Global economic imbalances

When a flow becomes a flood

The deep causes of the financial crisis lie in global imbalances—mainly, America’s huge current-account deficit and China’s huge surplus

ASK people what caused the financial and economic crisis and most are likely to plump for some mix of greed and incompetence. Bank bosses have been castigated for fee-seeking gluttony, reckless lending and failure to heed the risks to their institutions. Regulators have been accused of sleeping on watch. Central bankers once lionised for mastering inflation and the business cycle are feted no longer.

Few among the public would be likely to pin the blame on “global imbalances”: the pattern of large, persistent current-account deficits in America and, to a lesser extent, Britain and some other rich economies, matched by surpluses in emerging markets, notably China. The damage done to the financial system by lax controls, rotten incentives and passive regulation is plain. Yet underlying the whole mess was the deeper problem of imbalances. A growing number of policymakers and academics believe that these lay at the root of the financial crisis.

Economists had long feared that America would ruin itself on foreign borrowing. The current account, which measures the balance of investment and saving, has been in the red every year since 1992. Until 1997, the annual saving shortfall was modest but it grew steadily thereafter, reaching a peak of $788 billion, or 6% of GDP, in 2006. America needed to borrow from abroad or to sell assets—shares, bonds, property—to pay for the string of deficits. Deficits need not be ruinous, especially if they finance profitable investment. But economists worried that as America’s consumption boom took it deeper into hock, foreigners would become less willing to lend to it. That could lead to an abrupt halt to financing and a plunge in the dollar.

Puzzles and explanations

The deficits reflected a falling saving rate rather than a rising investment rate. To finance this, America was sucking in savings from abroad that could not be relied on for ever. The dollar started to decline gradually from 2002 but the current-account deficit only got bigger. There were other puzzles: long-term interest rates ought to have picked up to reflect the scarcity of American savings and the concern about the dollar. But even when the Federal Reserve started to raise short-term rates from the middle of 2004, long rates declined. The chairman of the Fed, Alan Greenspan, told Congress in February 2005 that this was a “conundrum”.

This spurred new thinking on global imbalances, which sought to rationalise why poor countries were so willing to send their savings to rich countries such as America and Britain. Ben Bernanke, now the Fed’s chairman, then a governor, argued in 2005 that America’s low saving was a passive response to a global “saving glut” washing onto its shores. It was not that America had lapped up foreign capital; rather capital had been thrust upon it. The money flooding in from willing foreign savers had bid up government-bond prices, lowering interest rates and lifting house prices. That encouraged Americans to run down savings and to keep spending.

As academics found fresh theories to explain the saving glut, they became less anxious about the imbalances it produced. The most developed financial markets were found in America, so it was the natural destination for foreign savers seeking safe returns. It could not run deficits for ever but the day of reckoning might be years away. Americans earned far higher returns on their investments abroad than foreigners did on their American assets. That and a weaker dollar helped to slow the increase in foreign indebtedness.

Both the old-school worrywarts and the new-school optimists got some elements of the story right and others wrong. “The dollar crisis that was predicted by the central view is the only one that hasn’t happened,” says Pierre-Olivier Gourinchas of the University of California, Berkeley. In the depths of the financial crisis in October, the dollar rallied against most currencies. America was not cut off from external funding. But equally there was a crisis—as the pessimists foresaw—and one that has undermined a pillar of the optimists’ thinking on imbalances: that America is a beacon of financial stability.

There are signs of a consensus emerging from these two schools. A growing band of economists agree that the forces behind the saving flows from emerging markets are likely to persist. The continuing thirst for dollar assets, albeit of the right sort, suggests that America remains a magnet for global capital. But the belief that its financial system can handle huge saving flows indefinitely has been punctured. Kenneth Rogoff of Harvard University, who had given warning of an eventual reckoning, believes that with $800 billion of net capital flows pouring into the United States in a year, some slippage of regulatory and lending standards was perhaps inevitable. The worry now is that if imbalances are not tackled, they may in time breed another calamity.

