Global economic imbalances and future of U.S. Dollar

Global economic imbalances
When a flow becomes a flood
The deep causes of the financial crisis lie in global imbalances—mainly, America’s huge current-account deficit and China’s huge surplus

Introduction:
What caused the financial and economic crisis and most are likely to plump for some mix of greed and incompetence. Bank bosses have been castigated for fee-seeking gluttony, reckless lending and failure to heed the risks to their institutions. Regulators have been accused of sleeping on watch. Central bankers once lionized for mastering inflation and the business cycle are feted no longer.
Few among the public would be likely to pin the blame on “global imbalances”: the pattern of large, persistent current-account deficits in America and, to a lesser extent, Britain and some other rich economies, matched by surpluses in emerging markets, notably China. The damage done to the financial system by lax controls, rotten incentives and passive regulation is plain. Yet underlying the whole mess was the deeper problem of imbalances. A growing number of policymakers and academics believe that these lay at the root of the financial crisis.
Economists had long feared that America would ruin itself on foreign borrowing. The current account, which measures the balance of investment and saving, has been in the red every year since 1992. Until 1997, the annual saving shortfall was modest but it grew steadily thereafter, reaching a peak of $788 billion, or 6% of GDP, in 2006.
America needed to borrow from abroad or to sell assets—shares, bonds, property—to pay for the string of deficits. Deficits need not be ruinous, especially if they finance profitable investment. But economists worried that as America’s consumption boom took it deeper into hock, foreigners would become less willing to lend to it. That could lead to an abrupt halt to financing and a plunge in the dollar.
Explanations:
The deficits reflected a falling saving rate rather than a rising investment rate. To finance this, America was sucking in savings from abroad that could not be relied on for ever. The dollar started to decline gradually from 2002 but the current-account deficit only got bigger. There were other puzzles: long-term interest rates ought to have picked up to reflect the scarcity of American savings and the concern about the dollar. But even when the Federal Reserve started to raise short-term rates from the middle of 2004, long rates declined. The chairman of the Fed, Alan Greenspan, told Congress in February 2005 that this was a “conundrum”.
As academics found fresh theories to explain the saving glut, they became less anxious about the imbalances it produced. The most developed financial markets were found in America, so it was the natural destination for foreign savers seeking safe returns. It could not run deficits for ever but the day of reckoning might be years away. Americans earned far higher returns on their investments abroad than foreigners did on their American assets. That and a weaker dollar helped to slow the increase in foreign indebtedness.
Both the old-school worrywarts and the new-school optimists got some elements of the story right and others wrong. “The dollar crisis that was predicted by the central view is the only one that hasn’t happened,” says Pierre-Olivier Gourinchas of the University of California, Berkeley. In the depths of the financial crisis in October, the dollar rallied against most currencies. America was not cut off from external funding. But equally there was a crisis—as the pessimists foresaw—and one that has undermined a pillar of the optimists’ thinking on imbalances: that America is a beacon of financial stability.
The glut and the gap
What persuades developing countries to export capital to the rich world that might be better used at home? Influences on saving vary from region to region. The income of oil-exporting countries, for instance, has ballooned since 2004 because of higher prices for crude. It would have been neither feasible nor wise for oil-rich nations to spend this windfall at home, so much of it was saved and sent abroad. Economists who have looked for something that unifies the saving behaviour of a disparate group of countries, from oil-exporters to metal-bashers, have converged on one important motive: the need to acquire reliable stores of value that can be sold easily when trouble strikes.
Mr Gourinchas doubts that depressing the exchange rate could sustain a high rate of saving for long. By flooding the foreign-exchange market with their own money, central banks risk driving up inflation which would erode the gain in competitiveness from a cheap currency. China has avoided that fate because it has been able to “sterilise” its currency interventions by selling bonds to banks, companies and households. That would be an expensive operation, says Mr Gourinchas, were it not for demand for savings. The reserves are collateral for the bonds held privately.
That may be too neat an explanation. In China’s tightly controlled financial system, savers have little choice. And firms, not households, account for the recent rise in net national saving. There is another puzzle: why have emerging-market currency reserves grown so large? This was largely a reaction to the painful memory of the Asian crisis: Asian countries wanted to insure themselves against another sudden flight of capital. Reserves need to be large enough to draw upon if foreign-currency financing suddenly dries up, and to ensure that trade flows smoothly. But reserve holdings in some emerging markets have gone way beyond levels suggested by prudential rules of thumb—enough to pay for three months of imports, say, or to cover short-term foreign-currency debt.
. In a more recent study they found that countries with insufficient reserves to insure their financial systems suffered bigger currency crashes during last year’s turmoil. The currencies of countries with full war chests did not depreciate; some rose. If economies draw the lesson that their reserves were not big enough, global imbalances will be even harder to tackle.
Mr Taylor reckons the policy of accumulating reserves accounts for a significant and growing fraction of global surpluses to finance as much as a third of America’s current-account deficit. The self-insurance against financial fragility is part of a more general bent towards precautionary saving in the developing world. If it persists, as seems likely, it will throw the problem of deficient global demand back to America.
The interaction between the two was fatal. After the dotcom bust, American firms turned cautious and investment spending was weak. That ruled out a natural home for foreign capital. Faced with strong external demand for AAA-rated assets, the financial system got creative. Marginal home loans were packaged into supposedly safe securities. That supply of credit lifted house prices and spurred a boom in residential construction, which filled the gap in demand left by sluggish business investment.
As these loans turned bad and losses mounted, it became clear that banks had set aside too little capital to protect themselves against unexpected losses. That left the banks crippled and the economy on its knees. The villains in this story are the banks for making silly loans and regulators for not insisting on more precautions. But what would a well-regulated financial system have done with the money?

