Forthcoming, Journal of International Money and Finance

The Immoderate World Economy

Keynote Speech by

Maurice Obstfeld*

3rd Annual JIMF-SCCIE Conference, UC Santa Cruz, May 2009

It has been a humbling time for macroeconomists. Dramatic events in the world’s
financial markets, spilling over forcefully to the real economy, ran far ahead of what our
neat, coherent models could describe, let alone predict. Just as a new virus strain can
evolve if given a favorable environmental niche, and then run rampant through the
human population for a while, financial instruments and strategies evolved to exploit
privately perceived profit opportunities, with disastrously contagious economic
repercussions. While it may be impossible to say anything truly new about the events of
the past couple of years, perhaps it will nonetheless be useful for me to bring some
familiar themes together.

Myths We Lived by through 2007

Through 2007 many of us economists lived with a set of beliefs that turned out to be
largely mythical. Here are some prominent myths; no doubt you in the audience could
add to this list:

• Efficient capital markets will smoothly finance and absorb large global
imbalances, notably the unprecedented demands on foreign finance by the
United States. Former Fed Chairman Alan Greenspan was a leading proponent
of this one (see Greenspan, 2005).

• In the event of a fall in home prices, real estate losses will be limited and any
wealth effects can be offset or at least contained through central bank interest
rate cuts.

*I gratefully acknowledge research assistance from Matteo Maggiori and Rajeswari Sengupta, as well as
the financial support of the Coleman Fung Risk Management Center at UC-Berkeley.

1
 • Central banks are securely independent and firmly in control of inflation and
deflation. The fiscal solvency of most major governments is a foregone
conclusion.

• A new era of stability in emerging markets may make the International Monetary
Fund (IMF) redundant. There is no systemic global threat because emerging
markets are secondary players and the rich countries have robust institutions of
political and corporate governance.

Although these assertions only recently would have commanded widespread

agreement, they donʹt look so convincing today.

Todayʹs Reality

Reality turned out to be disconcertingly different from what many of us expected:

• Global imbalances can now be seen to have been symptomatic of policy missteps
and financial-market distortions that also were central causes of a financial
meltdown unprecedented in severity and global scope since the Great
Depression. In my view global imbalances may pose further problems down the
road.

• Home-price losses served as the fulcrum for the financial crisis. Sharp cuts in
policy interest rates failed to offset or contain the ramifying effects of the real
estate sector’s problems.

• Deflationary pressures appeared and elicited unprecedented expansionary

responses from central banks. Longer-term, the prospect of continuing fiscal
deficits and huge public debts suggest that inflation may become a problem.
Although recent academic literature had focused almost exclusively on the
inflation-control function of central banks, the financial-stability, lender of last
resort role has been more important in the recent period. As a result, the Federal
Reserve has been forced into a quasi-fiscal role that has left it very vulnerable to
political attack from both right and left.

• IMF resources have been sharply augmented, and the Fund is lending to or
backstopping many countries. The mood in the halls of the IMF has turned from
depression to, if not ecstasy (which would be inappropriate under the
circumstances), at least purposeful determination. Incidentally, both of my
students who applied to the IMF for jobs this year received offers.

2
 Reality as we knew it changed dramatically because several interrelated and
ultimately unsustainable economic imbalances persisted far too long before coming to a
halt. We will spend many years picking through the wreckage and debating the
mechanisms at work.

Two Issues

I would like to focus on two specific issues tonight.

First, what exactly is the connection between the much-debated global current
account imbalances of the past decade and the U.S. financial collapse? In my view the
connection is an intimate one. It is nothing so simple as cause and effect, but a strong
case can be made that the imbalances were a primary symptom of forces that led
directly to the financial crash.

Second, what lessons of the crisis can we apply to reforming the global financial
architecture? A major lesson, I believe, is the need to take a systemic view of global
financial stability – a view that treats the global economy much as we would want to
treat an integrated domestic economy. This systemic perspective has not yet been
universally embraced even in the domestic context, of course, though the intellectual
case for doing so is now seen as compelling.

These two issues are closely linked, of course. The growth and adjustment of
large external imbalances will typically have systemically important causes,
accompaniments, and repercussions. As I argue below, large imbalances will warrant
future monitoring for several reasons, not the least of which is their potential
interconnection with global financial stability.

