Foreign Affairs, July/
The global financial crisis that began in 2007 has only just begun to recede, but economists and policymakers are already considering its future implications. Has the Great Recession introduced a new economic era? Or was it a temporary shock that will eventually correct itself? The answers to these questions will affect a number of vital economic issues, including the relationship between emerging and developed economies, the direction of international trade and capital flows, and the potential for currency wars or other economic conflicts.
Both the recent crisis and the policies that ended it were unprecedented. Compared to other periods of economic turmoil, this crisis was not only unparalleled in scale but also unique in its causes -- among them, many argue, global financial imbalances. Basic economic theory presumes that capital will flow "downhill" from capital-rich developed economies to capital-scarce emerging ones, as investors in the first seek profits in the second. Yet over the past 15 years, capital has, on net, flowed "uphill" from emerging economies to developed ones. Although private capital did travel downhill, as conventional wisdom predicts, it was offset by vast government reserves from emerging countries, chiefly from central banks and sovereign wealth funds, heading uphill. When the recession struck, this unprecedented flow of capital and accumulated reserves suddenly seemed less of a mystery, as emerging markets facing problems began to use the reserves they had accumulated to ride out the economic storm. With that insurance on hand, they defended their currencies, averted capital flight, buffered their financial systems, maintained access to capital markets, and pursued fiscal stimulus programs more successfully than they had during previous episodes of economic turmoil and with greater confidence than some of the developed economies.
Yet although these global imbalances may have helped emerging economies during the financial crisis, many have argued that they also contributed to fueling the financial crisis among developed markets in the first place.
Yet a closer look at both economic history and current trends suggests that even without government intervention, these global imbalances are likely to stop increasing at the same pace and may even decrease. And so, by doggedly emphasizing the importance of these imbalances, economists and policymakers risk fighting the last battle even as a new postcrisis economy emerges with its own set of challenges.
CRISES, THEN AND NOW
To understand the capital imbalances that occurred during the Great Recession, it is helpful to compare the period that led up to the crisis to earlier cycles of globalization. In the first era of globalization (from approximately 1870 to 1914) both trade and financial flows expanded dramatically. Capital came mainly from
But then, the first era of globalization fell victim to all-out war, the Great Depression, and war again. By 1945, most countries had retreated behind trade barriers and capital controls. The 1944 Bretton Woods conference, convened to rebuild the international economic system, established a global financial order that led to the creation of the IMF and, eventually, the
Yet the Bretton Woods system withered away in the 1970s and 1980s, undercut by financial innovations designed to evade capital controls, a lack of commitment to fixed exchange rates, and a willingness of governments, especially in the developed economies, to tolerate greater financial freedom at home and abroad. As a result, a more freewheeling system of finance arose, similar to that of the first era of globalization. This occurred first, in the 1980s, among developed markets and then, in the 1990s, among emerging markets as they opened up their economies and began to embrace financial globalization.
Financial crises then began reemerging. They did not immediately impact the seemingly resilient developed economies. Various crises in developed countries, from the widespread U.S. savings and loan failure in the 1980s to the collapse of Scandinavian banks in the early 1990s, were costly but not crippling. But the arrival in the emerging world of financial globalization, with its demands of political and institutional stability, financial supervision, and monetary and fiscal probity, proved far more damaging.
Emerging countries often experienced a double or triple crisis. A currency crash would weigh down banks and the government by magnifying the value of foreign hard-currency debts in local-currency terms, raising the risk of government default and banking crises. Or a bank collapse would injure the economy, triggering fiscal strains and capital flight and raising the risk of government default or currency crises. Additionally, a sovereign default would devastate banks' balance sheets and elevate the country's risk premium, raising the pressure for banking and currency crises. Any one of these types of crises was apt to trigger another.
Many emerging countries found themselves caught in this vicious cycle. The largest and most alarming wave came during the 1997-98 Asian financial crisis. Caused by a still-disputed combination of weakening macroeconomic conditions and self-fulfilling investor pessimism, the crisis shut down access to capital markets and led to widespread devaluations of currencies and credit crunches across South and
An agreement that
Around 1990, global central-bank reserves totaled approximately
Yet this self-insurance did not come cheap. Critics in emerging economies and abroad worried that such plans to save for later rather than spend now would result in unjustified opportunity costs, such as lost investment opportunities, lower consumption and social spending, and low interest rates on U.S. Treasury securities. These concerns magnified as the reserves grew from hundreds of billions of dollars to trillions from the 1990s to the early years of this century.
Costly or not, however, the emerging markets' insurance strategy has wildly exceeded expectations. These economies hardly suffered during the recent crisis, as they were able to use their vast reserves to bulwark currencies, prevent capital flight, and pay for fiscal stimulus programs.
TOO MUCH OF A GOOD THING?
