Global Imbalances, the Financial Crisis, and the International

Monetary System 

Maurice Obstfeld University of California, Berkeley, CEPR, and NBER

Keynote Address at the 14th CEPR/ESI Conference, “How Has Our View of Central Banking Changed with the Recent Financial Crisis?”

Izmir, Turkey, October 28-29, 2010

What links between imbalances and the financial crisis?

• Many conflicting views, for example:

• Portes: Global imbalances, “not greed, poor incentive structures, or weak financial regulation,” caused the crisis.

• Dooley and Garber: Crisis due to ineffective regulation, not global imbalances, easy money, or financial innovation.

• Paulson: High saving by EMs the ultimate cause.

Another view (SF Fed paper with Rogoff)• Distinguish between exogenous impulses and endogenous responses.

• Imbalances were among several complementary endogenous responses to more fundamental causes.

• Transmission to imbalances reflected distortions in:--financial markets--policy regimes--private-sector beliefs

• Bottom line: The underlying causes of the crisis also caused the outsized global imbalances.

• Option to run large deficits led to deceptive stability. Without it, higher US interest rates, weaker dollar, more CPI pressure.

What factors were primary?

• Monetary policies, including that of the United States.

• Exchange rate management policies in emerging market countries, including China.

• In line with the last, high saving/low investment in some emerging market countries, notably China.

• Financial market weaknesses.

Global imbalances, 1995-2009

-800

-600

-400

-200

0

200

400

Cu

rre

nt

ac

co

un

t (b

illio

ns

of

U.S

. d

olla

rs

)

Advanced ex-United StatesNewly industrialized AsiaDeveloping AsiaMiddle EastCIS and MongoliaCentral and Eastern EuropeWestern Hemisphere developingAfricaUnited States

Late 1990s-2004• US deficit of late 1990s reflected high investment, productivity-growth expectations.

• Dot-com collapse led to a fall in expected world productivity growth, fall in world real interest rates.

• Amplified, prolonged by monetary policy, esp. after 9/11.

• Notwithstanding “saving glut” view, little evidence of higher world saving until 2004 or so.

• EME surpluses not that big until then; even after, most of the story is fuel exporters. Up to 2004, advanced country (ex-US) surplus seems most important counterpart.

• Many emerging markets (notably China) peg to dollar, gain reserves. US interest rate effects?

Nominal US Asset Prices and US Real Interest Rate

0

200

400

600

800

1000

1200

1400

1600

1800

1/3

1/1

99

7

1/3

1/1

99

8

1/3

1/1

99

9

1/3

1/2

00

0

1/3

1/2

00

1

1/3

1/2

00

2

1/3

1/2

00

3

1/3

1/2

00

4

1/3

1/2

00

5

1/3

1/2

00

6

1/3

1/2

00

7

1/3

1/2

00

8

1/3

1/2

00

9

Asse

t p

rice

in

de

x

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5

Re

al in

tere

st ra

te

S&P Case-Shiller US real interest rate (10-yr TIPS)

*

-100

0

100

200

300

400

500

600

700

Annual change (billions of dollars)

Growth in Official Foreign Exchange Reserves

Interest rate responses

• To a substantial degree the fall in real interest rates was global.

• A reflection of international financial linkages, to be sure, but also of cyclical synchronization (global shocks) and policy complementarity.

Interest rate responses

• Policy interest rates are at zero in Japan.

• Nominal interest rates fall, but not to such low levels, elsewhere.

• Accommodation protracted in US and especially euro zone.

• Eventual tightening (starting in US in mid-2004) is measured and predictable.

Policy Interest Rates

0

1

2

3

4

5

6

7

8

Eonia UK base lending rate US fed funds rate

Macro-financial linkages greatly worsen global imbalances around 2004

• Housing prices rise globally.

Real estate appreciation and change in current account, 2000-06, modified Aizenman-Jinjarak (2009) sample

-20.0

-15.0

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

-100.0 -50.0 0.0 50.0 100.0 150.0 200.0 250.0 300.0 350.0 400.0

Real cumulative real estate appreciation (percent)

Change in C

A/G

DP

(perc

ent

of

GD

P)

From ECB, Monthly Bulletin, August 2007

Global Commodity Prices

20

40

60

80

100

120

140

160

180

200

Index (

2005=

100)

All commodities Crude oil price

• Commodity prices take off.

