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Excess liquidity growth typically occurs for two reasons: First, financial innovation or new money sources can lead to sharp increases in underlying money – for example the development and expansion of joint stock banks in the 1820s, the securitization of mortgages in the 1980s, or large gold or silver discoveries in the 19th century. Second, massive global imbalances are recycled – like German reparations in the 1920s or petrodollars in the 1970s.

During the period of excess liquidity growth several factors set the stage for the subsequent crisis – asset prices rise as money flows into asset markets, risk appetite rises as risk premia decline and risky investments prove profitable, and the perceived value of liquidity declines as trading volume surges. When this happens, regulatory attempts to reduce risk in the financial system generally fail. When any part of the financial system is constrained from taking on risk, the market simply evades these constraints in one of three ways: It innovates around them, it generates or develops new and unregulated parts of the financial system, or it conceals regulatory violations.
The recent explosion of derivatives – incorrectly blamed for the current crisis – was simply an efficient way to accomplish all three, and was no more the real “cause” of the current crisis than investment trusts were in the 1920s or out-of-control real estate lending was in 1980s Japan. The financial system was simply adjusting, as it must and always does, to surging liquidity and rising risk appetite.

The recent liquidity surge, to which the current crisis is the inevitable denouement, had its roots in the 1980s, when the securitization of US mortgages converted a huge pool of illiquid assets into highly liquid securities, and was subsequently reinforced by the recycling of the Japanese trade surplus with the US in mid-decade. The process took off, however, after 1998. During this time US household savings declined to rates never before seen and the US trade deficit, which until then had rarely exceeded 1 percent of GDP, rose to levels never matched in US history.
Also during this period several Asian countries, led by China, began running policies aimed at generating trade surpluses and accumulating foreign currency reserves, to the extent that net capital flows from developing countries soared to the highest recorded levels in history. It’s notoriously difficult to sort out causality in balance-of-payments relationships, but the fact that this process seems to have begun in 1998 suggests that it may have been a reaction to the Asian crisis of 1997, a shocking event for Asian policymakers to this day.

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http://yaleglobal.yale.edu/content/us-and-china-must-tame-imbalances-together

the reason the US, UK, spain, ireland, latvia etc experienced both cheap and easy money is ultimately that they ran large current account deficits. these are balanced of course by corresponding capital account surpluses — and this return flow of funds, being intermediated by the banking systems of the subject countries, was the fuel for the credit boom in all its forms.

it was the intense availability of these funds that drove down rates, particularly on the long end of the curve, pushing investors to seek yield on the one side and making mortgages cheap on the other. the availability of these funds gave a huge incentive to invent and pursue securitization, and to roll back the law to do so (see alternative net minimum capital rule for broker dealers!)

i think both you and marshall are right as far as it goes — the fed was often permissive with rates, and regulation was all but nonexistent. but both of those were really results of monster C/A imbalances. and i think the bubble would’ve taken off even if the fed had been tighter and regulation better — perhaps it would’ve manifested differently, but there would still have been a credit bubble.

so where is the headwater of these C/A imbalances? i think china, japan, asian tigers and germany managing their monetary policies and currencies for mercantilist advantage, which went unchallenged by the deficit nations as the cheap money rolled in.

i’d further argue the same problems arose when the world dumped the gold standard to finance the first world war between 1914 and 1925. while enabling the extravagant financing of total war, the result was also to create massive imbalances between europe (deficit) and the US (surplus) during and after the war. when ultimately discipline returned as the war powers came back onto gold, it set into motion the unwind which then lasted until the next war.