Global imbalances Martin Wolf, Associate Editor & Chief Economics Commentator, Financial Times Mont Pelerin Society New York March 2009

2 Global imbalances “Things that can’t go on forever, don’t” Herbert Stein

3 Global Imbalances Origin of the “global imbalances” US as borrower and spender of last resort Financial crisis Roads to reform Assessment

4 1. Origin of the “global imbalances” In the 1980s and 1990s, emerging market economies suffered a series of shattering foreign currency and banking crises These culminated in the Asian crises of , the Russian and Brazilian crises of and the Argentine crisis A central feature of many of these crises was current account deficits, financed by short-term foreign currency borrowing When the crises hit, the currencies collapsed and the currency mismatches created mass bankruptcies

5 1. Origin of the “global imbalances” ECONOMIC COLLAPSES IN THE ASIAN CRISIS

6 1. Origin of the “global imbalances” After these shattering experiences many emerging economies, particularly in Asia, decided “never again” They decided not to float their currencies freely, but to fix them at a “competitive” level They started to generate large trade and current account surpluses These were defended by massive foreign currency reserve accumulations That were themselves forms of insurance

7 1. Origin of the “global imbalances” They were also defended by deliberate policies to sustain domestic savings, which are the necessary counterpart of current account surpluses These policies included: –Sterilisation of the monetary impact of reserve accumulations; –Credit controls –Suppression of household borrowings –Large budget surpluses –Encouragement of high corporate savings This “system” is known to some as Bretton Woods II

8 1. Origin of the “global imbalances” This new regime is inconsistent with either of the classic liberal regimes: –Freely floating exchange rates; or –The gold standard It is, in short, a mercantilist hybrid

9 1. Origin of the “global imbalances” THE GREAT IMBALANCES

10 1. Origin of the “global imbalances” RISE OF FOREIGN CURRENCY RESERVES

11 2. US as borrower and spender of last resort Since a number of high-income countries – Germany, Japan, Taiwan, Singapore, Switzerland – continued to run large current account surpluses And since the oil exporters also started to run large current account surpluses, as the oil price rose Somebody had to run the offsetting deficits The most important “somebody” was the US, which imported about 70 per cent of the world’s surplus savings Other “somebodies” were the UK, Spain and Australia

12 2. US as borrower and spender of last resort I was concerned with two consequences: –Rising external debt; and –Rising household debt It turned out that external debt was well contained by the extremely low returns foreigners received Internal debt was a different matter, however The environment of low real and nominal interest rates and resulting house-price bubbles, expanding credit and financial innovation created extraordinary financial vulnerability

13 2. US as borrower and spender of last resort HOUSEHOLDS SPENT

14 2. US as borrower and spender of last resort PRIVATE DEBT BOOM

15 2. US as borrower and spender of last resort The imbalances can be seen as either a “savings glut” or a “money glut” My own view is that the savings glut caused the money glut, by driving the Federal Reserve to pursue expansionary monetary policies, which then led to the reserve accumulations in the creditor countries But it is also possible to view the Federal Reserve as the causal agent: the money glut causes the savings glut Either way, the reserve accumulations and fixed exchange rates played a big role in the story

16 3. Financial crisis The explosive increases in debt and the associated housing bubble could not last – and did not do so When the bubble burst, bad debt started to emerge across the global financial system Given the extreme undercapitalisation of the financial system, this started to create panics about solvency As the panic spread and risk aversion grew, the financial crisis spread It reached its worst after the bankruptcy of Lehman

17 3. Financial Crisis RISK AVERSION SPREAD, AS BANKS DREW BACK

18 4. Roads to reform This big US adjustment that I believe must lie ahead is compatible with global growth only if other countries have smaller surpluses or bigger deficits Non-oil exporters also need to reduce current account surpluses or increase deficits This means they must spend more relative to incomes China is the most important case

19 4. Roads to reform So how are emerging countries to run current account deficits safely? The answer is that the external finance must itself be relatively stable There are three solutions:` –Equity investment (FDI and portfolio); –Local currency bonds; or –More collective insurance – e.g. via the IMF The development of local-currency bond markets shifts a potentially lethal risk onto foreign investors

20 4. Roads to reform As important is a bigger global insurance system. The IMF’s lending capacity is about $250bn. It is trying to double it now, but it needs to be an order of magnitude bigger That will also require a big re-engineering of voting shares Today Europe has a third of the votes. That cannot last, particularly since the Europeans do not use the resources of the Fund

21 4. Roads to reform A still bigger question is the exchange rate regime I am pragmatically in favour of floating It is certainly true that the combination of a key currency with floating rates has proved an unviable way to transfer resources to emerging economies But if countries choose pegs, they must stick by the rules – no sterilisation, in other words

22 5. Assessment This is a turning point for the world economy –We have reached the end of the US as borrower and spender of last resort; –We have reached the end of the Asian export-led mercantilist model of growth. The reduction in internal imbalances depends on reducing the external imbalances, while maintaining global economic growth This depends on big changes in the rest of the world and reforms in the global financial system