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had ended, not the rise in global saving that occurred later in the 2000s, is a more 15

plausible explanation of the general level of low real interest rates at the decade’s start.

The fall in long-term interest rates brought down mortgage rates in the U.S. (and

elsewhere in the world), with powerful effects on real estate markets. Home prices had 16

been rising steadily in the U.S. since the middle 1990s; they began to rise more rapidly.

Given the wide extent of homeownership in the U.S. and the relative ease, compared to

other countries, of borrowing against housing equity, faster home appreciation reduced

saving sharply and had an especially strong effect on the U.S. deficit, as argued by

Bernanke. In most emerging markets, with much less developed financial markets, tighter

borrowing constraints, and more restricted asset ownership, we would expect such asset-

price effects on saving to be much weaker. For surplus countries, moreover, the

conventional substitution effect on saving of lower world real interest rates was largely

offset by an intertemporal terms of trade effect. But in the U.S. these effects reinforced

each other (Obstfeld and Rogoff 1996). Residential investment rose along with real

estate prices, adding a further impetus to deficits in countries with housing price booms.

While global factors have clearly been important for long-term real interest rates,

short-term nominal interest rates are controlled by central banks. In the United States, the

Federal Reserve had been allowing the federal funds rate to rise since early 2000,

reaching a target rate of 6.5 percent in May of that year (see Figure 8). Perceiving rapidly

accelerating weakness in the economy after the high-tech collapse, the FOMC initiated a

loosening cycle after a telephone conference on January 3, 2001. The FOMC cut the

15 Even before the high-tech bust, the Asian crisis had created conditions that contributed to a long-lasting

fall in investment in the crisis countries (for example, see Coulibaly and Millar 2008). This investment

decline contributed to current-account surpluses (“excess” savings) for those countries.

16 Figure 7 shows the Case-Shiller ten-city index. 14

federal funds rate by 50 basis points immediately and then cut by a further 50 basis points

at its next regularly scheduled meeting four weeks later. By the end of August 2001 the

target rate stood at 3.5 percent. Further sharp cuts followed the 9/11 attacks, however,

and at the end of 2001 the rate stood at 1.75 percent. The rate was reduced further

through 2002 and 2003, finally reaching a level of only 1 percent in June 2003. As argued

by the Bank for International Settlements (2009, p. 6), the dollar’s vehicle-currency role

in the world economy makes it plausible that U.S. monetary ease had an effect on global

credit conditions more than proportionate to the U.S. economy’s size.

In early 2003 concern over economic uncertainties related to the Iraq war played a

dominant role in the FOMC’s thinking, whereas in August, the FOMC stated for the first

time that “the risk of inflation becoming undesirably low is likely to be the predominant

concern for the foreseeable future. In these circumstances, the Committee believes that

17 Deflation was

policy accommodation can be maintained for a considerable period.”

viewed as a real threat, especially in view of Japan’s concurrent struggle with actual

deflation, and the Fed intended to fight it by promising to maintain interest rates at low

levels over a long period. The Fed did not increase its target rate until nearly a year later.

Other major central banks were also cutting their policy rates during the 2001-03 period,

although not as sharply as the Fed did (Figure 8). The Bank of Japan (not included in

Figure 8) had been following a zero interest rate policy since February 1999, with only a

brief (but somewhat disastrous) interruption, and it reaffirmed that policy in March 2001.

As Figure 7 makes clear, another U.S. stock market boom had started by the spring of

2003.

17 See Federal Reserve System (2003). 15

Coupled with low long-term real interest rates, the accommodative stance of

monetary policy, particularly U.S. monetary policy, played a key role in the expansion of

both housing-market excesses and the global imbalances starting in 2004. Among other

critics of the Fed, John B. Taylor (2009) has argued than the central bank adopted an

18

overly accommodative stance starting in 2001 and maintained it for much too long.

That policy accommodation, according to him, helped propel house prices and residential

19

investment upward. Of course, as we document later, many countries outside the U.S.

likewise experienced rapid housing appreciation during the 2000s, typically accompanied

by growing current account deficits. Many (but not all) of these countries were running

relatively loose monetary policies, policies seemingly justified by the absence of an

imminent inflation threat. We agree with Taylor that U.S. monetary ease was important in

promoting the U.S. deficit and setting the stage for the crisis. We argue below, however,

that the interaction among the Fed’s monetary stance, global real interest rates,

credit market distortions, and financial innovation created the toxic mix of conditions

making the U.S. the epicenter of the global financial crisis. Given the regulatory

weaknesses outside the U.S. and competitive pressures in the banking industry, financial

globalization ensured that the crisis quickly spread abroad, even to some countries with

current account surpluses.

18 Taylor’s critique is based on departures of actual Fed policy from historical Taylor rules consistent with

macro stability before the 2000s. Other dissenters, such as Borio and White (2004), argued in real time that

monetary policy could not adequately safeguard financial (and therefore macroeconomic) stability by

focusing only on the narrow set of macro variables included in the simple Taylor rule. Instead, they argued,

a broader view of the economic landscape, including asset prices and credit flows, should inform monetary

policy. 16

Global Imbalances: 2004 through 2008

During 2004 the global economic landscape evolved in a number of respects as global

imbalances generally widened under the pressure of continuing increases in housing and

equity prices. Three key interlocking causes of the widening were related to China’s

external position and exchange rate policies; the escalation of global commodity prices;

and an acceleration of financial innovation in the U.S. and in European banks’ demand

for U.S. structured financial products.

