WASHINGTON, D.C., DECEMBER 1, 2009--Prior to the recent financial crisis, "global imbalances," primarily large American budget and trade deficits financed by foreigners, were considered a potential trigger for a coming global financial crisis. Many economists were predicting a nightmare scenario in which the foreign investors' shifting preference away from the dollar would force the United States to finance its huge current account deficit through either a sharp increase in interest rates or devaluation of the dollar. Yet this prediction did not manifest as investors' demand for U.S. debt securities surged during the darkest moment of the crisis. At this AEI event, "Global Imbalances: The Next Crisis?" economist Frank Warnock and AEI resident scholar Desmond Lachman reassessed the continued threat from global imbalances.

"As it turns out we did have a crisis but not the global imbalances crisis," said Warnock. Yet Warnock's research on American debt leads him to believe that imbalances remain important. He expressed concern that reserve accumulation and global investors' preferences could more likely prolong, rather than end, financial imbalances.

In fact, major accumulators of U.S. debt may be unable to rebalance their economies. For countries with high saving rates, increasing domestic demand will be needed to end their recessions. For example, China pegged its currency to the U.S. dollar throughout 2008, which caused the Renminbi to depreciate against the dollar. This action further fueled the imbalance and carries negative consequences for U.S.-China bilateral balance. Lachman called this "a recipe for protectionism."
"We've seen a seismic shift in the nature, size, and composition of international capital flows to the U.S.," said Warnock. He explained that reserve accumulation by foreigners is a "choice variable," one that will react to market pressures. The pause in accumulation during the crisis, which Warnock calls a "true stop," is just one such reaction. As American deficits continue to rise, investors will likely demand higher interest rates to compensate for higher risk.

These demands will limit the U.S. government's ability to stimulate the domestic economy. The pace at which foreign investors are adding to their U.S. bond positions have slowed over the past year and their publicly held Treasuries have fallen 5 percent since mid-2008. However, according to Lachman, "you can't take the U.S. debt off the table quite yet."

One reason to keep the dollar on the table is that no other currency is able to replace it yet. As Lachman noted, the Euro, along with the Japanese Yen, is saddled with problems. Among Lachman's major concerns regarding investing in the Euro zone are the deficits sustained by some of its member countries. He compared the current account deficits of Spain, Portugal and Greece to that of crisis-prone Argentina.

"These countries don't have the policy instrument to get themselves out of awful current account deficit situations," said Lachman. While the United States and the International Monetary Fund came to Argentina's rescue, Lachman says the cost of bailing out these countries is simply too high. He concluded his presentation by saying "Europe is a train wreck waiting to happen."

While Warnock tried to demonstrate that global imbalances pose a major threat to global economic stability and growth, Lachman exculpated the imbalances as the main cause of the recent crisis, saying "Global imbalance is an excuse for policy makers. I don't see low rates absolving policy makers. I don't buy the notion that this whole crisis was because we had global imbalances."