The size of the saving glut is staggering. In 1996, the year before the Asian financial crisis began, economies designated by the IMF as emerging, developing and newly industrialised ran a collective current-account deficit of $78 billion. Over the next decade this turned into a surplus of several hundred billion dollars (see chart 1), with China and oil exporters accounting for almost all of the increase in the past three or four years. Much of the turnaround is mirrored in a widening American deficit. (The world’s sums do not add up. Statisticians are unable to offset the recent burgeoning surpluses with deficits elsewhere: according to the IMF, in 2007 the surpluses exceeded the deficits by $265 billion.)

The glut and the gap

What persuades developing countries to export capital to the rich world that might be better used at home? Influences on saving vary from region to region. The income of oil-exporting countries, for instance, has ballooned since 2004 because of higher prices for crude. It would have been neither feasible nor wise for oil-rich nations to spend this windfall at home, so much of it was saved and sent abroad. Economists who have looked for something that unifies the saving behaviour of a disparate group of countries, from oil-exporters to metal-bashers, have converged on one important motive: the need to acquire reliable stores of value that can be sold easily when trouble strikes.

This idea has been developed in a series of papers by Ricardo Caballero of the Massachusetts Institute of Technology (MIT), Emmanuel Farhi of Harvard University and Berkeley’s Mr Gourinchas. Their thesis is that emerging countries cannot create enough trustworthy saving vehicles to keep up with the pace of economic growth, because their financial markets are immature. Householders cannot rely on a ready supply of credit—or on government safety nets—so must save hard for a rainy day. But the domestic supply of financial assets is unreliable so the thrifty plump for foreign assets instead. America is the favoured place because it has broad and liquid markets for securities.

That interpretation sits awkwardly with another: that excess saving, particularly in China, is the result of exchange-rate policy. Emerging-market central banks have bought dollars to weaken their own currencies. That encourages exports and depresses spending at home. The result is a high level of net national saving, much of which ends up in central banks’ foreign-exchange reserves. These rainy-day funds have swollen since 2004, mostly because of increased hoarding by oil-exporters and by China (see chart 2). How can this reflect private saving?

Mr Gourinchas doubts that depressing the exchange rate could sustain a high rate of saving for long. By flooding the foreign-exchange market with their own money, central banks risk driving up inflation which would erode the gain in competitiveness from a cheap currency. China has avoided that fate because it has been able to “sterilise” its currency interventions by selling bonds to banks, companies and households. That would be an expensive operation, says Mr Gourinchas, were it not for demand for savings. The reserves are collateral for the bonds held privately.

That may be too neat an explanation. In China’s tightly controlled financial system, savers have little choice. And firms, not households, account for the recent rise in net national saving. There is another puzzle: why have emerging-market currency reserves grown so large? This was largely a reaction to the painful memory of the Asian crisis: Asian countries wanted to insure themselves against another sudden flight of capital. Reserves need to be large enough to draw upon if foreign-currency financing suddenly dries up, and to ensure that trade flows smoothly. But reserve holdings in some emerging markets have gone way beyond levels suggested by prudential rules of thumb—enough to pay for three months of imports, say, or to cover short-term foreign-currency debt.

Research by Maurice Obstfeld of Berkeley, Alan Taylor of the University of California, Davis, and Jay Shambaugh of Dartmouth College views these “excess” reserves as insurance for the domestic banking system. They argue that in economies with managed exchange rates and fast-growing bank deposits, there is increased risk of a “double drain”. When crisis hits, fear of devaluation could spark a rush out of bank deposits into cash, and from cash into hard currency. Reserves are not only a prudent safeguard against a “sudden stop” in foreign finance. They are also needed as insurance against the risk of “sudden flight” by domestic savers.

The authors found that a measure of financial depth—the ratio of broad money to GDP—helped to explain the size of reserves. In a more recent study they found that countries with insufficient reserves to insure their financial systems suffered bigger currency crashes during last year’s turmoil. The currencies of countries with full war chests did not depreciate; some rose. If economies draw the lesson that their reserves were not big enough, global imbalances will be even harder to tackle.