The ways in which these seemingly unrelated developments might interact were

certainly far from obvious at the time, yet by 2004 some policymakers were becoming

nervous about the ongoing effects of low policy interest rates, with inflation as well as

financial instability viewed as potential threats down the road. The minutes of the

FOMC’s March 2004 meeting stated that:

Some members, while supporting an unchanged policy at this meeting,

nonetheless emphasized that the maintenance of a very accommodative monetary

policy over an extended period in concert with a stimulative fiscal policy called

for careful attention to the possible emergence of inflationary pressures. And,

while adjustments in financial markets to low rates had generally been consistent

with the usual operation of the monetary transmission mechanism, some members

were concerned that keeping monetary policy stimulative for so long might be

encouraging increased leverage and excessive risk-taking. Such developments

could heighten the potential for the emergence of financial and economic

20

instability when policy tightening proved necessary in the future.

Perceiving increasing upward pressure on prices, the FOMC embarked on a tightening

cycle at the end of June 2004, initially raising the target federal funds rate from 1 to 1 ¼

19 Ahearne et al. (2005) present cross-country evidence on the effect of monetary ease on housing prices. A

more recent study is by Iossifov, Čihák, and Shanghavi (2008). See also the discussion in Mishkin (2008).

20 Federal Open Market Committee (2004). 17

percent. By November 2004 the target stood at 2 percent; from there it would rise (in a

sequence of small moves) to a peak of 5 ¼ percent by July 2006 (see Figure 8).

The ECB also perceived risks. Late in 2004 Jean-Claude Trichet noted that:

The shorter-term dynamics of M3 growth have strengthened over recent months.

This seems very much related to the low level of interest rates in the euro area.

This very low level of interest rates also fuels private sector demand for credit. In

particular, the demand for loans for house purchases is strong, supported by

strong house price dynamics in several euro area countries. The growth in loans to

non-financial corporations has also picked up over recent months.

As a result of the persistently strong growth in M3 over the past few years, there

remains substantially more liquidity in the euro area than is needed to finance

non-inflationary growth. This could pose risks to price stability over the medium

term. In addition, persistently high excess liquidity and strong credit growth could

also become a source of unsustainable asset price increases, particularly in

21

property markets. Such developments need to be monitored carefully.

Yet the ECB maintained its own policy rate unchanged at 2 percent for another year. The

22

rate would slowly rise to 4 ¼ percent by July 2007 (Figure 8).

In retrospect a number of interrelated macroeconomic developments were in train

in different parts of the world even as the most two powerful central banks gingerly

backed away from their highly accommodative stances.

One set of major repercussions on the global equilibrium emanated from China.

China’s real GDP growth had accelerated since the Asian crisis, averaging slightly above

10 percent per year over the 2003-05 period, then jumping to 11.6 percent in 2006 and 13

percent in 2007. Accompanying this more rapid growth was a sharply growing external

surplus – China’s current account surplus jumped from 3.6 percent of GDP in 2004 to 7.2

21 Trichet (2004). 18

percent in 2005, and had risen to a staggering 11 percent of GDP by 2007. As of 2004,

moreover, Chinese authorities were intervening to maintain a rigid peg of the renminbi

against the U.S. dollar. China’s export success – in the mid-2000s it was on track to

overtake Germany as the world’s premier exporter – fueled both the country’s rapid

growth rate and strong protectionist sentiment in destination markets.

Perhaps even more remarkable than China’s trade surplus was the huge size of the

underlying saving and investment flows that generated it. China’s gross investment rate

grew inexorably during the 2000s, reaching over 45 percent at the time of the crisis. But

its saving rate grew even faster. Whereas in earlier years, China’s high saving had been

fueled by the household sector (due to a mix of financial repression and a weak social

safety net), during the 2000s, the booming Chinese corporate sector accounted for close

23

to half of overall Chinese saving.

The years since the late 1990s had seen China’s accession to the World Trade

Organization as well as a major reorientation of trade within Asia, with China becoming

a major re-export center. In particular, many Japanese exports that had previously flowed

directly to the United States, making Japan the leading target for U.S. trade pressure

through the mid-1990s at least, now flowed to China for re-export to the U.S. Along with

China’s overall current account surplus, its bilateral surplus with the United States (and

slightly later, its surplus with the European Union) rose sharply as well in the early

2000s; see Figure 9. With an election looming in 2004, sentiment to label China as a

“currency manipulator” intensified in the U.S. Congress, culminating in the real threat of

22 The Bank of Japan did not begin to tighten until well after the Fed and the ECB. In July 2006 the BOJ

raised its target overnight lending rate from zero to 25 basis points. In February 2007 the BOJ raised the

rate to 50 basis points.

23 See Goldstein and Lardy (2008). 19

punitive trade legislation in 2005. China gained a temporary reprieve by slightly

revaluing the renminbi in July 2005 and embarking on a gradual appreciation process

against the dollar that lasted until the summer of 2008.