Global Imbalances

Figure 1 displays the evolution of major external imbalances over the period from 1999
through 2008; the 2008 figures are April 2008 IMF forecasts.

[Insert Figure 1 here]

Here we see the large but now shrinking U.S. external deficit, the counterpart
surpluses in Asia, the Middle East, and Japan, along with the deficit of Central and
Eastern Europe, which has become a factor in concerns about global stability today. The
global imbalances in Figure 1, which diverged increasingly over the course of the 2000s
until the crisis struck, are net flows. In Figure 2 we have a picture of gross assets stocks
based on data put together by Lane and Milesi-Ferretti (2007), and extended through
2007. The data displayed in this second figure are, for each country, the sum of gross
external assets and gross external liabilities, divided by GDP.

3
 [Insert Figure 2 here]

For years we have pointed to such position data as evidence of increasing

financial integration. From the perspective of todayʹs troubles, we may instead perceive
an orgy of leverage, an explosive proliferation of interlinked counterparty risks. For the
huge U.S. economy, gross assets and liabilities alike grew to exceed total output,
whereas the external asset positions of the euro zone are higher still. But the ratios that
characterize the U.K. and Switzerland dwarf even these. Certainly these gross positions
outstripped what any plausible model of risk sharing would predict. In many cases,
international asset trades, in an environment lacking any centralized clearing
mechanism, were creating a vast pyramid of interdependent credit risks.

It is important to acknowledge that the explosion in gross positions could have

occurred without any current account imbalances at all – that is, without any change in
net international asset positions. In that sense, there is little logic in arguing that the net
flows in some sense gave rise to the gross flows that set the stage for the crisis.

But I would argue that the same environment of financial globalization that
promoted the expansion of gross positions eased the financing of U.S. external net
borrowing. That circumstance, in turn, helped keep dollar interest rates lower, the
dollar stronger, and U.S. spending higher than they otherwise would have been.
Ultimately, the ease with which the American deficit was financed was not in the global
interest, because the unprecedented U.S. deficit resulted from the fundamental
constellation of expectations and distortions that does lie at the root of the financial
crisis.

The seminal locus of dysfunction was the housing market. Low interest rates,
excessive liquidity, a panoply of adverse financial incentives, and unrealistic
expectations about the future path of home prices combined to generate a massive
bubble (see Figure 3). The housing bubble, in turn, fueled high consumption through a
number of channels, including by generating collateral for borrowing throughout the
financial system. Foreign banks, especially European ones, eagerly invested in triple A-
rated but systemically quite risky structured products. In part, they did so to exploit the
Basel II regime’s low assessment of required capital based on such assets. Some recent
theories of global imbalances stress the U.S as a source of high quality assets that the
rest of the world’s savers crave. In the event, the quality of some U.S. assets that
foreigners rushed to buy has turned out to be questionable.

The behavior of home prices is intimately linked to the behavior of world real
interest rates. The rate on ten-year TIPS is shown in Figure 3; other U.S. real interest rate
proxies show broadly similar behavior. Measures of long-term real interest rates for

4
major economies outside the U.S. are well correlated with the U.S. rate over the medium
term, although there are differences in precise level and in major turning points. Indeed,
it is notable that the housing boom was a global, not just a U.S., phenomenon, with
many of the countries experiencing rapid real estate appreciation also running large
current account deficits during the mid-2000s, just as the U.S. did. Escalating stock
prices coincided with rising housing markets and increased wealth and liquidity
throughout the world.

[Insert Figure 3 here]

The U.S. real interest rate started to decline early in 2000. The S&P peaked later
in 2000 and bottomed out in early 2003 as housing prices continued to rise and indeed
accelerated. The year 2004 saw the beginning of a serious uptake in sub-prime,
adjustable interest rate issuances in the U.S. At the same time the global imbalances
widened sharply; see Figure 1. Long-term real interest fell through the second half of
2005 in the U.S. and then began to rise. Housing continued up through mid-2006. The
big question is: How are these events connected and what caused them?

