Are Global Imbalances the Root Cause of the Financial Crisis?

The group of 20 heads of state at G20 meeting in Pittsburgh last September came to a number of agreements.

One was that the G20 meetings henceforth would be the primary location where global economic cooperation would be discussed. This marked a substantial advance on the functioning of the earlier industrialised country G8 which it replaced.

A second was to establish something they called the Sustainability Initiative. The idea was through discussion and eventually action to have in place an agreed policy framework under which the global economy could return to sustained strong growth.

Countries were to prepare reports and exchange information as part of this process, but central to the initiative is the assertion that without dealing fundamentally with the problem of global imbalances, sustainable growth would not be achieved.

The term “global imbalance” refers to a range of deficits and surphises, as well as underlying differences in economics performance among major economies. It begins with trade deficits and surpluses (the difference between imports and exports). These are large and positive (surplus) for China, and large and negative (deficit) for the US. They had been growing quickly before the crisis.

It continues with the closely related current account surplus or deficit, which contains all non capital account transactions (remittances, interest, dividends). These imbalances are reflected in the large accumulation of reserves in the surplus countries (China, Japan, Gulf states).

It also includes discussion of high savings rates in China, low savings rates in the US, and public sector deficits now around the world. The assertion is that during the high global growth phase between 2005 and 2007, these imbalances steadily increased and these increases were not sustainable. The end of the growth in imbalances brought with it the financial crisis.

The issue in this discussion is whether these global imbalances are really the central cause of the financial crisis. Are they a primary factor, or largely a symptom of other deeper factors? This is an unresolved debate, but is central to the G20 process since global political leadership has staked its authority on the proposition that remedying imbalances will revive stable growth.

In my view, the discussion needs to be much more nuanced than the G20 assert. Previous episodes of global instability seem not to have been foreshadowed by a similar build up of imbalances. Trade and current account surphises and deficits were not seemingly a major factor in the 1930s, nor in the Asian Financial Crisis of 1997/1998. There was not an issue of sharply differential savings rates between countries in these same two episodes. In addition, when national instability has occurred, such as Japan in 1989, there did not seem to be prior issues of imbalances.

Japan and the Asian Financial Crisis would seem to be more likely the bursting of asset and price bubbles than imbalance lead. In the decades from 1970 to 1989 the Nikkei went, from a little over 3000 to 40,000 with a large expansion in earnings multiples. Real estate bubbles followed.

At the peak the claim was that the square kilometre of land in Tokyo around the Emperor’s Palace was worth more than all the land in California.

The capitalised value of all stocks on the Tokyo Exchange exceeded that of New York. Banks lent on these inflated asset values.

When the bubble bust, topsy cause down and imbalances per se seemed not to be central.

Equally, in the Asian Financial Crisis it was strong growth in the Asian economies, inflated real estate, and bank lending on these asset values that seemed to precipitate the crisis. As it first appeared in Thailand, excessive investment in Gulf courses and parking lots was claimed. In Indonesia, which had had macro stability for 25 years, it was short term debt in foreign currency denominated liabilities combined with capital flight by Indonesia’s foreign business community which while small in number were large in assets. The Indonesian Repiah moved from 500/$1 to 2500/$1 in a matter of weeks. Again, imbalances seem not to have been the central issues.

In the latest global financial crisis there is no doubting that imbalances have been present, as they were for many years prior. But we have also seen major global price declines in housing, stocks (with a rebound), oil (again with a rebound), and commodities such as copper.

If the financial crisis is at heart an unwinding of price bubbles, the global economy could potentially continue on its path towards stabilisation and resumed growth without major redress of imbalances. And by the time the G20 elaborate on its preferred structure for their Sustainability Initiative, the event could potentially be largely behind us.

It is not easy being a global politician making these tough calls. For every argument there seems to be a counter argument. On this one the G20 may have decide to proceed without a full weighting of the evidence, and in so doing take global policy rating down a path that may act be fully effective.

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