An undervalued renminbi peg subject to external political pressure attracted a

torrent of hot money, despite the Chinese government’s efforts to exclude financial

inflows and encourage outflows. These trades were especially attractive to speculators

because U.S. and European interest rates remained relatively low. Normally such a

process would spark inflation as in Germany and other U.S. trade partners at the end of

the Bretton Woods period, leading to real currency appreciation. Through aggressive

sterilization and other measures, however, China restrained inflation as well as the

consumption boom that would have driven prices higher. Output grew at an increasing

rate, as did the country’s current account surplus and its holdings of international reserves

(Figure 5). Of course, a number of other emerging markets intervened to discourage real

appreciation against the dollar, all the while accumulating reserves and battling the

resulting upward pressure on prices (see Figure 3).

Had the natural “Humean” international adjustment process been allowed to

function earlier on, rather than a combination of undervaluation and expenditure

compression policies, the dollar would have been weaker in real effective terms, there

would have been more upward pressure on world real interest rates, and the U.S. external

deficit would likely have been smaller. The Federal Reserve and ECB might have been

induced to raise interest rates earlier and more sharply.

The policies and performance of China and some other emerging markets were

not alone in adding to the world supply of excess savings. Commodity exporters were

20

another important source. Under the influence of monetary accommodation, low real

interest rates, and the emerging (and indeed advanced) world’s accelerating economic

growth, commodity prices, notably the price of oil, began to rise at an accelerating price

(see Figure 10 for real GDP growth rates and Figure 2 for commodity prices). An

immediate effect, familiar from past episodes of commodity-price boom, was a big

24

increase in the current account surpluses of commodity exporters. Figure 1 shows the

growing external surpluses of the Middle East and other developing commodity exporters

25

– as well as China’s growing surplus – starting in 2004.

Other countries had to absorb these flows of excess savings. What increased

deficits in the world economy corresponded to the higher surpluses of China and the

commodity exporters? As Figure 1 also shows, the overall surplus of advanced countries

other than the United States, which had been rising quickly prior to 2004, peaked in that

year and then declined. The deficit of the United States continued to rise through 2006.

As a result, the overall deficit of the advanced countries rose dramatically after 2004,

with Eastern Europe’s deficits adding to the total world demand for excess savings. In

part this increased deficit reflected the higher cost of commodity imports, but as we argue

below, that was only part of the story.

24 On the link between monetary policy and commodity prices, see Frankel (2008). Caballero, Farhi, and

Gourinchas (2008b) model the effect of a commodity boom on global net capital flows.

25 The events leading to the developing country debt crisis of the 1980s provide an instructive parallel with

recent financial history. Then, inflationary monetary polices helped to create an oil price boom resulting in

big oil exporter surpluses. The surpluses were recycled to “subprime” developing country borrowers

through money-center banks in the industrial countries. Because loan contracts featured adjustable dollar

interest rates, the Volcker disinflation led to repayment problems severe and widespread enough to

endanger the capital of the lending banks, Although a number of economic analysts argued prior to the

early 1980s that the sizable developing-country borrowings were justified by growth prospects, that episode

of global imbalances also ended in tears – especially for the developing borrowers, who lost many years of

growth. 21

IMF data on the global saving rate show overall world saving to be increasing

over this period. World gross saving averaged 22.6 percent of global output in 1987-94

and 22.0 percent in 1995-2002. But from 2003 through 2007 the annual numbers rise

steadily from 20.9 percent to 24.4 per cent. Evidently, increased saving by commodity

exporters and developing Asia outweighed decreased saving elsewhere in the world

economy.

This increase in world saving may help explain why long-term global real interest

rates remained relatively low (Figure 6), as did nominal long-term rates (Figure 11),

despite a shift toward monetary tightening in industrial countries starting in 2004 (Figure

8). Of course, world saving and investment must be equal in principle, but an

interpretation of the data as being driven by an exogenous increase in investment demand

seems inconsistent with the failure of long-term real interest rates to rise to anywhere

26

near late 1990s levels in the middle 2000s.

We emphasize that this increase in global saving starting in 2004 plays out largely

after the period Bernanke (2005) discussed in his “saving glut” speech, and arguably was

triggered by factors including low policy interest rates. In our view, the dot-com crash

along with its effects on investment demand, coupled with the resulting extended period

of monetary ease, led to the low long-term real interest rates at the start of the 2000s.

However, monetary ease itself helped set off the rise in world saving and the expanding

global imbalances that emerged later in the decade. Indeed, it is only around 2004 that the

26 A curious and so far unresolved aspect of the saving and investment data is the huge positive statistical

discrepancy that emerged between 2003 and 2008. The more customary “world current account deficit”

disappeared after 2002 and by 2007 and 2008, measured world saving exceeded measured world

investment by amounts in excess of $300 billion. There is a “mystery of the missing deficit.”

22

idea of a global saving glut (as opposed to a global dearth of investment) becomes most

plausible.

A further factor contributing to lower interest rates in the United States in

particular was the rapid pace of dollar reserve accumulation by emerging and developing

countries, which also accelerated in 2004 (Figure 4). Estimates by Krishnamurthy and

Vissing-Jorgensen (2008) and Warnock and Warnock (2009) suggest that official foreign

demand for U.S. government debt depressed Treasury yields by at least 50 basis points.

Partial-equilibrium estimates, however, almost certainly overstate the general-equilibrium

yield effects of diversification out of dollars by official reserve holders. While the true

magnitude is probably secondary to the effects of global saving flows and monetary

policy, reserve accumulation nonetheless probably contributed something to the

compression of yields in U.S. financial markets.

