What role did global imbalances play in the center (2007-) financial crisis? What were the primary causes of theses imbalances? What are the difficulties involved in resolving them?
Just as it takes two to tango, so current account imbalances require offsetting capital flows to keep international payments in balance. Global imbalances thus have two drivers: borrowers and lenders. In the middle of the last decade, the US’ growing twin fiscal and current account deficits were the focus of much debate.
On the other side of the equation were surplus countries, notably in emerging Asia, aggressively accumulating precautionary reserves, both to maintain competitive exchange rates, and to build up safety buffers in the event of a rapid, sustained balance of payments reversal. Having observed and experienced the IMF’s shock therapy after the Asian crisis in the late nineties, they had no desire to leave themselves so exposed again.
In Europe, since the advent of monetary union in 1999, it became conventional wisdom that intra-European current account imbalances were no longer of consequence. Sovereign risk premiums disappeared, and capital flowed freely from the German-led core to the so-called GIIPS on the periphery.
The Great Moderation came to a shuddering halt in 2007. What at first appeared to be a localized problem in the US sub-prime real-estate sector began to ripple outwards, inducing a global credit crunch and the threat of a second Great Depression. As with the Great Depression, the causes of, and appropriate policy responses to, the latest financial crisis are hotly contested.
According to Ben Bernanke (2009), “it is impossible to understand this crisis without reference to the global imbalances in trade and capital flows that began in the latter half of the 1990s.” Even before the crisis struck, Bernanke (2005) was taking aim at the US’ twin deficits and what he called the ‘global savings glut’.
Bernanke (2005) argued that it was the massive current account surpluses of China and the oil exporters, in particular, and the sterilization of the resulting reserve accumulation, that were to blame for global imbalances.
By failing to adhere to the rules of the game by recycling current account surpluses, thus holding down the value of their currency, these countries made the system unsustainable, and crisis inevitable. Thus, Bernanke argues (2011), the financial crisis followed a similar pattern to the Great Depression, at which time the US and France were the key ‘defectors’ that destabilized the gold standard.
Interestingly, Bernanke noted inflows from both developed and emerging markets, highlighting the fact that the former had a more diversified portfolio of US assets, proving to be ready buyers of the very Mortgage Backed Securities that later came to be at the heart of the sub-prime crisis.
Moreover, the appetite for AAA rated assets encouraged US based financial engineers to repackage Alt-A and sub-prime mortgages, and their derivatives, into supposedly risk-free assets in collusion with the rating agencies. These trends go some way towards explaining the transmission of the financial crisis to Europe and beyond.
Shin (2009) and others argue that it was this financial innovation, broken financial intermediation and misallocation of imported capital that were the root causes of the global crisis.
Indeed, Bernanke (2011) now appears to suggest that this, and not primarily the savings glut, is where the lion’s share of the blame lies, although he refuses to recognize that the Fed’s own ultra-loose monetary policy helped fuel the US housing bubble and consumption boom, themselves drivers of the current account deficit. Rather, he blames abovementioned capital inflows for “pushing U.S. and global longer-term interest rates below levels suggested by expected short-term rates and other macroeconomic fundamentals.” The Obstfeld-Rogoff (2009) synthesis, however, blames not only the savings glut and financial intermediation, but also the Fed’s overly accommodative monetary policy stance.
Thus, Bernanke (2011) now accepts that blame lies with “misaligned incentives in mortgage origination, underwriting, and securitization; risk-management deficiencies among financial institutions; conflicts of interest at credit rating agencies; weaknesses in the capitalization and incentive structures of the government-sponsored enterprises; gaps and weaknesses in the financial regulatory structure; and supervisory failures”.
In Europe, the role of current account imbalances in its ongoing sovereign debt crisis followed a similar pattern. During the last decade, Germany in particular introduced comprehensive labor market reforms which had the effect of dampening wage growth, and making its exports highly competitive vis-à-vis its neighbors.
As a result, Germany and the Netherlands led Europe’s core in running up large current account surpluses while countries on Europe’s periphery – namely the GIIPS, Greece, Ireland, Italy, Portugal & Spain – ran current account deficits, enjoying consumer booms and, in the case of Ireland and Spain, housing bubbles that have since burst spectacularly.
