The crisis, global imbalances and
the role of emerging markets
Shanghai conference
Gilles Saint-Paul
A. The Context: Global
Imbalances
An unsustainable boom
• Very large trade deficits of the US
• These deficits were due to a very low savings
rate (= high consumption)
• They were financed by excess savings in China,
Japan, and producers of primary materials
• This was further fueled by
– BofC exchange rate policy
– Low FED interest rates
What should the adjustment look
like?
• A large, permanent fall in US private
consumption expenditure (by 5 % of US GDP)
• A reallocation of economic activity to the
export sector (by 5 % of US GDP)
• A depreciation of the US real exchange rate
(by 20 % to 40 %)
A crisis difficult to avoid
• US consumption has to fall by 2 % of World
GDP
• US export increase has to be sustained by a
rise in demand outside the US, i.e. in China
• But this conflicts with the Chinese mercantilist
policies as well as their inadequate internal
market
• Furthermore, US fall in aggregate demand as
well as depreciation will have massive effects
on the Eurozone
B. The Housing Bubble
Fig. 2.2
Case-Shiller House price index
January 2000=100
240
220
200
180
160
140
120
100
80
60
40
88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08
Source: Standard & Poor Case-Shiller, composite index.
What is a bubble?
• Loosely, « prices are too high »
• However, too high prices can be rational
• Price deviates from the fundamental because
prices high in the future
• Asset held even though bubble may rationally
be expected to burst
• In this case, it rises even more quickly
Are bubbles sustainable in general
equilibrium?
• In the long-run, the bubble cannot grow faster
than the economy
• A bubble is more likely,
– The higher the growth prospects
– The lower the interest rate
• These conditions were satisfied during the
relevant period
Fig. 1.1
9.0
Economic growth and Ifo economic climate
for the world
%
1995=100
Real GDP growth
8.0
7.0
140
(left-hand scale)
130
Ifo World Economic Climate a)
120
(right-hand scale)
110
6.0
100
5.0
90
4.0
80
3.0
2.0
3.4 3.3
2.9
1.0
1.5
2.0 2.0
4.9
4.7
3.7 4.0
3.6
3.5
2.5
4.5
2.2
70
5.1 5.2
2.8
60
3.4
2.3
1.4
0.0
50
40
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
a) Arithmetic mean of judgements of the present and expected economic situation.
Sources: IMF, World Economic Outlook Database October 2008, Update January 2009 (GDP 2008, 2009 and
2010, EEAG forecast); Ifo World Economic Survey (WES) I/2009.
Fig. 1.15
Central bank interest rates
7.0
%
Federal funds rate (US)
6.0
5.0
Bank rate (UK)
4.0
3.0
2.0 %
2.0
Main refinancing
bid rate (ECB)
1.0
1.5 %
0.25 %
0.1 %
Average target rate (BoJ)
0.0
1999
2000
2001
2002
2003
2004
2005
2006
Sources: European Central Bank; Federal Reserve Bank of St. Louis; Bank of England; Bank of Japan.
2007
2008
2009
The consequences of bubbles
• A wealth effect  consumption goes up
– Ex: consumption loan taken out of a loan against
appreciation in the value of the house
• Most houses owned by US residents  US
trade deficit goes up
• Foreigners may want to join the bubble  rise
in demand for US assets  US trade deficit
goes up
The consequences of bubbles (II)
• Corporations and entrepreneurs make capital
gains
• They can use their assets as collateral
• Borrowing easier
• The cost of capital falls
• Investment goes up
• This is called the financial accelerator
Fig. 1.12
Credit growtha) in the euro area
%
16
14
Lending for house purchases
12
10
8
6
4
2
Corporate credit
Consumer credit
0
2001
2002
2003
2004
2005
2006
2007
2008
a) Annual percentage chnage; corporate credit = credit to non-financial corporations; lending to house
purchases = credit to private households and Non Profit Institutions Serving Households.
Sources: European Central Bank; Ifo Institute calculations.
Fig. 1.18
Spread between corporate and government bonds
6.0
%
%
1.6
1.4
5.0
1.2
4.0
1.0
3.0
0.8
0.6
2.0
0.4
1.0
0.2
0.0
0.0
1986
1988
1990
1992
1994
1996
1998
USA Baa long term (left-hand scale)
Bank bonds Germany 9-10 years (right-hand scale)
Sources: Deutsche Bundesbank; EcoWin; Ifo Institute calculations.
2000
2002
2004
2006
2008
Euro area BBB 10 years (left-hand scale)
Euro area AAA 10 years (right-hand scale)
Fig. 2.5
1200
Commercial paper outstanding in the United States
Billions of dollars
1100
1000
Asset-backed CP
900
800
Non-asset backed CP
700
600
2004
Source: Federal Reserve Bank.
2005
2006
2007
2008
The consequences of bubbles (III)
• If asset is accumulable, greater incentives to
produce it
• Excess investment in the bubbble-ridden
sector
• Ex: construction boom in US, Spain
C. The crisis
A 3-dimensional crisis:
• A solvency problem
• A liquidity problem
• A demand problem
The solvency problem
• Lenders assumed house prices would not fall
–  Bank made whole by seizing the house
–  Everybody can get a loan
– Add deregulation and the loan can be 100% of the
purchase price
• But prices did fall
– Giving back the house cheaper than reimbursing
– This would have happened anyway as repossessions
would have taken place and depressed the price
The spreading of insolvency
• Securitization diluted ownership of mortgages
throughout the financial system
• In principle, this is good, BUT
– Systemic price risk ignored
– Institutions highly leveraged  all ended
vulnerable
– Moral hazard problem in monitoring the loans
How to deal with insolvency?
•
•
•
•
Insolvency is taken care of by bankruptcy
What is bankruptcy?