World Savings Glut and Reserve Accumulation

One prominent theory of low global real interest rates that emerged in the mid 2000s
was the idea of a world glut of savings starting around the time of the Asian crisis.
Bernanke (2005) is the most prominent and lucid exponent. I have never been totally
convinced by this theory as a full explanation, although it has been widely accepted and
it is even argued in some quarters that a global glut in savings is the ultimate cause of
the United States’ external deficit. In other words, some conclude that because all those
foreign savings had to be absorbed in equilibrium, the U.S. was essentially forced to run
its deficits.

How convincing is this account? Figure 4 graphs the 10-year TIPS rate against
the world gross saving measure reported in the IMF’s World Economic Outlook database.
(In this figure all data are annual.) The negative correlation is compelling at best for the
years 2003-05, and in those years the fall in the real interest rate is slight. World saving
continues to rise from 2005 levels but the real interest rate rises.

[Insert Figure 4 here]

Determination of national real interest rates in the global economy is the result of
many factors affecting global saving and investment – and of course, it is not always
possible to infer the exogenous driving factors directly from the equilibrium responses
of prices and quantities. I find it striking in Figure 4 that the trend decline in the real

5
interest rate starts as the high-tech equity market bubble collapses in 2000, and at that
time world saving (equal to world investment) heads downward as well. The post-2000
downward interest-rate trend, for the U.S., is surely accentuated by the Federal
Reserve’s monetary response to a slowing economy, and later, to the 9/11 attacks of
2001.

Under the influence of low real interest rates, commodity prices – notably the
price of petroleum – began to soar in 2004. China, pegging its currency to the dollar at
an undervalued level, battled large speculative capital inflows through energetic
sterilization and other measures, but robust income growth directly raised Chinese
saving while pushing world commodity prices even higher. High commodity prices
augmented the world supply of savings through a transfer effect, shifting income to
countries in the Middle East and elsewhere that in the short run could not raise
consumption quickly enough to keep pace with their higher incomes – as also happened
in the 1970s. Figure 4 shows the rise in world saving that resulted from these factors; it
was accompanied by a sharp widening, in 2004, of global imbalances. As I noted
above, 2004 also saw a marked deterioration of mortgage-loan quality in the U.S. and
accelerating home prices.

Some argue that a factor complementary to world savings was world

accumulation of international reserves – that the demand for liquid dollar assets helped
also to push down dollar real interest rates. There are a number of empirical studies
indicating significant effects of reserve demand on long-term U.S. Treasury nominal
interest rates. Warnock and Warnock (2009) offer a high-end estimate of around 80 basis
points, while Krishnamurthy and Vissing-Jorgensen (2008) find a somewhat lower
range, but I am skeptical that this type of effect played more than a secondary role. For
example, reserve accumulation by emerging markets was also rapid in 2005-2006, but in
that period world real interest rates (and U.S. nominal rates) rose.

High saving and official dollar accumulation abroad did not cause the U.S.
current account deficit. But I think there is a case to be made that high saving and
reserve growth elsewhere dampened the effect of U.S. over-spending on world interest
rates. In that sense, foreign surpluses contributed to the events that followed.1

The Role of Monetary Policy

I believe that monetary policy, especially in the United States, played a

significant role in promoting global imbalances and in setting the stage for the crisis. To

1
Econometric studies such as those of Chinn and Ito (2007) and Gruber and Kamin (2007) conclude that the savings
glut theory offers at best a partial explanation of the high U.S. external deficit over the 2000s.

6
illustrate the evolution of Federal Reserve policy, Figure 5 shows the Federal funds rate
as well as the rates on five- and ten-year U.S. government bonds.

[Insert Figure 5 here]

The Fed held short-term rates very low in 2003-04 because of concerns about
deflation. The Japanese example was very much on the minds of some governors,
influenced by academic analysis suggesting that an effective way to fight deflation was
to commit to hold policy interest rates low for a long period of time. And indeed,
FOMC statements in this period promised to maintain policy accommodation for an
extended period. The low interest-rate environment promoted housing appreciation,
excesses in the mortgage market, excessive borrowing on home equity, a compression
of risk premia, excessive leverage by financial-market actors, and commodity-price
inflation.

