Should We Worry About Global Imbalances?

On the significance of safe asset shortages

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In my previous post, I asked whether dollar dominance is beneficial to the United States. In some sense, the main issue is about whether or not one should worry about persistent current account deficits and/or the large budget deficits of the U.S. federal government.

This week I would like to revisit these issues and maybe provide some additional structure to the argument. In doing so, I would like to provide some insight into the literature on “safe assets.” This literature was all the rage in the Econ blogosphere in the aftermath of the financial crisis. However, from the feedback I’ve received in response to recent posts, it seems that the explanatory power of this literature and the insights about broader issues perhaps haven’t been as influential as I thought.

I will start the post by re-framing the discussion of global imbalances in the context of safe assets. Given that basic framework, I will then discuss how and why we can think about the effect of safe asset shortages on global imbalances. Finally, I will use this as the context in which to ask whether or not we should care.

The United States as Intermediary of the World

As I mentioned in my previous post, a common argument that you hear from people about current account deficits is that persistent deficits will lead to a depreciation of the currency. At least one economist who replied to the post scoffed at this claim. I found that reaction odd for two reasons. The first reason that it was odd is that this indeed is a common argument that one hears. For example, Olivier Blanchard, Francesco Giavazzi, and Filipa Sa wrote a Brookings paper back in 2005 that argued that the U.S. current account deficit had been driven by a combination of an increase in the U.S.’s demand for foreign goods as a result of higher growth in the U.S. and the rest of the world’s growing demand for U.S. assets. Their model suggested that this would ultimately result in a real depreciation of the dollar to correct the imbalance. People like Maurice Obsfeld and Kenneth Rogoff have made similar arguments about the real depreciation of the dollar.

A second — and more important — reason that I found this criticism odd is that I rejected this claim. As I explained in the previous post, things are different for the U.S. It is possible that the U.S. could run current account deficits forever. In fact, the argument that I made is that, given the current system, it is essentially required. This same economist replied to this point by showing that other countries tend to run persistent current account deficits as well. Again, yes. This doesn’t refute anything that I said. I didn’t claim that only the U.S. can run persistent current account deficits, but rather that this characteristic is necessary for the current international monetary system.

Given this confusion, perhaps it is worth going back to first principles and explaining some basic concepts.

Much of the discussion of global imbalances focuses on accounting, which in turn leads to a focus on savings and investment. I think that this is the wrong framing. Instead, I think that it is best to think about the U.S. (and others who run persistent current account deficits, but henceforth I will only refer to the U.S.) as an intermediary to the rest of the world. But why would this be the case?

People around the world need some way to store their wealth over time. A lot of assets that they could purchase are risky. They do not want to store all of their wealth in risky assets. They would prefer to hold “safe” assets. What I mean by “safe assets” are those that are likely to preserve their value when bad things happen.

Countries that are better able to produce safe assets are therefore likely to run persistent current account deficits. However, the dollar’s role as the global reserve currency and the U.S. Treasury securities role as global reserve asset make the U.S. the focal point of this analysis.

There are several reasons why some countries might have an advantage in providing safe assets. One reason could be that the government of that country has a history repaying its debts and does a reasonable job of maintaining the purchasing power of its currency. In such scenarios, the government’s bonds serve as safe assets.

Another reason could be more sophisticated financial markets. To some extent, this goes hand-in-hand with the prior argument. A strong secondary market for the government’s bonds is essential for it to be considered a safe asset. At the same time, more well-developed financial markets also create the potential for privately-produced safe assets.

Once, we think about it like that, it is easier to understand why some countries might run persistent current account deficits. For example, an influential paper by Ricardo Caballero, Emmanuel Farhi, and Pierre-Olivier Gourinchas showed that countries can run permanent current account deficits when they have what we might call greater financial capacity, or more well-developed financial markets that allow the creation of more financial instruments tied to real investments. Thus, rather than thinking about current account deficits as temporary or even unsustainable, they argued that we can think about current account deficits as an equilibrium phenomenon.

