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FEDERAL RESERVE BANK OF CLEVELAND pd papers NUMBER 13 By Michael D. Bordo POLICY DISCUSSION PAPER Globalization and Imbalances in Historical Perspective JANUARY 2006 POLICY DISCUSSION PAPERS FEDERAL RESERVE BANK OF CLEVELAND Globalization and Imbalances in Historical Perspective By Michael D. Bordo Global imbalances associated with the U.S. current account deﬁcit have given rise to speculation about the nature of the impending adjustment: Will it be smooth and gradual, or will it be sudden and costly? This Policy Discussion Paper summarizes the two views and then considers three historical periods with similar pressures—an earlier era of globalization from 1870 to 1914, the interwar gold standard, and Bretton Woods. A comparison of the periods and their outcomes suggests current global imbalances might resolve themselves quietly. This paper was originally presented to the Cleveland Committee on Foreign Relations at the Federal Reserve Bank of Cleveland on March 9, 2005. Michael D. Bordo is a professor of economics Rutgers University and a research associate at the National Bureau of Economic Research. Materials may be reprinted, provided that the source is credited. Please send copies of reprinted materials to the editor. POLICY DISCUSSION PAPERS Policy Discussion Papers are published by the Research Department of the Federal Reserve Bank of Cleveland.To receive copies or to be placed on the mailing list, e-mail your request to email@example.com or fax it to 216-579-3050. Please send your questions comments, and suggestions to us at firstname.lastname@example.org. Policy Discussion Papers are available on the Cleveland Fed’s site on the World Wide Web: www.clevelandfed.org/Research. Views stated in Policy Discussion Papers are those of the authors and not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System. ISSN 1528-4344 FEDERAL RESERVE BANK OF CLEVELAND The Current Situation The Gloomy View Recent concerns over global imbalances associated with the U.S. current-account-deﬁcit-to-GDP ratio in excess of 5 percent (see ﬁgure 1) and U.S. net foreign liabilities of $2.7 trillion or 25 percent of GDP (see ﬁgure 2) have raised fears of a drastic readjustment involving a massive depreciation of the dollar (as large as 90 percent in some scenarios [Blanchard et al. 2005]). It has already fallen about 30 percent in nominal trade-weighted terms against our major trading partners (see ﬁgure 3)—with attendant potentially serious effects on the U.S. and global economies (see, for example, Obstfeld and Rogoff 2004).The adjustment would involve reallocation of consumption and production in the United States from nontraded to traded goods and a possible rise in inﬂation, which would lead to greater tightening of monetary policy, which would, in turn, induce a recession.The decline in income would reduce both the demand for imports and domestic consumption and encourage domestic saving, simultaneously improving the two faces of imbalance—the current account and the savings investment gap. At the same time, the adjustment would have opposite effects in Europe and Japan, areas with current account surpluses and excess savings (see ﬁgures 4 and 5).To the extent that European nominal rigidities prevent it from adjusting to the decline in demand for its exports to the United States, its real economy could suffer. China, with its currency pegged to the dollar, would not have to adjust much and would gain a competitive advantage in the U.S. market—especially against Europe. In addition, it is argued that, to the extent that the imbalances have been ﬁnanced by foreign—especially East Asian—central banks’ accumulation of U.S. treasury bills (up to 65 percent of their international reserves), some point will be reached where these central banks will dump their depreciating dollar assets and shift their portfolios towards the euro, thereby aggravating the situation. The current situation is often attributed to the IT boom of the 1990s, which induced a massive private capital inﬂow to U.S. equity markets.The bursting of the tech boom (bubble) in 2000, followed by 9/11, a U.S. recession, and the wars in Afghanistan and Iraq, led to a shift of the U.S. budget deﬁcit from surplus to a deﬁcit of close to 4 percent of GDP. This twin deﬁcit problem is viewed as a key determinant of the deteriorating situation (Frankel 2004). The Benign View An alternate view does not regard the outlook in such bleak terms. It posits that adjustment will be smooth, protracted, and benign, very much like what happened in the late 1980s, when the U.S. current account deﬁcit recorded a peak of about 4 percent of GDP.This view (see, for example, Greenspan 