Shareholders lose their shares
Creditors take over and the losses are
allocated between them
• The firm starts again
Why not?
• It is a lengthy process
• Some assets may be inefficiently liquidated
• But it could have been doable with
coordination by the government
• One simple way of doing it is
– Computing the true value of the assets
– Do a debt/equity swap
A debt-equity swap:
Assets
Debt
Equity
Before the crisis
120
100
20
During the crisis
60
100
-40
Conversion
1 $ of Debt  0.45 $ of Debt + 0.15 $ of equity
After the crisis
60
45
15
Why a bailout instead?
• Policymakers feared a run on the financial system
• Runs exist because assets are less liquid than
liabilities
• Example:
– 100 $ of deposits == 100 $ of a house
– If all withdraw their deposits, all houses have to be
sold
– But the equilibrium price will fall, not all can be paid
– It is then rational for me to withdraw before the
others  Bank run is one equilibrium
Two aspects of liquidity
• A (real) asset is worth less if liquidated now
than allowed to continue to run
– Deposit insurance will eliminate the « run »
equilibrium, since everybody will be served
• A (financial) market may be too thin for
absorbing a large supply shock
– Government purchases may render the market
liquid
The transmission mechanism
• The bursting bubble reduces aggregate
demand through two mechanisms:
– Wealth effect on consumers
– Financial accelerator on firm
• Furthermore, this is exacerbated by debtdeflation:
– Which increases the default rate
– And reduces the (net) collateral of borrowers
The policy response
• Replace the bubble by the same nominal
amount of public debt (Bail out)
• Replace private consumption by public
consumption (Stimulus)
• Print money
D. The response to the crisis
Bail out
• Bailout prevents technical bankruptcy of
bailed out institutions
• Bail-out can be win-win if value of assets <
true value because of liquidity (ex. Sweden)
• Unlikely in the present situation: cost to tax
payer is real
• Furthermore:
– Opacity on the withdrawal of toxic assets
– Sets the stage for another round of excessive risktaking (Moral hazard)
“The TARP was originally conceived to purchase
troubled assets directly from banks. However, as quickly
became apparent, properly valuing these assets was
extremely difficult as a result of ongoing home mortgage
foreclosures, defaults, and falling house prices. The
financial turmoil intensified in the weeks following the
bill’s passage, and to move quickly, the U.S. Treasury
established the Capital Purchase Program (CPP), which
became the centerpiece of TARP. The goal of the CPP
was to recapitalize healthy banks by purchasing
preferred shares of stock in banks instead of purchasing
their troubled assets”
Stimulus
• Governments apply standard Keynesian
analysis
• But the required US fall in consumption is
permanent, not temporary
• Stimulus postpones the adjustment by
preventing real exchange rate depreciation
and price falls
– G instead of X replaces C
Perverse effects of stimulus
• If future taxes highly distortionary, adverse
response of consumption and stimulus
contractionary (Cf japanese experience)
• Furthermore, expectations of stimulus make
recession worse in the short run by
maintaining high prices
• Finally, one may exit in a worse situation, with
impoverished consumers and deteriorated
public accounts
Money
• The liquidity injected replaces internal money
with external one
• This may prove highly inflationary when the
internal money creation process resumes
• Furthermore, a chunk of the money is backed
by poor assets
• Withdrawing the money when exiting the
crisis may prove a delicate task
Fig. 2.7
2400
Central bank balance sheets
Billions of dollars
Billions of euros
2400
2200
2200
2000
2000
1800
1800
a)
ECB
1600
1600
1400
1400
1200
FED
1200
b)
1000
1000
800
800
600
600
J
F
M
A
M
J
J
A
S
O
N
D
J
F
M
A
M
2007
a) Total assets/liabilities. b) Total factors supplying reserve funds.
Source: European Central Bank; Federal Reserve Bank.
J
J
2008
A
S
O
N
D
J
2009
E. The near future and the role of
China and emerging markets
Implications for China:
consumption
• Consumption must rise in China
– Because US aggregate demand cannot continue
at that rate
– Because Chinese growth rates are high and
consumption should be smoothed
– Because China has accumulated a large
– stock of foreign assets
Implications for China: real
exchange rate
• To sustain higher consumption, the Chinese
real exchange rate must appreciate
• Pegging the renmibi to the US dollar does not
prevent it
• It postpones it and makes it happen through
inflation
• Dangerous because of inflation inertia
• Better to let the renmibi float, albeit in a
managed way
Where should the money go?
• US assets have low return
– Recession
– Uncertainty about the dollar
– Uncertainty about inflation
– Potential high future taxes, including on capital
• In similar circumstances, many countries have
experienced massive depreciation and BoP
crisis
• This is not happening (yet). Why?
The investors lack alternatives
• Eurozone suffer from similar problems
• Other zones suffer from insecure property
rights and/or undeveloped markets
• Consequently US assets remain paradoxically a
good deal
The Euro option:
• Inherited stock of public debt typically higher
than in the US
• Monetary policy more conservative  lower
LT inflation risk
• Euro may be over-valued
• Some countries with fiscal/competitiveness
problems may jeopardize the Euro
The emerging market options
• No country among B,R,I,C has an established
reputation of securing property rights (I ?)
• Return on investment also depends on
development of internal markets:
– Access to customers
– Existence of a mass consumption sector
– Financial development
– Lack of financial repression
Conclusion
• It is illusory to stimulate by perpetuating the
diseases of the boom, i.e.
– Overconsumption
– Overindebtedness and bad loans
– Misallocation of activity
• Aggregate demand must move where the money
is (China, etc.)
• The US Real exchange rate must depreciate (this
process has started)
• The US is lucky to have avoided sharp capital
flight so far.