More generally, this focus on safe assets suggests that we should think of safe asset-producing countries as intermediaries for the rest of the world. This is a view that dates back at least to Charles Kindleberger in the 1960s. To understand this idea, consider the world without these safe assets. In that world, the only assets that one can buy are risky assets. One might want to diversify by purchasing safe assets and reducing the volatility of one’s investments, but there is no ability to do so. Now, along comes someone capable of providing safe assets. This person could issue a liability that is considered safe. For the purchaser of the liability, this is a safe asset. Meanwhile, the issuer of the liability uses the proceeds from the sale to buy the risky asset. Since the safe asset will have a lower expected rate of return than the risky asset, the intermediary is able to profit (at least on average) from issuing the safe liability to buy a risky asset. This makes for a useful analogy since global imbalances look like this in the aggregate accounting for places like the U.S. Recall that this is the basic mechanism of the model of the global hegemon who issues the reserve asset that I discussed in my previous post.

In other words, what the safe asset producers are doing is they are transforming a portfolio of risky assets into safe assets and earning a profit via the risk premium.

Safe Asset Shortages and Global Imbalances

Thinking about global imbalances through the intermediary lens is helpful. It helps us to focus on the source of the imbalances and the potential implications.

From the early 2000s through the middle of that first decade, there was growing recognition around the world of the importance of safe assets. The Asian financial crisis of 1997, the Russian financial crisis of 1998, and the tech stock collapse of the early 2000s seemed to create greater demand for safe assets. Furthermore, faster growth among developing countries led to greater demand for safe assets as well.

However, because the countries demanding safe assets were growing faster than the countries that produce them, the demand for safe assets tended to outpace the supply. As a result, the real interest rate declined. Furthermore, this is why the framing of current account deficit countries as intermediaries to the rest of the world is useful. Given the U.S.’s role as an intermediary to the rest of the world, it follows that an increase in the foreign demand for safe assets leads to (a) an increase in the prices of domestic risky assets, and (b) an increase in leverage in the U.S. financial system. By around 2005, people like Ben Bernanke were referring to these general patterns as being the result of a “global savings glut” whereas people like Ricardo Caballero more precisely identified it as a “safe asset shortage.”

One significant effect of the growing demand for safe asset was that private financial intermediaries in the U.S. sought to provide another supply of “safe” assets through things like mortgage-backed securities. For a time, this private supply, along with European sovereign debt, helped to meet the demand for safe assets. However, the safety of these alternative supplies of assets proved illusory, as neither the mortgage-backed securities nor Italian and Spanish government bonds proved to be safe assets after all.

The financial crisis itself can mainly be described as a story of the dramatic reduction in the supply of safe (or perceived to be safe) assets. This is something that David Beckworth and I have written about elsewhere.

In the aftermath of the financial crisis, the same economic forces remained, but this time without the illusion of financially engineered safe assets. This exacerbated the excess demand for safe assets, which tended to put downward pressure on the real interest rate. Furthermore, the U.S. federal government debt began to make up a greater percentage of safe assets, both as a percentage of total “safe” assets and as a percentage of world GDP.

So Should We Care About Global Imbalances?

I think that this discussion can help shed light on the various positions that people take about global imbalances. On the one hand, these imbalances seem to be driven by the fact that some countries, most notably and significantly the U.S., are capable of providing safe assets to the rest of the world. When one thinks about these balances through that lens, it is easy to see why some countries run current account deficits and why others run current account surpluses as well as why we shouldn’t think of these global imbalances as being inherently unsustainable or disequilibrium outcomes. Instead, it is possible to think about them as equilibrium outcomes.

Nonetheless, saying that something is an equilibrium outcome does not necessarily mean that it is a “good” outcome — and even if it is “good” under certain circumstances, it is not necessarily good under other circumstances.

One challenge of the current system is that, in recent decades, there hasn’t been enough of a supply of these safe assets. This tends to drive the real interest rate lower, and asset prices and leverage higher in the safe asset-producing countries. Those unconcerned about global imbalances dismiss these changes as inconsequential. After all, aren’t these just relative price changes? Isn’t this just market clearing? Why should we care.