2003) stresses the underlying force of ﬁnancial globalization—a burgeoning phenomenon since the 1970s and one which has encouraged residents of open economies to increase their holdings of foreign assets as a way to diversify portfolios and smooth out shocks to consumption. Global assets and liabilities have mushroomed in the past three decades, especially in the 1990s (Lane and Milesi-Ferreti 2005). Globalization and a decline in home bias—a tendency of domestic investors to prefer domestic assets in their portfolios—have deepened and broadened ﬁnancial markets around the world and, above all, in the United States, which has seen a disproportionate growth in the demand for its assets because it offers a higher real rate of return based on the economy’s long-run good performance. 1 POLICY DISCUSSION PAPERS FIGURE 1 NUMBER 13, JANUARY 2006 CURRENT ACCOUNT BALANCE Billions of dollars 200 Percent of GDP 2 100 1 0 0 –100 –1 –200 –2 –300 –3 –400 –4 –500 –5 –600 –6 –700 –7 1990 1992 1994 1996 1998 2000 2002 2004 Sources: Board of Governors of the Federal Reserve System, “Selected Interest Rates,” Federal Reserve Statistical Releases, H.15; and Bloomberg Financial Services. FIGURE 2 NET INTERNATIONAL INVESTMENT POSITION—CURRENT COST BASIS Trillions of dollars 2 Percent of GDP 20 1.1 15 1 10 0.5 5 0 0 –0.5 –5 –1 –10 –1.5 –15 –2 –20 –2.5 –25 –3 –30 –3.5 –35 1980 1983 1986 1989 1992 1995 1998 2001 2004 Sources: Board of Governors of the Federal Reserve System, “Selected Interest Rates,” Federal Reserve Statistical Releases, H.15; and Bloomberg Financial Services. FIGURE 3 NOMINAL TRADE-WEIGHTED MAJOR CURRENCY EXCHANGE RATE Index, March 1973 = 100 140 130 120 110 100 90 80 70 1973 1977 1981 1989 1989 1993 1997 2001 2005 Sources: Board of Governors of the Federal Reserve System, “Selected Interest Rates,” Federal Reserve Statistical Releases, H.15; and Bloomberg Financial Services. 2 FEDERAL RESERVE BANK OF CLEVELAND Thus in this view, the current account deﬁcit and the rise in U.S. net foreign liabilities reﬂect the demand for U.S. instruments by foreigners. Adjustment, to the extent it needs occur, will be benign because the underlying long-run positive fundamentals will continue, and for two additional reasons: valuation and a reduced pass-through. Valuation effects refer to the fact that, to the extent dollar depreciation is unexpected, it will reduce the value of U.S. foreign liabilities (Gourinchas and Rey 2004). A reduced pass-through is suggested by recent empirical evidence, which shows that only a very small fraction of dollar depreciation passes through to higher inﬂation (Greenspan 2005). Globalizing Capital Flows and the Adjustment Mechanism: A Benign Outcome a Century Ago A different and perhaps enlightening perspective on the issue is to delve into economic history for earlier episodes of global imbalances, which may have some resonance for today and which may tell us what is in store for the future. An important precedent for the benign outcome view is the previous era of ﬁnancial globalization, which took place from 1870 to 1914. It was characterized by a rapid FIGURE 4 EURO-AREA’S CURRENT ACCOUNT BALANCE Percent of GDP Billions of euros 30 1.5 20 1.0 10 0.5 0 0.0 –10 –0.5 –20 –1.0 –30 1980 –1.5 1983 1986 1989 1992 1995 1998 2001 2004 Source: Federal Reserve Bank of Cleveland. FIGURE 5 JAPAN’S CURRENT ACCOUNT BALANCE Trillions of yen Percent of GDP 6 6 5 5 4 4 3 3 2 2 1 1 0 0 –1 –1 –2 –2 –3 1980 –3 1983 1986 1989 1992 1995 1998 2001 2004 Source: Federal Reserve Bank of Cleveland. 3 POLICY DISCUSSION PAPERS NUMBER 13, JANUARY 2006 global buildup of external assets and liabilities and also of long-standing current account imbalances comparable to today’s experience. The 50 years before World War I saw massive net private ﬂows of capital from the core countries of Western Europe to the countries of recent settlement overseas (mainly the rapidly developing Americas and Australasia), ﬁnancing railroads and other infrastructure as well as budget deﬁcits (especially in the form of bonds but also in the form of foreign direct investment). At the peak, the associated current account surpluses in Britain reached 9 percent of GDP and were almost as big in France, Germany, and the Netherlands (See ﬁgure 6). For the principal capital importers in the late nineteenth century (Argentina, Australia, and Canada), current account deﬁcits exceeded 5 percent of GDP on average. Earlier in the century, the United States experienced similar ﬂows but by the century’s end it began to run current account surpluses. In addition, data on ratios of stocks of foreign assets and liabilities to GDP for selected countries and regions, compiled in Obstfeld and Taylor (2003), presents a picture of