As noted above, the housing bubble was a global phenomenon. But in many
cases outside the U.S. accommodative monetary policy was likewise at work, as were
direct spillovers in real estate markets. For example, it is arguable that within the euro
zone, ECB policy, while perhaps appropriate for Germany, was too loose for Spain and
Ireland, among other member countries. Across the world during the 2000s, there is a
strong confluence between housing appreciation and current account deficits (see
European Central Bank, 2007, chart 5; Aizenman and Jinjarak, 2009). Within the euro
zone, which was largely in balance as a unit, a large divergence in current account
positions developed around 2004, with Germany moving into massive surplus and
Spain and some smaller euro members running bigger deficits.

In the U.S. a tightening cycle began in mid-2004 as an inflation threat seemed to

emerge. As Figure 5 shows, the five-year nominal bond rate responded strongly to the
rise in the Federal funds rate, the ten-year nominal rate less so. But the ten-year rate had
anticipated the policy tightening by quite a few months. Then real long-term rates rose.
Eventually, as we all know, adjustable rate mortgages reset and the home bubble
popped, making mortgage refinancing problematic. Subprime defaults commenced on
a substantial scale in 2006. The initial read by U.S. officials – that subprime losses, while
large, would be contained – seemed plausible at the outset, though we all
underestimated the amount of money riding on that particular horse. Indeed, financial
markets showed few signs of stress until the summer of 2007, and equity markets
peaked in October 2007.

The Unwinding

Through the second quarter of 2007:II, foreign demand for U.S. assets and the
U.S. demand for foreign assets both boomed. The volumes of gross flows are huge. The

7
level of foreign asset demand far exceeded the net current account financing needs of
the U.S. Superficially, therefore, there was no sign of external financing problems in the
gross financial flow data. But this was not to last. Figure 6 shows gross external
financial flow data for the U.S., but data released in April 2009 by the Bank for
International Settlements show a similar pattern of retrenchment more generally in the
world economy.

[Insert Figure 6 here]

For most countries, as for the U.S., gross cross-border financial flows collapsed as a
result of the deleveraging process. The picture for the U.S. in Figure 6 (showing
seasonally adjusted data) is particularly interesting because of the Fed’s special role.
The upper line measures foreign private net purchases of U.S. assets, which become
zero or negative (indicating foreign net sales of U.S. assets) after the Lehman event of
September 2008. The lower line shows U.S. private net sales of foreign assets -- so when
these are negative, American residents are net purchasers of foreign assets, and when
this line goes above the horizontal axis, Americans are actually net sellers of foreign
assets. After Lehman, Americans repatriated substantial assets from abroad. Foreigners
stopped buying U.S. assets and repatriated more gradually.

There is a third line in Figure 6 that hugs the horizontal axis until the end of 2007.
That line represents U.S. government net sales of foreign assets other than official
reserves. Negative values thus are purchases of nonreserve foreign assets by the U.S.
authorities. These are essentially nil until the crisis erupts; then they become strongly
negative. These numbers, in fact, reflect the swap arrangements that the Fed set up with
a number of other central banks starting late in 2007. When those foreign authorities
drew on their dollar credit lines, the U.S authorities received foreign-currency balances
that are reflected in the figure. The U.S. did not need those balances, did not pay
interest on them, and swapped them back at the initial exchange rate (with a large
reverse flow evident in the first quarter of 2009). The foreign authorities lent the dollars
to local financial institutions that needed dollar financing of their positions and could
not get it more directly from the Fed. Their earnings on those loans were supposed to be
passed back to the Fed.

In essence, the collapse of international financial flows was associated with a

disappearance of dollar funding for many foreign banks, notably some banks
headquartered in Europe. Many of them had invested heavily in dollar-denominated
mortgage-backed structured products. The Fed stepped into the breach through the

8
extension of the swaps. Without that action, financial turbulence, including exchange-
rate effects, would have been harsher than they were.

The balance of private and official financial flows still must finance the U.S.
current account, which remains in deficit albeit at a reduced level compared to the first
part of 2008 and years immediately earlier. As Figure 7 shows, the compressed U.S.
deficit, in turn, results from falling levels of exports and imports, with imports falling
more. Of course, this picture of shrinking trade volumes has been replicated for
countries across the globe, in many cases more dramatically than in the U.S. case. While
the U.S. deficit is moving quickly in the direction of sustainability, it is hard to know if
the trend will continue in coming quarters as the fiscal stimulus kicks in. There are
further questions about the growth of consumption and investment demand abroad
and about the medium-term path of the dollar’s exchange rate.