In principle, a country with a currency peg and running a current-account surplus

27 In other words, it

need not simultaneously have a surplus in its balance of payments.

need not be building up foreign exchange reserves. Indeed, the flow of net purchases of

claims on rich countries by developing-country residents expanded dramatically over the

2000s up until the crisis; and if the capital account is open to financial outflows, the

central bank can reduce its reserves at a given exchange rate by purchasing domestic

assets. In practice for emerging markets, financial outflows are not completely

frictionless, but it also seems clear that in many cases countries purposefully accumulated

28 Emerging market

reserves as a precaution against internal or external financial crises.

borrowing spreads fell to very low levels in the mid-2000s as investors in richer countries

27 Conversely, a country can accumulate reserves even if its current account is in deficit.

28 See Obstfeld, Shambaugh, and Taylor (2010). 23

searched for higher yields, and the resulting financial inflows, resulting from

interventions meant to slow appreciation against the dollar, led to further increases in

foreign exchange reserves. Higher reserve war chests contributed to the perception of

increased safety.

China, with a relatively restricted capital account and a tightly managed (albeit

adjustable) exchange rate peg, had less flexibility than countries with better developed

and more open financial markets to put a brake on reserve acquisition. It also was (and

remains) the largest buyer of dollar reserves. Although the Chinese authorities undertook

opportunistic financial outflow liberalizations in an attempt to reduce balance of

payments pressures, the combination of a growing current account surplus, strong inward

FDI, and hot money inflows in response to expected appreciation spelled massive growth

29

in foreign exchange reserves, as we have noted.

Holding the bulk of reserves in dollars rather than, say, euros was a matter of pure

choice, however, motivated by the liquidity of U.S. bond markets and the dollar’s

dominant vehicle-currency position in world trade and finance. A country pegging its

currency to the dollar need not hold dollar reserves at all, as it can maintain an unchanged

domestic monetary stance while selling any dollars it acquires for a nondollar foreign

currency. Most official emerging-market reserve holdings were held in dollars

nonetheless.

Within the group of advanced countries, as noted above, the two current-account

developments that stand out starting in 2004 are the sharp increase in the U.S. external

deficit and a halt in the earlier trend of increasing surpluses for the aggregate of other

advanced economies, including the euro zone. Fueling the higher overall deficit of the

24

advanced-country group was (along with higher commodity import prices) equity-market

appreciation and, more powerfully, an acceleration in real estate appreciation and real

30 The euro zone itself, wherein the ECB set a single interest rate for a

estate investment.

diverse set of national economies, presented a microcosm of the divergence in current

account positions concurrently taking place on a global scale. Starting in 2004, the

German external surplus rose sharply, but was offset by increasing deficits for a number

of other member countries such as Italy, Greece, and especially, Spain (Figure 12).

In the United States, low interest rates fed into a powerful multiplier mechanism

based on unrealistic expectations, asset-market distortions, and agency problems, notably

in markets for housing finance. The resulting asset appreciation, especially housing

appreciation, was a major driver of high consumer spending and borrowing. Home prices

in the U.S. had been rising steadily for nearly a decade. Starting in March 1997, the Case-

Shiller 10-city home price index declined in only two months before July 2006 – in

November 1998 and December 2001, and in those cases by very small amounts. Thus,

neither the Asian crisis and its aftermath nor the dot-com crash and ensuing recession did

much to dent the upward trend in U.S. home prices.

Entrenched expectations of housing appreciation interacted with low interest rates

and financial innovation to push home prices up even more rapidly after 2003. The stock

of mortgage debt expanded rapidly, as did residential investment, while at the same time,

mortgage quality in the U.S. deteriorated. Figure 13 shows how subprime and nonprime

mortgage originations more generally jumped up in 2004. At the same time, the share of

29 For a useful chronology and discussion, see Lane and Schmukler (2007).

25

subprime originations being securitized increased until it reached over 80 percent in 2005

and 2006. In the low interest rate environment, the share of adjustable-rate mortgages

(ARMs) also rose. As has often been noted, these loans were designed to refinance or

default when the interest rate reset, but in many cases the refinance contingency was

predicated on the assumption that home prices would not fall. Figure 14 shows the rapid

growth of residential investment and mortgage debt outstanding (both expressed as shares

of GDP, with the mortgage debt series covering commercial as well as family-owned

properties). U.S. home prices rose at double-digit rates in 2004 and 2005, while the stock

of mortgage debt pulled even with total annual U.S. GDP in 2006.

Low nominal short-term U.S. interest rates, and the expectation that rates would

rise only at a measured pace, encouraged the proliferation of ARMs. At the same time,

low nominal rates and the low-inflation environment, in and of themselves, eased credit

constraints. At higher inflation rates, the monthly nominal interest payment in part

reflects real amortization of the loan, which places an additional strain on the borrower’s

cash flow. Of course, the evidence indicates that mortgage-lending standards in the U.S.

deteriorated far beyond what any prudent assessment of borrowers’ repayment prospects

would suggest.

As many commentators have noted, the process was fed by wider financial

innovation that repackaged mortgages (as well as other forms of debt, including

consumer debt) into structured products endowed with very high levels of systemic risk –

what Coval, Jurek, and Stafford (2009) have aptly labeled as “economic catastrophe

bonds.” These products began to proliferate in the mid-2000s. For example, CDO

30 Mishkin (2008) surveys evidence on the impact of housing wealth on consumption. In subsequent work,

Greenspan and Kennedy (2007) document the strong link between home equity extraction in the U.S. and

26

issuance started to rise markedly in 2004, as indicated by figure 10.2 in Acharya et al.

