Global Imbalances and their Role in the Global Financial Crisis

Global Imbalances and their Role in the Global Financial CrisisBy John J. Maughan

Global Imbalances - Current Accounts

Obstfeld & Rogoff 2010

Global Imbalances - History

• Spanish gold and silver hoarding – chronic deficits

• British silver drain in Far East – gunboat diplomacy

• Interwar gold standard• German balance of payments• Piecemeal devalations in 1930s

Global Imbalances – Me Bad?

“Good”imbalancesHigh savings for education, social security, etc.High investment due to real productivity increasesHigh portfolio investment through deep and liquid financial markets

“Bad” imbalancesDomestic market distortions – high and low savingsSystemic distortions – global large surpluses, reserves

Global Imbalances and Crisis

Three ways imbalances could be bad news:1. “Disruptive adjustment” or protectionism

2. Product of common causes

3. Global liquidity imbalances

Global financial crisis shifted concern to implications of global imbalances

Up to the Crisis: 1995-2003

Asian financial crisis -> trade surpluses, high savings, large dollar reservesUS dot-com boom -> domestic and foreign investment, lower US savings, stronger dollar, equity gains

Commodity price boom -> higher US deficit

US dot-com bust -> monetary loosening, falling interest rates (real and policy)Rising real estate values -> shift from equity to real estate after dot-com bust, US savings do not increase

Up to the Crisis: 2004-2008

A “new and more dangerous phase.” Four factors:Commodity price boom -> higher US trade deficitUS expansionary monetary policy -> low policy interest rates, low inflation, high liquidity, cheap creditChina’s rise -> low inflation on goods, high savings, dollar reserves, finance cheap US creditUS financial innovation -> cheap and easy US credit, EU demand, inflated housing prices

Commodity Price Boom

Obstfeld & Rogoff 2010

Cheap Credit in the US of A

Obstfeld & Rogoff 2010

Cheap Credit in the US of A

Obstfeld & Rogoff 2010

China’s Rise - Trade Surplus

Obstfeld & Rogoff 2010

China’s Rise - Reserves

Obstfeld & Rogoff 2010

US Financial Innovation

Obstfeld & Rogoff 2010

Key Causal Factors 1-5Low global real interest rates. Effect: lower US interest rates.Low inflation. Effect: lower US interest rates, higher credit availability, more spending on real estate.Low US interest rates (both policy and real). Effect: inflated leverage and housing bubbles. Rising US housing values, uninterrupted by Asian financial crisis or dot-com bust. Effect: entrenched expectations of housing appreciation, inflated housing bubble.US dollar. Effect: upward pressures lead to cheaper foreign borrowing and expansionary monetary policy (to reduce current account deficit).

Key Causal Factor 6-10China 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.)China et al. trade surpluses. Effect: higher dollar reserves.China & Asia incoming FDI. Effect: higher dollar reserves.Deflation in Japan. Effect: more expansionary monetary policy to combat low inflation.High commodity prices. Effect: increased global savings, larger global trade surplus, greater US deficit, and higher dollar reserves.

Key Blame Factors 1-4US expansionary monetary policy. Effect: lower US interest rates.US poor financial regulation. Effect: higher US housing values, inflated leverage and housing bubbles. US politics. Effect: postpone tough policy decision to reduce fiscal deficit, lower foreign borrowing, and rebalance trade. China politics. Effect: postpone tough policy decision to rebalance economy by appreciating currency, reducing reserves, and relying more on domestic demand for growth.

Key Blame Factors 5-7China et al. dollar pegs or managed floats. Effect: larger trade surpluses. 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. EU regulatory arbitrage. Effect: increased demand for US structured investments.

Policy Recommendations

US should increase private and public saving – former has largely been achieved.China et al. should attempt to reduce their savings rates by relying more on domestic demand and providing social services. Will greatly reduce global imbalances, but will be politically painful.