Financial Imbalances in the World Economy

1. Financial Imbalances in the World Economy Maintaining growth and improving distribution Cambridge Endowment for Research in Finance (CERF) Alphametrics Ltd.

2. A global economy needs a global model • interdependence in • trade • production • finance • results in interdependence in demand and overall economic performance

3. A global model must accurately account for interdependence • must be based on a fully articulated accounting system • must link real economy and financial stocks and flows: • income – spending = net acquisition of financial assets = balance of payments current account • and will provide new insights into the effects of national and international policy-making

4. Financial stocks and devaluation 6% of NNP 800 • traditionally devaluation is assessed in terms of income and substitution effects • wealth effects matter too 600 Holding gains due to $ devaluation 400 3% of NNP 200 (Bn.US$ , 3 Q. moving avg.) 0 -200 -400 -600 -800 82 84 86 88 90 92 94 96 98 00 02 04 06

5. 2000 160 1500 120 1000 80 500 40 0 0 -500 -40 -1000 -80 Financial flows and domestic spending Pers. S. Spending (), RHS • changes in personal sector expenditure are partly driven by holding gains (Bn.US$, chained,1st. Diff; mov.avg) (Bn.US$, chained, 3 Q. m.avg, lagged 1Q) Pers. S. holding gains, LHS 90 92 94 96 98 00 02 04

6. Financial balance in the world economy today • Everyone is encouraged (and actually achieves) surpluses • But not all the countries can have surpluses at the same time Average current account balance in billion dollars 2000-2003

7. A global imbalance of unprecedented proportions • The current account deficit of the U.S.A. is by a very long way the largest ever seen. World's largest current account deficits since 1970 ($ billion)

8. From the inside ... • The deficit reflects borrowing by the US government and households Net lenders Net borrowers Lending and borrowing in 2005 first half as % of US national income Corporate (3.3%) Savings gap financed by the rest of world (7%) Govt (3.9%) Households (6.2%)

9. 55 60 65 70 75 80 85 90 95 00 05 10 Personal borrowing 8 % • Since the early 1990's the US current account deficit has been driven by the household sector Net Lending Personal S. 4 % % of Net National Income Current Account - 4 % - 8 %

10. 24 20 16 12 8 4 0 The internal frontier 28 • US citizens have invested hugely in real estate financed by mortgage borrowing Real estate assets personal sector Trillion US$ Debt personal s. 55 60 65 70 75 80 85 90 95 00 05 10

11. $50 trillion of personal wealth Assets Liabilities • Average net worth is now $160,000 per person (woman, man or child) • Real estate accounts for about half of this total • The investment paid off as property prices continued to rise Durables Debt Real estate Pensions NET WORTH Equity Deposits & securities

12. How households became so rich 1.4 20 • Interest rates were low and falling through the 1990s Relative house price 1.3 18 1.2 16 1.1 14 30 yrs mortgage interest rate 1.0 12 House prices relative to GDP deflator 0.9 10 0.8 8 0.7 6 Mortgage int. rte. 0.6 4 1975 1980 1985 1990 1995 2000 2005

13. …and why households borrow 2000 • Appreciation of real estate and other assets led to real balance effects which encouraged spending • But holding gains are not cash-flow income… 120 1500 Holding gains 80 1000 40 500 Holding gains (Bn.US$, chained, mov.avg) Expenditure (Bn.US$, chained,1st. Diff; mov.avg) 0 0 -500 -40 Personal sect. spending -1000 90 92 94 96 98 00 02 04 06

14. 6 4 2 0 -2 Government borrows too 8 • The government has generally been in deficit and acted counter-cyclically • The deficit was briefly eliminated in 2000 • Since then borrowing has resumed to keep the economy growing Government Deficit PSBR: % of NNP//Growth: avg % rate 2 years 2yr. growth rate of NNP 1970 75 80 85 90 95 2000 05

15. 38 36 34 32 30 28 26 Tax cuts and spending both play a role 42 • Up to the mid-80s spending and revenue increased with spending in the lead • Spending cuts in the 90s briefly restored a balance • Tax cuts since 2000 have shifted the government back into deficit Govt. spending 40 6 % of NNP % of Net National Income Govt. revenue 60 65 70 75 80 85 90 95 00 05

16. After years of household and government borrowing • The USA has accumulated over $12 trillion liabilities to the rest of the world $ trillion, mid-year

