Currency stockpiles point to vulnerabilities of global economy

Back in 2005, while he was a member of the Federal Reserve Board of Governors but not yet the chairman, Ben Bernanke gave a speech entitled “The Global Savings Glut.”

Bernanke suggested that low interest rates in the U.S. were, to a good degree, the result of several sets of behaviors by central banks and governments around the world. Asian economies, badly burned by the crisis of 1997, were stockpiling official reserves. Oil producing countries, benefiting from high oil prices, were doing the same. 

{mosads}Little of Bernanke’s speech reached the attention of the broader public. But, in retrospect, it is now clear that Bernanke was talking about a key cause of the Financial Crisis that broke out in 2007. 

This massive reserve stockpiling kept U.S. long-term interest rates low, fueling the enormous mortgage lending boom that would famously burst in the great housing market meltdown. This led to a wave of major investment bank failures that launched the world’s worst economic downturn since the 1930’s.

Bernanke’s speech was part of a wave of research and discussion among economists about “global imbalances.” International trade and financial flows are a zero-sum game at the world level — all of the surpluses and deficits have to add up to zero.

When some countries are accumulating massive reserves of financial assets, they have surpluses as well. Other countries, logically, must have deficits. One country’s exports of goods are another’s imports; one country’s exports of capital (e.g. China’s purchases of U.S. Treasury Bonds) are another country’s imports of capital.

Ten years ago, the worry was that this broad pattern of surpluses in the Asian economies and oil producers relied on the U.S. trade deficit. In effect, the United States was financing high levels of consumption and a borrowing binge with funds from other countries.

Economists competed to calculate how far the value of the dollar would have to fall to bring things back into balance, and they worried about a crash in the value of the dollar precipitating a spike in U.S. interest rates that would bring down the U.S. economy.

As it happened, it was not the dollar, but the seemingly all-powerful U.S. financial system, mainly massive investment banks such as Lehman Brothers and Merrill Lynch and the insurer AIG, that brought down the world economy. As the world moved into recession, global imbalances faded into the background and financial crisis and deflation became the problems du jour.

Fast forward to 2017. The world has changed a great deal. Low inflation and slow growth are the norms. Oil prices tumbled after 2014. Growth in rich economies ranges from moderate in the U.S. to modest in Japan to downright sluggish in most of Europe. The financial crisis may be behind us, but its results still linger. 

Still, two elements of the global imbalances problem have emerged recently. First, as Brad Setser pointed out in a recent article for the Council of Foreign Relations, six important Asian economies, Japan, China, South Korea, Hong Kong and Singapore, continue to save extremely high fractions of their income.

They run enormous current account surpluses. Their exports of capital could be difficult to manage in the next years, echoing Bernanke’s savings glut concerns of the 2000’s.

Second, Europe as a whole is now adding to the surplus. Before the crisis, the surpluses of Germany and other stronger European countries were offset by extraordinarily high deficits in the “periphery” countries — Greece, Portugal and Spain — and many of the former communist EU members.

By 2017, European austerity policy toward the debt crisis in Europe has forced the deficit countries to drastically reduce their deficits, but the surplus countries have not eliminated their surpluses.

One sign that the imbalances problem is getting serious again is that about two-thirds of central banks around the world increased their reserves last year. There is some good news in this — increased central bank reserves can be considered “self-insurance” because they give the banks more ammunition to resist a currency crisis.

Since reserves can only be increased if capital is flowing into a country, the renewed stockpiling confirms that money is flowing to many emerging market countries, not at all a bad thing.

However, stockpiling reserves implies buying major currency assets, usually U.S. government bonds. This helps push down interest rates in the U.S. It also helps prevent the local currency from strengthening, which in turn promotes the country’s exports.

To take a concrete case, the Bank of Korea would both lend money to the U.S. and prevent the Korean Won from gaining value, promoting Korean exports. From the U.S. perspective, we get pressure toward lower long-term interest rates and a larger trade deficit. 

This issue of a new global savings glut is a lot like last time. There are new wrinkles, however. The most important is the massive surplus of both the eurozone (especially Germany and the Netherlands) and Europe in general (add Switzerland, Denmark and Sweden).

