1. FIXING GLOBAL FINANCE 2. Capital Flows Upstream: the emergence of the global imbalances Martin Wolf, Associate Editor & Chief Economics Commentator, Financial Times The Bernard Schwartz Forum on Constructive Capitalism March 29 th 2006

2. 2 Capital flows upstream: introduction “Over the past decade a combination of diverse forces has created... a global saving glut.” Ben Bernanke, Governor of the Federal Reserve, March 10 th 2005.

3. 3 Capital flows upstream: introduction “Long-term rates have moved lower virtually everywhere.” Alan Greenspan, chairman of the Federal Reserve, June 6 th 2005.

4. 4 Capital flows upstream: introduction The failure to make the global financial system work well has had profound macroeconomic consequences. In particular, it is one of the main explanations for the “global savings glut” that has created the “global imbalances” of today. So failures of finance have both micro-economic and macro-economic consequences.

5. 5 1. Capital flows upstream: outline Greenspan’s “conundrum” and the savings glut The origins of global excess savings The emergence of the global “imbalances” The US as the world’s spender and borrower of last resort The case for change

6. 6 1. Conundrum Why have monetary and fiscal policies had to be so loose? Why are global real interest rates so low, even though fiscal deficits are substantial? Why is the US running huge current account deficits? There is one answer to these questions: the global savings glut.

7. 7 1. Conundrum This global savings glut has had three main causes: the aftermath of the emerging market financial crises; post-bubble blues in high-income countries; and the oil shocks. I will focus below mostly, but not exclusively, on the first. The failure of the global financial system to manage the incorporation of emerging market economies into the global financial system has turned the US into the world’s borrower of last resort.

8. 8 1. Conundrum: US current account

9. 9 1. Conundrum: long-term real rates

10. 10 1. Conundrum: real interest rates

11. 11 1. Conundrum: conclusion Exceptionally aggressive monetary and fiscal policies, to escape the slow down. Low real rates, despite the strong global economic growth. Exploding US current account deficits. What is going on?

12. 12 2. Savings surpluses and deficits What lies behind all this is a move into a surplus of savings over investment in a wide range of countries In some case savings have risen more than investment In many cases investment has fallen In some cases savings have risen and investment has fallen In important cases, the private sector’s excess savings has risen sharply, creating both fiscal deficits and current account surpluses

13. 13 2. Savings surpluses and deficits

14. 14 2. Savings surpluses and deficits

15. 15 2. Savings surpluses and deficits

16. 16 2. Savings surpluses and deficits

17. 17 2. Savings surpluses and deficits

18. 18 2. Savings surpluses and deficits

19. 19 2. Savings surpluses and deficits

20. 20 2. Savings surpluses and deficits

21. 21 2. Savings surpluses and deficits

22. 22 2. Savings surpluses and deficits

23. 23 2. Savings surpluses: conclusion The world is awash with excess savings. Almost every region is in surplus. The US is absorbing about three-quarters of the world’s surplus savings, not in extra investment, but in consumption. All this must be equilibrated through the global balance of payments. And it is.

24. 24 2. Savings surpluses: conclusion There are two principal surplus regions at the global level: –Asia –Oil exporters Since Asian growth is an important cause of high oil prices, one can argue that the rise of Asia is directly or indirectly behind both phenomena.

25. 25 3. Global imbalances

26. 26 3. Global imbalances

27. 27 3. Global imbalances

28. 28 3. Global imbalances There are two broad groups of surplus countries: –Mature high-income countries with slowly growing economies and chronic excess savings. Japan and “Old Europe” generate a combined current account surplus of $336bn in 2004, up from $189bn in 1996. –The emerging market economies - have moved from minus $99bn in 1996 to $323bn in 2004. –Thus the swing for the high-income countries was $147bn, but the swing for the rest was $421bn.

29. 29 3. Global imbalances The most important point, however, is that these surpluses in Asian emerging market economies and Japan did not “just happen” They are the result of a deliberate policy: exchange-rate protectionism. What does this mean? Assume a country tries to fix its real exchange rate at below the market clearing level.

