.9% in 2007, as shown in Figure 1.
Remarkably, gross debt-financing flows have driven the expansion of gross capital flows. Figure 3 demonstrates the composition of gross capital inflows among advanced countries. Portfolio and other investment flows, which mainly reflect banking flows, were extremely volatile in comparison with foreign direct investment (FDI) and equity investment. Thus, it appears from the observations of global financing patterns presented in this section that gross capital flows, particularly gross debt-financing flows, were likely more important than net capital inflows that the global imbalances view draw attention to understanding the global financial crisis in the 2000s.
The majority of gross capital flows were conducted by a handful of large, complex financial institutions (LCFIs) at the center of the global financial system. The process of financial deregulation and consolidations among financial conglomerates spurred a growing convergence between the activities of the banks and the other financial institutions since the 1990s. The development led to the emergence of LCFIs in the U.S. and Europe, which dominate the global financial markets for debt and equity securities, syndicated loans, securitizations, structured-finance products and OTC derivatives. Our analysis will suggest how gross capital flows had expanded in the 2000s, emphasizing the key role of the US dollar, as LCFIs increased their balance sheet on a global scale before the financial crisis.
 Bernake , the most prominent proponent of this view, refers to this phenomenon of excess savings as the emergence of the “global saving glut”. The global saving glut consists of excess domestic savings over investments in emerging Asian countries, oil-exporting countries and some advanced countries.
 IMF [2011a], p.32.
 The U.S. played a central role in the expansion of gross capital flows. Mainstream economists and policymakers argue that the U.S. has been playing the role of “global financial intermediary” in gross capital flows since the latter 1990s. Gourinchas and Rey  point out that the role of the U.S. changes from a ‘world banker’ to a ‘venture capitalist of the world’ since the 1990s. As Milesi-Ferreti, Strobbe, and Tamirisa  analyze, U.S. gross capital inflows and outflows expanded vis-à-vis the euro area and offshore financial centers (OFCs) such as the U.K. and Caribbean offshore financial centers (pp.15-16).
 IMF [2010b], p.8.
 Wilmarth , pp.994-95. By 2007, sixteen large complex financial institutions (LCFIs)—including the four largest U.S. banks (Bank of America, Chase, Citigroup and Wachovia), the five largest U.S. securities firms (Bear Stearns, Goldman, Lehman, Merrill and Morgan Stanley), and seven major foreign universal banks (Credit Suisse, Deutsche, Barclays, RBS, HSBC, BNP Paribas and Societe Generale) collectively dominate the global financial system (Wilmarth , p.994). In addition, FSB  identifies an initial group of “Systemically Important Financial Institutions” (SIFIs), namely 29 global systemically important banks (G-SIBs).