Global Imbalances and Future Crises

I’ve been trying to figure out how much danger there is of a sudden unwinding of global imbalances that could extend and potentially deepen the recession. I’ve been worried there is a chance this could happen, but Barry Eichengreen explains that there are “two hopes for avoiding this disastrous outcome”: Fix global imbalances to avert future crises, by Barry Eichengreen, Commentary, Project Syndicate: Future history books, depending on where they are written, will take one of two approaches to assigning blame for the world’s current financial and economic crisis.

One approach will blame lax regulation, accommodating monetary policy, and inadequate savings in the US. The other, already being pushed by former and current US officials like Alan Greenspan and Ben Bernanke, will blame the immense pool of liquidity generated by high-savings countries in East Asia and the Middle East. All that liquidity, they will argue, had to go somewhere. Its logical destination was the country with the deepest financial markets, the US, where it raised asset prices to unsustainable heights.

Note the one thing on which members of both camps agree: the global savings imbalance – low savings in the US and high savings in Chinaand other emerging markets – played a key role in the crisis… Preventing future crises similar to this one therefore requires resolving the problem of global imbalances. …

Whether there is a permanent reduction in global imbalances will depend mainly on decisions taken outside the US, specifically in countries like China. One’s forecast of those decisions hinges, in turn, on why these other countries came to run such large surpluses in the first place.

One view is that their surpluses were a corollary of the policies favouring export-led growth that worked so well for so long. China’s leaders are understandably reluctant to abandon a tried-and-true model. They can’t restructure their economy instantaneously. … They need time to build a social safety net capable of encouraging Chinese households to reduce their precautionary saving. If this view is correct, we can expect to see global imbalances re-emerge once the recession is over and to unwind only slowly thereafter.

The other view is that China contributed to global imbalances not through its merchandise exports, but through its capital exports. What China lacked was not demand for consumption goods, but a supply of high-quality financial assets. It found these in the US, mainly in the form  of Treasury and other government-backed securities, in turn pushing other investors into more speculative investments.

Recent events have not enhanced the stature of the US as a supplier of high-quality assets. And China, for its part, will continue to develop its financial markets and its capacity to generate high-quality financial assets internally. But doing so will take time. Meanwhile, the US still has the most liquid financial markets in the world. This interpretation again implies the re-emergence of global imbalances once the recession ends, and their very gradual unwinding thereafter.

One development that could change this forecast is if China comes to view investing in US financial assets as a money-losing proposition. US budget deficits as far as the eye can see might excite fear of losses on US Treasury bonds. A de facto policy of inflating away the debt might stoke such fears further. At that point, China would pull the plug, the dollar would crash, and the Fed would be forced to raise interest rates, plunging the US back into recession.

There are two hopes for avoiding this disastrous outcome. One is relying on Chinese goodwill to stabilise the US and world economies. The other is for the Obama administration and the Fed to provide details about how they will eliminate the budget deficit and avoid inflation once the recession ends. The second option is clearly preferable. After all, it is always better to control one’s own fate.


Originally published at Economist’s View and reproduced here with the author’s permission.

One Response to "Global Imbalances and Future Crises"

  1. Boondigga   May 27, 2009 at 11:10 am

    Another option is for the developed countries to finally react aggressively to China’s exchange rate controls at a time of their choosing rather than China’s. China will very unlikely take the nuclear option if it means a collapse of its growth engine.An economy as big as China’s paired with a manipulated exchange rate relies on the outside world being permissive