Mr Taylor reckons the policy of accumulating reserves accounts for a significant and growing fraction of global surpluses—enough (in the early years of this decade) to finance as much as a third of America’s current-account deficit. The self-insurance against financial fragility is part of a more general bent towards precautionary saving in the developing world. If it persists, as seems likely, it will throw the problem of deficient global demand back to America.

An unsatisfying implication of the literature on the saving glut is that it paints America as a tragic victim of forces beyond its control (though some of the authors insist this is not their belief). The emerging markets’ need for insurance, in its many guises, drives them to export capital to America (and to similar places, such as Britain). America, by implication, has no choice but to make room for it.

In fact, Asian savings may have provided the rope; but America hanged itself. The macroeconomic forces that drove the capital flows were hard to reverse. But what made them so devastating was that they were met by microeconomic failures—described in the special report in this issue.

The interaction between the two was fatal. After the dotcom bust, American firms turned cautious and investment spending was weak. That ruled out a natural home for foreign capital. Faced with strong external demand for AAA-rated assets, the financial system got creative. Marginal home loans were packaged into supposedly safe securities. That supply of credit lifted house prices and spurred a boom in residential construction, which filled the gap in demand left by sluggish business investment.

As these loans turned bad and losses mounted, it became clear that banks had set aside too little capital to protect themselves against unexpected losses. That left the banks crippled and the economy on its knees. The villains in this story are the banks for making silly loans and regulators for not insisting on more precautions. But what would a well-regulated financial system have done with the money?

The bait for capital inflows is that America provides reliable and liquid assets, which cannot be found at home. Ideally its financial system might have provided an intermediary service—funnelling emerging-market savings into emerging-market projects. That would have lowered deficits in America and surpluses abroad. Only a fraction of the capital that flows into America is swallowed by the current-account deficit. Much of it finances capital outflows—the purchase of foreign assets by American residents (see chart 3).

In a world of perfect regulation, the likely outcome would be fewer new assets, such as securities backed by subprime mortgages, and higher prices (and lower returns) on the best assets. That implies long-term interest rates would have dropped even further. That might have given more life to business investment but it might also have fuelled a bigger housing boom, at least in prime real-estate.

Could macroeconomic policy have better addressed the global imbalances? One option would have been to keep an eye on the current-account balance when setting monetary and fiscal policy. Tighter policy might then have dampened consumer spending and curbed imports.

The trouble is that the much tighter policy needed to make a meaningful dent in the trade deficit would have led to recession in America and perhaps in emerging markets too. It would have been hard to justify with inflation so low (and it would also rule out low interest rates and fiscal stimulus now). Mr Caballero at MIT, for one, is sceptical: “I know from my experience in emerging markets that it is very hard to fight capital when it is flooding in. Policy mistakes may have been made at the margin but no more than that.” Yet America’s loose monetary policy after the dotcom bust does bear some blame. After all, a lot of subprime mortgages with variable interest rates were originated when the federal funds rate was very low.

Illustration by Bill Butcher

An alternative would be to try to tackle imbalances from all sides. That would require co-ordinated action by surplus and deficit countries. Such attempts failed in the past because everyone had something to gain from sticking with the status quo. China might think Americans should save more but only as long as that did not curb their spending on Chinese imports. America would ask China to revalue its currency and boost its domestic demand. But it was also keen for China to keep buying its public debt.

Policymakers blithely assumed they would avoid a dollar crisis and that America would export its way out of any trouble. And that was how things were starting to play out before a quite different crisis, in the financial system, blew up.

With luck and good judgment some of the worst excesses of the financial system will now be reined in. The danger is that by focusing on regulatory reform and less clumsy ways to deal with bank failures, policymakers fail to tackle the underlying causes of the crisis. The anxieties that prompt emerging markets to run big current-account surpluses have not been assuaged. Indeed, the crisis may have spurred some countries to seek even more self-insurance in reserves and other forms of prudential saving.