30. 30 3. Global imbalances Then two things will happen: large current account surpluses and large speculative capital inflows. The country must then buy the incoming foreign exchange and put it in reserves. It must also pursue tight fiscal policies and monetary sterilisation to preserve the excess savings that are the domestic counterpart of the current account surplus. Should it fail to do so, there will be domestic overheating and the excess savings will disappear. This is exactly the pattern shown by Asian emerging market economies.

31. 31 3. Global imbalances

32. 32 3. Global imbalances

33. 33 3. Global imbalances

34. 34 3. Global imbalances

35. 35 3. Global imbalances

36. 36 3. Global imbalances It is not just the current account surplus. Asian emerging countries are also recycling the capital inflow This supports the dollar within what economists working at Deutsche Bank call the “new Bretton Woods area”

37. 37 3. Global imbalances Asian countries have been remarkably successful in keeping their exchange rates down. In doing so, they have accumulated vast quantities of foreign currency reserves. Almost $2.5 trillion in additional reserves have been accumulated since January 2000. So much for the view that this is an era of free floating!

38. 38 3. Global imbalances On the contrary, the conclusion many countries seem to have reached is that it is fine to control the exchange rate, so long as it remains at a highly competitive level. As a result the money is being recycled, predominantly to the US.

39. 39 3. Global imbalances

40. 40 3. Global imbalances

41. 41 3. Global imbalances

42. 42 3. Global imbalances

43. 43 3. Global imbalances: conclusion The rest of the world is generating large savings surpluses and parking them in the US. The big swings have been the result of the financial crises of the 1990s and the recent oil price surge. The crises persuaded the Asian emerging market economies to stick with export-led growth. They are running current account surpluses and recycling capital inflows. This keeps the dollar up against their currencies.

44. 44 4. US as spender of last resort US seeks internal balance, what used to be called full employment and now might be called the “non- accelerating inflation rate of unemployment” (NAIRU). It accommodates the external imbalance imposed by the rest of the world. As issuer of the world’s key currency, the US is in a unique position to be the world’s borrower and spender of last resort. Indeed, it is chosen to do so, by the exchange-rate targetting of much of the rest of the world.

45. 45 4. US as spender of last resort In seeking internal balance in the US, the Federal reserve also generates internal balance in the open economies of the rest of the world. It does this by offsetting their desired export surpluses.

46. 46 4. US as spender of last resort Think about it as follows: –The rest of the world’s capital outflow supports the dollar. –At the resulting elevated (real) exchange rate, the output of the US sectors producing tradeable goods and services shrinks (other things being equal). –The Federal Reserve cuts interest rates, to expand the economy. –As the US central bank (and fiscal authorities) expand demand, a large excess demand for tradeables emerges. –This shows itself in the trade and current account deficits. –The rest of the world tail wags the US dog.

47. 47 4. US as spender of last resort

48. 48 4. US as spender of last resort What would have happened if the US fiscal deficit and household financial deficit had not emerged? The answer is simple: there would have been a deep recession in the US and the rest of the world, unless it would have been possible to force (or persuade) the rest of the world to pursue much more expansionary economic policies

49. 49 4. US as spender of last resort Six features of the US external position are noteworthy: –On a net basis, foreign governments have financed roughly a third of the current account deficit since 2001. – Imports have been growing more than 50 per cent faster than exports, in real terms, since 1990. –Imports are now 60 per cent bigger than exports. –US net liabilities have been rising, in relation to GDP, by much less than one would expect from the current account deficit. The explanation is the falling dollar: what makes the capital inflow relatively safe for the US makes it a bad deal for foreign investors, especially lenders.

50. 50 4. US as spender of last resort –On average, the nominal yield on assets held by foreigners in the US was a mere 2.7 per cent between 2002 and 2004. –Even if import growth were to fall sharply, to the rate of growth of exports, the net liability position would reach 70 per cent of GDP by 2015 and the current account deficit would rise to 8.5 per cent of GDP by 2015.

51. 51 4. US as spender of last resort

52. 52 4. US as spender of last resort

53. 53 4. US as spender of last resort

54. 54 4. US as spender of last resort

55. 55 4. US as spender of last resort

56. 56 5. The case for change It would surely be better if the world’s poor countries were not providing so much capital to the richest. Failings of the financial system have now had huge global macroeconomic results. So what needs to be done and by when? That is the subject of the third lecture.