[Insert Figure 7 here]

One of the fascinating features of the earlier 2000s is that the U.S. borrowed
abroad at an accelerating pace, yet its net external asset position deteriorated by far less
than the cumulated sum of current account deficits. Holding a net international
portfolio long on equity and short on debt, long on foreign currency and short on
dollars, the U.S. benefited from unexpected stock-market appreciation and dollar
depreciation. With the coming of the global crisis, much of that has gone into reverse.
So much for exorbitant privilege: the underlying risk in the U.S. external portfolio has
come home to roost.

[Insert Figure 8 here]

Figure 8 graphs both the net international investment position (NIIP) of the U.S.
and the path of net external claims that would be implied by simply cumulating
external deficits and ignoring capital gains and losses.2 Throughout most of the 2000s,
the cumulated current account deficit mounted to over 40 percent of GDP while the
NIIP did not get much below −15 percent. All of that changed in 2008. In that year, the
U.S. external debt increased at a rate far above, not below, the flow deficit. The 2008
current account deficit was slightly over $500 billion, whereas exchange rate changes
and equity-market losses inflicted an additional hit of over $800 billion on the U.S. NIIP.
Taken altogether, the result was an increase in U.S. net liabilities to foreigners of nearly
10 percent of GDP, all in a single year. Given the precarious state of U.S. public finances
going forward, questions of future external sustainability remain legitimate.

2
These data, taken from the U.S. Commerce Department’s Bureau of Economic Analysis, value direct investments
on a cost basis rather than at market value.

9
Global Responses to Crises Have Been Inadequate

So far I have focused quite heavily on the U.S. and its experience. Of course. the
financial crisis has been a global pandemic, made more devastating by the absence of
any significant “decoupled” segments of the world economy. The universal reach of the
crisis makes it more important than ever to ask ourselves how we got here. What went
wrong and what can we do to ensure a safer future?

Even recent history is marked by regular near-death experiences in the realm of

global finance. The international community has tried to address the causes in various
ways, some more successful than others. But we continue to leave ourselves very
vulnerable. Part of the problem is that financial markets continue to evolve and
innovate: in part, we are always fighting the last war. But there is another factor at
work, too. In an interesting paper, Aizenman (2009) advances a relevant hypothesis
about human nature: the longer we go without some sort of disaster, the less we think
that precautions are needed. Surviving a near-death experience leads us to believe that
our financial system is more resilient than it really is.

The first major crisis in the modern era of global floating currencies was the
Bankhaus Herstatt collapse (1974), which was brought on by ill-advised foreign
currency exposures. It was this event that inspired the creation of the Basel Committee
of international supervisors, which has done much valuable work over the years and
has served as an indispensable forum for communication and coordination among
national regulators.3 The less-developed country debt crisis (1982-89) could have wiped
out the capital of large money center banks. Catastrophe was avoided through the
significant involvement of monetary authorities and the IMF in orchestrating concerted
lending operations. More recently we have the Mexican crisis (1994-95) and its
spillovers, the Asian crisis (1997-98), and the Long Term Capital (LTCM) and Russian
crises (1998). In those cases, we saw potential and actual contagion effects of the kind
seen on a large scale in 2008. There have also been notable episodes of equity-market
meltdown (for example, the collapse of the high-tech bubble starting in 2000).

We in the industrial countries largely sidestepped the worst potential effects of

these events, though citizens of emerging markets suffered greatly. But as of a decade
ago, any financial reform effort with a chance of succeeding would have had to
originate among the rich countries. The various crises did lead to reform efforts, but
reformers lacked the determination warranted by the potential risks. Each crisis leads to

3
There is a current debate, however, about the alleged procyclical nature of the Basel capital guidelines, which are
held by some to have helped to worsen the financial crisis.

10
incremental institutional progress, but the perceived urgency of reform tends to peter
out while the markets keep evolving. Not understanding the likely source of the next
crisis, we make some of the repairs indicated by the last crisis and then largely mark
time.

