Journal of Policy Modeling 29 (2007) 783796
Global imbalances and financial stability
Miranda Xafa Executive Board, International Monetary Fund, Washington, D.C. 20431, USA
Available online 3 June 2007
There are two opposing views on global imbalances: The traditional view, which regards the imbalancesas a threat to global economic and financial stability, and the new paradigm view, which considers that theyare the natural consequence of economic and financial globalization. In terms of their policy implications, thetraditional view focuses on monetary and fiscal policy decisions in the United States that need to be urgentlyreversed to avoid an abrupt unwinding of the imbalances involving a sell-off of dollar assets, a sharp increasein U.S. interest rates, and a hard landing for the global economy. By contrast, the new paradigm viewconsiders that the imbalances will be resolved smoothly through the normal functioning of markets. Thispaper argues that an abrupt unwinding of imbalances is highly unlikely and advances a number of argumentsin support of the new paradigm view. 2007 Published by Elsevier Inc. on behalf of Society for Policy Modeling.
JEL classication: F02; F21; F36; F4Keywords: Global imbalances; Financial stability; Traditional view; Real-side models; Portfolio balance models; Newparadigm
The U.S. current account deficit has grown steadily since the early 1990s to the historicallyunprecedented level of US$ 857 billion (6.5% of GDP) in 2006 (Fig. 1). Much attention hasfocused on the causes and sustainability of the global imbalances a euphemism for the largeU.S. deficit and on the appropriate policy response. Observers are divided in two camps: thosewho think that this is a dangerous situation which poses serious risks for global economic andfinancial stability [Obstfeld & Rogoff, 2000, 2004; Roubini & Setser, 2004], and those who believeit is a natural by-product of real and financial globalization [Caballero, Farhi, & Gourinchas, 2006;
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0161-8938/$ see front matter 2007 Published by Elsevier Inc. on behalf of Society for Policy Modeling.doi:10.1016/j.jpolmod.2007.06.012
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Fig. 1. Current account deficit and real effective exchange rate of the dollar (March 1973 = 100). Sources: Federal Reserveand Bureau of Economic Analysis.
Dooley, Folkerts-Landau, & Garber, 2003, 2004; Gave, Kaletsky, & Gave, 2005]. At the risk ofoversimplifying, in what follows I refer to the first view as the traditional view and to thesecond as the new paradigm view. The traditional view regards the imbalances as a temporaryaberration that needs to be urgently addressed through policy action, while the new paradigmview considers that they are the result of structural changes in the global economy whose impactwill be felt for years or even decades.
2. The traditional view
The traditional view focuses on the decline in the U.S. national saving rate since the beginningof this decade, reflecting the swing from fiscal surplus to deficit and the decline in householdsavingsthe result of asset bubbles in the equity and housing markets. In this view, the wideningof the U.S. current account deficit is the result of fiscal and monetary policy decisions in theUnited States that need to be urgently reversed to avoid a possible loss of market confidence. Asudden stop of capital flows to the United States would trigger an adjustment process involvinga massive sell-off of dollar assets, a sharp increase in U.S. interest rates and a hard landing ofthe U.S. and global economy. To avoid the possibility of such an abrupt unwinding of imbalances,policymakers have called for joint action to rebalance demand across regions, with the UnitedStates reducing its fiscal deficit, the European Union implementing growth-enhancing structuralreforms and Asian countries boosting domestic demand and letting their currencies appreciate(IMFC Communique, September 17, 2006). Multilateral consultations involving the main players(U.S., EU, Japan, China and Saudi Arabia), launched by the IMF in the spring of 2006, wereaimed at discussing the policies needed to rebalance demand while maintaining robust globalgrowth. These consultations resulted in a joint communique in April 20071 spelling out the policycommitments of the countries/regions involved. Market reaction to the joint communique wasmuted, presumably because the announced policy commitments represented old news.
