The global economic imbalances and the sub prime crisis

At the heart of the sub prime crisis lies the huge global economic imbalances that have developed in recent years. In the past decade, emerging markets have grown impressively by exporting to the western countries especially the US in a big way. As Raghuram Rajan[Federal Reserve Bank Of St. Louis Review September/October, Part 1 2009. pp. 397-402.]mentions, this was a response to a wave of crises that swept through the emerging markets in the late 1990s. East Asia, Russia, Argentina, Brazil, and Turkey all went through turmoil during the 1997-98 currency crisis. As a result, these countries became far more circumspect about borrowing from abroad to finance domestic demand. They cut back on investment and reduced consumption. Formerly net absorbers of financial capital from the rest of the world, many of these countries started to record trade surpluses and became net exporters of financial capital.

Many of these emerging markets were also characterised by high savings rates. In mid-2008, emerging-economy central banks held over $5 trillion in reserves, a five fold increase from 2000. The large savings surplus in these economies caused a flood of capital to America. These surplus funds had to go somewhere. Bulk of these funds were parked in safe government securities in the US. This flood of capital helped in pushing long-term interest rates down.
In a speech in Beijing on December 9, 2008, Lorenzo Bini Smaghi of the European Central Bank explained how a marked asymmetry in the global financial system aggravated the economic imbalances. In the developed countries, rapid financial innovation and sophisticated financial products encouraged easy financing and consequently indebtedness. On the other hand, relatively rudimentary financial systems in the emerging markets encouraged the recycling of current account surpluses and savings into developed countries, especially the US to fund their growing deficits. At the same time, economies like India and China “managed” their currency even as many western countries had floated their currencies. To manage their currencies, the emerging markets were compelled to buy dollars and dollar denominated assets. If they did not do so, their currencies would have appreciated, making exports more difficult. These countries also made significant purchases of paper issued by government sponsored enterprises like Fannie Mae and Freddie Mac.

At the same time, the rise of China and India not only made many products cheaper but also added vast pools of cheap and skilled labour to the global economy. So inflationary pressures remained low, enabling the Fed to manage the economy with low interest rates. The Fed’s simple argument was: Why raise interest rates and thereby threaten the growth prospects of an impressively performing economy when inflation is under control?

Low interest rates, while good for economic growth, also created a bubble in the real estate market. They spurred off an unprecedented demand for homes and home loans. Raghuram Rajan has explained how the surplus capital might have landed in the real estate sector. Corporations in the US and industrialized countries initially absorbed the savings of emerging markets by expanding investment, in areas such as information technology. But this proved unsustainable. The investment was cut back sharply after the collapse of the information technology bubble. And as monetary policy continued to be accommodative, these funds moved into interest sensitive sectors such as automobiles and housing. This triggered off a housing boom.
But the housing boom had to collapse at same point of time. And only when it collapsed, did policy makers begin to appreciate the true significance of the global economic imbalances. Indeed, the sub prime crisis can be viewed as the consequence of the disorderly, unwinding of the economic imbalances that had accumulated in the global financial system over time. The disorderly adjustments have thrown the system out of balance. There has been a sudden escalation in risk aversion even as there have been corrections in prices of real estate, oil, various financial assets. There have also been sharp reversals in the direction of capital flows and exchange rates movements. The net consequence is that the global GDP growth has come down sharply.

Tackling the global imbalances will require a complete change in the mindset of the countries involved. And by no stretch of imagination, will it be an easy task. In mid August, 2009, a leading US Economic policy spokesman, Larry Summers called for a shift in the US economy from a consumption based one to an export oriented one. At the same time, American politicians have been putting pressure on China to revalue its currency, thereby reducing exports and increasing domestic consumption. Many commentators have argued that China’s high savings – high investment economy (at the cost of consumption) is destabilizing for the world economy. Some progress has already been made since the onset of the financial crisis. The US trade deficit has already come down from 6% of GDP at the peak to about 3% currently. At the same time China’s current account surplus has shrunk from 11% of GDP to about 9.8%. But there is no guarantee that this trend will continue unless the US can tackle its huge budget deficit. At the G-20 meeting at Pittsburgh in September 2009, a lot of time was devoted to the issue of achieving balanced, higher global GDP growth.