Global imbalances and the current account deficits and surpluses they create have been a topic of debate over the past few years. Some have argued that they were a key factor in causing the financial crisis, believing that emerging market's excess savings and lack of investment improved financial conditions in those advanced economies running current account deficits and lowered world interest rates. This inflow of saving contributed to create a boost in not only credit but also risk-taking in advanced economies such as the United States of America, which led to such events as the housing market collapse and started the chain of events for the financial crisis. For this excess savings hypothesis to run true, it would mean that the capital flows from the countries running a current account surplus to those in deficit financed the pre-financial crisis boom in the deficit countries and also the increase in the ratio of ex ante global savings to investment in the countries with a current account surplus lowered world interest rates.
Global imbalances can be defined as "External positions of systemically important economies that reflect distortions or entail risks for the global economy". (Bracke et al. 2008). To fully understand this we need to break down this definition, firstly external positions encompass financial positions and current account balances and secondly the "systemically important economies" are those where economy decisions and status can have serious implications on the global economy. The distortions that the quote refers to are divergences in the equilibrium that would occur in a flexible and perfectly competitive market. The risks these imbalances pose to the global economy could be if these imbalances were to unwind, causing disruptions to stability and also if these imbalances were to increase, as Bracke fears the "risk of a protectionist backlash". (Bracke et al., 2008).
The introduction of international trade brought about the existence of global imbalances. Countries with high potential for production who export to countries with less production increase their current account balances, whereas countries that have a higher tendency to import goods are more likely to hold deficits in their current account. At the start of the twentieth century countries such as Great Britain and France had surpluses in their current account but due to the increase in foreign trade over this time these countries have increased their imports due to other countries having higher comparative advantages in trade against them, it has meant that it has been cheaper to source goods from overseas where the labour and production costs are lower. This has meant that these countries are now in the positions of holding current account deficits. The United States of America has gone from being the world's largest creditor to a debtor. This was partially due to the increased flow of investments into the country, tax cuts, the oil crisis in the 1970's, but also due to the increased importance of international trade, meaning it is cheaper for companies to outsource a lot of their production to developing countries such as those in South America and Asia. During the 2000's it has increasingly been these developing countries that have held current account surpluses whilst the advanced countries' account deficits seem to be increasing. The economic crisis and subsequent recovery in Southeast Asia meant that their new policies of increasing their exports led to economic growth in these countries and also current account surpluses.
Blanchard and Milesi-Ferretti (2009) argue that in an economy with international trade there is no reason for balanced current accounts to be necessary, infact the opposite of this is attractive, it is better for investments to go where they will have the greatest effect and therefore imbalances will emerge due to certain economies having a greater attraction for savings due to their possibilities for production. Due to imbalances being very common it is important that we can distinguish between good and bad imbalances, as bad imbalances can create distortions and risks in the market.
There are many causes of these global imbalances, one being increase of the fiscal deficit which brings in "twin deficit" hypothesis, which is when the current account balance is equal to saving minus investment, so an increase in fiscal deficit and reduces savings will in turn increase the current account deficit. An increase in public spending will also increase interest rates, attracting foreign investment and therefore strengthening the currency, increasing these imbalances even further. Private spending can also have an impact on the current account deficit, the United States personal saving rate has reduced in recent years to around 2% of disposable income (Gruber and Kamin 2006), Ferguson (2005) explained that this decline in the rate of savings along with an increase in interest rates crowd out investment more than it does net exports, thus adding to the problem of the deficit. Gruber and Kamin also argued that expanding global financial intermediation was a cause of the global imbalances and thus financial crisis, Whelan (2010) quoted that in the period 2002-2007 foreign liabalities of the US increased from 83% to 147% of GDP, although only a third of this increase was credited to the swell of the current account deficit, as the rest was put down to financial globalisation. The US's deficit can also be attributed to the increase of saving overseas, a large proportion of the inflow of foreign saving came from developing countries, and also from the USA's increasing reliance on imported goods and not their own production, from 2002-2005 the USA's industrial sector grew by 5%, whilst their demand for consumption of these manufactured goods increased by 30% (Å vihlíková, 2008), meaning they were consuming a higher proportion of their goods from imports.