(2009, p. 238); or see figure 3 in Blundell-Wignall and Atkinson (2008). Rajan (2006)

suggests mechanisms through which low interest rates might promote such financial

innovation, as well as more risk taking. Hoping to reduce their required regulatory capital

under the Basel II framework, European banks eagerly acquired AAA-rated (but

31

systemically risky and opaque) structured products.

Such regulatory arbitrage was one factor underlying the sharp increase in gross

industrial-country external assets and liabilities documented by Lane and Milesi-Ferretti

(2007) for the 2000s; see Figure 15, which shows some of their updated data series. In

many cases, for example, European banks funded their dollar positions in U.S. structured

products with dollars obtained through repo deals with U.S. money market mutual

32 Such socially unproductive gross flows into (and out of) the U.S. could of course

funds.

have taken place even if the U.S. current account had been in surplus at the time.

The role of the U.S. net external deficit, in our view, was to enable a constellation

of interest rates and asset prices consistent with apparently low inflation but

simultaneously conducive to housing appreciation, lax mortgage lending practices,

overall credit expansion, and strong incentives toward high leverage and regulatory

33 These market dynamics created a vicious circle in which the expectation of

arbitrage.

ongoing housing appreciation fed mortgage credit expansion, which in turn pushed

consumption in the 2000s.

31 Acharya and Schnabl (2009). See also Blundell-Wignall and Atkinson (2008, p. 64), who suggest that

“about one-third of the securitised sub-prime related products were sold to offshore investors.”

32 See Baba et al. (2009).

33 Asset swapping leading to gross flows may be motivated by many factors beside regulatory arbitrage, of

course, ranging from risk-sharing opportunities to differences in risk aversion. The U.S. external portfolio

as a whole has tended to be short on (dollar) bonds and long on foreign equities (and currencies), with

foreign official holdings of dollar reserves comprising one important component of U.S. foreign liabilities.

27

housing prices higher (Mian and Sufi 2008). All the while, the U.S. current account

deficit widened.

Housing appreciation was not limited to the United States, of course, though it

was mainly financial innovators in the U.S. who built an inverted pyramid of leverage on

the narrow fulcrum of ongoing domestic home-price appreciation. Over the 2000s, real

estate prices rose even more rapidly in some European Union countries, in Eastern

Europe, and elsewhere than in the United States. But the trend was not universal – house

prices in Germany did not rise, while land prices in Japan fell in real terms. Certainly the

high level of global liquidity, including the possibly global reach of U.S. monetary ease,

contributed to the worldwide upward pressure on housing. An intriguing regularity is the

negative unconditional correlation between current account surpluses and housing

appreciation, illustrated in Figure 16 for a sample of 43 mature and emerging countries.

The figure plots the change in the ratio of the current account to GDP over 2000-2006

34 There is a clear

against cumulative real housing appreciation over the same period.

negative relationship, in which greater appreciation is associated with bigger deficit 35

increases. Figure 17 shows the same relationship for the advanced-country subsample.

The negative relationship in the figures likely reflects two-way causality. Housing

appreciation fuels increased borrowing from abroad in several ways, whereas increased

availability of foreign funds could ease domestic borrowing terms and encourage housing

Caballero and Krishnamurthy (2009) present a model of how foreign demand for safe U.S. assets may have

led to low risk-free rates, asset appreciation, and financial fragility.

34 The basic data come from Aizenman and Jinjarak (2009), though we have added to their sample Iceland

and removed two countries with rather special circumstances, Russia and Serbia. The negative correlation

survives the addition of Russia and Serbia, but it is somewhat attenuated. Figures 14 and 15 are inspired by

chart 5 in European Central Bank (2007), which covers an advanced-country sample over 1995-2005. We

are grateful to Joshua Aizenman for sharing these data.

35 Of course, there is a long historical association between housing booms, current account deficits, and

financial crises; see Reinhart and Rogoff (2009). 28

appreciation. In addition, the bivariate plots are silent on the influence of third variables.

Aizenman and Jinjarak (2009) regress real estate prices on the lagged current account and

other control variables, including financial depth, the real interest rate, and urban

population growth. Their baseline estimate suggests that a one percent of GDP increase in

36

the current account deficit is associated with a 10 percent increase in real estate prices.

In many countries, easy lending conditions, including an influx of finance from foreign

banks, helped to fuel housing booms. Similar capital inflow and real estate dynamics

37

helped set the stage for the 1997-98 Asian crisis.

As the U.S. external deficit swelled after 2004, the Fed gradually raised the funds

rate, as noted above. That rate peaked in the summer of 2006 (by which time ECB and

Bank of England policy rates were also on the rise; see Figure 8). The U.S. long-term real

interest rate had also risen to a peak by then, and real long-term rates began to rise in

some other industrial countries (Figure 6). According to Federal Reserve data, the rate on

thirty-year, fixed-rate, conventional mortgages, having bottomed at 5.23 percent in June

2003, hit 6.76 percent in July 2006. United States housing appreciation stopped in late

2005 and 2006 and went mildly into reverse, although the stock market continued upward

(Figure 6). Around this time 2/28 and 3/27 ARMs were resetting at sharply higher

interest rates than when they were issued, straining or exceeding the payment capacities

of many who had signed mortgage contracts two or three years before. Mayer et al.