International economists such as those attending this conference are all too
familiar with the fundamental mechanisms of financial fragility that the 2007-09 crisis
laid bare. We have all analyzed runs on emerging market countries and sudden stop
scenarios in which short-term debts cannot be rolled over. It is not surprising to us that
in an environment with pervasive short-term finance, in large part through repo
markets, there could be similar runs on nonbank financial institutions, for example, the
broker-dealers Bear Stearns and Lehman Brothers. Writers such as Gorton and Metrick
(2009) argue persuasively that this is exactly what we saw in the crisis. With a bit more
imagination –- and possibly a lot more knowledge of the large financial players’ balance
sheets – more economists and policymakers might have seen the potential outlines of
the kind of crisis that occurred.

A Systemic View of Global Finance

Future reformers of the international financial architecture will need to view world
markets as components of an integrated system. And they will have to view the group
of emerging economies as an integral and quantitatively central part of that system.

Emerging markets have been becoming and will continue to become bigger
players not only in international trade but also in the international financial markets. In
the future, these countries will be significant financial exporters of shocks to the
advanced countries, not just importers of shocks. We now have to worry that runs on
emerging markets might have substantial knock-on effects even on the larger, richer
economies.

Recent financial data are suggestive of growing potential effects. In 2007, private
residents of developing and emerging market countries bought nearly $1.1 trillion in
claims on richer countries. In 2008 they bought only $745 billion in claims. Official
reserve acquisitions are not counted in the preceding totals, but for 2007 and for all of
2008 these were, respectively, $1.2 trillion and $850 billion. Significant backflows from
the private and public sectors of the emerging markets to advanced-country asset
markets are a development of the last decade, but they will naturally expand over time.
Later in 2008 some countries ran down their official foreign exchange reserves, Russia
being a leading example, but only one of several. In some cases reserves were
withdrawn directly from private financial institutions in he richer countries.

11
 As we contemplate the increasing likelihood that runs on emerging markets will
have repercussions in the advanced financial markets, we also realize that the latter
markets are not quite as robust, resilient, or well governed as we had convinced
ourselves that they were. In this light, we can see a systemic drawback of emerging-
market self-insurance through large international reserve holdings. From the standpoint
of an individual emerging market, reserves provide liquidity insurance. They have
served the countries that hold them very well as protection against internal as well as
external drains. But there may be a macro-stability cost of this type of micro-prudence.
When countries draw on their reserves in a global crisis, liquidity in some advanced-
country financial markets could be impaired. Writers such as Crockett (2000),
Brunnermeier et al. (2009), and Morris and Shin (2008) have all stressed the potential
fallacy of composition in thinking that measures to enhance an individual institution’s
(or country’s) stability must necessarily enhance the stability of the system.

Most international reserves held by emerging markets are not a source of

outside, systemic liquidity. But in the current crisis, the ability of lenders of last resort to
create outside liquidity has played a critical role in staving off disaster. Had the U.S.
Federal Reserve not stepped in with some very creative and bold actions, the world
economy would be in much worse shape today. Except on an ad hoc and short-term
basis, however, the Fed cannot act as the lender of last resort (LLR) for the entire world.
It has tried to do so in the recent crisis by extending dollar swap lines – in some cases
unlimited – to foreign central banks. These facilities essentially gave a few foreign
central banks such as the ECB the right to print unlimited quantities of dollars and lend
them to non-U.S. financial institutions. The Fed chose subcontractors to exercise its LLR
function. Quite rightly, the Fed will not agree to institutionalize this sort of a credit
facility permanently. As the crisis goes away the Fed will unwind these swap facilities
as has happened in the past. That will leave the world without a systemic crisis lender.

Inadequate as it appears in its current form, the only real candidate to be a global
LLR is the IMF. The Group of Twenty’s April 2009 decision to boost Fund resources was
a step in the right direction. Unlike a central bank, the Fund cannot create unlimited
liquidity in any currency, but it does have the capacity to add somewhat to outside
liquidity. It has also made access to its resources more flexible – a precondition for
effectiveness in a crisis. The Fund’s growth will be an ongoing process, and past failures
to streamline its lending procedures suggest that success is not assured.
Complementary measures to enhance the Fund’s perceived political legitimacy in the
developing world are also long overdue.

