Fixing Global Finance
by Martin Wolf
Johns Hopkins University Press
My hero Martin Wolf has published probably the most unfortunately timed book about finance ever, which was written just before Earth caught on fire, because of finance. Despite the title, the book has little to say about the current financial crisis. Still, the content is highly relevant, surveying the massive global macroeconomic shifts that laid the groundwork for the current awesomeness. Wolf argues that the global imbalances that developed after the emerging market crises of the 1990s left the global economy vulnerable precisely to the kind of events we're seeing now. He is also not shy about fingering the culprits: dirty, dirty foreigners!
Wolf highlights the spike in frequency of financial crises since the collapse of the Bretton Woods system in 1971, with the crises of the 1990s being particularly destructive. Many countries ran current account deficits financed with lots of short-term foreign currency debt. Most had pegged their currencies to the dollar which perversely encouraged this kind of borrowing. As the deficits grew it left these countries vulnerable to a "sudden stop" of financing, as investors began to doubt whether governments could maintain their currency pegs. When financing finally did in fact stop, countries ran out of reserves to defend their currencies and they plummeted, amplifying the real burden of the foreign currency debt and causing massive, painful swings in the current account from deficit to saving. Most resigned themselves to IMF debt peonage.
China was one of few to come out relatively unscathed, managing to successfully defend the yuan, despite massive short positions against it. Surveying the carnage, it and other affected countries resolved "never again." Wolf is certainly sympathetic to China's desire to insure itself against such outcomes, but the mechanism through which it achieved this created its own problems. China intervened in foreign exchange markets to keep the yuan below the dollar to benefits its exporters, the byproduct of which was a massive accumulation of foreign currency reserves, as incoming foreign exchange was taken from exporters by the government and placed into US treasuries. This allowed the US to borrow freely leading to the huge bilateral deficit with China.
This is the "global savings glut" argument which Wolf comes down in support of, as opposed to the idea that US profligacy is largely to blame for global imbalances, though he acknowledges the argument is not without merit. US current account deficits with oil exporters and Japan are more or less explained by structural differences in their economies, but with China it looks like deliberate policy. The key piece of evidence is that long-term real interest rates have been low and falling the entire decade. If US profligacy were to blame, foreign investors would have demanded a higher risk premium on US debt, but that wasn't the case. Low rates were the result of China's accumulation of US treasuries, on which the return for the Chinese has been terrible, indicating ulterior motives.
Wolf argues this led inevitably to overconsumption and the housing bubble in the US, and indeed other countries as well. The US Federal Reserve after all sets short term rates, not long, which matter less for housing finance. This is where I would quibble, since its not as if the People's Liberation Army was kicking in doors making banks issue home equity loans on dog houses, but yea, low rates made it way easier.
So what the hell to do? Wolf wants China to stop being such a pussy about running current account deficits. Having one of the poorer countries on earth export capital to the richest on such a scale is perverse and should not last. Some kind of grand bargain must be made with China trading currency appreciation for a bigger seat at the IMF.
Easing this process along would be some sort of mechanism to allow countries to borrow in their own currency, eliminating the need to horde foreign exchange reserves. This is the "original sin" of emerging markets, that no one wants to lend to them in their own crappy currency. It refers to a story in the Bible where Jesus tries to take out a second mortgage in drachmas but the moneychangers got all Jewy and demanded euros so Jesus was like "fuck that" and trashed the place, or so I gather. Wolf's solution, in addition to insisting that developing countries get their finances and inflation under control, is for an IMF or World Bank facility to allow them to borrow in their own currency, but I'm not sure how this does anything other than shift currency risk onto the international financial institutions.
All that being said, for a primer on the important underlying macroeconomic issues that remain with us in the current crisis you could hardly do better. I would bear Martin Wolf's children if biology permitted.