Macro-financial linkages greatly worsen global imbalances around 2004

• Higher surpluses of emerging markets keep lid on global real interest rates; higher US deficit; rise in world saving.

• China becomes protectionist target after WTO entry, attracts hot money, large-scale sterilization.

• Growth in leverage, financial engineering in US, decline in lending and prudential standards, further house-price inflation.

• Probable link to low interest rate environment. Important research question.

China's Trade Surpluses with United States and European Union

-50000

0

50000

100000

150000

200000

Source: IMF, Direction of Trade

Mill

ions

of d

olla

rs

Bilateral surplus with US Bilateral surplus with EU

China's Monetary Base and International Reserves

0

2000

4000

6000

8000

10000

12000

14000

16000

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Bill

ions

of R

MB

International reserves Monetary base

Gross External Assets and Liabilities, Selected Countries

0

2

4

6

8

10

12

14

(Ass

ets

+ L

iabi

liti

es)/

GD

P

Switzerland United Kingdom Euro Zone United States Japan China

• Elevated leverage shows up in Lane, Milesi-Ferretti foreign position data.

20012002

20032004

20052006

Securitized subprime

Subprime originations

Nonprime originations

ARM originations

0

10

20

30

40

50

60

Source: Jaffee et al. (2009)

Percent

US Nonprime and Subprime Mortgage Originations

• Housing finance activity accelerates in 2004.

U.S. Mortgage Debt and Residential Investment

0.4

0.5

0.6

0.7

0.8

0.9

1

1.1

Source: Board of Governors of the Federal Reserve System and U.S. Department of Commerce

Mo

rtg

ag

e d

eb

t/G

DP

0.025

0.03

0.035

0.04

0.045

0.05

0.055

0.06

0.065

Re

sid

en

tia

l in

ve

stm

en

t/G

DP

Mortgage debt/GDP Residential investment/GDP

Two historical precedents

• End of Bretton Woods period--Hot money into Germany, Switzerland--Accumulation of USD reserves, attempts at sterilization--Helped spark global inflation, including commodity shocks

--In 2000s these pressures showed up in housing, commodities

• Payments patterns of the later 1970s/early 1980s--Global liquidity pushes up oil prices, oil surpluses--Transfer effect keeps lid on world real interest rate--Money-center banks recycle petrodollars--Developing (subprime) borrowers have trouble with adjustable- rate loans once Fed raises interest rates --LDC debt crisis of1982-89 erupts

The end game• US monetary tightening: home prices decline starting ’06.

• Financial super-structure built on rising home prices collapses.

• Worldwide housing bust.

• Runs on US and foreign banks and nonbanks. Collapse of interbank markets.

• Consistent with earlier papers by Rogoff and me (’01,’05,’07), housing collapse caused a recession and a rather disorderly process of current account adjustment.

US Current Account Balance

-7

-6

-5

-4

-3

-2

-1

01995:I 1996:II 1997:III 1998:I 2000:I 2001:II 2002:III 2003:I 2005:I 2006:II 2007:III 2008:I

Source: BEA

Pe

rce

nt o

f G

DP

(q

ua

rte

rly d

ata

at a

n a

nn

ua

l ra

te)

• US external deficit has fallen sharply and IMF predicts it will stabilize near current level (as % of GDP) over 4-5 years.

Dollar depreciation trend slowed

Real Exchange Rate of the U.S. Dollar

85

90

95

100

105

110

115

120

Sources: International Monetary Fund and Board of Governors of the Federal Reserve System

Index

(Jan

uary

2004

= 10

0)

Whither the dollar?• “Dollar shortage” of 2008 has unwound. Safe haven?

• I believe dollar probably will fall some more as US national saving rises – hopefully an orderly process.

• Necessary adjustment process slowed by China’s dollar peg, US fiscal stimulus.

• Korea, Taiwan, NZ, Japan, others, voice concern on appreciation of their currencies. More resistance?

• Capital inflow controls--Prudential versus anti-appreciation.--External effects on other EMEs – where to invest if shut out?

Some issues on the table

• Is low US interest (and in other countries) fueling asset bubbles and external inflation? (Another Bretton Woods analogy.)

• In future, monetary policy should be more concerned with imbalances of flows or prices.

