A good GFS can sustain global imbalances safely
New attempts are being made to resuscitate the “savings glut” hypothesis of the origins of the great financial collapse and recession and the eurozone’s agony. This hypothesis is wrong.
What matters is not saving but financing. Countries running current account surpluses do not finance those running current account deficits.The deficits are financed by banks, investors and other suppliers of funds.
Analysis confined to national account concepts like savings and investment throws no light on the cross-border flows that actually finance credit booms. Indeed, it diverts attention away from the monetary and financial factors that have been the main cause of repeated financial crises. It is the financial decisions of market participants that determine financing flows, not the ex post distribution of savings and investment.
In the build-up to the global financial crisis, there is no evidence that the US current account deficit was “financed” by an increase in global savings. While the US deficit began to rise in the early 1990s, the world saving rate was actually declining, and this continued at least until 2004. At the same time, the cut in US current account deficits after 2006 occurred against the backdrop of an increase in emerging market saving rates.
The global economic boom from 2003 is hard to reconcile with the hypothesis of an increase in ex ante global saving, which other things being equal will depress demand.
Further, many surplus countries have had also had huge credit booms. Look at China from 1997 to 2000, India from 2001 to 2004, Brazil from 2003 to 2007 and economies in the Middle East. Japan in the 1980s is another case in point. The occurrence of financial crises have only a tenuous connection with the ex-post distribution of current account imbalances.
The roots of the global financial crisis should be traced to a global credit and asset price boom fuelled by central bank monetary policies and commercial bankers’ aggressive risk-taking.
Expenditures are constrained not by savings, but by access to finance. Spending can be financed by borrowing and this then determines ex post savings. If agents in the deficit sector obtain financing to enable them to spend more than their incomes, this very spending creates the corresponding saving in the surplus sector.
Advocates of the excess-savings thesis do not just use the wrong theory. They get the evidence wrong too. The evidence on how the asset boom was financed in the build-up to the crisis just does not support the view that it was all the fault of excess savings by some countries.
By far the most important source of financing for the 2003-2007 credit boom in the US was Europe, not emerging markets. Europe accounted for around one-half of total inflows in 2007. Of this, more than half came from the UK, a country running a current account deficit, and roughly one-third from the euro area, a region roughly in balance. Little came from China, Japan or the Middle East
From this perspective, the role of Asia – in particular China – and oil exporters in ‘funding’ the US current account deficit or the credit boom was insignificant.
Turning to policy remedies, to reduce the likelihood and severity of future financial crises, the challenge is how to reduce destabilising capital and credit flows, not whether savings are excessive or not in some countries. The fundamental weaknesses is that the system lacks any mechanism to prevent the build-up of unsustainable booms in credit and asset prices which lead to serious financial strains.
Another conclusion follows: even if the scale of current account imbalances were to be permanently reduced, whether in the euro area or at the global level, that would not make the financial system or the global economy any safer.
By the same token, a strong global financial system (GFS) is one that is able to accommodate large and long-lasting imbalances on current account, which are indeed a natural accompaniment of international economic development.
NB See Chapter 8 of The Money Trap and especially Claudio Borio and Piti Disyatat, ‘Global imbalances and the financial crisis: Link or no link?’, BIS, Working Papers No 346, May 2011.