What does this chart mean to you?
For central bankers such as Ben Bernanke and Mervyn King, these international imbalances were partially to blame for the financial crisis. Reverse capital flows smashed open a proverbial Pandora’s box of financial fun: searches for yield, mispricing of risk, and so on.
The debate hasn’t gone away, of course. Bernanke continues to see China’s current account surplus as a distorting influence – while the Chinese think he doth protest too much. And with demographic trends and immature markets acting against reducing developing countries’ surpluses in the long run, this issue ain’t going away anytime soon.
Timely walking the imbalances tightrope, then, is a new National Bureau of Economic Research working paper from Òscar Jordà, Moritz Schularick and Alan M. Taylor, promisingly titled ‘Financial crises, credit booms, and external imbalances: 140 years of lessons’.
The paper looks at recession data from 14 rich countries, dating back to 1870, in order to identify factors that are correlative with, or predictive of, national and global financial crises. Think of it as This Time Is Different – the sequel.
Do its findings make happy reading for messrs Bernanke and King?
Not quite.
The authors first look at whether there is any ‘temporal and spatial coherence’ in the data – in layman’s terms, whether there any patterns that could help us predict when and where financial crises happen:
…we fi nd no evidence of serial correlation in the crisis data pattern, but we do fi nd moderately strong evidence of some spatial dependence. Thus, in the
case of the big global crises, if other countries are having a crisis there is a good chance that your
country is having, or is about to have, a crisis too.
In other words, there is no mysterious mathematical pattern to when financial crises happen but as we’re all too aware, contagion is real.
On to the beef. What do 140 years worth of data tell us about what factors are predictive of financial crises – and, do they include imbalances?
Several results deserve comment. First, boom and bust dynamics seem to be more pronounced in big international crises as measured by growth and investment dynamics. Second, both credit and money growth are strongly elevated before national and global financial crises. Third, national crises are preceded by larger current account deficits relative to the country’s own history. Lastly, we find historical evidence that the global crises occurred in an environment of depressed natural rates (i.e. when measured by the difference between nominal short term rates and real growth). In other words, international crises have tended to happen after non-inflationary real booms. However, no such misalignment is apparent if real interest rates are calculated using current inflation real interest rates. Prices were relatively static in the run-up to normal and common crises. In light of the evidence from 140 years of modern economic history, the big international crises are different in that they combine strong credit growth with an environment of low real interest rate (relative to real growth) and tame inflation. External imbalances could play an additional role, but at a first glance they appear secondary to the role played by credit growth and interest rates.
What’s Mandarin for ‘told you so’?
The data suggests then that overleveraging in the context of low rates was more important (and will be more important) than current account imbalances to financial crises.
Now, there are loads of caveats that are worth briefly highlighting. These data are, for a start, from an inevitably small sample of global financial crises; sensitive to timing classifications of when crises start and end; and crucially, it’s hard to disentangle the alleged cause (imbalances) from the alleged effect (massive loan growth to fund the search for yield, for example). Some would no doubt argue, too, that the sheer scale of the current imbalances mean they are more distortionary than ever before.
Regardless, it’s a qualified victory for the imbalances doves.
Paper in the usual place.
Related links:
800 years of financial folly – FT Alphaville
Get off my global savings glut, you damn kids – FT Alphaville
Trade deficit back to (ab)normal – FT Alphaville
Global imbalances and EM financial markets – FT Alphaville