This attitude is somewhat understandable. As economists, we tend to be allergic to arguments about “excess demand” or “excess supply.” For example, when the media reports on an ongoing banana shortage, economists don’t expect that to persist. The reason is that prices adjust and we move toward equilibrium. Banana prices simply rise until the market clears.

The challenge when it comes to safe assets is that we are not talking about a market with private sellers and private buyers. There is a basic friction in the market that prevents safe assets from being competitively supplied. The largest supplier of safe assets (by far) is the U.S. federal government. But the federal government is not deciding how much debt to issue based on the demand for safe assets (although they might respond to lower interest rates by borrowing more). Nonetheless, the market will clear. It is important to consider how the market clears and the corresponding welfare consequences.

A shortage of safe assets can be eliminated through an increase in the supply of safe assets and/or an increase in the real value those assets. Let’s focus one of those factors at a time.

Without any change in supply, the real value of a safe asset can rise through an increase in its price. But remember that these safe assets tend to be things like government bonds. As the price rises, the yield declines. Yields are subject to a lower bound (there are reasons to believe that the lower bound is below zero, which you can read about here, but let’s stick with zero for simplicity). Once the yield falls to zero, since demand is coming from abroad, the real value could continue to rise through an appreciation in the currency of the safe asset-issuing country. Thus, in our context that means that the dollar appreciates to increase the real value of the asset to borrower. This benefits the consumers in the safe asset-issuing country, but it harms producers.

As I mentioned in my previous post, a prolonged real appreciation of the dollar can also result in offshoring. Thus, while economists are apt to attribute such things to comparative advantage, they can also be driven by a shortage of safe assets.

Eliminating the shortage of safe assets through an increase in the supply is also possible. However, again it is important to keep in mind the intermediation role being provided by the U.S. What are considered safe assets to the rest of the world are liabilities to the U.S. (primarily the U.S. federal government). There are some potentially costly consequences associated with the fact that the global reserve asset is a debt instrument.

The primary challenge is that a safe asset today isn’t necessarily a safe asset tomorrow. Whether government debt is “safe” depends on things like how much is in circulation, expected future tax revenues, and expected future spending. As I discussed in my previous post, Emmanuel Farhi and Matteo Maggiori have an excellent paper in which they show that this is of little concern when the debt levels of the global hegemon are sufficiently low. However, the system becomes unstable when debt gets sufficiently large because it raises the likelihood of a devaluation. Again, the intermediary analogy works well here. All that is needed for the system to break down is for people to believe that the debt is too high and that can become a self-fulfilling prophecy. The collapse of the system can resemble something like a bank run.

A second challenge is that increasing government debt in order to increase the supply of safe assets might also crowd out private debt issuance and thereby reduce profitable investment projects. One must consider therefore consider whether the benefits of safe asset issuance offset the costs of reductions in private investment.

So, should we care about imbalances?

I think that the answer is yes, but not for reasons that are often offered. For example, global imbalances aren’t necessarily inherently unstable. In fact, one can make a compelling argument that such imbalances can be considered equilibrium phenomena. Nevertheless, saying that such imbalances aren’t inherently unstable isn’t the same thing as saying that they can never be the source of instability.

The current international monetary system contains features that make equilibrium current account imbalances more likely, with net safe asset producers running current account deficits. However, the last few decades of safe asset shortages have challenged conventional wisdom on a number of issues and, in the case of the global financial crisis of 2008-9, have also been the source of significant economic costs.

In more recent years, we have seen an increase in the growth rate of U.S. government debt. An unsustainable trajectory of debt not only poses potential costs to the U.S., but can also threaten to unwind the dollar-based system. Furthermore, parallel to this acceleration in the growth rate of U.S. government debt has been the consistent application, across political parties and U.S. presidents, of dollar-based sanctions as a significant tool of U.S. foreign policy. Currently, these seem like somewhat effective tools against U.S. adversaries and, as it relates to foreign policy, must be weighed against the proper counterfactual. Nonetheless, it is not unreasonable to believe that the potential overuse of these sanctions could also contribute to the instability of the system itself.

Maybe things will work out. People have been saying that this system is unsustainable for decades. Nonetheless, it is not unreasonable to be concerned about these global imbalances and the trends we have observed over the last couple of decades.