It’s good to talk

Earnest editorials often call for international talking shops to co-ordinate global demand. Alas, Sino-American exchanges on international economic affairs are often heated: when America’s treasury secretary, Hank Paulson, said recently that imbalances played a role in the run-up to the crisis, he provoked an outcry in China. Past failures of co-ordination initiatives do not offer much hope either. Yet as Raghuram Rajan of Chicago University’s Booth School of Business points out, the crisis has lasted a long time and there is no end in sight: so the situation may soon be ripe for a cooler exchange between surplus and deficit countries. The two big surplus countries in the rich world, Germany and Japan, are suffering deep recessions, which may bring them to the table. The problem of imbalances goes much wider than America and China.

One necessary task is to assure emerging-market countries that they will not be caught out if they run short of liquidity. The IMF might have to be prepared to offer funds more quickly and with fewer strings. Another option would be for emerging markets themselves to pool reserves. The politics of that would be messy at best. As Hélène Rey of London Business School points out, the devaluations within Europe’s exchange-rate mechanism in the early 1990s showed that risk-sharing is far from perfect even where countries have well-established political ties.

The IMF’s resources are puny in comparison with the amounts in the vaults of emerging-market central banks. That is why the swap lines offered by the Fed to four emerging economies in October were a welcome innovation (even if the recipients were flush with their own reserves). But countries will not be persuaded to stop accumulating reserves unless such credit lines can be relied upon in future. The Fed cannot be asked to vet potential recipients: that may be a job for the fund.

America, Britain and other deficit countries have drowned themselves in cheap credit from abroad. Because the structural forces behind the global saving glut are unlikely to abate quickly, there is a real risk that the dangerous imbalances will persist—with America’s public sector as the new consumer of last resort. It would be foolish to focus on fixing the financial industry only to find that the public finances are left in ruins.

The coming days

The week ahead

China's leader visits Europe to discuss the worsening state of the world economy

• CHINA’S prime minister, Wen Jiabao, begins a week-long visit to Europe on Tuesday January 27th. His “trip of confidence” will take in Germany, Spain and Britain and is intended to reassure Europe that China is keen to help in tackling the world’s economic and financial ills. But relations with America are set to sour. Timothy Geithner, America’s incoming treasury secretary, has accused China of “manipulating” its currency to keep Chinese exports cheap.

For background, see article

• AMID deepening economic gloom America’s Federal Reserve begins a two-day meeting on Tuesday January 27th. As financial institutions continue to wobble and grim economic news is released the world over, America’s central bankers have little room for manoeuvre: interest rates are close to zero and will stay there for some time. On Friday the extent of the damage to America’s economy will become more apparent with the release of figures for fourth-quarter GDP.

For background, see article

• ANOTHER stop for the Chinese leader will be in Davos. The Swiss ski resort is hosting its annual get-together of the world business and political elite (and a bunch of journalists) beginning on Wednesday January 28th. The mood at the World Economic Forum is likely to be sombre. But many bosses of financial institutions will feel relatively happy if they are there at all; many of their erstwhile peers will not be making the trip, victims of the credit crunch.

For background, see article

• AFRICAN leaders will have a busy week. On Monday January 26th the 15-country Southern African Development Community holds a special summit in Johannesburg to discuss the ever-worsening situation in Zimbabwe: cholera deaths are nearing 3,000; President Robert Mugabe still looks to be unwilling to consider sharing any real power with the opposition. The crisis in Zimbabwe may also loom large at a meeting of the African Union in Addis Ababa, Ethiopia, which kicks off on Sunday February 1st.

There's Safety in the Euro Zone

Thinking of leaving the single-currency area? Think again.

From today's Wall Street Journal Europe

According to a cruel joke making the rounds these days, the difference between Iceland and Ireland is one letter and six months. An even crueler epithet calls London "Reykjavik on the Thames." As European governments pile on mountains of debt to recapitalize their overleveraged banks and pump-prime their economies, the hitherto unthinkable is now a distinct possibility: national defaults.

On Monday, S&P downgraded Spain's credit rating to AA+ from triple A, following a similar cut for Greece last week. Ireland and Portugal were put on credit watch, and Italy may be next in line. The yield spreads between German bonds, the euro zone benchmark, and Greek, Belgian, Italian, Portuguese, Spanish and Irish bonds have widened to new heights -- an indication that the market considers the latter less safe.

