By common consent, we have been living through the greatest economic downturn since World War II. It originated, as we all know, in a collapse of the banking system, and the first attempts to understand the resulting economic crisis focused on the reasons for bank failures. The banks, it was said, had failed to “manage” the new “risks” posed by financial innovation. Alan Greenspan’s statement that the cause of the crisis was the “underpricing of risk worldwide” was the most succinct expression of this view.1 Particular attention was paid to the role of the American subprime mortgage market as the source of the so-called “toxic” assets that had come to dominate bank balance sheets. Early remedies for the crisis concentrated on bailing out or refinancing the banks, so that they could start lending again. These were followed by “stimulus packages,” both monetary and fiscal, to revive the real economy.
Now that we are—or may be—over the worst of the crisis, attention has partly switched to trying to understand its deeper causes. The two most popular explanations to have emerged are the “money glut” and the “saving glut” theories. The first blames the crisis on loose fiscal and monetary policy, which enabled Americans to live beyond their means. In particular, Greenspan, chairman of the Federal Reserve in the critical years until his retirement in early 2006, used low interest rates to keep money too cheap for too long, thus allowing the housing bubble to get pumped up till it burst.
The second explanation sees cheap money in the US as a response to a “global saving glut” originating in East Asia and the Middle East. The “exorbitant privilege” enjoyed by the US dollar as the world’s key currency allowed the US to pursue a fiscal and monetary policy that pushed domestic demand for goods and services well beyond domestic output, thereby absorbing the foreign savings hurled at it. The trouble was that foreign, and particularly Chinese, “investment” in the US economy, which in recent years has taken the form of buying US Treasury bonds, failed to create a corresponding flow of American tradable goods and services with which to repay the borrowing. As a result, America’s domestic and foreign debt just went on increasing. In the technical jargon, both the US current account deficit and its debt-financed housing boom were unsustainable: it was unclear whether the dollar or the housing bubble would collapse first.
Concern about the US current account deficit—the excess of expenditures over receipts in a country’s balance of payments—long preceded the financial crisis. By 2005, it had already ballooned to 5 percent of GDP. How had this happened? The conservative explanation was that the US monetary and fiscal authorities had provided Americans with the money to make payments to foreigners for imports far in excess of the payments they received from foreigners for exports. This “spending beyond your means” is the classic road to ruin, for households as well as for countries. In the case of households, it is normally brought to an end by a notice from your bank or credit card company saying that you have reached your credit limit or your account has been frozen. In the case of countries, it is normally ended by the refusal of other countries to lend the profligate country the means to continue its spending spree. The puzzle, though, was why the countries with surpluses continued to pour their hard-earned savings into the debt-ridden American economy.
In a notable lecture in 2005, Ben Bernanke, about to become chairman of the Federal Reserve, gave the answer. At first, he said, it was because the US was a highly productive economy. But following the financial crisis of 1997–1998, East Asian countries had deliberately started accumulating foreign exchange reserves to guard against another flight of capital similar to what they had just suffered or observed. To accumulate reserves they had to run current account surpluses, by earning more in exports than they spent on imports. This tied in with their policy of undervaluing their currencies against the dollar in order to maintain export-led growth.
After the collapse of the dot-com boom in 2000, the US became a much less desirable place for direct foreign investment. So East Asian countries, especially China, started to buy US Treasury bonds. They adopted aggressive policies of buying large quantities of dollars and resisting market pressure for appreciation of their currencies. Investing their dollars in US securities was a way of segregating their dollar purchases from the domestic money supply, thereby preventing domestic price increases that would have eroded their export competitiveness. Like other economists at the time, Bernanke saw considerable merit in the arrangement: it enabled emerging and developing countries to reduce their foreign debts, stabilize their currencies, and reduce the risk of financial crises. Without US willingness to act as a “consumer of last resort,” the global savings glut would exert a huge deflationary pressure on the world economy.
But Bernanke also pointed out three snags in the situation. First, for developing countries to be lending large net sums to mature industrial countries with abundant capital was undesirable: the flow should be going the other way—to countries with a capital shortage. Second, much of the inflow of capital to the US went not into improving productivity but into the housing sector and consumption. Third, the arrangement depressed US exports, encouraging instead the parts of the economy that produce nontraded goods and services, such as the financial industry. Yet to repay its foreign creditors, the US needed healthy export industries. A fall in the dollar was, therefore, needed to shrink the nontradable economy relative to the export sector. Nevertheless, Bernanke concluded, “fundamentally, I see no reason why the whole process [of rebalancing] should not proceed smoothly.”