In a world of perfect regulation, the likely outcome would be fewer new assets, such as securities backed by subprime mortgages, and higher prices (and lower returns) on the best assets. That implies long-term interest rates would have dropped even further. That might have given more life to business investment but it might also have fuelled a bigger housing boom, at least in prime real-estate.
An alternative would be to try to tackle imbalances from all sides. That would require co-ordinated action by surplus and deficit countries. Such attempts failed in the past because everyone had something to gain from sticking with the status quo. China might think Americans should save more but only as long as that did not curb their spending on Chinese imports. America would ask China to revalue its currency and boost its domestic demand. But it was also keen for China to keep buying its public debt.
Policymakers blithely assumed they would avoid a dollar crisis and that America would export its way out of any trouble. And that was how things were starting to play out before a quite different crisis, in the financial system, blew up.
It’s good to talk
Earnest editorials often call for international talking shops to co-ordinate global demand. Alas, Sino-American exchanges on international economic affairs are often heated: when America’s treasury secretary, Hank Paulson, said recently that imbalances played a role in the run-up to the crisis, he provoked an outcry in China. Past failures of co-ordination initiatives do not offer much hope either. Yet as Raghuram Rajan of Chicago University’s Booth School of Business points out, the crisis has lasted a long time and there is no end in sight: so the situation may soon be ripe for a cooler exchange between surplus and deficit countries. The two big surplus countries in the rich world, Germany and Japan, are suffering deep recessions, which may bring them to the table. The problem of imbalances goes much wider than America and China.
One necessary task is to assure emerging-market countries that they will not be caught out if they run short of liquidity. The IMF might have to be prepared to offer funds more quickly and with fewer strings. Another option would be for emerging markets themselves to pool reserves. The politics of that would be messy at best. As Hélène Rey of London Business School points out, the devaluations within Europe’s exchange-rate mechanism in the early 1990s showed that risk-sharing is far from perfect even where countries have well-established political ties.
The IMF’s resources are puny in comparison with the amounts in the vaults of emerging-market central banks. That is why the swap lines offered by the Fed to four emerging economies in October were a welcome innovation (even if the recipients were flush with their own reserves). But countries will not be persuaded to stop accumulating reserves unless such credit lines can be relied upon in future. The Fed cannot be asked to vet potential recipients: that may be a job for the fund.
America, Britain and other deficit countries have drowned themselves in cheap credit from abroad. Because the structural forces behind the global saving glut are unlikely to abate quickly, there is a real risk that the dangerous imbalances will persist—with America’s public sector as the new consumer of last resort. It would be foolish to focus on fixing the financial industry only to find that the public finances are left in ruins.

To sum up, I can say…with luck and good judgment some of the worst excesses of the financial system will now be reined in. The danger is that by focusing on regulatory reform and less clumsy ways to deal with bank failures, policymakers fail to tackle the underlying causes of the crisis. The anxieties that prompt emerging markets to run big current-account surpluses have not been assuaged. Indeed, the crisis may have spurred some countries to seek even more self-insurance in reserves and other forms of prudential saving.


U.S. DOLLAR
Many foreign banks as well as foreign branches of U.S. banks accept deposits of U.S. dollars and grant the depositor an account denominated in dollars. Those dollars are called Eurodollars. As we will see, they exist under quite different constraints from domestic dollars. While Eurodollar banking got its start in Europe, such banking is now active in major financial centers around the world.
Importance
Today the Eurodollar market is the international capital market of the world. It includes U.S. corporations funding foreign operations, foreign corporations funding foreign or domestic operations, and foreign governments funding investment projects or general balance-of-payment deficits.

Example
Suppose the AAA Corporation draws a check for five million dollars on Citibank, its New York bank, and deposits it at a London Eurodollar bank. The result is that the ownership of five million U.S. dollars has passed from AAA to the London bank in exchange for a Eurodollar time deposit. The London bank now holds a deposit at Citibank balanced by a liability, the time deposit credited to AAA.
Since that money earns no interest at Citibank, the London bank will use the funds to make a loan, say to the BBB Corporation which banks at Wells Fargo. Citibank will then show a decrease of five million dollars on deposit at the Fed and a decrease in liability of that amount to the London bank. Wells Fargo will gain that deposit at the Fed and an equal liability as a deposit for BBB. The London bank will record a loan of five million dollars to BBB balanced by a time deposit owed to AAA.
Unlike domestic U.S. banks, Euro banks cannot create money in U.S. dollars through the act of lending. Their lending only transfers ownership of deposits at U.S. banks.
sources
The funds that form the basis for the Eurodollar market are provided by a wide range of depositors: large corporations (domestic, foreign, multinational), central banks and other government bodies, supranational institutions such as the Bank for International Settlements, and wealthy individuals. Most of the funds come in the form of time deposits with fixed maturities.


Future
The number of sovereign states in the EU that are facing difficulty selling new debt, or even a rollover of current debt, is growing. The Eurozone and the EU are both in trouble. Clearly, the structure that exists today is flawed and will not withstand the rigors and pressures that are headed directly its way.The ability to kick the can down the road is about to end, and with it some hard decisions will need to be made by the political and wealthy elite.