Global imbalances

Last updated

Global imbalances refers to the situation where some countries have more assets than the other countries. In theory, when the current account is in balance, it has a zero value: inflows and outflows of capital will be cancelled by each other. Hence, if the current account is persistently showing deficits for certain period, it is said to show an inequilibrium. Since, by definition, all current accounts and net foreign assets of the countries in the world must become zero, then other countries become indebted with the other nations. During recent years, global imbalances have become a concern in the rest of the world. The United States has run long term deficits, as well as many other advanced economies, while in Asia and emerging economies the opposite has occurred.

Contents

GlobalImbalances.png

A technical definition

They refer to global imbalances as "external positions of systemically important economies that reflect distortions or entail risks for the global economy". [1] The three parts of this definition can be re-defined further:

  1. External positions: this refers not only to current account flows, but also the net foreign assets of countries (which, if changes in the prices of those assets and liabilities are zero, then it is the accumulated sum of past net current account flows).
  2. Systemically important economies: these are the economic blocks running the imbalances, that are relevant to the world market operations, e.g. China, the Euro area or the United States.
  3. Reflect distortions or entail risks: this parts concerns both the causes (distortions) and possible consequences (risks) of the imbalances. This means that even an external imbalance that was not originated on some market distortion, would fall under the definition of global imbalances, if significant risks arise from it.

History

Global imbalances are far from being a new phenomenon in economic history. There are many periods where they were present, although here only those periods where some data is available will be referred to.

The first period of global imbalances that will be presented, occurred during the years 1870 to 1914 (a former era of financial globalisation) where massive flows of capital flew from the core countries of Western Europe to the countries of recent settlement overseas (especially the Americas and Australasia). Current account surpluses run by Britain, Germany, France and the Netherlands reached approximately 9% of GDP, while for the destination of the flows (Argentina, Australia and Canada) the deficit exceeded 5%. [2]

The process of adjustment of these imbalances relates to the price specie flow mechanism of the classical gold standard, which was smooth, in general, with exception of the Barings Crisis in 1890 for some countries.

During the First World War, the participating countries abandoned gold convertibility, with exception of the United States. After the war, by 1926, the major countries got back to a gold standard, where the countries held reserves in dollars, sterling and francs, and the United States, Great Britain and France held gold. But this system had some serious flaws which prevented that the imbalances generated were adjusted smoothly. Real exchange rates were misaligned, and the system began to lose credibility (since, at the time, it seemed that external concerns came second after domestic concerns). [3] The collapse began after 1929: speculative attacks on countries following expansionary policies to alleviate the effects of the Great Depression, and soon had to leave the gold standard. The United States continue until 1933. The imbalance during this period, however, where not as large in magnitude as they were before the First World War.

After the Second World War, under the Bretton Woods system, the U.S. was the country with the largest gold reserves, and had to peg the dollar to gold at 35 dollars per ounce, as the rest of the world pegged to the dollar. Stronger restrictions existed on cross-border capital flows, compared to the gold standard, that did not allow countries to run big surpluses or deficits in the current account, as it was the case during the classical gold standard regime. The system ended in 1971, amidst expansionary policies in the United States, that lead European countries to begin converting their dollar claims into gold, threatening U.S. gold reserves.

Another periods of smaller imbalances began after the end of the Bretton Woods system, but their magnitude is much smaller than the ones of the beginning of the 21st century, involving different sets of countries and with different resolutions. [1] [4]

Current episode

Making a comparison with the former global imbalances, the current period has unprecedented features. This is the first time that capital flows go mostly from emerging market economies (mainly Asia and the Oil exporting economies), to advanced economies. Also, the foreign asset positions have become much larger in both gross and net terms, and the degree of capital mobility is the highest in decades. [5] Hence, the size of these imbalances are only comparable to the period previous to the First World War. Also the conditions under which they appeared are different. New participants that were in the periphery of global trade and finance before, have become an important part of the international markets, after a process of economic liberalisation, falling transportation costs, information technology and the deepening of financial markets and global chains of production. The financial links among the economies has also increased. And the macroeconomic and financial conditions improved, especially during 2003-2007, with record economic growth and low financial market volatility. As it will explained later, this are important factors in generating the increased globalisation of financial markets.

Causes

The essential requirement to make large global imbalances in world, is the monetary globalisation or, in other words, freeing and opening the financial markets. Without this, it is not able to produce the amount of capital flows between countries. However, not every monetary globalisation should lead to imbalances. Other factors are important as well.