36 See also the regression evidence in Jagannathan, Kapoor, and Schaumberg (2009). Fratzscher, Juvenal,

and Sarno (2009) use a Bayesian VAR methodology to show that positive home and equity price

innovations, especially the former, have large negative effects on the U.S. trade balance. For other VAR

evidence documenting the importance of housing, see Punzi (2007) and Gete (2009). Gete (2009) also

documents the strong cross-sectional relationship between housing booms and external deficits. In their

cross-country study, Iossifov, Čihák, and Shanghavi (2008) find only a marginally significant correlation of

home prices with the current account in equations that also control for the policy interest rate.

37 See, for example, Edison, Luangaram, and Miller (2000), Quigley (2001), and Koh et al. (2005).

29

(2009) document how, starting in 2006, the share of nonprime housing loans with

negative equity shot up, first in the Midwest, and then, much more rapidly, in California,

Florida, Arizona, and Nevada. The stage was set for the more general financial crisis that

finally erupted in August 2007.

Global Imbalances in 2009 and Beyond

As we predicted in our earlier work, the decline in U.S. housing prices starting in

2006 set off a process of current account adjustment for the United States. In some

respects, though, the process has been quite different from what we foresaw. Most

notably, the dollar’s foreign exchange value, while quite volatile since August 2007, has

not collapsed. Financial instability spread globally from the United States, not due to the

large and abrupt exchange rate movement that we feared, but because of international

financial linkages among highly leveraged institutions as well as the global nature of the

housing bust. The fragility of the international financial system was not well appreciated

before the crisis. The magnitude of global imbalances up to 2008 both reflected that

underlying fragility and allowed the system to become ever more fragile over time.

Figure 18 shows quarterly data on the U.S. current account balance, expressed as

a percentage of GDP at an annual rate. Although the deficit has been on a declining trend

since late in 2006, the decline in recent quarters is particularly dramatic. The IMF

forecast as of October 2009 was that the U.S. external deficit would average somewhat

below 3 percent of GDP over the following half-decade or so, less than half its value in

2005-06. This is a very significant adjustment. Nonetheless, that balance may well grow

over time if U.S. monetary and fiscal policies remain accommodative. Indeed, as the U.S.

30

public debt/GDP ratio grows, it will become more difficult for the Fed to raise interest

rates without creating significant additional fiscal tensions.

Figure 1 gives a sense of the global reconfiguration of global imbalances,

measured in dollars (2009 figures are IMF forecasts). Alongside the sharply reduced

deficit of the United States, the surpluses of the other advanced countries and of the oil-

exporting CIS and Middle East have fallen dramatically. Newly industrialized Asia has

maintained its surplus while that of developing Asia (largely due to China) has continued

upward.

Reduction of a current-account deficit always entails a medium-term real currency

depreciation (while appreciation is needed when a surplus falls). The required

compression of relative domestic demand compared to relative domestic supply implies a

fall in the relative price of domestic nontraded goods, as well as a terms of trade

deterioration that lowers the relative price of domestic tradables consumed intensively at

home. This reasoning led us, in our earlier work on the U.S. current account, to predict

significant real dollar depreciation (in some simulations, 30 percent or more) as a result

of a disappearing U.S. deficit.

Figure 20 illustrates the dollar’s evolution in real multilateral terms since the start

of 1995. Over brief spans of time, exchange rates can be moved far away from long-term

equilibria by developments in financial markets, such as changes in policy interest rates,

expectations shifts, fluctuations in risk aversion, safe haven effects, and credit-market

disruptions. Each of these short-term factors has played a role in recent years. To

illustrate the forces at work, Table 1 reports numerical changes in the dollar’s real

31

exchange rate over different subperiods. (Changes are expressed in log points so as to be

additive over time.)

The large U.S. deficit’s emergence starting in the latter 1990s we marked by

strong real dollar appreciation of more than 20 percent. Appreciation was propelled by

booming investment, the Asian crisis, and the growing perception of a “Great

Moderation.” Under the pressure of very loose U.S. monetary policy after the dot-com

Table 1: Movements in the Real Dollar Exchange Rate

Period Percent change

20.3

January 1995 - February 2002 -16.2

February 2002-January 2007

January 2007-April 2008 -11.5

April 2008-March 2009 16.4

-10.8

March 2009-October 2009

crash and 9/11, however, the dollar depreciated by more than 16 percent from early 2002

through the start of 2007, with a significant (but temporary) reversal over 2005 as the Fed

tightened. Through 2006, however, the U.S. current account deficit only widened as

imports outstripped exports.

As the U.S. housing boom stopped and went into reverse, and as the external

deficit began slowly to shrink, the dollar plummeted, falling by better than 11 percent

between January 2007 and April 2008. But with the intensification of perceived financial

32

instability in the spring of 2008, the dollar began to rise again, benefiting from a safe

haven effect in the presence of a financial crisis that was truly global in scope rather than

U.S.-specific. A second factor pushing the dollar up was a global shortage of short-term

38

dollar funding for foreign banks’ long positions in illiquid (often toxic) U.S. assets.

These factors helped produce a 16 percent real dollar appreciation between April 2008

and March 2009, deepening the onset of the recession in the U.S.

Since the spring of 2009, the dollar has resumed its descent, leaving its real

exchange rate currently about 6 percent below its level of January 2007, shortly after the

process of current account adjustment began. The dollar is likely to depreciate quite a bit

further as adjustment proceeds, although the process will be slower to the extent that

major U.S. trading partners, notably China, resist the appreciation of their own

currencies.