The success of emerging markets in withstanding the brunt of the financial crisis counts as an enormous victory for the reserve-accumulation strategy. But is this strategy good for all countries, and how far should it be taken? If reserves are to continue insulating economies against financial risk, their levels may need to keep pace with GDP growth.
Yet by doing so well during the recent financial crisis, many emerging economies have demonstrated that they have, or are close to having, sufficient levels of reserve funds to guard against potential disruptions. To be sure, these reserves may not permanently protect them, and so governments must remain vigilant. But they have unquestionably made emerging markets much safer than they were ten or 20 years ago, when they had far fewer reserves, especially given the low costs involved in accruing such reserves compared to suffering a financial crisis. Now that they have built safer levels of external wealth, emerging markets may feel less pressure to keep piling up reserves. This may mean that the world economy will soon enter a new and unprecedented phase of rebalancing, as adjustments to the patterns of investment, saving, and capital flows take effect.
As in past eras of structural transformation, the emerging economies are growing faster than the developed ones, powered by their desire to achieve parity with developed countries in technology, industry, and living standards. The emerging countries' share of world output in goods and services is already nearing 50 percent, and since before the onset of the recent economic crisis, the gap between their growth rates and those of developed markets has become wider than ever (between five percent and seven percent per year since 2006). This shift will inexorably raise global investment demand since emerging markets traditionally engage in high levels of investment.
In addition, the supply of global savings will likely decline. Aging demographics in developed countries will likely depress savings, even though governments may flirt with fiscal austerity and households may try to reduce their debt. In the emerging world, the accumulation of reserves will likely taper off, allowing resources to be diverted toward other needs, such as spending on investment, boosting consumption, and building social safety nets. Reserve holdings may not fall in absolute terms, but the pace of hoarding may slow. For capital markets to reach equilibrium given these shifts, global real interest rates will have to rise worldwide; otherwise, investment will exceed the supply of savings. The era of a so-called savings glut will thus end, and the impetus for capital to move downhill from developed countries to emerging ones will strengthen.
Finally, adjustments among emerging countries will require the surpluses of emerging markets to fall or even reverse on net. But as history shows, such shifts from surpluses to deficits are accompanied by stronger currencies in real terms. To run current account surpluses, emerging markets have had weaker currencies for years. As these imbalances correct themselves, emerging economies' currencies will tend to strengthen in real terms one way or another, either as local prices rise or as currencies appreciate relative to developed markets. A new era with less capital flowing uphill and stronger emerging currencies is therefore within the realm of possibility. But when and how can it happen?
There are signs that this process of correction is already under way. Emerging-market currencies began strengthening against the U.S. dollar around 2004-5, approximately when
Yet this transition to global rebalancing cannot be taken for granted, and a supportive policy environment in both the developed and the emerging worlds will greatly influence its course. In particular, the shift toward currency appreciation will prove easier if it is led by
Even if it appears to be doing so too cautiously and too reluctantly for some of its critics, however,
THE IMBALANCE DISTRACTION
Beyond the Great Recession and the recovery, long-term trends support the idea that a rebalancing is under way. A broad range of economic figures suggest that emerging markets are catching up to developed markets. As the Great Recession fades, this trend is likely to continue. The emerging-market history of low growth and high volatility is fading, while developed markets are experiencing more instability and financial impairments. Emerging markets have decreased their debt-to-GDP ratios, even as developed markets, including
If policymakers can reinforce these trends, enhancing the emerging world's growth prospects, they will round out the decade or two of adjustments set in motion by the once-in-history opening of emerging markets to economic and financial globalization. The imbalances of the recent era of globalization represented a specific response to a peculiar set of historical circumstances, as emerging markets learned to navigate a fragile financial landscape. These imbalances have begun and will continue to even out through patience and gradual shifts in market mechanisms and policy.
Even as the threat of global imbalances fades, the next phase of globalization will present new risks and opportunities that policymakers will need to confront. Developed markets could remain lethargic or suffer further slumps, increasing the risk of a global downturn. Financial stabilization policies may not be implemented effectively and evenly enough to avert the risk of another global financial crisis. Net capital flows could reverse and drain investment away from developed countries, potentially triggering protectionism. Inequality trends could persist or even widen. As the Doha Round limps along, the open trading environment built over the last 65 years could face rising pressure. Political and economic reforms across the world may stall, halting or reversing recent progress.
By devoting time, energy, and political capital to correcting today's perceived imbalance problem rather than tackling the challenges on the horizon, world leaders risk fighting the last war. It may be not just the global economy that needs some rebalancing but also policymaking itself.
Alan M. Taylor is a Senior Adviser at Morgan Stanley and is joining the economics faculty at the University of Virginia as Souder Family Professor of Arts and Sciences
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