Since 2008, these countries have experienced sudden stops in capital flows, as investors ‘fled to safety’, buying US Treasuries and German bonds. Sovereign yields rose precipitously, to the point where Greece, Ireland and Portugal had to resort to EU-IMF bailout funding as they could no longer re-finance maturing debts at sustainable levels. Spain may not now be far behind.
Confronting efforts at global adjustment are two asymmetries, in evidence both globally and in Europe. Firstly, there is little pressure on surplus countries to adjust meaning that, without international cooperation, the entire burden falls on deficit countries by default. As Keynes put it in 1941, adjustment is “compulsory for the debtor and voluntary for the creditor”.
In Europe, while a cooperative outcome may yet be forthcoming, this asymmetry is manifest in German insistence that deficit countries must adjust through nominal wage and price decreases, while not being willing itself, as yet, to tolerate higher inflation. This was much the same as the US’ attitude when, in a similar position, it vetoed Keynes’ ‘bancor’ plan in 1941, advocating the establishment of the IMF in its stead.
To date, the sudden stop in capital inflows to Europe’s periphery has been mitigated through the provision of official EU-IMF funding, but the underlying conundrum remains at the heart of the ongoing European crisis. It is as yet unclear whether either course – higher inflation / fiscal transfers at / from the core or nominal wage and price reductions on the periphery – or a combination of both will prove politically sustainable.
The second asymmetry relates to currency adjustments. While the US dollar has fallen since the onset of the crisis, it has proved highly resilient as a safe haven despite massive quantitative easing which would have been expected to debase the currency ceteris paribus.
Moreover, while the dollar has fallen somewhat relative to emerging market currencies like the Brazilian real, giving rise to what the Brazilian finance minister Guido Mantega has labeled a ‘currency war’, it has experience more modest depreciation vis-à-vis, for instance, the Chinese renminbi.
The global economy is experiencing a twin speed recovery from the financial crisis. Booming emerging markets continue to generate surplus capital that they do not yet have the means to employ profitably in domestic markets, while the asymmetric nature of Balance of Payments adjustment means the adjustment burden falls disproportionally on sluggish developed economies.
As central banks in developed economies pursue expansionary monetary policy, including quantitative easing where interest rates are at or near the zero-bound, investors are in turn incentivized to engage in ‘carry’ trades, borrowing at low rates in developed economies in order to purchase higher yielding emerging market assets. Consequently, this puts upward pressure on emerging market exchange rates, and potentially contribute to inflation and asset price bubbles.
Lord Skidelsky, celebrated biographer of Keynes, argues that the resurrection of Keynes’ proposal, vetoed by the US in 1941, for an International Clearing Union whereby imbalances are managed through a central global authority which would share the adjustment burden between creditor and borrower. Ultimately, comprehensive reform of the global monetary regime may well be necessary to stave off a return to widespread mercantilist protectionism.
References:
Bernanke, Ben; February 18, 2011; ‘Global Imbalances: Links to Economic and Financial Stability’.
http://www.federalreserve.gov/newsevents/speech/bernanke20110218a.htm
Bernanke, Ben; March 10, 2005; ‘The Global Saving Glut and the U.S. Current Account Deficit’.
http://www.federalreserve.gov/boarddocs/speeches/2005/200503102/default.htm
Faruqee, Hamid; February 19, 2008; IMF Research Department; ‘IMF Sees Global Imbalances Narrowing, But More to Be Done’. http://www.imf.org/external/pubs/ft/survey/so/2008/res021908a.htm
Obstfeld, Maurice and Rogoff , Kenneth; November 2009; ‘Global Imbalances and the Financial Crisis:
http://elsa.berkeley.edu/~obstfeld/santabarbara.pdf
Shin , Hyun Song; November 2009; ‘Global Imbalances, Twin Crises and the
Financial Stability Role of Monetary Policy’.
Skidelsky, Robert and Joshi , Vijay; June 23, 2010; ‘Keynes, Global Imbalances, and International Monetary Reform, Today’.
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