I like the way Sherle R. Schwenninger, director of the Economic Growth Program at the New America Foundation, summarized the situation. Writing in The Nation (December 23, 2008), he noted: "The root cause of this unbalanced world economy was the enormous pool of excess savings generated by China, Japan and, more recently, the petrodollar states of the Persian Gulf. This global savings glut, as Federal Reserve chairman Ben Bernanke called it, helped fuel a succession of asset bubbles in the United States, culminating in the expansion of easy credit and the rapid run-up of housing prices following the collapse of the techstock bubble," notes Schwenninger. "These housing and credit bubbles in turn helped inflate consumption by enabling households to take on more debt; household debt as a percentage of disposable income rose from 90 percent in the late 1990s to 133 percent in 2007."
To put it in simple terms, the banks and sovereign wealth funds holding Mrs. Tanaka's savings in Japan, Mr. Zhou's savings in China, and Mr. Abdullah's savings in Kuwait shipped them to Wall Street, where some of America's best rocket scientists designed financial products to get them a higher rate of return—without greater risks, or so they were told. With all that money chasing all that yield, it was inevitable that the financial houses managing all that money would lobby Washington to give them more and more "flexibility" to design investment instruments that could produce higher and higher yields. And Washington accommodated. With the end of the Cold War and the intensification of globalization, market-friendly presidents (Ronald Reagan, George H. W. Bush, Bill Clinton, and George W. Bush), along with congressmen and senators whose palms had been greased by Wall Street through campaign donations, rolled back banking regulations that had limited risk-taking. Some of these regulations had been on the books since the Great Depression.
So more and more money flowed into a less and less regulated financial system, and the banks took greater and greater risks with it—not just on subprimes but on all kinds of instruments—in more and more places using more and more exotic instruments and greater and greater leverage, making transactions that fewer and fewer people understood and were less and less transparent.
Consider one example—derivatives. In December 2000, the U.S. Congress passed, and then President Clinton signed, legislation spurred by the financial services industry that exempted derivatives from most oversight. Derivatives are financial instruments that "derive" their value from the price of some real stock, bond, service, or good. "Typically, the seller receives money in exchange for an agreement to purchase or sell some good or service at some specified future date," according to Wisegeek.com. So a bank or insurance company could earn money selling derivatives that insured mortgage-backed securities against default. These are called credit-default swaps. The poster child for this sort of innovation turned out to be the American International Group, the insurance giant.