Financial Imbalances in the World Economy

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

A global economy needs a global model


interdependence in
  

trade production finance



results in interdependence in demand and overall economic performance

CERF and Alphametrics

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 policymaking
CERF and Alphametrics

Financial stocks and devaluation
traditionally devaluation is assessed in terms of income and substitution effects  wealth effects matter too

800

6% of NNP

(Bn.US$ , 3 Q. moving avg.)

600

400
200 0 -200 -400 -600

Holding gains due to $ devaluation
3% of NNP

-800 82 84 86 88 90 92 94 96 98 00 02 04 06
CERF and Alphametrics

Financial flows and domestic spending


changes in personal sector expenditure are partly driven by holding gains

2000 1500 1000 500 0 -500

Pers. S.160 Spending (), RHS
120 80 40 0

(Bn.US$, chained, 3 Q. m.avg, lagged 1Q)

(Bn.US$, chained,1st. Diff; mov.avg)

-1000 90 92 94 96 98 00 02 04

Pers. S. holding gains, LHS

-40 -80

CERF and Alphametrics

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
USA E Europe Other America Africa Other devpd China Russia M East Japan W Europe Rest of Asia

-500 -400 -300 -200 -100

0

100

200

CERF and Alphametrics

A global imbalance of unprecedented proportions
USA, 2004



The current account deficit of the U.S.A. is by a very long way the largest ever seen.

Hong Kong, 1996

UK, 1989

Mexico, 1994

Australia, 2003

Brazil, 1997

Korea, 1996

0

200

400

600

800

World's largest current account deficits since 1970 ($ billion)
CERF and Alphametrics

From the inside ...


The deficit reflects borrowing by the US government and households Net lenders
Corporate (3.3%)

Lending and borrowing in 2005 first half as % of US national income

Savings gap financed by the rest of world (7%)

Net borrowers

Govt (3.9%) Households (6.2%)

CERF and Alphametrics

Personal borrowing


Since the early 1990's the US current account deficit has been driven by the household sector

8% % of Net National Income

Net Lending Personal S.

4%

Current Account -4%

-8%

55 60 65 70 75 80 85 90 95 00 05 10
CERF and Alphametrics

The internal frontier
28



US citizens have invested hugely in real estate financed by mortgage borrowing

24 20
Trillion US$

Real estate assets personal sector

16 12

8
4 0 55 60 65 70 75 80 85 90 95 00 05 10
CERF and Alphametrics

Debt personal s.

$50 trillion of personal wealth
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

Assets Durables Debt Real estate Liabilities

Pensions
Equity Deposits & securities

NET WORTH

CERF and Alphametrics

How households became so rich


Interest rates were low and falling through the 1990s

1.4
1.3 1.2 1.1 1.0 0.9

Relative house price

20
18 16 14 12 10

House prices relative to GDP deflator

30 yrs mortgage interest rate

0.8
0.7

8

Mortgage int. rte.

6

0.6 4 1975 1980 1985 1990 1995 2000 2005
CERF and Alphametrics

…and why households borrow
Appreciation of real estate and other assets led to real balance effects which encouraged spending  But holding gains are not cash-flow income…

2000 1500 1000 500 0 -500 Holding gains (Bn.US$, chained, mov.avg)

120

Expenditure (Bn.US$, chained,1st. Diff; mov.avg)

Holding gains

80 40 0

-1000 90 92 94 96 98 00 02 04 06

Personal sect. spending

-40

CERF and Alphametrics

Government borrows too
PSBR: % of NNP // Growth: avg % rate 2 years 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

6

Government Deficit

4

2

0

2yr. growth rate of NNP
80 85 90 95 2000 05
CERF and Alphametrics

-2 1970 75

Tax cuts and spending both play a role


Up to the mid-80s spending and revenue increased with spending in the lead Spending cuts in the 90s briefly restored a balance

42 40

Govt. spending

% of Net National Income

38 36 34 32 30 28 26 60 65 70 75 80 85 90 95 00 05
CERF and Alphametrics



6% of NNP
Govt. revenue



Tax cuts since 2000 have shifted the government back into deficit

After years of household and government borrowing


The USA has accumulated over $12 trillion liabilities to the rest of the world

$ trillion, mid-year
14 12 10 8 6 4 2 0 2000 2001 2002 2003 2004 2005
CERF and Alphametrics

Total Assets Total Liabilities

The pattern of investment


Foreigners hold corporate assets, public securities and bank deposits

Direct investment

18%
Corporate equities

20%

Corporate bonds

20%

Treasury & agency securities

30% 12%

Bank deposits

0

1

2

3

CERF and Alphametrics

How did foreigners finance their investment in the USA ?