Far from being deterred by the absence of joint policy action during 20002006, foreigninvestors displayed an ever-growing appetite for U.S. securities (Fig. 2). By 2006, net foreign
1 IMF Press Release 07/72, April 14, 2007.
M. Xafa / Journal of Policy Modeling 29 (2007) 783796 785
Fig. 2. U.S. current account deficit and net foreign purchases of U.S. securities (US$ billion). Sources: U.S. Treasury TICdata and Bureau of Economic Analysis.
purchases of U.S. securities had reached US$ 1142 billion, of which US$ 956 billion were fromprivate investors and only US$ 185 billion from official sources.2 Subtracting net U.S. purchasesof foreign securities of US$ 249 billion, the net inflow of US$ 893 billion still exceeded therecord-high current account deficit of US$ 857 billion.
A puzzling aspect of the imbalances is that the counterpart of the growing U.S. current accountdeficit is no longer surpluses mainly in Germany and Japan, as was the case a decade ago, butalso in the emerging market countries as a group, whose external position shifted from a deficitof US$ 74 billion in 1996 to a surplus estimated at US$ 587 billion in 2006 (or from a US$ 63billion deficit to US$ 305 billion surplus excluding the oil-producing Middle East). The shift ofemerging market countries to a surplus position goes against the textbook view that they shouldbe capital importers.
Another puzzling fact surrounding the imbalances is that global long-term interest rates, bothnominal and real, are well below their historical norms at this stage of the business cycle, and theyhave hardly risen following the tightening of U.S. and global liquidity conditions since mid-2004(Fig. 3). This fact, known as Greenspans conundrum, has helped limit the cost of servicingU.S. external debt.
The low U.S. savings view is not convincing for a number of reasons. First, it is incompatiblewith the observed low nominal and real interest rates at this stage of the cycle, after consider-able tightening by major central banks. Second, it cannot explain the fact that the U.S. currentaccount deficit started rising during the 1990sa period during which the U.S. fiscal deficitdeclined sharply and swung into surplus. Third, there are reasons to believe that U.S. savings areunderstated. Cooper (2005) notes that U.S. national accounts (NIA) data underestimate savingsby excluding purchases of consumer durables and expenditure on education and R&D from thedefinition of savings. Taken together, these categories amounted to 19% of GDP in recent years.I would add that NIA data also exclude capital gains (e.g. on housing and financial investments)
2 The U.S. Treasury International Capital data (TIC) record transactions based on the location of the transactor ratherthan the ultimate investor, and may therefore underestimate official transactions booked through brokers in financialcenters.
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Fig. 3. U.S. 10-year Treasury yield and fed funds rate (%). Sources: Federal Reserve and Bloomberg.
from the definition of savings, although they, too, potentially raise future consumption. At aminimum, low U.S. savings alone cannot explain the imbalances.
Other theories, focusing on developments outside the United States or previously neglectedbenign factors, take a more sanguine view. These theories, reviewed in an earlier paper (Xafa,2007) and briefly summarized below, have important implications for the sustainability of theU.S. external deficit. Together with the portfolio balance models and asset shortages dis-cussed below, they should be viewed as complementary to, rather than competing with, the newparadigm view.
(a) The Global Savings Glut view, first advanced by Bernanke (2005), points to a combinationof factors that have encouraged savings outside of the United States. These include the agingof populations in Europe and Asia and the associated need for precautionary savings, a lackof investment opportunities in Asia as it recovers from the 19971998 crisis, and the rise inoil prices and related rise in the current account surpluses of oil exporters. According to thisview, we just have to be patient until the factors that attracted global savings to the UnitedStates unwind.
(b) The Revived BrettonWoods view (Dooley et al., 2003, 2004) explains the paradox of savingsflowing from developing countries to the United States, as well as the low global interest rates,through the export-led strategy pursued by Asian countries. This strategy requires keeping theexchange rate undervalued by resisting appreciation in order to channel domestic and foreigndirect investment to the export industries. The result is persistent current account surpluses andreserve accumulation by Asian central banks, thus generating Bernankes global savings glutand keeping interest rates low.3 In this view, Asian countries with underdeveloped financialsystems are better off exporting their savings to the United States by buying U.S. bonds, andre-importing some of these savings in the form of FDI. The accumulation of dollar assetsby Asian central banks is effectively used as collateral for FDI. Contrary to co