This was the standard view before the present crisis broke. Martin Wolf, the world’s most respected financial columnist—mainly for the Financial Times —published a book in 2004 called Why Globalization Works.2 He saw globalization as a mighty engine for ending global poverty, and was scornful of arguments against it, most of which he dismissed as lacking professional competence. He pointed to the huge success of China in reducing extreme poverty (people living on less than $1 a day). He saw no problem arising from the macroeconomic imbalances that resulted from lopsided trade. As he wrote:
The pattern of surpluses and deficits will create difficulties only to the extent that the intermediation of the flows from the savings-surplus to the savings-deficit countries does not work smoothly…. But no insuperable difficulty should arise. If some people [Asians] wish to spend less than they earn today, then others need to be encouraged to spend more.
As late as mid-2007, he thought that the possibility that “huge calamities” could be generated by world financial markets “looks remote.”3
His message just two months later was very different:
Nothing that has happened has been a product of Fed folly alone. Its monetary policy may have been loose too long. The regulators may also have been asleep. But neither point is the heart of the matter…. Today’s credit crisis…is also a symptom of an unbalanced world economy.4
Wolf more recently argued that the accumulation of dollar reserves by China and other East Asian countries that have maintained undervalued exchange rates against the dollar explains the low long-term interest rates and monetary easing of the US in the 2000s. Cheap money, he writes, had “encouraged an orgy of financial innovation, borrowing and spending” that created housing bubbles:
High-income countries with elastic credit systems and households willing to take on rising debt levels offset the massive surplus savings in the rest of the world. The lax monetary policies facilitated this excess spending, while the housing bubble was the vehicle through which it worked.5
Wolf’s most recent book, Fixing Global Finance, marks a turning point in his worldview. Written in 2007, just before the first signs of the current financial crisis were starting to register, it explains how unprecedented macroeconomic imbalances have repeatedly created the preconditions for financial crises over the last three decades. It offers the reader a chance to test Wolf’s predictions and prescriptions a few months after they were made.
Wolf’s main argument is that the microeconomics of finance is intimately intertwined with the nature of the global macroeconomy. If the latter is not sound, the former will not be sound either. His eight chapters take us through a detailed account of the role of exchange rate regimes—i.e., policies used to maintain currencies at a desired level against the dollar—and their influence on balance of payments and, ultimately, on the availability and use of credit in domestic economies.
It was the large macroeconomic effects of financial crises in emerging markets in the 1990s that enabled America to become what Wolf calls the “borrower and spender of last resort.” There were four steps toward these crises: mismanaged liberalization (and globalization), run-up to currency crisis, currency crisis, and, finally, full financial crisis. South Korea offers a good example. During the 1990s, in order to qualify for OECD membership, South Korea had been liberalizing its exchange controls and credit markets. Spurred by their government to keep growing, large Korean companies and banks started borrowing abroad despite dwindling profits. Rising foreign interest rates undermined their creditworthiness and increased the cost of servicing their debt. They therefore needed to borrow even more—but now under worse conditions. This led to a general skepticism among foreign lenders. Whether solvent or not, Korean companies were faced by an ever-worsening credit situation.
Under these conditions of uncertainty, Koreans and other foreigners started selling the domestic currency, which therefore plummeted in value and triggered a currency crisis. This is when the full financial crisis of the 1990s really got going. With a devalued domestic currency, neither private nor public institutions could afford to take out new loans in foreign currencies, and the old ones could not be repaid. Interest rates soared and insolvent companies were wiped out, bringing solvent banks down with them. “Domestic credit seizes up. Inflation surges as the currency tumbles. The economy falls into a deep recession.” Partly because of similarity of circumstances and partly because of contagion effects, this was the fate of most East Asian economies in 1997–1998.
During the three decades preced- ing 1997, financial crises were always followed by periods of large inflows of capital into emerging market economies ranging from East Asia to Latin America, as foreign investors shrugged off their losses and cheerfully started lending again. However, East Asian countries realized that being a net importer of capital comes at huge cost when their domestic currency faces devaluation. Thus, at the end of the 1990s, most emerging economies simply said “enough.” No longer would they run current account deficits; instead they would keep their currencies artificially low—but stable—to facilitate export-led growth and become net exporters of capital.
Alan Greenspan, The Age of Turbulence: Adventures in a New World (Penguin, 2008), p. 507.↩
Yale University Press, 2004.↩
"Risks and Rewards of Today's Unshackled Global Finance," Financial Times, June 26, 2007.↩
"The Federal Reserve Must Prolong the Party," Financial Times, August 21, 2007.↩
"Asia's Revenge," Financial Times, October 8, 2008.↩
Alan Greenspan, The Age of Turbulence: Adventures in a New World (Penguin, 2008), p. 507.↩
Yale University Press, 2004.↩
“Risks and Rewards of Today’s Unshackled Global Finance,” Financial Times, June 26, 2007.↩
“The Federal Reserve Must Prolong the Party,” Financial Times, August 21, 2007.↩
“Asia’s Revenge,” Financial Times, October 8, 2008.↩