Having a bigger, more powerful, more effective lender of last resort raises the
specter of moral hazard. Thus, more effective surveillance and regulation of global
financial markets becomes even more important. Preliminary noises can be heard. The

12
memberships of the Basel Committee and of the Financial Stability Forum (now
Financial Stability Board) have been expanded to include some prominent emerging
markets. But how can these groups cooperate effectively, especially given their large
sizes, to address the many externalities of divergent national financial systems and
regulatory regimes? Clearly regulators will have to get much better at spotting and war-
gaming potential crises, especially those with significant systemic implications. In
particular, more attention must be paid to systemically sensitive assets, those subject to
the most severe economic disaster risk. One suspects that market participants have put
insufficient weight on the probability of such disasters in the past – and may well come
to do so again in the future.

Concluding Thoughts

Once again, the late Herbert Stein has been proved right about the finitude of
unsustainable trends. How can economists do better in foreseeing future meltdowns?
We need to be wary of large anomalies and think about the possible consequences
before they unwind. As we know, reversals can happen quite rapidly, and with
devastating effects. These anomalies may be overvaluations of currencies, of homes, or
of stocks. They could take the form of large borrowing flows, elevated leverage, or big
current account deficits. When we see a price trend as extreme as the U.S. housing
bubble, accompanied by an unprecedented current account deficit, we need to think
harder than we did about the possibility that something dangerous is at work – and
perhaps think a bit less hard about how to rationalize the imbalances within a rational,
equilibrium model.

Only by recognizing the possibility of multiple market failures in a context of

tightly interconnected balance sheets can we imagine the repercussions of collapse. This
is the macro-prudential perspective. Implementing it will require constant vigilance as
to potential macroeconomic imbalances. We cannot identify these with anything close
to perfection, but that is no reason not to try, and not to pursue intellectually the
implications of assuming the worst. The resulting analysis can only improve the quality
of future economic policy.

13
References

Aizenman, J., 2009. On Prudent Regulation: To Regulate Foreign or Domestic

Intermediation? Harvard International Review, 30 (4), 60-64.

Aizenman, J., Jinjarak, Y., 2009. Current Account Patterns and National Real Estate
Markets. Journal of Urban Economics 66 (2), 75–89.

Bernanke, B. S., 2005. The Global Saving Glut and the U.S. Current Account Deficit.
Remarks by Governor Ben S. Bernanke at the Homer Jones Lecture, St. Louis, Missouri,
March 10.
http://www.federalreserve.gov/boarddocs/speeches/2005/20050414/default.htm

Brunnermeier, M., Crockett, A. D., Goodhart, C., Persaud, A. D., Shin, H., 2009. The
Fundamental Principles of Financial Regulation. Geneva Reports on the World
Economy 11. Geneva and London, International Center for Monetary and Banking
Studies and Centre for Economic Policy Research.

Chinn, M. D., Ito, H., 2007. Current Account Balances, Financial Development and
Institutions: Assaying the World “Saving Glut.” Journal of International Money and
Finance 26 (4), 546-569.

Crockett, A. D., 2000. Marrying the Micro- and Macro-Prudential Dimensions of

Financial Stability. Remarks before the Eleventh International Conference of Banking
Supervisors, Basel, 20-21 September. http://www.bis.org/speeches/sp000921.htm

European Central Bank, 2007. Adjustment of Global Imbalances in a Financially

Integrating World. Monthly Bulletin, August, pp. 61-73.

Gorton, G., Metrick A., 2009. Securitized Banking and the Run on Repo. Yale ICF
Working Paper No. 09-14, Yale School of Management.

Greenspan, A., 2005. Current Account. Remarks by Chairman Alan Greenspan at

Advancing Enterprise 2005 Conference, London, England, February 4.
http://www.federalreserve.gov/boarddocs/speeches/2005/20050204/default.htm

Gruber, J. W., Kamin, S. B., 2007. Explaining the Global Pattern of Current Account
Imbalances. Journal of International Money and Finance 26 (4), 500-522.

Krishnamurthy, A., Vissing-Jorgensen, A., 2008. The Aggregate Demand for Treasury
Debt. Mimeo, Northwestern University, Evanston, IL.

14
Lane, P. R., Milesi-Ferretti, G. M., 2007. The External Wealth of Nations Mark II: Revised
and Extended Estimates of Foreign Assets and Liabilities, 1970-2004. Journal of
International Economics 73 (2), 223-50.