17. The pattern of investment • Foreigners hold corporate assets, public securities and bank deposits 18% 20% 20% 30% 12%

18. How did foreigners finance their investment in the USA ? $ trillion cumulative flow from mid-2000 • They earned the money by selling goods, services and assets • Capital inflow = current outflow + capital outflow assets sold to the USA surplus on goods and services

19. Benefits for US citizens ? • Growing wealth from real estate • Goods and services imported from around the world Imports of goods and services as a percentage of national income

20. It didn't cost US jobs overall • Losses in manufacturing were far outweighed by gains in services Unemployment rate private service employment government other industries manufacturing

21. Looking from the outside Other DV Japan USA W Europe Russia EE China Rest of America M East The network of trade in manufactured goods Africa Rest of Asia

22. The US deficit ... • Directly adds around 1.5% to income of the rest of the world. • The gain is much bigger for some of the partners.

23. This solves some problems from the past • Trade deficits • Borrowing • Currency crisis • Financial adjustment 1996 Current account balances as per cent of world exports 1980

24. By relying on the USA USA borrowing spending • US households and government borrow, providing liquidity for the whole world • Banks and financial markets recycle savings from the rest of the world to the borrowers in the USA Goods & services Financial markets Rest of world saving earning

25. But what if ... Another recession ? • Interest rates rise • Property prices fall • US households borrow less • Recession ? • Or more tax cuts ? • Or ... Year-on-year increase in national income Financial balance of households as % of national income

26. Can the trade gap be closed ? • Exports are now 65% of imports • It could take 15 or 20 years of 'performance improvement' to close this gap We are here now

27. A deficit-reduction scenario • Capital inflows = • current outflows • + capital outflows To be financed by rest of world

28. Slower growth in the USA ... • Reduced investment in real estate • Higher investment in energy saving and new sources of supply • Growth of labour-intensive personal services USA: annual growth of real income (per cent)

29. More growth elsewhere ... • Driven by internal demand elsewhere Other blocs: annual growth of real income (per cent)

30. Generating price signals ... • to which the US economy could respond $ billion index

31. The same signals • will encourage other developing regions to supply energy and raw materials to China, India and Japan

32. And will expand markets for US industrial exports • if US producers can retain their links in Asia and the rest of the Americas • it's not just a question of technology or real exchange rates to rest of world US exports of manufactures to W Europe to other America to Asia

33. So there is a scenario for reduction of the US deficit • without a slow-down in world economic growth • the most important condition being ... • faster growth of internal demand in other blocs

34. Europe ... 0.7% more growth • Financial policies to stimulate internal demand and ... • support trade and investment in surrounding regions, including exports from those areas to Asia • Do not apply the Stability Pact to growth programmes a smaller trade surplus $ 1 trillion more income by 2015 $ 250 billion more industrial imports by 2015

35. Asia ... 2% more growth keep total surplus below $300 billion • Don't rely only on export-led growth • Manage internal demand to sustain Asian markets and limit the surplus of the region as a whole • Develop investment markets within the region $ 7 trillion more income by 2015 $ 400 billion more industrial imports from other regions $ 800 billion more energy and raw materials from other regions

36. Summing up the new pattern • The US is the main deficit country and the major global debtor • Most LDCs & OECD’s are not running deficits any more • Reserve accumulation and high dollar liquidity worldwide seem to be preventing currency crises • Disruptions might occur with excess demand for oil • Or with reversal of asset price gains and portfolio investment positions

37. We require policies as well as rules • Strategies of the main players are going to change • Asset valuations have a greater impact on spending and portfolio decisions • Flows are highly interdependent and structural adjustments take time • Fiscal and monetary policy do matter • Infrastructure and education may matter too • It is not sufficient to negotiate rules of the game • Negotiation on policy is required

38. And we need realistic models • which examine interactions between finance, spending, trade and income distribution at the global / regional level and for individual countries • which provide an appreciation of long-run dynamics as well as short-term adjustments • and ultimately, facilitate realistic negotiation of strategies and policies.

39. Open to debate… • Are the WEO recommendations sufficient to resolve the global economic imbalances? • Can governments and central banks act individually on this, or is collaborative action needed? • How can the representatives of developing countries push the IMF to target growth and distribution as well as financial stability, and the WB to target structural imbalances as well as poverty reduction?