They earned the money by selling goods, services and assets
Capital inflow = current outflow + capital outflow

$ trillion cumulative flow from mid2000
6

Capital inflow Current outflow

5

4

assets sold to the USA

3



2

1

surplus on goods and services
2002 2004
CERF and Alphametrics

0

2000

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
Non-oil imports
20

Oil imports

15

10

5

0 1970 1980 1990 2000

CERF and Alphametrics

It didn't cost US jobs overall
Non-farm employment, millions
160



Losses in manufacturing were far outweighed by gains in services

Unemployment rate

120

private service employment
80

40

government
other industries

manufacturing
0 1990 1995 2000 2005
CERF and Alphametrics

Looking from the outside
Other DV

Japan

Russia

USA
China
Rest of America

W Europe

EE

Africa

M East

Rest of Asia

The network of trade in manufactured goods
CERF and Alphametrics

The US deficit ...
Allocation of US deficit to



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

trading partners by trade share (% of partner's income)

Other Devpd Other America Other Asia China W Europe



0

2

4

6

CERF and Alphametrics

This solves some problems from the past
Trade deficits  Borrowing  Currency crisis  Financial adjustment

Current account balances as per cent of world exports
Africa 3%

1996

L Amer Oth Asia China

1% M East CP Oth dev -1% Japan

1980
-3%

W Eur USA

CERF and Alphametrics

By relying on the USA
borrowing

USA
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

Financial markets

Goods & services



saving

earning

Rest of world
CERF and Alphametrics

But what if ...
Interest rates rise  Property prices fall  US households borrow less
   
Year-on-year increase in national income

Another recession ?

10

5

Recession ?
2000 2005 2010

0

Or more tax cuts ? Or ...
Financial balance of households as % of national income

-5

-10

CERF and Alphametrics

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

Imports growing at 5% pa Exports growing at 8% pa

We are here now

2000

2005

2010

2015

2020

CERF and Alphametrics

A deficit-reduction scenario
Capital inflows =  current outflows  + capital outflows

To be financed by rest of world
Capital outflow
$ trillion 1.5

Trade deficit

1

0.5

0 1980 1990 2000 2010

-0.5
CERF and Alphametrics

Slower growth in the USA ...


Reduced investment in real estate
Higher investment in energy saving and new sources of supply
9 6 3 0

USA: annual growth of real income (per cent)





Growth of labourintensive personal services

1971

1981

1991

2001

2011

-3

CERF and Alphametrics

More growth elsewhere ...
Other blocs: annual growth of real income (per cent)
W Europe
1976-85 1995-05 1986-95 2005-15



Driven by internal demand elsewhere

Japan China Other Asia Other Amer Africa 0 3 6 9 12

CERF and Alphametrics

Generating price signals ...
Balance on energy & raw materials Real price of oil

$ billion

index
2



to which the US economy could respond

200

100

1.5

0

1

-100

0.5

-200 1970 1980 1990 2000 2010

0

CERF and Alphametrics

The same signals


Exporters W Europe

Asia incl Japan USA

$ trillion, 2003 purchasing power

will encourage other developing regions to supply energy and raw materials to China, India and Japan

1

0.5

0

-0.5

-1 1970 1980 1990 2000 2010

CERF and Alphametrics

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

$ trillion, 2003 prices 2

1.5

to rest of world
1

US exports of manufactures



to W Europe to other America
0.5

0 1970 1980 1990

to Asia
2000 2010
CERF and Alphametrics

So there is a scenario for reduction of the US deficit
Trade balance



without a slow-down in world economic growth the most important condition being ... faster growth of internal demand in other blocs

Imports of manufactures Exports of manufactures Energy & raw materials $ trillion, 2003 pp 3

2



1



0

-1 1970 1980 1990 2000 2010
CERF and Alphametrics

Europe ...


0.7% more growth a smaller trade surplus $ 1 trillion more income by 2015 $ 250 billion more industrial imports by 2015

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





CERF and Alphametrics

Asia ...


2% more growth
keep total surplus below $300 billion $ 7 trillion more income by 2015

Don't rely only on exportled growth
Manage internal demand to sustain Asian markets and limit the surplus of the region as a whole



$ 400 billion more industrial imports from other regions $ 800 billion more energy and raw materials from other regions
CERF and Alphametrics



Develop investment markets within the region

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
CERF and Alphametrics

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
CERF and Alphametrics

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.
CERF and Alphametrics



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?

CERF and Alphametrics