What links between imbalances and the financial crisis?

1. Global Imbalances, the Financial Crisis, and the International Monetary SystemMaurice ObstfeldUniversity 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

2. 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.

3. 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.

4. 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.

6. 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?

9. 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.

11. 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.

13. Macro-financial linkages greatly worsen global imbalances around 2004 • Housing prices rise globally.

14. From ECB, Monthly Bulletin, August 2007

15. Commodity prices take off.

16. 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.

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

20. Housing finance activity accelerates in 2004.

22. 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

23. 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.

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

25. Dollar depreciation trend slowed

26. 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?

27. 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?

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

30. Reserve demand for US dollars has been trending downward. Likewise, FX market share (April 2010 survey).

31. 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?

33. Lenders of last resort: • 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?

34. 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).

35. 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.

37. 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.

38. 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.

39. 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.