Download E809 International Monetary and Financial Systems

Global Imbalances and their Role in the Global Financial Crisis
By John J. Maughan
Abstract
Global imbalances refer to external (e.g., current account) surpluses and
deficits. There is no fundamental reason why global imbalances in and of
themselves must be seen as ‘bad’; in fact, they may result from normal,
healthy economic processes. The danger is that global imbalances can
correlate with unhealthy domestic economic developments, which threaten
global financial stability. Global imbalances may signal potential future
instability, as prior to the current crisis, or may prolong existing crises. This
policy brief views global imbalances through the lens of the global financial
crisis and provides recommendations for how to alleviate potential future
threats.
Introduction
Global imbalances refer to external (e.g., current account) surpluses
and deficits.1 In the period between the mid-1990s and mid-2000s, global
imbalances moved from moderate to historically unprecedented levels (see
Figure 1). In particular, the US ran up its current account deficit from under
$200 billion in 1995 to a whopping $800 billion in 2006, prior to the outbreak
of the subprime mortgage crisis. At the same time, China and other Asian
nations as well as oil exporters in the Middle East and around the globe
(hereinafter “China et al.”) ran up record current account surpluses and
mountains of reserves. The unprecedented nature of these numbers, as well as
the impact of subsequent events, have invited concern about whether global
imbalances could be signs of imminent economic doom.
However, global imbalances are not new phenomena. Balance of
payments concerns have arisen in every century at least since the colonial era.
The Spanish developed an appetite for extracting gold and silver bullion from
the new world and hoarding it at home, creating large current account deficits
that ultimately impeded its economic strength and undermined its dominance
in world affairs. So much British silver flowed into India and China in the
18th-19th centuries that it alarmed the Crown, which then used “gunboat
diplomacy” to achieve a favourable balance of payments in the Far East
(Spence 1999). Pegging to gold in the interwar period challenged Germany’s
ability to repay its war debts (Keynes 1929) and piecemeal devaluations from
the gold standard during the 1930s amplified the Great Depression
(Eichengreen & Sachs 1985).
For a more operational definition, Brack et al. (2008) defined global
imbalances as “external positions of systemically important economies that
reflect distortions or entail risks for the global economy.”
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Figure 1: Global Imbalances – Current Account (Obstfeld & Rogoff 2010)
Nor are global imbalances inherently bad. Some imbalances are
expected and even favourable due to normal economic activity (Blanchard &
Milesi-Ferretti 2009). These include at least three factors. First, high savings
may be necessary for access to housing, education, healthcare, and retirement,
leading to current account surpluses. Second, a country with good investment
opportunities leading to productivity increases may wish to finance its
operations with foreign savings, leading to current account deficits. Finally,
on a related point, a country with a favourable investment portfolio and deep
and liquid financial markets may attract foreign capital more easily. Each of
these could be considered “good” imbalances, resulting from different but
complementary national priorities.
The concern, however, is that global imbalances will be distorted by
domestic market developments and systemic problems. There are three ways
in which global imbalances may harm the global economy or set off alarm
bells. First, the traditional concern prior to the outbreak of the global financial
crisis was that large global imbalances would cause a crisis by a sudden need
for readjustment (Brack et al. 2008). For example, China held huge amounts of
dollar-denominated foreign exchange reserves. Had investors suddenly
reversed their demand for US assets, the US would be unable to service its
debts and default, wreaking havoc on the global economy. Alternatively, high
current account deficits could raise the risk of global protectionism. Second,
global imbalances may signal underlying distortions. Obstfeld & Rogoff
(2010) made this argument to link the global financial crisis to global
imbalances. In short, imbalances were the “products of common causes” that
also led to the leverage and housing bubbles behind the crisis. Third, global
imbalances may indicate global liquidity at risk. Gourinchas (2011) argues
that the real focus for the global economy should be liquidity imbalances – the
cross-border mismatch between maturities and currency.
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Although “disruptive adjustment” of US current account deficit did
not pan out, the global financial crisis that did occur has not alleviated
discomfort with global imbalances. Instead, it appears to have shifted
concerns from disruptive adjustments to the implications of large imbalances.
Just how this shift occurred largely results from the events of the crisis itself,
which reveal the importance of underlying causes.
Co-Determinants of Global Imbalances and the Crisis
The key global imbalances include the rising US current account deficit
and rising current account surpluses of China et al. The key factors leading to
the global financial crisis were the leverage and housing bubbles fuelled not
only by cheap and easy access to credit in the US, but a range of related
factors. Global imbalances facilitated easy access to credit and other factors.
Obstfeld & Rogoff (2010) divide the pre-crisis timeline into two
important periods affecting global imbalances: mid-1990s to 2003 and 20042008. The key events between 1995 and 2003 were the Asian financial crisis
from 1997-1998, the US dot-com boom (1998-2000) and bust (2000-2001), and
on-going real estate boom in US and elsewhere from 1997 onward. The Asian
financial crisis was a key event because emerging market countries doubleddown on encouraging trade surpluses and building up dollar-denominated
reserves, thereby encouraging high savings rates and investments in foreign
bonds (especially US treasury bills). This would hedge against future crises
and avoid another painful IMF intervention. The US dot-com boom and bust
was important because it first created positive incentives for both foreign and
domestic investment on the promise of US productivity gains. The US dollar
strengthened, savings fell, and equity prices jumped. At the same time, as the
Asian financial crisis wound down and the dot-com boom flourished, global
commodity prices rose and increased the US deficit. The gap between the US
and China et al. widened. With the dot-com bust, US savings did not recover.