Morris, S., Shin, H. S., 2008. Financial Regulation in a System Context. Brookings Papers
on Economic Activity, Fall, pp. 229-261.

Warnock, F. E., Warnock, V. C., 2009. International Capital Flows and U.S. Interest
Rates. Journal of International Money and Finance 28 (6), 903-919.

15
FIGURE 1. GLOBAL IMBALANCES: NET FLOWS

C ur r ent A cco unt

Sur p l us ( D ef icit i f
N eg at i ve) , B i lli o ns o f
U . S. D o l lar s

400

200

-200

-400 1999
2000
2001
-600 2002
2003
2004
-800 2005
2006
2007
-1000 2008
U ni t e d C e nt r a Eur o We st N e wl y R ussi a J a pa n M i ddl e Devel.
St at es l a nd Ar ea He mi - I ndus- Ea st A si a
Ea st sp he r e t rial
Eur o pe A si a

Source: I MF, World Economic Outlook , various issues.

FIGURE 2. GLOBAL IMBALANCES: GROSS STOCKS

14

12
(Assets + Liabilities)/GDP

10

0
70

72

74
76

78

80

82

84

86

88

90

92
94

96

98

00

02

04

06
19

19

19
19

19

19

19

19

19

19

19

19
19

19

19

20

20

20

20
Switzerland United Kingdom Euro Zone
United States Japan China
FIGURE 3. BUBBLE AND BUST: U.S. ASSET PRICES AND THE REAL INTEREST RATE

1800 5

1600 4.5

1400 4
3.5

Real interest rate

1200
Asset price index

3
1000
2.5
800
2
600
1.5
400 1
200 0.5
0 0
1/31/1997

1/31/1998

1/31/1999

1/31/2000

1/31/2001

1/31/2002

1/31/2003

1/31/2004

1/31/2005

1/31/2006

1/31/2007

1/31/2008

1/31/2009
S&P 500 Case-Shiller index US real interest rate (10-yr TIPS)
FIGURE 4. WORLD SAVINGS GLUT?

25 4.5

24.5
4
24

23.5
3.5

US real interest rate

23
Saving/GDP

22.5 3

22
2.5
21.5

21
2
20.5

20 1.5
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

World gross saving US real interest (10-yr TIPS)

 0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
8.0
9.0
Mar-94
Sep-94
Mar-95
Sep-95
Mar-96
Sep-96
Mar-97
Sep-97
Mar-98
Sep-98
Mar-99
Sep-99
Mar-00
Sep-00
Mar-01

Federal funds rate

Sep-01
Mar-02
Sep-02
Mar-03
FIGURE 5. TERM STRUCTURE OF U.S. NOMINAL INTEREST RATES

Sep-03
Mar-04
Ten-year rate

Five-year rate

Sep-04
Mar-05
Sep-05
Mar-06
Sep-06
Mar-07
Sep-07
Mar-08
Sep-08
FIGURE 6. THE UNWINDING: UNITED STATES CROSS-BORDER FINANCIAL FLOW DATA

800000

600000
Millions of US dollars

400000

200000

-200000

-400000

-600000
1999:III

2000:III

2001:III

2002:III

2003:III

2004:III

2005:III

2006:III

2007:III

2008:III
1999:I

2000:I

2001:I

2002:I

2003:I

2004:I

2005:I

2006:I

2007:I

2008:I

2009:I
Foreign private net purchases of US assets
US private net sales of foreign assets
US government net sales of nonreserve foreign assets
 Millions of US dollars

-1000000
-800000
-600000
-400000
-200000
0
200000
400000
600000
800000
1999:I
1999:III
2000:I
2000:III
2001:I

Exports
2001:III
2002:I
2002:III
2003:I

Imports
2003:III
2004:I
FIGURE 7: SHRINKING UNITED STATES TRADE VOLUMES

2004:III
2005:I
2005:III
2006:I
2006:III
2007:I
2007:III
2008:I
Current account = Exports - imports

2008:III
2009:I
FIGURE 8: THE U.S. NET INTERNATIONAL INVESTMENT POSITION COMPARED WITH
CUMULATED DEFICITS

-0.05

-0.1

-0.15

-0.2

-0.25

-0.3

-0.35

-0.4

-0.45

-0.5
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
Cumulated CA balance United States NIIP