Are today’s somewhat compressed external imbalances still a problem? Perhaps

one could hope that the current pattern is sustainable and will require little further

adjustment. A number of considerations suggest, however, that global imbalances remain

problematic, both for the U.S. and the world:

• The large private foreign purchases of U.S. assets that helped finance the

U.S. deficit in past years have, for the moment, contracted. Given the prospect of

much larger U.S. public-sector deficits down the road, with no clear and credible

timetable for their reduction, U.S. external borrowing will be prolonged and

investor faith in the dollar cannot be taken for granted. Recent research on crises

suggests several avenues of vulnerability as U.S. government deficits and debt

38 See McGuire and von Peter (2009).

. 33

grow, including self-fulfilling funding crises and currency collapses once fiscal

fundamentals enter a danger zone. Given the multiple equilibria involved, the

timing of such events is inherently impossible to predict. It is even conceivable, if

the fiscal regime comes to be perceived as non-Ricardian and therefore not self-

financing over time, that inflation expectations lose their customary monetary

39

anchor, thereby making inflation control by the Fed more difficult. In short, the

prospect of dollar instability remains.

• In the past a combination of exchange rate and other asset price

movements benefited the U.S. by bestowing capital gains on its external asset

40 These gains and

portfolio and losses on holders of U.S. external liabilities.

losses were not fully offset by differences in dividend and interest flows. As a

result, the U.S. net external position did not keep pace with cumulated current

account balances; in effect, the U.S. was borrowing at very low cost. That pattern

has, however, swung into reverse. In 2008 the U.S. deficit was slightly over $500

billion, whereas exchange rate changes and equity-market losses inflicted an

additional loss of over $800 billion on the net international investment position

(NIIP). The full result was an increase in U.S. net liabilities to foreigners of nearly

10 percent of GDP; see Figure 19. If such patterns continue for long, even a

reduced level of U.S. foreign borrowing raises sustainability concerns. It seems

plausible that in the future, foreign private investors will become less willing to

hold dollar debt in view of the unsettled U.S. fiscal predicament, while official

holders of dollar reserves may well wish to diversify into euros or other

39 See, for example, Woodford (2001). 34

currencies. As Figure 21 shows, there is a long-term trend of official reserve

diversification away from U.S. dollars, especially among the fast-growing,

reserve-hungry emerging and developing economies, and this trend continues in

41

recent data. If a global portfolio shift out of dollars occurs, U.S. external

borrowing rates could rise, while the customary favorable impact of dollar

depreciation on the U.S NIIP would be muted.

• China’s current and projected external surpluses remain huge. In terms of

an intertemporal trade analysis, Chinese policy is subsidizing the country’s export

of current consumption power in world asset markets, thereby keeping world real

interest rates below their true equilibrium levels. Apart from the implied

deflationary pressure on the world economy, the rest of the world’s monetary

response to this phenomenon – in the form of exceptionally low policy interest

rates – provides a breeding ground for potential new bubbles. Reduced surpluses

by China (and by Asian and other high-surplus countries more generally) would

make it easier for the U.S. to reduce its deficit further. As a concomitant, Asian

currencies would need to appreciate in real terms. These changes would have the

further benefit of reducing protectionist tensions, notably those between China

and the United States. The Asian model of export-led growth becomes more

problematic if the U.S. is no longer the world’s borrower of last resort.

40 See footnote 33 above. Gourinchas and Rey (2007) present an econometric analysis demonstrating that

U.S. net exports have predict these price adjustments in past decades.

41 There was an abrupt decline in the dollar’s reserve share for emerging and developing economies

between 2002 and 2004 (as the dollar began its recent depreciation trend). The euro was the main

beneficiary. There is evidence of a further decline in relative dollar holdings in recent quarters. In Figure

21, the dollar shares are computed relative to the reserves of only those countries that report reserve

composition to the IMF. 35

• Global imbalances reflect national regulatory systems that still await

major reforms. With the added post-Lehman investor perception that more big

institutions are operating under a predictable umbrella of government protection,

future financial instability could be in store. Large net capital inflows could

inflate asset prices and make it easier for policymakers to avoid tough choices,

including the politically difficult choice to tighten financial-sector regulation.

Historically, it has been difficult to tighten prudential supervision in bubble

episodes because inflated asset prices allow financial actors to argue that their

balance sheets are strong.

What changes in the international monetary system might mitigate global

imbalances in the future? A first concern is the proper reaction of domestic monetary

policies to outsize movements in asset prices or credit flows. It has now become clear that

ex post cuts in interest rates cannot be relied upon clean up the debris of a financial

collapse. To some degree, monetary policies should take greater account of financial-

market developments than they have in the recent past (although effective financial

regulation must be the first line of defense, as discussed below). In particular, there is a

case to be made that large current account deficits, other things equal, call for a

tightening of monetary policy. Ferrero, Gertler, and Svensson (2008) present an example

in which better macro performance comes from a monetary rule that recognizes how an

external deficit raises the natural real rate of interest. The question deserves more

research attention.

Another aspect of the international monetary system that is ripe for improvement

is the surveillance of and coordinated response to large imbalances. The current

36

configuration of imbalances again reveals the familiar asymmetry between the adjustment

pressures facing deficit and surplus countries. The continuing U.S. external deficit is

perilous, as we have noted. Yet, reducing that deficit is hard in the face of ongoing

recession; the U.S. is in no position to take the lead.