Although these factors can cause global imbalances, we still need to find out whether these imbalances had a significant effect on the financial crisis, as referred to in the introduction in order for this to be the case, then the pre-financial crisis boom would have had to be financed by these inflow of savings causing the global imbalances and secondly that the rise in ex ante global saving in relation to ex ante investment in the countries running current account surpluses depressed interest rates significantly enough.
For this hypothesis to hold true we must understand the basic model that holds these views together. The current account by definition is the difference between savings and investment, (CA=S-I). We take two identical countries, one domestic and one foreign where both countries are open to international trade and borrow/lend at the world real interest rate. In this model savings are fixed, as it is based on income minus consumption which we are holding steady. Investment falls as the real interest rate increases, which therefore implies that the current account will increase in line with real interest rates. To fully understand how global imbalances influence the international economy we must look at how the world interest rate varies. If we again picture a global economy made up of just two countries, where globally savings and investments are equal we can see how the world real interest rate is determined as the worlds current account must be equal to zero, as it can not trade with another world. We therefore know that;
This model shows us how the current account, and investment and savings influence world real interest rates and how shocks to savings and investment create global imbalances. If we imagine that the foreign country in our model experiences an exogenous rise in saving, this causes the world savings supply curve to shift out, resulting in an excess of world saving supply compared to world investment demand at the world real interest rate. To achieve equilibrium the world real interest rate must fall in order to increase investment in both countries, at the new interest rate the home country will have an excess demand of investment to saving and the foreign country will have an excess supply of saving to investment, result in both countries having an imbalance in their current account whilst the world current account remains at zero. This is a result of the foreign country's saving shock bidding down the world real interest rate. If we suppose, instead of a savings shock we have an investment shock, this process will happen in reverse, the world savings curve will shift out and therefore to achieve equilibrium the world real interest rate will have to increase, causing an excess of saving in one country and an excess of saving in the other, again both countries have current account imbalances but the world current account is in equilibrium
When assessing the first of these conditions we can note that current accounts disclose little about international financing, they instead show net resource flows from trade in goods and services but do not reveal variations in gross flows and transactions solely in financial assets, which add up to a large proportion of international trade activity. Therefore, not really explaining a country's true role in financial intermediation and the level of which its investments are financed from overseas, or the impact of international flows in capital on domestic policy. When analysing current accounts in relation to international capital flows, this detracts attention from the global financing patterns that financial fragility stems from.
When we instead look at gross capital flows rather than net, this puts a different light on the view that global account imbalances was a large factor in bringing about the financial crisis. Gross capital flows have increased vastly since the late 1990's, more than tripling from 1998-2007 from around 10% of world GDP to more than 30%, the majority of this has been brought about by flows between advanced economies, rather than from emerging economies to the advanced. The majority of flows into the USA economy, instead of being from emerging markets, was from Europe, which made up around half of the total flows into the country in 2007. A quarter of the overall inflows came from the UK alone, who itself were running a current account deficit. The amount incoming from Europe's advanced economies who were either running deficit or were roughly in balance was greater than that coming from either China or Japan, who were both running current account surpluses, the outflows from the US tell a similar story, again outflows to Europe dominated and exceeded those to Asia. When trying to explain global imbalances as a source of the crisis, this also does not tell the story of international bank lending, the majority of gross inflows into the USA were in the private sector, US bank's liabilities and foreign demand for US securities increased dramatically between 2000 and 2007, a main cause of the pre-financial crisis boom. When in 2008 global current account imbalances slightly narrowed, gross capital flows buckled due to the cutback in flows between the advanced economies, much of the reduction in flows was between the previously high route between USA and Europe, net capital inflows into USA from the world fell by $20bn and gross inflows dropped by around 75% of their 2007 height.
This gives us a different image from that which the excess savings theory would have us believe, the view that Asia pretty much financed the pre-financial crisis boom in the USA seems somewhat flawed when in reality it seemed to mainly be caused by the banks of Europe's economically advanced countries, supporting the idea that the route of the cause of the financial crisis did not stem from unwinding of global imbalances but rather problems within international financing and intermediation.
