Hans-Joachim Voth UPF, CREI etc.

1. Discussion of “An Equilibrium Model of “Global Imbalances” and Low InterestRates” by Caballero et al. Hans-Joachim Voth UPF, CREI etc.

2. Summary • Takes three key recent trends as a starting point • Fall in real interest rates • Rise of US current account deficit • Increase in US assets in foreign portfolios • Comes up with a simple model that can explain these facts, by • Europe and the US compete to supply assets • R demands assets • Arguing that a big decline in E+J growth prospects led to less investment – high savings flow abroad • Shocks to confidence in domestic financial instruments, expropriation risk, etc. lead investors in R to send their money abroad • Higher growth in ROW amplifies these effects • The US may never have to close its current account deficit…

3. Normally we think of the current account being driven by goods trade, competitiveness, unit labor costs, exchange rates etc., with the asset side adjusting In recent years, some papers the “tail wags the dog”, i.e. the US current account reflects sharp changes in demand and supply of asset Giavazzi+Blanchard 2005 – foreign goods attractive to the US and US assets to foreigners Kraay+Ventura 2005 – sequencing of the Nasdaq bubble + Bush deficits drives up capital imports in the US Bernanke 2005 – global savings glut This is the first to link global interest rates, asset demand + supply, and to model a three-region world Another case of “wag-the-dog-onomics”

4. What is to like about the paper Links 3 important facts Elegant and simple analysis Calibration exercise “works” Changes on the asset side key item in the equation Relative attractiveness of US assets high Asian crisis a key part of the story What is harder to accept European slowdown leads to lower investment; because of continued high savings, this can serve asan explanation of higher demand for US assets Decline in ability of ROW to generate financial assets Fall in the US savings rate largely driven by wealth effects Pros and Cons

5. Great story… shame about some of the facts • The great slowdown in European investment… is actually non-existent • So is Europe’s contribution to financing the US deficit  the empirically relevant part of the story is capital exports from the developing world • Caballero et al. argue that it is a decline in the supply of attractive financial assets in ROW that is responsible for inflows in the US • However, over the period when the US current account deficit widened the most, emerging markets have generated a lot of liquid, tradeable assets that investors – both in emerging markets and abroad – have bought • The most likely explanation rethinks the connection between these last two aspects

6. The slowdown in comparative European growth is clearly there…

7. … but spot the decline in European investment

8. Great story… shame about some of the facts • The great slowdown in European investment… is actually non-existent • So is Europe’s contribution to financing the US deficit  the empirically relevant part of the story is capital exports from the developing world, principally industrializing Asia + oil-exporting countries • Caballero et al. argue that it is a decline in the supply of attractive financial assets in ROW that is responsible for inflows in the US • However, over the period when the US current account deficit widened the most, emerging markets have generated a lot of liquid, tradeable assets that investors – both in emerging markets and abroad – have bought • The most likely explanation rethinks the connection between these last two aspects

10. 26 115 48 -545 416 -25.5 23.3 163.8 106 Japan Euro-Area Other Asia Latin America Middle East Russia USA DETERMINANTS OF CHANGE IN CURRENT ACCOUNT BALANCES, 1996-2004 in bn of US-$

11. Great story… shame about some of the facts • The great slowdown in European investment… is actually non-existent • So is Europe’s contribution to financing the US deficit  the empirically relevant part of the story is capital exports from the developing world, principally industrializing Asia + oil-exporting countries • Caballero et al. argue that it is a relative decline in the supply of attractive financial assets in ROW that is responsible for inflows in the US • However, over the period when the US current account deficit widened the most, emerging markets have generated a lot of liquid, tradeable assets that investors – both in emerging markets and abroad – have bought • The most likely explanation rethinks the connection between these last two aspects

12. 100% 90% R 80% J 70% 60% E 50% 40% 30% 20% U 10% 0% 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 ROW stockmarkets have grown relative to the world – and even the US SIZE OF STOCK MARKETS in % of world stock market capitalization Source: FIBV

13. Some facts about the supply of “reliable financial assets” in ROW • Over the past decade, emerging market bond markets have deepened markedly. The issuance of international securities by emerging market sovereigns and corporates has increased from a level of $325 million in 1995 to roughly $700 million in 2003. Meanwhile, the level of domestic bond issuance by emerging markets issuers over the same period has increased from $1 trillion to $2.4 trillion. Source: Fitch Ratings. • The level of foreign investment in emerging market local currency bonds has risen dramatically in recent years. In surveys of investors carried out by the Emerging Markets Traders Association, the volume of trade in secondary markets in local currency bonds, as a percentage of total trade volume, has risen from 25 percent in 1997 to 45 percent in 2004. Source: Global Financial Stability Report, September 2005, International Monetary Fund.  • The market capitalization of emerging market countries has more than doubled over the past decade, growing from less than $2 trillion in 1995; it is set to exceed $5 trillion in 2006. As a percentage of world market capitalization, emerging markets are now more than 12 percent and steadily growing. Source: Standard & Poor’s Global Stock Markets Factbook 2005. • Emerging market equity funds absorbed $20.3 billion of net inflows in 2005, five times more than last year and beating the previous record of $14.4 billion of inflows from 2003. Source: Emerging Portfolio Fund Research.

14. The ability to generate financial assets… was higher outside the US [with the exception of Japan]

15. What we used to think US accounting rules were the toughest in the world, and accounts were pretty much up to date, honest summaries of the financial situation of a company SEC stops insider trading very effectively Incentives of executives + shareholders closely aligned through options, etc. What we think now The relative attractiveness of US assets…

17. “Isn’t it funny that governments and central banks don’t hedge much more? These guys are operating in 21st century financial markets with the tools of the 19th century”. Famous words…

18. “Isn’t it funny that governments and central banks don’t hedge much more? These guys are operating in 21st century financial markets with the tools of the 19th century”. - Ricardo Caballero, 17.6.2006 Famous words…

19. This might be a bit of an exaggeration • Lessons from the Asian Crisis • The Asian crisis brought home the risks of fixed exchange rates in a period of rapid financial globalization. • Rare, big events lead to a updating of beliefs (some of it may or may not be rational, cf Cogley+Sargent 2005) • One way to hedge against meltdown + attacks is to build up massive reserves • Asian governments have issued a lot of debt domestically – no shortage of the “production of attractive assets” • Used the proceeds to build up reserves • Invested much in the Treasury market, etc., to minimize opportunity cost of reserves • Combines with Bretton-Woods II motives (Dooley + Garber 2005)

20. Additional factors that could benefit from Caballero et al.-style analytics • Decline in the US demand for foreign assets • Differential rates of return? • Increase in correlations? • Savings glut of US firms • Private sector savings in the US has NOT collapsed because firms have started to save massively • Profits are unusually high • …but investment is also unusually depressed

21. It’s not just foreign demand for US assets that has changed over time

22. Openness and return correlations, 1890-2000

23. The business sector has started to save on average