International Imbalances: Measurement and Implications

Paul Kedrosky has observed that a statistical analysis (word cloud) of the American Economic Association session titles, or even of the papers, leads to the impression that the economics profession has been relatively uninterested in the ongoing financial and economic crisis. Unfortunately, this observation misses ignores the fact that session proposals are submitted a full eleven months ahead of the ASSA meetings. Think back to January 2008, and the terms ascribed to those who warned of a severe slowdown (“alarmist”, etc.), and the whole discussion is cast in a different light.

Furthermore, the correlation between scheduled paper titles and actual is, shall we say, fairly loose. In any case, the main messages of the papers are usually discussed in the context of current events.I’ll illustrate this last point by discussing the only complete session I made it to (most of my time was spend interviewing job candidates): “The Capital Flows behind Financial Globalization” (organized by Kristin Forbes). I had to make it since I was presiding. As it turns out, it was a very lively session, and — despite the title — quite relevant to ongoing events. (And if you don’t think this was timely, take a look at Brad Setser‘s post today.)usliab07.gifFigure 1 from Kristin Forbes (2008).First on the agenda was my former colleague Joshua Aizenman. He actually presented results from two papers. In “Globalization and the Sustainability of Large Current Account Imbalances: Size Matters,” [pdf] Aizenman and Yi Sun conjecture how China’s current account will evolve over time, in a context where China is a large player. From the abstract:

This paper evaluates the sustainability of large current account imbalances in the era when the Chinese GDP growth rate and current account/GDP exceed 10%. We investigate the size distribution and the durability of current account deficits during 1966-2005, and report the results of a simulation that relies on the adding-up property of global current account balances. Excluding the US, we find that size does matter: the length of current account deficit spells is negatively related to the relative size of the countries’ GDP. We conclude that the continuation of the fast growth rate of China, while maintaining its large current account/GPD surpluses, would be constrained by the limited sustainability of the larger current account deficits/GDP of courtiers that grow at a much slower rate. Consequently, short of the emergence of a new “demander of last resort,” the Chinese growth path would be challenged by its own success.

In a second paper, Joshua presented results indicating that the United States served as the “demander of last resort”, wherein US current account deficits appeared to be a key determinant of LDC current account surpluses, even after accounting for other factors (demographics, etc.). This paper is available on Aizenman’s website here. In that paper, Aizenman and Yothin Jinjarek write:

We identify an asymmetric effect of the US as the “demander of last resort:†a 1% increase in the lagged US imports/GDP is associated with 0.3% increase of current account surpluses of countries running surpluses, but with insignificant changes of current account deficits of countries running deficits.

The discussant, Jeffrey Frankel, lauded the paper for its eschewing complicated intertemporally optimizing models of the current account balance, in favor of an approach that could more useful be empircally implemeted. He also observed that perhaps the current crisis dealt a serious blow to the proposition that the reason why capital had flowed to the US was our “deep and sophisticated capital markets” or the credibility of our financial institutions, but something more simple such as profligacy. (Obviously, this is a view I am very sympathetic to [1], [2], [3].) On a more substantive note, he observes that capital account openness should enter into the authors’ specification interactively rather than as a levels effect — that is capital account openness should determine the easy of financial flows, rather than their sign. In the end, he agreed that these papers were useful in thinking about how the imbalances arose, and how they may now be in the process of abrupt shutoff.

In “Why Do Foreigners Invest in the United States?” [pdf], Kristin Forbes writes:

Why are foreigners willing to invest almost $2 trillion per year in the United States? The answer affects if the existing pattern of global imbalances can persist and if the United States can continue to finance its current account deficit without a major change in asset prices and returns. This paper tests various hypotheses and finds that standard portfolio allocation models and diversification motives are poor predictors of foreign holdings of U.S. liabilities. Instead, foreigners hold greater shares of their investment portfolios in the United States if they have less developed financial markets. The magnitude of this effect decreases with income per capita. Countries with fewer capital controls and greater trade with the United States also invest more in U.S. equity and bond markets, and there is no evidence that foreigners invest in the United States based on diversification motives. The empirical results showing a primary role of financial market development in driving foreign purchases of U.S. portfolio liabilities supports recent theoretical work on global imbalances.

I’ll observe that this paper represents an impressive compilation of disparate datasets, so people interested in a thoughtful analysis of the data (as opposed to hyperbole and anecdotes) should consult this paper.

The discussant, Linda Tesar, observed that while the paper did not provide any big surprises, it was interesting to see how the trends evolved over time. In particular, the Gourinchas and Rey (2007) finding of higher returns on US holdings of foreign assets than foreignors earn on their holdings of US assets held true even after the adjustments of Curcuru, Dvorak and Warnock (2008).

More importantly, Tesar took issue with the view that if foreign returns were high (even after risk adjustment) and US returns low, it was a puzzle why foreigners invested in the US. But portfolio theory suggest that just because returns are low, the optimal level of investment in the US is not zero, as long as markets are not perfectly correlated. The question is how much investment, not whether to invest in the US.

The last two papers were closely related in terms of subject matter: measurement.

Pierre Olivier Gourinchas and Helene Rey produced a new version of their tabulation of the US external accounts, in order to generate new estimates of foreigners’ returns on US assets versus Americans’ returns on foreign assets. Their methodology was basically a more elaborate version of the approach laid out in this paper, discussed briefly in this post.

The discussant, Frank Warnock, wondered whether it made sense for academics to be constructing their own data. In particular, Gourinchas and Rey combine flow and stock data to impute stocks, even though the data were never constructed with this objective in mind (i.e., the data are not compatible). Instead, he argued that maybe it made more sense to utilize the estimates that statisticians in the Federal government were developing, especially to cover holes in the current statistics-gathering system. Some of Warnock’s results in this context were discussed in this post, and can be found in his papers found here.

From “Where Did All The Borrowing Go? A Forensic Analysis of the U.S. External Position,” [pdf] by Philip Lane and Gian Maria Milesi-Ferretti:

The deterioration in the U.S. net external position in recent years has been much smaller than the extensive net borrowing associated with large current account deficits would have suggested. This paper examines the sources of discrepancies between net borrowing and accumulation of net liabilities for the U.S. economy over the past 25 years. In particular, it highlights and quantifies the role played by net capital gains on the U.S. external portfolio and ‘residual adjustments’ in explaining this discrepancy. It discusses whether these ‘residual adjustments’ are likely to be originating from measurement errors in external assets and liabilities, financial flows, or capital gains, and explores the implications of these conjectures for the U.S. financial account and external position

While this paper seems unrelated to the ongoing crisis, during the rejoinder session, Milesi-Ferretti noted that — using the framework outlined in the paper, and incorporating the fact that foreign equity markets had performed even worse than the US — it was likely that the US net foreign asset position deteriorated substantially in 2008.

Kenneth Rogoff lauded the attempts by the authors to try to measure the US, and other country, net foreign assets. But he spent most of his time talking about — how net foreign assets related to the ongoing crisis, relying much on his presentation to the joint AEA/AFA luncheon.

So, returning to the departure point for this post, don’t be misled — discussion of the ongoing crisis (and how global imbalances might have contributed) was everywhere at the AEA’s, even if not explicitly in the session and paper titles.

Originally published at Econbrowser and reproduced here with the author’s permission.