The US current account deficit grew to nearly 2% of world GDP in 2006 before the recession, whilst there were significant increases of surpluses in Asia, especially China and other countries who export oil. After the Asian financial crisis, they used exports to aid their economic growth and recovery, during this growth, Asian central banks defended against appreciation pressures through foreign exchange reserve accumulation, for the past few years, foreign exchange reserve accumulation has surpassed Asia's current account surplus. The excess savings view of how global imbalances caused the financial crisis holds strong links between current account deficits, world interest rates and the recession. This view, as held by Bernanke (2005) maintain that an excess of saving and lack of investment in emerging countries such as China are the key to global imbalances, this excess then flowed into advanced countries such as the United States who hold current account deficits, this inflow eased tensions in the economy, decrease long-run interest rates, the lowering of these interest rates meant borrowing was at a much lower cost and encouraged a boom in credit, such as the vast amount of mortgages before the collapse of the housing market. Bernanke (2005) believes that the boost of Asian exports, higher oil prices and a lack of investment in the economically advanced countries led to a "global savings glut".
Contrary to these views, current account deficits/surpluses and long-run interest rates do not seem to hold a significant link between one another, as the US's deficit rose to huge levels before the financial crisis, contrary to what the believers of the global imbalances causing the financial crisis would think, the US long-run interest rates increased between 2005 and 2007, this was also with an absence of capital outflows from the countries with current account surpluses. The link between interest rates and the current account that needs to hold for Bernanke's view to be correct is also weakened by the fact that since the onset of the financial crisis, USA's long-run interest rates have fallen whilst their current account deficit has started to improve. There also does not appear to be a strong link between the USA's current account status and global savings. For Bernanke's hypothesis to hold true, the USA's increased deficit should go hand in hand with an increase in the global savings rate, however, whilst the USA's budget deficit was increasingly deteriorating in the 1990's, the world saving rate was on a downwards trend until the end of 2003 (graph 3 from article), also, as the USA's current account has started to improve, since 2006 there seems to have been an upwards trend in the savings rate of the emerging economies. Credit booms are also not solely associated with countries running a current account deficit, Hume and Sentence (2009) highlighted that countries running current account surpluses have also experienced credit booms such as China (1997-200) and India (2001-2004). Before Japan's financial crisis, they too had a credit boom, however they were running a large surplus in their current account, as did the USA previous to the great depression of the 1930's.
The problem with being able to discriminate clearly between gross and net capital flows is a symptom of being unable to differentiate between saving and financing. Saving, in a national accounts sense, can be defined simply as income that is not being consumed whereas financing is a different concept dealing with cash-flow, and is access to investment through means such as borrowing, investment therefore requires financing rather than saving. This means that saving gives little bearing on the state of financial assets at any one time. Also, an economy, which has a balanced current account, is able to take part in international intermediation and all of its investment could come from foreign sources. Hence, countries with surplus current accounts are not necessarily financing those with deficits, the investment and savings which explain their current account positions could be financed either domestically or from abroad.
The "saving glut" explanation of lowering interest rates does not provide a complete insight and again flaws the excess savings view of how the financial crisis came about. World interest rates result from a variety of factors such as the policy rates set by central banks of each country, future expectations about policy rates and risk which are generated by perceptions of future financial assets and future risk. The excess saving theory explains interest rates by flows explained by real factors such as actual saving and investment, where a natural rate equilibrium is always achieved. The real interest rates my infact gravitate towards this long-run equilibrium, before the financial crisis this did not seem to be evident. The pre-financial crisis credit boom was a sign of a gap between real interest rates and the natural long-run equilibrium, even though the inflation rate remained at a constant steady level. Also, seen as though the natural interest rate should always be at equilibrium, it should never have been the cause of such a huge shock such as the financial crisis. Instead, central banks and other players in the market set interest rates too low, thus increasing levels of borrowing to unnatural rates and therefore elevating levels of risk to worrying levels, one of the main features of the cause of the financial crisis.
In conclusion, global imbalances do not explain the patterns of global intermediation in regards to the pre-financial crisis credit boom or how market interest rates are actually determined. The theory that global imbalances were at the root of the financial crisis takes away from the monetary and financial reasons that started the chain of events. When looking at global financial stability, current account imbalances are rarely the main feature, instead it is more important to try to rectify weaknesses in international monetary and global intermediation systems. These systems do not have strong enough bases in order to prevent unnatural booms which led to the roots of the problem of the financial crisis such as unnaturally high lending and the housing collapse as there is excess elasticity in the market. There needs to be stricter rules in place in order to anchor this system. Therefore Bernanke's view that global imbalances were such a key role in causing the financial crisis is flawed, due to two main reasons; the excess saving theory does not discriminate well enough between saving and financing, and also does not take into account the market determinants of the natural interest rate.