Instead, the Fed embarked on an expansionary monetary path, policy and real
interest rates fell, and domestic investors opted for real estate over fallen stock
prices (with steadily rising housing values since the 1990s and falling
mortgage interest rates since 2001). As a result of the shift from stock market
to real estate, the US savings rate remained low.
The key events between 2004 and 2008, a “new and more dangerous
phase” for global imbalances according to Obstfeld & Rogoff (2010), were US
monetary policy, US financial innovation, the commodity price boom
following recovery from the dot-com bust and September 11, and China. The
US continued on its expansionary path to combat low inflation following the
dot-com bust (Brunnermeier 2009) and Japanese deflation in 2003. This,
combined with a high savings rate and large dollar-denominated reserves in
China et al. created a US market flush with dollar liquidity. While prices
remained low on goods due to cheap Chinese and emerging economy imports
and capped inflation, more dollars went to real estate (Overholt 2009).
Meanwhile, real estate prices sored due to high demand, expectations of
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perpetual value gains and, most importantly from 2004-2006, as securitized
subprime mortgages and adjustable-rate mortgages (ARMs) became
commonplace (see Figure 2) (Obstfeld & Rogoff 2010; Brunnermeier 2009).
Increased access to credit combined with financial innovation rapidly drove
up mortgage demand and inflated the leverage and housing bubbles.
European banks seeking regulatory arbitrage under Basel I amplified demand
for US structured products. The commodity price boom further exacerbated
US current account deficits. China’s growth contributed to each of these
factors by providing more cheap exports (in part due to its currency peg
against the dollar), skyrocketing dollar reserves, high savings rate, high FDI
inflows raising its surplus still further, and its high demand for commodities.
Figure 2: Mortgage Originations (percent of total) (Obstfeld & Rogoff 2010)
Key Causal Factors
The abbreviated list of events above reveals at least ten causal factors
and seven “blame”(that is, policy) factors tying global imbalances to the crisis.
The causal factors may or may not have resulted from targeted policies:
1. Low global real interest rates. Effect: lower US interest rates.
2. Low inflation. Effect: lower US interest rates, higher credit availability,
more spending on real estate.
3. Low US interest rates (both policy and real). Effect: inflated leverage
and housing bubbles.
4. Rising US housing values, uninterrupted by Asian financial crisis or
dot-com bust. Effect: entrenched expectations of housing appreciation,
inflated housing bubble.
5. US dollar. Effect: upward pressures lead to cheaper foreign borrowing
and expansionary monetary policy (to reduce current account deficit).
6. China et al. high savings. Effect: lower global real interest rates. (High
savings rate fuelled primarily by young and old for housing and social
security, respectively. See Chamon et al. 2011.)
7. China et al. trade surpluses. Effect: higher dollar reserves.
8. China & Asia incoming FDI. Effect: higher dollar reserves.
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9. Deflation in Japan. Effect: more expansionary monetary policy to
combat low inflation.
10. High commodity prices. Effect: increased global savings, larger global
trade surplus, greater US deficit, and higher dollar reserves.
The seven “blame” factors and their effects may or may not be conceded by
the parties involved:
1. US expansionary monetary policy. Effect: lower US interest rates.
2. US poor financial regulation. Effect: higher US housing values, inflated
leverage and housing bubbles.
3. US politics. Effect: postpone tough policy decision to reduce fiscal
deficit, lower foreign borrowing, and rebalance trade.
4. China politics. Effect: postpone tough policy decision to rebalance
economy by appreciating currency, reducing reserves, and relying
more on domestic demand for growth.
5. China et al. dollar pegs or managed floats. Effect: larger trade
surpluses.
6. China et al. dollar reserves. Effect: stronger US dollar, leading to both
cheaper foreign borrowing and decreased US terms of trade, which in
turn leads to further monetary loosening.
7. EU regulatory arbitrage. Effect: increased demand for US structured
investments.
These causal factors reveal that global imbalances rose and intensified due to
several domestic developments, policy and otherwise, around the world.
Similarly, the imbalances could be self-exacerbating – as the current account
surplus in China et al. grew together with their reserves, the US deficit
became easier to finance. The global imbalances then grew further.
Conclusion: Policy Recommendations
The new emphasis on the correlation of global imbalances with
troublesome domestic factors has shifted concern from global imbalances
themselves to the underlying distortions. As a result, the fear is that global
imbalances, which shrunk in the wake of the crisis but are due to recover,
could stall the global recovery (Gourinchas 2011; Blanchard & Milesi-Ferretti
2009). Even if the recovery succeeds in due course, if global imbalances
remain there are fears that another future crisis could erupt (Obstfeld &
Rogoff 2010; Blanchard & Milesi-Ferretti 2009). With most researchers
concluding that imbalances remain dangerous, the following policy options
should be considered in order to reduce global risk.
The US should increase private and public saving. The leverage and
housing bubbles may have burst, with consumer spending and domestic
investment now turning toward saving, but public saving to reduce fiscal and
trade deficits will take time, not to mention political will. China et al. should
attempt to reduce their savings rates by increasing access to social insurance,
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strengthening corporate governance, and increasing access to credit for
households and SMEs. China has already set out on a path to restructure its
economy away from export-led growth to domestic demand. This should
help reduce its trade surplus and excess reserves. Commodity prices are
rising again and oil exporters should, like China, focus more on stimulating
domestic demand and providing social services. Addressing these global
imbalances will help prevent future leverage and asset bubbles like those that
led to the global financial crisis.
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