One factor is increases in the bank savings from emerging countries, especially in Asian Countries and Commodity Exporter economies, part of what is known as the Savings Glut. These economies increased their foreign exchange reserves to respond to future balance of payment. [6] Of course, there are some other reasons, such as low levels of social security in emerging countries, as well as the fixed or flexible foreign exchange systems of many of these countries. In some advanced countries, such as Germany, Japan and New Zealand, the ageing issue has been a very important factor increasing the amount of the savings.

So far, we have explained why some countries have accumulated many savings, but not why they are held abroad (besides the precautionary savings explanation). One reason, is that the financial development has not been followed at the same pace as the financial openness. This can be seen in a very small markets to generate safe assets where to store value from one period to the next. For this reason, many countries have decided to invest those assets abroad, in the more financially developed countries, such as the United States and the United Kingdom, in the form of Sovereign Wealth Funds, portfolio investments and foreign reserves, indicating the existence of shortages in safe assets as well. [7] [8] Another explanation is that ageing population do not find profitable investment vehicles to invest at home, and end up investing them abroad. [1] [4]

Also, some coincidental factors amplified the extent of the imbalances. The decreasing output volatility in advanced economies (i.e. Great Moderation), led to less savings and a decrease in risk aversion, that was reflected in deepening current account deficits. [9]

The Great Recession

Global imbalances helped fuel the financial crisis, even though it did not cause it. [10] The Savings Glut helped push down the yields on Treasury bonds, through the foreign purchases. This reduction in interest rate, in addition to other policy measures adopted by central banks, encouraged risk taking and underestimation of risks, on the verge of financial innovation, that might as well had been boosted by this financial environment. It also helped in the increase of leverage in advanced economies, and the formation of the housing market bubble in many of them, through the relaxed credit conditions. Also the increase in the financial linkages, lead to a rapid contagion across economies. [11] It would not be hard to argue that the economic policies followed by the emerging markets, led to the ability of advanced economy to borrow cheaply abroad and finance the bubbles in the housing and financial markets. [12]

Even though many of the policies adopted or discussed since the beginning of the Great Recession, have centred on the sectors of Finance, Housing and Public Debt, among other issues, the presence of Global Imbalances still remains as a factor, that although reduced, points out the need of reforms of the international monetary and financial system to correct the imbalances, and hence, the distortions and market imperfections that gave them origin in first place.

See also

Related Research Articles

<span class="mw-page-title-main">Balance of trade</span> Difference between the monetary value of exports and imports

Balance of trade is the difference between the monetary value of a nation's exports and imports over a certain time period. Sometimes a distinction is made between a balance of trade for goods versus one for services. The balance of trade measures a flow variable of exports and imports over a given period of time. The notion of the balance of trade does not mean that exports and imports are "in balance" with each other.

<span class="mw-page-title-main">Global financial system</span> Global framework for capital flows

The global financial system is the worldwide framework of legal agreements, institutions, and both formal and informal economic action that together facilitate international flows of financial capital for purposes of investment and trade financing. Since emerging in the late 19th century during the first modern wave of economic globalization, its evolution is marked by the establishment of central banks, multilateral treaties, and intergovernmental organizations aimed at improving the transparency, regulation, and effectiveness of international markets. In the late 1800s, world migration and communication technology facilitated unprecedented growth in international trade and investment. At the onset of World War I, trade contracted as foreign exchange markets became paralyzed by money market illiquidity. Countries sought to defend against external shocks with protectionist policies and trade virtually halted by 1933, worsening the effects of the global Great Depression until a series of reciprocal trade agreements slowly reduced tariffs worldwide. Efforts to revamp the international monetary system after World War II improved exchange rate stability, fostering record growth in global finance.

<span class="mw-page-title-main">Balance of payments</span> Difference between the inflow and outflow of money to a country at a given time

In international economics, the balance of payments of a country is the difference between all money flowing into the country in a particular period of time and the outflow of money to the rest of the world. In other words, it is economic transactions between countries during a period of time. These financial transactions are made by individuals, firms and government bodies to compare receipts and payments arising out of trade of goods and services.

In macroeconomics and international finance, a country's current account records the value of exports and imports of both goods and services and international transfers of capital. It is one of the two components of the balance of payments, the other being the capital account. Current account measures the nation's earnings and spendings abroad and it consists of the balance of trade, net primary income or factor income and net unilateral transfers, that have taken place over a given period of time. The current account balance is one of two major measures of a country's foreign trade. A current account surplus indicates that the value of a country's net foreign assets grew over the period in question, and a current account deficit indicates that it shrank. Both government and private payments are included in the calculation. It is called the current account because goods and services are generally consumed in the current period.

