How the seeds of global financial meltdown were sown

BOOK REVIEW: Fixing Global FinanceBy Martin WolfJohns Hopkins University $24.95 (€19)

ONE OF the most striking features of the global economy in the period before the present crisis erupted was the huge size and rapid growth of the US current account balance-of-payments deficit.

By 2006, it had reached almost $900 billion, nearly 7 per cent of GDP, in contrast to the early 1990s when it was, briefly, close to balance. This enormous deficit primarily reflected the collapse of the household savings rate in the US. It implied that the US was borrowing huge sums of money from the rest of the world to finance consumption.

In international terms, the counterpart to the US current account deficit was a surplus of equivalent size in the rest of the world. That surplus was very unevenly distributed, however.

Indeed, some other countries – mainly in Europe – were also running current account deficits, while some – oil exporters, China and other developing Asian economies – were running extremely large surpluses. These countries were using their surpluses to accumulate foreign exchange reserves, mostly in the form of dollar-denominated assets. In the process, they were keeping their currencies at a low value, all the better to maintain strong export growth.

At one level of abstraction what was playing out here was a benign symbiotic relationship. The surplus countries were filling the gap between spending and earning in the deficit countries and lending them the money to finance that gap.

The problem was that the gap was widening rapidly and the process was unsustainable: the US could not indefinitely increase its indebtedness to the rest of the world and China could not indefinitely increase its claims on the US.

One of the great fears harboured by economists as these financial imbalances grew was that their eventual reversal would not occur smoothly, but would be triggered abruptly and would proceed in a manner severely disruptive of the world financial system.

The global financial imbalances just outlined, their origins, dynamics and implications, provide the material for Martin Wolfs book. Although it carries a 2009 publication date, it was in fact written in the autumn of 2007. Prospective readers should be warned, therefore, that it does not contain an account of the financial crisis that has unfolded with devastating consequences over the past 18 months.

Nor does it set out to provide an explanation for why that crisis occurred, but it will greatly enrich the reader’s understanding of the macroeconomic background to the current crisis, of which the financial imbalances in the US and elsewhere were a key part.

A popular take on the global imbalances in question is that they resulted from US profligacy.

According to this version of events, US consumers embarked on an orgy of spending, fuelled by overly lax monetary policies, and the resultant US trade deficit drove the rest of the world into surplus. Wolf’s thesis is very different.

According to him, the imbalances originated with the succession of serious financial crises that wreaked havoc throughout the developing world in the 1980s and 1990s, and particularly those that affected Asia.

These crises had a number of features in common, among them the fact that they followed episodes of large private capital inflows from abroad and large current account deficits; that made the countries concerned extremely vulnerable to the painful consequences of a sudden turnaround in investor sentiment.

Wolf’s view is that, chastened by these crises and determined to secure protection against their recurrence, China and the developing countries of Asia decided to adopt policies that would prevent current account balance-of-payments deficits from re-emerging, through the aggressive pursuit of export-led growth based on “exchange rate protectionism”, that is the deliberate engineering of undervalued exchange rates.

The other side of the coin was the suppression of domestic consumption in these developing countries and the emergence of a “glut of savings”. (China, we learn, has an overall savings rate of an astonishing 60 per cent of GDP. This compares with rates in the range 10-20 per cent in most advanced economies.)

The savings glut in turn forced down global interest rates, thus contributing to the explosion of credit and household indebtedness in the deficit countries, most notably the US, and sowing the seeds for the financial meltdown that we have witnessed over the past 18 months.

In this scheme of things, the US is cast as a passive agent in the process, playing a purely accommodative role.

The decisions that were critical in the emergence of global imbalances were not those made in the US, but those made by the Chinese and other Asian countries to fix their currencies. One obvious inference to be drawn from this is that it is fanciful in the extreme to imagine that the current woes of the global economy can be sorted without fully engaging China in the effort.

The book does a very good job of conveying the fragility of financial systems. Apart from documenting the frequency and dynamics of crises (there were an estimated 112 systemic banking crises in 93 countries between the late 1970s and the end of the 20th century), Wolfs exposition of how the financial system works is especially lucid in its treatment of risk and how risk multiplies when finance goes international.

He uses a wonderfully evocative phrase to capture all this: the financial system, he says, is a “pyramid of promises”. The creation and sustenance of trust in such an arrangement is a truly astonishing institutional achievement. The corollary is clear. Abusing that trust invites catastrophe, as recent events so starkly illustrate.

Jim O’Leary is a senior fellow of the department of economics, finance and accounting at NUI Maynooth