Global Imbalances and Low Interest Rates: An Equilibrium Model vs. A Disequilibrium Reality

Jeffrey Frankel

Working Paper Series from Harvard University, John F. Kennedy School of Government

Abstract: The most obvious explanation for the large and widening US current account deficit is the high budget deficit and low national saving. But a variety of clever economists have come up with 8 other, more sanguine, explanations: (1) the siblings are not twins, (2) investment boom, (3) low US private savings, (4) global savings glut , (5) “It’s a big world ” (6) valuation effects will pay for it, (7) “Intermediation rents…pay for the trade deficits,” and (8) China’s development strategy entails accumulating unlimited dollars. The impressive paper by Caballero, Farhis, and Gourinchas falls under category (7). Their theoretical model is innovative and interesting, and has the virtue of being able to explain the current account deficit together with the anomalously low long-term interest rates during 2001-2005. The basic idea is that fast growth in emerging markets coupled with their inability to generate local store of value instruments increases their demand for saving instruments from the developed countries. More growth potential in the United States than in Europe means that a larger share of global saving flows to US assets. Ultimately, however, I am not sure that it is the correct explanation, or a reason to consider the deficits sustainable, any more than the others. Their hypothesized collapse in the desirability of emerging market assets and stagnant growth in Europe and Japan fit the 1990s fairly well. But they don’t fit 2003-2006 as well, which is the puzzle period, that is, the period that featured the record US current account deficits coinciding with low long-term interest rates. Emerging markets have had a high capacity during 2003-06 to generate assets that others want. More persuasive is the hypothesis that the US continues to exploit the exorbitant privilege under which others accumulate dollars as reserves, but that this exclusive position of the dollar will not necessarily continue forever.

Date: 2006-08
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