Financial Turmoil and Global Imbalances: The End of Bretton Woods II?
Hunt, Chris, The Reserve Bank of New Zealand Bulletin
Since August 2007, the global economy has been subject to a sharp and adverse financial shock, with re-pricing of risk and higher cost of funds. This article argues that this shock is a consequence of an unsustainable period of global economic growth involving very large external imbalances. These imbalances-large current account surpluses in many emerging markets matched by current account deficits (CADs) in a number of advanced economies - contributed to an unsustainable cheapening of credit and increased risk-seeking behaviour by financial markets. The development of the imbalances can be explained by financial underdevelopment in many emerging markets, together with particular savings and investment dynamics across the surplus and deficit countries. These factors established 'Bretton Woods II', a global macro-financial dynamic that tied the deficit and surplus economies together in a co-dependent relationship. The current credit crisis appears to mark the limits of this relationship. However, the precise nature of any subsequent adjustment in global imbalances is not immediately clear.
This article examines the relationship between the ongoing turmoil in financial markets, and the pattern of capital flows that has underwritten global growth in recent years. The global credit crisis that originated in the US sub-prime mortgage market can be understood as a consequence of the unsustainable nature of very large external imbalances that have evolved since the late 1990s (figure 1). The current deleveraging associated with the credit crisis therefore marks the beginning of the end of the broader economic and monetary configuration that has underpinned these imbalances. In short, the credit crisis signals the end to what, following Dooley et al. (2003), we will refer to as Bretton Woods II (BWII).
[FIGURE 1 OMITTED]
The term BWII is used to signify the mutually beneficial and codependent relationship between the world's largest economy (the US) and an emerging periphery. (1) This arrangement has allowed China and other emerging economies to pursue an export-led development strategy and run persistent current account surpluses, while enabling deficit economies such as the US to consume far more than their domestic income would otherwise allow. The sustainability of this global arrangement has been subject to debate within such global fora as the G7 and the IMF. The general consensus has been that while global imbalances could persist in the short run, BWII did not constitute an enduring architecture for long-term economic growth. (2)
Until recently, the resilience of the global economic expansion and associated optimism had meant that it was possible to overlook the more sober warnings about the non-sustainability of BWII. However, the financial shock that erupted last August in the sub-prime sector of the US housing market, and that has since spread throughout a heavily leveraged global financial sector, has given rise to concerns about the health of the global economy more generally. The "global economy is now facing a widespread deleveraging as mechanisms for credit creation have been damaged in both the banking system and the securities market - that is, both of the financial system's twin engines are faltering at the same time" (IMF, 2008, pp. 6-7). Financial institutions in many OECD countries have become much more highly leveraged in recent years, reflecting the excess liquidity generated by global imbalances, financial innovation produced by an under-pricing of financial risk, and unsustainable growth in prices across a range of financial assets. In short, "the unsustainable has run its course" (BIS, 2008, p. 3).
In the next section, we situate the BWII system and underlying imbalances in historical context. Current account imbalances and the corresponding flows of financial capital have traditionally been a key mechanism by which countries have lent resources to other countries. …