In economics, hot money is the flow of funds from one country to another in order to earn a short-term profit on interest rate differences and/or anticipated exchange rate shifts. These speculative capital flows are called "hot money" because they can move very quickly in and out of markets, potentially leading to market instability.

<span class="mw-page-title-main">Foreign exchange market</span> Global decentralized trading of international currencies

The foreign exchange market is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all aspects of buying, selling and exchanging currencies at current or determined prices. In terms of trading volume, it is by far the largest market in the world, followed by the credit market.

Foreign exchange reserves are cash and other reserve assets such as gold and silver held by a central bank or other monetary authority that are primarily available to balance payments of the country, influence the foreign exchange rate of its currency, and to maintain confidence in financial markets. Reserves are held in one or more reserve currencies, nowadays mostly the United States dollar and to a lesser extent the euro.

In macroeconomics and international finance, the capital account, also known as the capital and financial account, records the net flow of investment into an economy. It is one of the two primary components of the balance of payments, the other being the current account. Whereas the current account reflects a nation's net income, the capital account reflects net change in ownership of national assets.

A currency crisis is a type of financial crisis, and is often associated with a real economic crisis. A currency crisis raises the probability of a banking crisis or a default crisis. During a currency crisis the value of foreign denominated debt will rise drastically relative to the declining value of the home currency. Generally doubt exists as to whether a country's central bank has sufficient foreign exchange reserves to maintain the country's fixed exchange rate, if it has any.

<span class="mw-page-title-main">International economics</span> Economics between nation states

International economics is concerned with the effects upon economic activity from international differences in productive resources and consumer preferences and the international institutions that affect them. It seeks to explain the patterns and consequences of transactions and interactions between the inhabitants of different countries, including trade, investment and transaction.

The Triffin dilemma is the conflict of economic interests that arises between short-term domestic and long-term international objectives for countries whose currencies serve as global reserve currencies. This dilemma was identified in the 1960s by Belgian-American economist Robert Triffin. He noted that a country whose currency is the global reserve currency, held by other nations as foreign exchange (FX) reserves to support international trade, must somehow supply the world with its currency in order to fulfill world demand for these FX reserves. This supply function is nominally accomplished by international trade, with the country holding reserve currency status being required to run an inevitable trade deficit. After going off of the gold standard in 1971 and setting up the petrodollar system later in the 1970s, the United States accepted the burden of such an ongoing trade deficit in 1985 with its permanent transformation from a creditor to a debtor nation. The U.S. goods trade deficit is currently on the order of one trillion dollars per year. Such a continuing drain to the United States in its balance of trade leads to ongoing tension between its national trade policies and its global monetary policy to maintain the U.S. dollar as the current global reserve currency. Alternatives to international trade that address this tension include direct transfer of dollars via foreign aid and swap lines.

Capital controls are residency-based measures such as transaction taxes, other limits, or outright prohibitions that a nation's government can use to regulate flows from capital markets into and out of the country's capital account. These measures may be economy-wide, sector-specific, or industry specific. They may apply to all flows, or may differentiate by type or duration of the flow.

At the micro-economic level, deleveraging refers to the reduction of the leverage ratio, or the percentage of debt in the balance sheet of a single economic entity, such as a household or a firm. It is the opposite of leveraging, which is the practice of borrowing money to acquire assets and multiply gains and losses.

A sudden stop in capital flows is defined as a sudden slowdown in private capital inflows into emerging market economies, and a corresponding sharp reversal from large current account deficits into smaller deficits or small surpluses. Sudden stops are usually followed by a sharp decrease in output, private spending and credit to the private sector, and real exchange rate depreciation. The term "sudden stop" was inspired by a banker’s comment on a paper by Rüdiger Dornbusch and Alejandro Werner about Mexico, that "it is not speed that kills, it is the sudden stop."

The term exorbitant privilege refers to the benefits the United States has due to its own currency being the international reserve currency. For example, the US would not face a balance of payments crisis, because their imports are purchased in their own currency. Exorbitant privilege as a concept cannot refer to currencies that have a regional reserve currency role, only to global reserve currencies.

<span class="mw-page-title-main">Financial position of the United States</span>

The financial position of the United States includes assets of at least $269 trillion and debts of $145.8 trillion to produce a net worth of at least $123.8 trillion. GDP in 2014 Q1 decline was due to foreclosures and increased rates of household saving. There were significant declines in debt to GDP in each sector except the government, which ran large deficits to offset deleveraging or debt reduction in other sectors.