All this has led to speculation that the euro zone's breakup is imminent. Jean-Claude Trichet, president of the European Central Bank, felt compelled yesterday to dismiss such talk as "unfounded."

The thinking of those who believe Greece or Italy may drop the euro goes something like this: Freed of the shackles of a one-size-fits-all monetary policy and back in charge of their own currencies, these countries could devalue themselves out of the crisis, giving their industry a competitive advantage.

But this makes little economic sense. Any benefit from a devalued currency would be short-lived; it would surely lead to wage inflation, thereby neutralizing the advantage for exporters. The pitfalls of leaving the euro, though, would be enormous.

The bond spreads mean that the markets consider the likelihood of a default of German debt to be much lower than for, say, Greek or Spanish debt. The idea that those concerns would disappear if only Athens and Madrid dropped the euro is absurd. If the Greek and Spanish governments have to pay a premium for issuing euro-denominated bonds, imagine what the surcharge would be if they tried to sell investors peseta or drachma bonds.

Even though the insurance against debt default has ballooned for these countries, they haven't yet had any problems raising money. Greece is attracting strong demand for a planned five-year bond. Whether investors, even for an additional risk premium, would flock so willingly to drachma-denominated bonds is questionable. A Greek currency bond market would be much less liquid and therefore less attractive.

The "tensions" in the euro zone, i.e. the bond yield spreads, actually underline that joining the euro was the right decision and leaving now would make things worse. Leave aside the huge costs of reintroducing national currencies and redenominating all debt. Even if this could be done at zero administrative and political cost, it would still be economic suicide.

Let's say Italy tried to go it alone. Since it would be clear that Rome was leaving the euro to devalue its resurrected national currency, investors would pull out their money faster than Italy could print 100,000 lira notes. A bank and lira run would follow; inflation and borrowing costs would skyrocket.

Consider the example from across the Channel. British euro skeptics always considered it a blessing that the U.K. never joined the single currency and they are particularly happy about their independence in the current crisis. It allows the country to do what euro zone countries can't do: watch their currencies decline. The pound has lost 20% in value versus the euro over the past year and even more against the dollar and the yen. How much this will help British manufacturers remains to be seen.

What is certain is that with the rapid fall of sterling, servicing British debt denominated in foreign currencies is becoming increasingly costly. In addition, the U.K. will have to pay a hefty exchange-rate risk premium for issuing new debt while investors are selling British assets. What some consider a necessary adjustment of an overvalued currency, others fear may actually be a run on their currency. A veritable sterling crisis would only aggravate the banking problems.

This is one headache euro zone members don't have to worry about. It's also one of the reasons why Fitch, unlike S&P, affirmed Madrid's triple-A rating on Monday. "Spain's membership of the euro area supports its rating, as it eliminates the risk of a currency crisis," its statement read.

There is safety in numbers. As a global reserve currency, the euro enjoys advantages the relatively small sterling zone lacks. In this global financial crisis, investors increasingly will seek relative security in the dollar and euro zones.

The euro has also brought other advantages. We never thought much of the arbitrary rule that budget deficits must not be higher than 3% of GDP, but the overriding idea of fiscal responsibility is sound. As a result, many euro zone countries are now in a better position to absorb their rising deficits.

Last but not least, having one single currency for 16 European countries has made international coordination during this global banking crisis much easier. Henry Kissinger's famous question -- "Whom do I call when I want to talk to Europe?" -- does not apply to monetary policy. The existence of the ECB facilitated coordinated interest-rate cuts with central banks around the world. Imagine the cacophony of policy responses if there were an additional 15 central banks in Europe.

The euro is an anchor of stability, particularly for small members that otherwise would be much more exposed. Denmark may hold a referendum on joining the euro next year and in Iceland, which hitherto has declined to join even the European Union, a clear majority now favors adopting the single currency.

Perhaps the euro skeptics in the other Reykjavik, the one on the Thames, may soon rethink their position as well.