Who’s to blame for the worldwide financial crisis? The list of potential culprits for the meltdown of the US financial system is long and the rogues’ gallery will no doubt expand a great deal before the economy is out of the woods. But a worldwide crisis calls for a global villain. And there is indeed one at hand – global macroeconomic imbalances, characterised by large current account deficits in the US and a few other advanced industrial countries, with these deficits financed by excess savings in China and many other emerging market economies.
Do these imbalances constitute the proximate cause of the crisis?
That depends on whom you ask. Whatever the right answer, however, we must guard against the risk that these imbalances could actually worsen during the global recovery – whenever that comes – and set the stage for the global economy to stumble again in the future.
The view from the US, which has been at the epicentre of the crisis, is interesting. In its waning days, the Bush White House issued a statement that in part reads “…the President highlighted a factor that economists agree on: that the most significant factor leading to the housing crisis was cheap money flowing into the US from the rest of the world, so that there was no natural restraint on flush lenders to push loans on Americans in risky ways. This flow of funds into the US was unprecedented. And because it was unprecedented, the conditions it created presented unprecedented questions for policymakers.” In other words, it’s all the foreigners’ fault.
This builds on Bernanke’s saving glut hypothesis, and officials in the new administration seem to have picked up the theme. These statements invariably end up either implicitly or overtly laying the blame at the feet of China for its currency management policies that have created a current account surplus that could amount to about $350 billion, or about 9% of GDP, in 2008.
Global imbalances and US financial problems
There is no doubt that global imbalances allowed problems in the US financial system to fester. Excess savings in Asian and other emerging markets and the bloated revenues of oil-exporting countries were recycled into the US financial markets. The resulting low interest rates in the US created incentives for financial shenanigans in the US and blocked self-correcting mechanisms such as rising interest rates due to higher government borrowing. What could have been a bubble that would sooner or later have popped instead turned into a blimp that soared heavenward before crashing back to earth.
The Chinese, for their part, have reacted with scorn to the notion that anyone but the US bears central blame for the crisis. In any event, whether or not one regards global imbalances as the root cause of the crisis, the underlying policies that generated those imbalances were clearly not in the long-term interests of the countries concerned.
US fiscal profligacy and a financial system that encouraged the consumption binge helped bring on the financial instability. For its part, China has done itself no favours with a currency regime that has tied its hands on macroeconomic policy, kept its economy dependent on exports (most of which go the US and the EU), and hindered a much-needed rebalancing of growth towards private consumption. In a cruel irony, the thriftiness of the Chinese has come back to haunt them with the collapse in the demand for their exports.
Indeed, there is an even richer set of ironies in the way the crisis has played out.
- First, the global macro imbalances are not unravelling in the way that many economists had expected (present company included). Rather than experiencing a decline in the value of the dollar, the US current account deficit may apparently adjust with just a massive contraction in private consumption.
- Second, the epicentre of the crisis has become the safe haven, with the flight to quality around the world turning into a flight to US treasury bonds.
- Third, and most worryingly, the rest of the world still seems to be counting on the US as a demander of last resort.
- Fourth, all signs are that the global crisis may lead to emerging markets rethinking old notions of reserve adequacy and consider building up even larger stocks of reserves.
In short, as the world economy pulls out of the crisis, the imbalances that created much of the problem could intensify rather than dissipate. This is why the solutions need to be global as well. Moreover, while much has been said about how to redesign financial regulation, this has to be supported by a clear focus on macroeconomic policies.
Some of the necessary steps are as follows.
- Additional macroeconomic stimulus measures are clearly going to be needed in all of the major economies. These should be coordinated in order to prevent the stimulus in any one country from seeping out and reducing the overall bang for the buck. Moreover, coordination would also bolster business and consumer confidence that governments are serious about stimulating their economies with all tools available and enlightened enough to do this in a cooperative manner.
- The major world economies need to map out and forcefully communicate their strategies to solve their domestic problems. For instance, the US needs clear plans to bring its public finances under control over a reasonable horizon after the recovery gets going and to retool its financial regulatory mechanisms. The Chinese need to have an effective strategy to rebalance their economy towards private consumption and away from investment and exports. This will require greater social spending and a more flexible exchange rate.
- A revamp of global governance is essential. The IMF (or an equivalent institution) needs to be given the teeth to call not just emerging markets but also the rich industrial economies to the woodshed when they run policies that might be in their apparent short-term self-interest but against the collective long-term interests of the world economy. It also needs to have enough resources and sufficient legitimacy among emerging markets that they can count on it as an insurer, and thereby save themselves the trouble and costs of self-insuring by building up large stocks of reserves.
While financial regulatory reform is needed, reform of the international arrangements for macroeconomic policy surveillance and the international financial architecture are equally urgent priorities. Otherwise, we will be back where we started, with a perfectly good crisis gone to waste.