On the other hand, China, with its international reserves at $2 trillion and rising,

has plenty of room to take the lead and should. Until now China has followed the Asian

model that Japan pioneered, orienting its economy towards exports in order to exploit

scale economies in production, to learn by doing, and to move up the value chain. With

its vast internal market, however, China (unlike smaller Asian economies) is in a unique

position to reorient its growth toward domestic demand without losing the advantages of

scale. That difficult task will require an improved social safety net, but with Chinese

consumption well under 40 percent of GDP, roughly half the U.S. rate, there is enormous

room for upward adjustment. China’s position as the leading international lender,

however, gives it little incentive to undertake consumption-enhancing reforms that would

benefit not only its citizens, but also the entire world economy. Nor, as a surplus country

able to sterilize reserve gains, is China under pressure to revalue its currency rapidly. In

the past, even credible threats of trade barriers have evoked only minor exchange-rate

changes, while China’s trade surplus has continued to rise as share of GDP.

The September 2009 G-20 Pittsburgh statement on the surveillance of external

imbalances therefore is a useful step in drawing attention to the dangers they create and

to their underlying origin in national policy choices. The recent crisis has dramatically

illustrated the important and pervasive external effects of domestic macro and financial

policies. In the interest of global stability, the policy choices of sovereign nations,

37

including their exchange rate arrangements, must be viewed as legitimate subjects for

international discussion and negotiation.

Another area that deserves attention is the system of self-insurance through large

holdings of international reserves. While a large stock of international reserves may

enhance the financial stability of an individual country, a system in which many countries

hold reserves as their primary form of liquidity insurance could be collectively

destabilizing. Aside from the opportunity costs of reserves to individual countries, there

are systemic costs due to external effects of reserve management. Reserve holdings may

unduly depress reserve-currency interest rates, reduce liquidity abroad when they are

mobilized in a crisis, or create exchange rate instability as markets speculate on official

portfolio shifts between different reserve currencies. Such systemic problems – discussed

in earlier incarnations by Robert Triffin and others – have come to the fore in recent

42 They could be mitigated by international

discussions of financial-system resilience.

institutions capable of creating and allocating outside liquidity in a crisis. But even a

better-endowed IMF is a very partial answer to this need. Its effectiveness requires

significant governance changes, as well as greater global attention to the worsening of

moral hazard that a bigger international lender of last resort entails. Reform of the

international monetary system is bound up with reform of the international financial

system.

What changes in the international financial system might mitigate global

imbalances in the future? We see at least two first-order agenda items.

42 For an early and insightful discussion, see Crockett (2000).

38

The first is domestic financial development in the poorer economies. In some

emerging-market countries, notably China, high saving is promoted by

underdevelopment and inefficiencies in financial markets. Structural shortcomings tend

to raise both corporate and household saving rates. For example, if typical Chinese savers

had access to relatively safe instruments offering higher rates of return, huge positive

income effects would in all likelihood swamp substitution effects, resulting in lower, not

higher, household saving. The result would be higher household welfare in China, as well

as a reduction in China’s foreign surplus.

The second agenda item is the regulation of internationally integrated financial

markets. Now that the fig leaf of constructive ambiguity has been torn away,

development of a globally more effective framework for financial regulation is an urgent

priority. It is well understood that a rational and politically robust regulatory framework

will have to be based on more extensive international cooperation than currently exists –

notwithstanding the considerable progress made since the initiation of the Basel process

in the 1970s. Given their significant and growing importance in world trade and finance,

the emerging markets will rightly be full partners in any new arrangements.

As the 2009 Pittsburgh G-20 summit illustrated, however, international agreement

on further concrete common measures is far away. While this is the case, large global

imbalances will remain dangerous as possible manifestations of underlying financial

excesses. Macro-prudential regulatory stringency that responds forcefully to financial

booms will be the most important lever for avoiding financial busts in the future. A key

challenge is to devise a set of reasonably simple and transparent rules for macro-

prudential interventions, rather than relying on a complex and shifting web of

39

discretionary levers. Some observers have suggested that emerging markets use

countercyclically intensive regulatory oversight in response to big financial inflows

(Mohan and Kapur 2009; Ocampo and Chiappe 2003). Richer countries can usefully

apply the same precepts in the face of big current account deficits.

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DESCRIZIONE DISPENSA

Lettura consigliata dalla Prof.ssa Lilia Cavallari per il corso di Macroeconomia Internazionale. Trattasi del rapporto stilato dai professori Maurice Obstfeld e Kenneth Rogoff dal titolo "Imbalances and the Financial Crisis: Products of Common Causes". Al suo interno viene operata un'analisi della recente crisi finanziaria correlandola con le politiche economiche adottate a partire dal 2000 e con la diseguaglianza economica e sociale che queste hanno comportato.


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Corso di laurea: Corso di laurea magistrale in relazioni internazionali
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I contenuti di questa pagina costituiscono rielaborazioni personali del Publisher Atreyu di informazioni apprese con la frequenza delle lezioni di Macroeconomia internazionale e studio autonomo di eventuali libri di riferimento in preparazione dell'esame finale o della tesi. Non devono intendersi come materiale ufficiale dell'università Roma Tre - Uniroma3 o del prof Cavallari Lilia.

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