Didn?t global imbalances do it?

A prominent view is that an excess of saving over investment in emerging market countries eased financial conditions in deficit countries and exerted significant downward pressure on world interest rates, fuelling a credit boom and risk-taking in major advanced economies and sowing the seeds of the global financial crisis.The central theme of the excess saving (ES) story hinges on two hypotheses: (i) net capital flows from current account surplus countries to deficit ones helped to finance credit booms in the latter; (ii) a rise in ex ante global saving relative to ex ante investment in surplus countries depressed world interest rates, particularly those on US dollar assets.

There is increased stylised evidence that appears prima facie inconsistent with the ES view. First, the link between current account balances and long-term interest rates looks tenuous. For example, US dollar long-term interest rates tended to increase between 2005 and 2007 with no apparent reduction in either the US current account deficit or net capital outflow from surplus countries, such as China. Second, the depreciation of the US dollar for most of the past decade sits uncomfortably with the presumed relative attractiveness of US assets. Third, the link between the US current account deficit and global savings appears to be weak. While the deficit began its trend deterioration in the early 1990s, the world saving rate actually trended downward to the end of 2003 (graph 1). Fourth, real world long-term interest rates as well as term premia have trended downwards since the early 1990s, irrespective of developments in the global saving rate (graph 2). Fifth, starting in 2003, the world economy experienced a string of years of record growth (graph 3). This is hard to reconcile with an increase in ex ante global saving, which should depress aggregate demand.

The purpose of listing these observations is not to refute the ES hypothesis, but simply to raise some doubts about its validity. Our main objections are of an analytical character.

Our objection to the first hinge of the ES view is that because it does not distinguish sufficiently clearly between the notions of saving and financing. It fails to properly distinguish between gross and net capital flows across countries. Current accounts capture the net financial flows that arise from trade in real goods and services. But they exclude the underlying changes in gross flows, including all the transactions involving only trade in financial assets, which make up the bulk of cross-border financial activity. Net capital flows thus capture only a very small slice of global financial flows. Therefore, a fortiori, on a multilateral basis it is not possible to infer from current account balances the pattern of global finance and cross-border intermediation that is taking place.

The expansion of global cross capital flows has been spectacular since the late 1990s, dwarfing current account positions and largely resulting from flows among advanced economies. By comparison, flows between, or from, EMEs were much smaller. And yet, the ES view sees emerging market countries as the main drivers of global financial conditions. Moreover foreign holdings of US securities by European residents made up almost half of all foreign holdings immediately before the crisis, suggesting that Asia?s role in financing the US housing boom was not substantial in relative terms despite the ES view saying it was.

We now turn to the second main tenet of the ES view. This holds that a major factor underpinning the decline in world interest rates over the last decade has been an increase in the surplus of ex ante saving over ex ante investment in a number of emerging market countries. We argue that the saving-investment framework is best regarded as explaining developments in the natural, rather than in the market, interest rate?the market rate being primarily determined by monetary and financial factors as opposed to real factors. If market interest rates are determined as we suggest, then they are not directly influenced by changes in the ex ante saving-investment balance. The influence of the saving-investment balance on market rates is only indirect, through the reaction function of the central bank, market participants? expectations and their risk preferences. Moreover, once it is recognised that, analytically, the ES view assumes that market and natural interest rates are broadly in line with each other, one may wonder about its internal consistency as an explanation for the financial crisis. In fact, before the crisis, the interpretation of global imbalances from a saving-investment perspective was typically a benign one.

The preceding analysis raises key issues about the international monetary and financial system. Once attention shifts from current account balances to the gross financing flows that underpin economic activity, monetary and financial factors take centre stage.

A useful concept to approach the question is that of ?elasticity?. This is defined to be the degree to which the monetary and financial regimes constrain the credit creation process, and the availability of external funding more generally. Weak constraints imply a high elasticity. A high elasticity can accommodate the build-up of financial imbalances and ?externalities?. The major policy efforts to revamp prudential regulatory and supervisory frameworks in the wake of the recent financial crisis go some way towards reducing this elasticity. But it would be unwise to expect prudential policy to do the job on its own. Our analysis indicates that monetary policy plays a crucial role.

This paper is a plea for a more systematic inclusion of monetary and financial factors in current macroeconomic paradigms. In macroeconomic models, the role of money and credit should be essential, not ancillary.

Claudio Borio is deputy head of the monetary and economic department and director of research and statistics, Bank for International Settlements & Piti Disyatat is head, forecasting and macro surveillance division, Bank of Thailand

This is an edited extract of the BIS working paper no 346, titled ?Global imbalances and the financial crisis: Link or no link??

The original document is available free of charge from the BIS Website http://www.bis.org