Economic logic would suggest that surplus countries should expand government spending to bolster their economies, increasing their demand for imports and pulling their partners’ economies up with them. Germany, the leading surplus country in Europe, continues to resist this.

Their arguments have to do with the whole architecture of the eurozone: Germany leaders, strongly backed by the German public, deeply believe that they must show other European countries how to maintain responsible fiscal policy, keeping budgets balanced and returning government debt levels to the limits agreed on in the Maastricht Treaty that created the euro.

Arguably, German “fiscal responsibility,” along with the drastic austerity imposed on the peripheral countries, have played a significant role in keeping Europe’s recovery from its debt crisis so feeble.

In turn, the slow recovery has clearly played a key role in encouraging the rise of populism, seen most dramatically in the Brexit vote and the Trump victory in the U.S. As fears of political instability rise, investors seek out safe havens.

In February, the Swiss National Bank reported its largest increase in reserves since December 2014, the month before Switzerland abandoned its cap on the franc’s value. Similar motivations probably explain some of the strength of the U.S. dollar. Interestingly, the Czech National Bank also had to take strong measures to prevent their currency from appreciating too much in January, too.

What are the biggest dangers going forward? In Europe, the biggest issue, frankly, is politics. The French elections will present a critical moment. A victory for Marine Le Pen would probably imperil the euro, at the very least driving up safe haven currencies and creating massive capital flight from France and other countries perceived in danger. 

Elsewhere in the world, increased capital flows from the surplus countries could fuel lending booms, housing and asset bubbles. The U.S. seems the most likely recipient of capital flows. Unwise weakening of regulations, such as the Trump administration’s promise to “gut” the Dodd-Frank financial regulatory law, would only make the country more vulnerable to such problems.

At the same time, there are some countries beyond the rich world that are quite vulnerable. The International Monetary Fund reports that 26 low-income developing countries fell into the category of high risk of debt distress in 2016.

This an increase of four countries compared to 2015. Even an individual country’s problems must be taken seriously, since debt crises can quickly spread. Debt crises are more likely when U.S. interest rates rise and capital flows shift towards the U.S. With the Federal Reserve discussing a set of interest rate increases for this year, it would be wise to be on guard for such a crisis.

Is there anything to do other than worry? For one thing, Europe should move to decrease its surplus and forgive debt. Significant changes in the design of both the euro and the EU’s fiscal arrangements would be needed.

Contrary to the impression one might have from this side of the Atlantic, the EU has made major changes since 2010, but they are far too limited. Politically, it may be too late to stem the tide. But, if Le Pen were to be defeated, there might be a breathing space that would allow for bolder moves.

Another set of actions could be taken in Asia. China has moved to “rebalance” its economy toward relying more on domestic demand as opposed to exports. Greater progress on this would help.

Japan, too, remains locked in a struggle to revive the domestic economy. All of the countries would have to change tax systems, pensions and a whole host of policies and institutions promoting export-led growth to decrease their surpluses.

Finally, the U.S. could contribute as well. It is still not too late to take advantage of low interest rates to fund infrastructure investments that will create jobs and bolster long-term productivity.  

This would be a much more constructive reaction to the global savings glut then simply allowing a repeat of the housing bubble, or another financial mania. This path to strengthening the U.S. economy would not achieve prosperity at the expense of trading partners, and it would contribute to a global economic recovery.

The U.S. also must maintain a strong regulatory system to shield its economy from another round of financial instability. 

Internationally, the U.S. can contribute by leading an open international trading system and by advocating within the IMF and other international financial fora for appropriate debt forgiveness in Europe and proactive assistance to low-income countries with high risk of debt distress. 

Attempts to put “America first” could easily push this highly stressed world system over the edge. Strong, forward-looking leadership will be required to avoid the coming storm, and it is hard to see where it will come from at the moment. 

Evan Kraft specializes in the economics of transition, monetary policy and banking issues as a professor at American University. He served as director of the research department and adviser to the governor of the Croatian National Bank. 

The views expressed by contributors are their own and not the views of The Hill.