Rising Global Imbalances Likely to Precipitate New Crises

It is not a sign of intelligence to repeat a course of action and expect different results. Yet our officialdom is doing pretty much just that on the economic front. Treasury and the Fed in particular seem quite pleased with their success in patching up the financial system with duct tape and baling wire and prodding it into a semblance of operation via massive support, most notably via super low interest rates. Even so, the mortgage market is on life support, with government guaranteed mortgages accounting for over 95% of the market in first quarter 2010, versus roughly 40% pre-crisis. Banks are still not lending much, and have reined in particularly hard with small businesses who are the engine of hiring. Financial firms seem to be deriving their real cash earnings primarily from yield curve arbitrage (borrowing at near zero and parking the proceeds in longer-dated Treasuries or other low risk assets) and trading. While these may rebuild their balance sheets, the banks have yet to write down and restructure bad debts sufficiently (while the banks do appear to have taken some hits on impaired assets, a fair bit of anecdotal evidence suggests the markdowns are not deep enough).

The failure to change the structure, operation, or leadership of major financial firms means they are just about certain to repeat the same behavior that led to mind-numbing bonuses in 2007 and 2009.

The same inability to move away from a broken paradigm exists on a macro level as well. Even though Carmen Reinhart and Kenneth Rogoff’s book This Time is Different demonstrates how high international capital flows are inextricably linked with frequent, severe financial crises, none of the influential G20 players seems willing or able to take action to reduce global imbalance (but they do give the idea lip service). To a large degree, the problem is political; countries, even more so that companies, find it hard to change strategies, particularly since the beneficiaries nearly always are have become powerful players. In addition, policymakers who have grown up with a system that appeared to comport itself well for a long period of time find it difficult to abandon it.

Fred Bergsten describes the coming train wreck probable consequences in the Financial Times. He argues that imbalances are certain to become more pronounced, with disastrous consequences:

Global imbalances are about to jump again…

No one would accuse the eurozone of competitive devaluation. However, there is considerable satisfaction throughout Europe with the weak currency.. Whatever the intent, these European developments will have effects similar to the overt steps taken by other major countries to enhance their trade competitiveness. The most extreme case is the massive intervention by China and surrounding countries to keep their currencies severely undervalued. Other emerging markets are likewise seeking to expand further their war chests of foreign exchange by running large external surpluses. Switzerland has intervened substantially to hold its currency down. The eurozone has joined this “new mercantilism” and the result will be a sharp rise in global imbalances.

The counterpart increases in deficits will again accumulate mainly in the US as no other country could attract the requisite financing….Investor proclivities to buy Treasury securities and dollars could finance the American deficits for a while. The US would provide the global collective good, as in the past, by accepting increased dollar overvaluation and further increases in its external debt and deficits.

There are three glaring problems with this vision, however, all centred on the US. First, the sharp escalation of its own domestic and international imbalances would intensify the risk of future market attacks on the dollar and US financial assets. As soon as Europe and other alternatives regain their acceptability to investors, the unsustainability of the US situation would return to centre stage at even more dangerous levels.

Second, the higher imbalances themselves could sow the seeds of a new financial crisis just as they helped sow the seeds of the last crisis. Such huge inflows of foreign capital would keep US financial markets excessively liquid, hold interest rates down, promote underpricing of risk and thus again generate irresponsible lending and borrowing.

Third, a renewed explosion of the US trade deficit could well trigger the outbreak of protectionist trade policies that has been largely avoided to date. With unemployment remaining very high, job losses to the “new mercantilism” abroad are likely to incite strong political reactions. The virtual absence of a positive trade policy under President Barack Obama has created a dangerous vacuum in which new import restrictions, especially aimed against “unfair exchange rates,” could readily prevail.

At its upcoming summits in Toronto and Seoul, the G20 must adapt its rebalancing strategy to prevent this new threat to continued recovery and lasting global stability. Surplus Germany, along with China and Japan, must stimulate domestic demand. China must let the renminbi strengthen substantially. Joint intervention in exchange markets should prevent or reverse any significant further fall in the euro. Additional allocations of Special Drawing Rights would enable countries to build reserves without running trade surpluses.

Most importantly, the US must convince the world it is unwilling again to become the consumer and borrower of last resort…But it will also have to end the chronic dollar overvaluations of the last 30 years, and euro depreciation along with continued renminbi manipulation will inevitably push currency issues back to the top of the global agenda.

Yves here. I beg to differ with the first item on his list. The US, like any country that issues its own currency, does not have to “fund” its own deficit spending. Its constraint on “printing” is inflation, and with labor having pretty much no bargaining power, that risk seems remote. In addition, any country that was to assume the reserve currency role would have to be willing to run trade deficits, and none of the candidates-in-waiting seem keen about the idea.

But recall that the notion among many policy-makers is that the US needs a resumption of consumer spending. The risk is we see a continuation of consumers using debt to help support spending, and continued capital inflows are likely to support rising indebtedness of various forms. Thus imprudent lending and heightened protectionism, both likely outcomes in the not-at-all distant future seem more than enough to lead to a renewal of 2007-2008 type financial upheaval.

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

One Response to "Rising Global Imbalances Likely to Precipitate New Crises"

  1. Carlo Resta
    Carlo Resta   June 15, 2010 at 4:19 am

    Dear Yves,I find your description among the best. Thank you.It is a picture in which I fundamentally agree with and, unfortunately, a comprehensive and realistic snapshot of the major factors which are affecting the macro trends.The thing that strikes me the most, and that seems not ending any time soon, is the level of general confusion and pitiful inability, inaction and lack of effectiveness of regulators, Financial Authorities, Governments, and the absolute “poverty of vision” of the majority of market players.Your comment on the small businesses it is so real.Small and medium size businesses are the catalysts to resolve most problems but nobody seems to really understand it.Regards,Carlo Resta