In the five years since Lehman Brothers declared bankruptcy, the scale of the financial sector debacle has become clear. The global financial crisis can now be seen as the product of multiple policy and institutional failures embedded within misguided doctrine.
Amazingly, with the full spectrum of failure much clearer now, some high-profile commentary has returned to an early partial explanation, laying primary blame on international imbalances experienced in the years preceding the crisis. China’s large current account surplus is central to this narrative.
If this was just a matter of recording the history of an unfortunate period, this mis-assessment might be of minor policy relevance. But the legacy of the GFC is still with us. Financial reform is far from complete, the global recovery is feeble, and intractable domestic structural problems crimp longer-term prospects in US, Europe and Japan. Addressing these challenges needs a clear-eyed understanding of what went wrong. To elevate international imbalances beyond a minor transitory role will distract policy deliberation.
Looking back at the pre-GFC debate, it’s not as if the international imbalances were ignored. Bill White, chief economist at the Bank for International Settlements, incurred America's wrath (and that of Fed chairman Greenspan in particular) by worrying aloud that the large US current account deficit might prove unsustainable and precipitate disruptive adjustment. In 2005 Ben Bernanke, already on the US Fed Board but not yet chairman, identified the current account surpluses of emerging countries (the counterpart to the US deficit) as the key disruption. The foreign ‘savings glut’ flowed to the US in the form of official reserve holdings, pushing down bond yields. America’s bilateral deficit with China, in particular, left the US with deficient domestic demand.
What is missing, particularly from the 2005-vintage Bernanke analysis, is even a tiny hint of the incipient disasters lurking within the US financial system.
Mortgage credit growth and housing price increases were both noted, but without alarm. The thrust of the wider policy discussion at the time was externally focused, particularly through the efforts to get China to appreciate its currency, thus blunting the edge of its international competitiveness. Within the US Congress there were threats to declare China a ‘currency manipulator’.
Whatever damage China’s export-oriented strategy caused, this was overwhelmed by the multiple misjudgments and deficiencies subsequently revealed by the unfolding GFC.
Loans had been given to borrowers who had no capacity to repay. These loans had been bundled up to disguise their flaws, given totally fictional endorsements by credit rating agencies, and onsold by charlatans to unsuspecting buyers. Financial intermediaries over-leveraged their balance sheets to super-charge profits and bonuses. Markets invented increasingly opaque derivatives and created quasi-casinos to trade them. Rules were side-stepped by shifting transactions into the shadow banking sector. Prudential supervisors stood by passively, awed by the political power of Wall Street, with its ‘light-touch’ self-regulatory free-market mantra.
Now that the multitude of interacting causes have been identified, the ‘international imbalances’ narrative should have faded into an obscure footnote. Not so. The doyen of financial journalists, the Financial Times’ Martin Wolf, has revived ‘internal imbalances’ as the key element in the GFC story.
Lehman might have set off the panic, argues Wolf, but if not Lehman, something else would have triggered the collapse, which reflected the wider problem: ‘economies had become dependent on debt-fuelled spending’. The best explanation for this debt-fuelled spending was, Wolf says, Ben Bernanke’s 2005 view: Asia’s saving glut and the international imbalances this produced. The Fed responded to the external contraction by promoting a debt-fuelled bubble: ‘it simply had to do so’.
There were, however, plenty of other viable policy options for the US. Competent bank supervision would have forestalled the mortgage disaster. Derivatives could have been more tightly regulated. Monetary policy didn’t have to accept lower interest rates just because there were capital inflows. More equitable income distribution would have sustained demand without excessive debt growth. Once the crisis arrived, the US authorities could have saved Lehman the way they saved Citibank, AIG, the money market, Fannie Mae, Freddie Mac and General Motors. Instead of a limping fiscal policy jerked around by sequestration and threats of debt ceilings, there could have been a combination of less austerity together with a credible medium-term plan to address structural fiscal issues. Fewer taxation loopholes and more equitable income distribution would have put purchasing power back with those who were ready to spend.
To ignore these lost policy opportunities and see international imbalances as the key to the unfolding tragedy seems absurd. Yet this same external focus still has currency in the US debate, distracting attention from domestic policy deficiencies and unfinished financial reform. Instead, some US commentators would revive international imbalances (and in particular China’s high reserve levels) as the major talking point for international economic meetings.
An alternative (and far more fruitful) debate involves not only the incomplete US reform agenda, but the wider global structural and cyclical exigencies which have left Europe (excepting Germany but including the UK) with GDP lower than in 2007. To explain, justify and correct this parlous situation requires more than just blaming international imbalances.