Quotes of the Day

Blame China, Saudi Arabia and, yes, Canada.

Much of the fault of the financial crisis has been heaped on Wall Streeters, unscrupulous mortgage lenders and weak regulators. But in a new research paper, economist Ricardo Caballero says there is another major group of contributors to America's monetary mess who are not getting the blame they deserve: foreigners.

"There is no doubt that the pressure on the U.S. financial system [that led to the financial crisis] came from abroad," says Caballero, who is the head of MIT's economics department. "Foreign investors created a demand for assets that was difficult for the U.S. financial sector to produce. All they wanted were safe assets, and [their ensuing purchases] made the U.S. unsafe."

Caballero, who is from Chile, is not absolving American bankers and regulators. But he says investigators and lawmakers who are looking into the financial crisis are spending too much time grilling Wall Streeters and not enough time looking into the global imbalances that are largely to blame. "What worries me is Congress trying to create new regulations, but not asking where the pressure was coming from to create these products," says Caballero. "In terms of formulating a solution, just looking at the U.S. financial system is not the answer."

A number of economists and policy analysts believe Caballero makes a lot of sense. Alex Pollock of the American Enterprise Institute says it's clear the foreign investors who bought the bonds of mortgage guarantors Fannie Mae and Freddie Mac served to fuel the housing bubble. Ohio State University professor René Stulz, who has studied the financial crisis, says Caballero has hit on a critical contributor. Says Stulz, "Investors looking for safe investments in the U.S. created a demand for new products that caused our financial system to work differently from how it had worked in the past and to become more fragile in ways that were not well understood at the time."

Of course, not all economists are buying the Caballero's blame them, not us, explanation of the financial crisis. They say just because there was money flowing into the United States doesn't mean the credit crunch was inevitable. They say stricter regulations could have stopped U.S. investment bankers from creating mortgage bonds filled with risky home loans and then passing those bonds off as safe investments to foreign investors. "Most of the blame for the financial crisis lies in the choices that were made inside the U.S.," says Anil Kashyap, an economics professor at University of Chicago's Booth School of Business.

Nonetheless, even if foreigner investors' role in America's credit boom and bust is debatable, what's beyond doubt is that this aspect of the crisis is not getting as much attention as, say, bankers and their bonuses. On Thursday, the Financial Crisis Inquiry Commission wrapped up its second day of hearings. Global imbalances is one of the 22 areas that the panel is supposed to investigate as a possible cause of the credit crunch. But in two days of hearings, which included testimony from top financial executives, economists, analysts, regulators and a hedge fund manager, there wasn't a single question that had to do with what role foreign investment might have played in creating the crisis.

Caballero says that is wrong. His story of the financial crisis begins not in the rising condo buildings or growing developments in Miami or Las Vegas, but in investment houses and offices of central bankers in Beijing and Riyadh. Caballero asserts that international investors, particularly those tasked with deploying the reserves of foreign governments, prefer relatively safe investments, which made the normally stable U.S. economy a natural hunting ground. The money might have gone into stocks, but after the Nasdaq and stock market rout of the early 2000s, investors' appetite shifted to bonds.

China, contending with a huge trade surplus with the U.S., bought more and more Treasury bonds, pushing down yields and making Treasuries less attractive to other foreign investors. As a result, the rising demand for higher yielding U.S. debt opened the door for Wall Street investment bankers to spin out new classes of fixed-income securities, most notably collateralized debt obligations or CDOs. Much of the money raised by those investments was funneled in the mortgage market. That gave lenders the ability to make more loans, allowing more people to buy houses and push up real estate prices. Many of those loans, it turns out, were made to people who couldn't afford to pay. What happened next — real estate bust, foreclosures and Wall Street mayhem — is well known.

How to prevent a similar crisis from happening again is the question that Caballero thinks we are getting wrong. He believes reforming the U.S. financial system is only part of the answer. Foreign investors, he says, need to change their behavior as well. Specifically, Caballero believes the U.S. needs to encourage foreign governments to hold a range of U.S. investments, instead of just funneling all of their money into say Treasuries or mortgage bonds. One way to do that is to require foreign governments or investors who only buy Treasuries or mortgage bonds to place a certain portion of their U.S. investments in an account at the Federal Reserve. Rather than park their money at the Fed, Caballero contends that many investors will choose to put their money into riskier U.S. investments.

"There is a crack in the U.S. financial system, but it's important to ask where the water that caused the crack came from," says Caballero. "The only way to really make the U.S. system resilient to systemic shocks is to fix the supply side."

• Stephen Gandel