A global saving glut is a situation in which desired saving exceeds desired investment. By 2005 Ben Bernanke, chairman of the Federal Reserve, the central bank of the United States, expressed concern about the "significant increase in the global supply of saving" and its implications for monetary policies, particularly in the United States. Although Bernanke's analyses focused on events in 2003 to 2007 that led to the 2007–2009 financial crisis, regarding GSG countries and the United States, excessive saving by the non-financial corporate sector (NFCS) is an ongoing phenomenon, affecting many countries. Bernanke's global saving glut (GSG) hypothesis argued that increased capital inflows to the United States from GSG countries were an important reason that U.S. longer-term interest rates from 2003 to 2007 were lower than expected.

Macroprudential regulation is the approach to financial regulation that aims to mitigate risk to the financial system as a whole. After the 2007–2008 financial crisis, there has been a growing consensus among policymakers and economic researchers about the need to re-orient the regulatory framework towards a macroprudential perspective.

Prudential capital controls are typical ways of prudential regulation that takes the form of capital controls and regulates a country's capital account inflows. Prudential capital controls aim to mitigate systemic risk, reduce business cycle volatility, increase macroeconomic stability, and enhance social welfare.

Linda L. Tesar is a professor of economics and director of graduate studies at the University of Michigan College of Literature, Science, and the Arts (LSA), the liberal arts and sciences school of the University of Michigan in Ann Arbor. She is also a research associate at the National Bureau of Economic Research and the Editor-in-Chief of the IMF Economic Review. She has been a visitor in the Research Departments of the International Monetary Fund, the Federal Reserve Board of Governors and the Federal Reserve Bank of Minneapolis. In the past, she has also served on the academic advisory council to the Federal Reserve Bank of Chicago. From 2014 to 2015, Tesar served as Senior Economist on the Council of Economic Advisers.

References

  1. 1 2 3 Bracke, T.; Bussière, M.; Fidora, M.; Straub, R. (2010). "A Framework for Assessing Global Imbalances1" (PDF). The World Economy. 33 (9): 1140. doi:10.1111/j.1467-9701.2010.01266.x. S2CID   154997273.
  2. ↑ Bordo, Michael (May 2005). "Historical Perspective on Global Imbalances". NBER Working Paper Series (11383). SSRN   731038.{{cite journal}}: Cite journal requires |journal= (help)
  3. ↑ Eichengreen, Barry (30 July 2010). "Fetters of gold and paper" . Retrieved 17 February 2012.
  4. 1 2 Anton Brender; Florence Pisani (2007). Global imbalances: is the world economy really at risk?. Dexia. ISBN   978-2-87193-326-7.
  5. ↑ Obstfeld, Maurice; Alan Taylor (2002). "Globalization and Capital Markets". NBER Working Paper Series (8846). SSRN   305072.{{cite journal}}: Cite journal requires |journal= (help)
  6. ↑ Jeanne, O.; Rancière, R. (2011). "The Optimal Level of International Reserves for Emerging Market Countries: A New Formula and Some Applications". The Economic Journal. 121 (555): 905. doi:10.1111/j.1468-0297.2011.02435.x. S2CID   154793832.
  7. ↑ Mendoza, Enrique; Vincenzo Quadrini; José-Víctor Ríos-Rull (2009). "Financial Integration, Financial Development, and Global Imbalances". Journal of Political Economy. 117 (3): 371–416. CiteSeerX   10.1.1.422.4598 . doi:10.1086/599706. S2CID   9295230.
  8. ↑ Caballero, Ricardo; Emmanuel Fahri; Pierre-Olivier Gourinchas (2008). "An Equilibrium Model of "Global Imbalances" and Low Interest Rates" (PDF). American Economic Review. 98 (1): 358–393. doi:10.1257/aer.98.1.358.
  9. ↑ Fogli, Alessandra; Fabrizio Perri (2006). "The "Great Moderation" and the US External Imbalance". NBER Working Paper Series (12708). SSRN   984513.{{cite journal}}: Cite journal requires |journal= (help)
  10. ↑ King, Mervyn (February 2011). "Global imbalances: the perspective of the Bank of England". Financial Stability Review. 15: 1–8.
  11. ↑ Mendoza, E. G.; Quadrini, V. (2010). "Financial globalization, financial crises and contagion". Journal of Monetary Economics. 57: 24–39. CiteSeerX   10.1.1.584.1307 . doi:10.1016/j.jmoneco.2009.10.009.
  12. ↑ Obstfeld, Maurice; Kenneth Rogoff (November 2009). "Global Imbalances and the Financial Crisis: Product of Common Causes" (PDF). Retrieved 8 March 2012.{{cite journal}}: Cite journal requires |journal= (help)
This page is based on this Wikipedia article
Text is available under the CC BY-SA 4.0 license; additional terms may apply.
Images, videos and audio are available under their respective licenses.