• US must defuse its public debt bomb or risk dollar meltdown. Question is: When?

• External sustainability: Will US lose the Gourinchas-Rey bonus?

On one measure, US lost about $2.2 trillion on NIIP in 2008.

US NIIP and Cumulated Current Accounts

-8000000

-7000000

-6000000

-5000000

-4000000

-3000000

-2000000

-1000000

0

1000000

Millions of USD

Cumulated CA NIIP (FDI at market value)

Changes in U.S. NIIP (FDI at Market Value)

-3,000,000

-2,500,000

-2,000,000

-1,500,000

-1,000,000

-500,000

0

500,000

1,000,000

1,500,000

2,000,000

Financial flows Valuation component Total change in IIP

Official US Dollar Reserves as Shares of Country-Group Totals

0.55

0.6

0.65

0.7

0.75

0.8

1999:I 2000:I 2001:I 2002:I 2003:I 2004:I 2005:I 2006:I 2007:I 2008:I 2009:I

Source: IMF COFER database

Advanced economies Emerging and developing economies

Reserve demand for US dollars has been trending

downward. Likewise, FX market share (April 2010 survey).

• Expansion of gross external asset positions, shown above, raises stakes for international regulatory and monetary reform.

• Issues go far beyond CA balance, yet I believe CA remains relevant on several counts.

• The crisis exposed many weaknesses in advanced-country financial systems.

• But reform must include EME’s which are increasingly big players in world financial markets.

• More global cooperation on reform is essential.

• Who can provide global liquidity insurance?

Gross Asset Accumulation and Current Accounts of Developing and EMEs

-1

0

1

2

3

4

5

6

7

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Percent of advanced-country GDP

Reserve accumulation Nonreserve gross foreign asset acquisitions Current account balance

• The crisis saw a temporary collapse of capital flows, and extensive deleveraging.

• EMEs with gross short-term debts suffered most.• Upward pressure on USD due partly to short-term dollar

finance needs of banks holding, e.g., RMBS. • Fed extended swap lines – outsourced its LLR role to

foreign central banks.• Other central banks extended swaps and many followed

unconventional policies, including EMEs.• Liquidity support in multiple key currencies.• IFI resources raised, IMF programs for some EMEs.• FCL, PCL. Programs with systemic trigger?

Lenders of last resort:

Source: Patrick McGuire and Goetz von Peter, “The US Dollar Shortage in Global Banking and the International Policy Response,” BIS Working Papers No. 291, October 2009, at http://www.bis.org. Light arrows are USD, dark arrows other currencies. Arrows show direction of flow (if known).

Self-insurance through reserves?

• Many policy makers concluded that reserves were helpful in the crisis.

• In many countries including EMS’s, were used for unconventional operations – not for conventional FX intervention. Wave of the future?

• The path of reserves has resumed its upward trend.

Reserve Holdings (milions of USD)

0

1,000,000

2,000,000

3,000,000

4,000,000

5,000,000

6,000,000

Source: IMF, COFER database

High-income Emerging and developing

Drawbacks of reserves:

• Some drawbacks are purely domestic (carry cost, sterilization costs, illusion of security).

• Others raise systemic issues:

--Not outside liquidity.

--Exchange rate and interest rate effects (case of China)

--Mrs. Machlup effects--keeping up with Joneses.

--Case of Korea.

IMF has central roles to play, as illustrated in Greek crisis. How can IMF be strengthened? Reforming its governance is key.

Goodhart (1999) on IMF:

If the IMF were abolished, or so circumscribed in its resources and functions that it could not play an effective LOLR role, the alternative would not be the restoration of a perfectly free market, in which each country stood, or fell, on the basis of its own individual successes. There would, instead, develop an ad hoc system of regional (self-help) systems centered on a major currency, and a major power.... Proponents of pure international laissez-faire should be aware that the political realities suggest that the result of curtailing the IMF would be a descent into a murkier world of regional major-power groupings, and not a system of pure free markets.

Major lessons

• We are increasingly interdependent.• Global imbalances are important.• But so is the evolution of gross asset positions.• National monetary policies of larger areas can have

powerful external effects.• Exchange rate and capital control policies also have

significant external repercussions.• Global institutions of surveillance, suasion, and liquidity

support are still inadequate.• Globalized finance and trade cannot proceed safely very

far beyond the boundaries of globalized governance.