a u-shaped pattern. At its pre–1914 peak, the share of foreign assets to world GDP was approximately 20 percent. It declined from that level to a low of 5 percent in 1945, with the prewar level only being reached by 1985.After that point, it rose to 57 percent by 1995.A similar picture emerges from the ratio of liabilities to overall GDP. The British held the lion’s share of overseas investments in 1914—50 percent—followed by France at 22 percent, Germany at 17 percent, the United States at 6.5 percent, and the Netherlands at 3 percent. By comparison, the United States held 25 percent of global assets in 1995. These funds in turn represented up to one-half of the capital stock of one of the major debtors (Argentina) and close to one-ﬁfth for Australia and Canada. FIGURE 6 CURRENT ACCOUNT BALANCES (PERCENT OF GDP) SURPLUS COUNTRIES (DURING GOLD STANDARD) 10 8 United Kingdom 6 4 Germany 2 0 –2 France –4 –6 1880 1883 1886 1889 1892 1895 1898 1901 1904 1907 1910 1913 DEFICIT COUNTRIES (DURING GOLD STANDARD) 15 10 5 0 –5 –10 –15 Canada Australia –20 Argentina –25 –30 –35 1880 1883 1886 1889 1892 1895 1898 1901 1904 1907 1910 1913 SOURCE: Obsteld and Taylor (2003). 4 FEDERAL RESERVE BANK OF CLEVELAND A striking feature of the pre–1914 data is the persistence of imbalances in the current account. Bordo, Eichengreen, and Kim (1998), using the coefﬁcients of an AR(1) regression as well as an augmented Dickey-Fuller (ADF) test, ﬁnd evidence of signiﬁcantly greater persistence in both the deﬁcits of the principal capital recipients and the capital exporters compared to the recent experience. Similar evidence is seen in variance ratios calculated by the authors. Finally, the mechanism of adjustment to the massive capital transfer worked very smoothly. It occurred through the price-specie-ﬂow mechanism of the classical gold standard (Bordo 1984). The transfer of long-term capital from Europe to the New World to ﬁnance railroads and other infrastructure was also accompanied by gold ﬂows as the demand, for example, for U.S. railroad bonds by British investors led to a demand for dollars, pushing the dollar to the gold-import point.The gold inﬂows in turn tended to raise the price of U.S. exports relative to imports, that is, to improve the terms of trade, (as well as raise the ratio of the prices of traded and nontraded goods). It also allowed the United States to import more goods than otherwise—much of these imports consisting of capital goods such as rails from Britain.As relative prices adjusted, the gold ﬂows would tend to be reversed, closing the imbalance. Moreover, short-term capital movements speeded up adjustment as gold ﬂows into the United States reduced interest rates relative to Britain. Many believe that the smooth adjustment to the capital transfers of the pre–1914 era reﬂects the fact that the world was on the gold standard, which provided a stable and credible nominal anchor. The gold standard also served as a signal of ﬁscal rectitude (“a good housekeeping seal of approval”), which assured investors that their debt would be repaid and serviced (Bordo and Rockoff 1996).Also, many of the capital recipients were part of the British Empire, which established institutions and safeguards that virtually eliminated country risk. For example, colonial (Dominion) governments were given debt trustee status in the United Kingdom (which meant they had a de facto British government guarantee). However, the adjustment mechanism in the earlier era of globalization was not always benign. Although current account imbalances were more long-lived in the pre–1914 era than in the recent period, they were punctuated in some countries by severe reversals, especially in the crisis-ridden 1890s (Bordo and Eichengreen 1999). The classic ﬁnancial crisis of the era was the Barings crisis of 1890, which began with a debt default in Argentina and spread like wildﬁre to the rest of the emerging world. Lenders in London and Paris cut off capital ﬂows to emerging countries like Brazil (Triner and Wandschneider 2005) with fundamentals similar to those of Argentina, while other countries deemed sound, such as Canada, were only marginally affected (Bordo and Murshid 2000). Thus the emerging-market crisis problem had historical precedents. Most of the countries affected, those of Latin America and Southern Europe, lacked the fundamentals, speciﬁcally, institutions and policies, associated with the more successful recipients. Although the imbalances of the previous age of globalization has considerable resonance for today—especially the fact that both eras were characterized by stable meta regimes (the gold standard then and the adherence by many countries today to credible domestic nominal anchors, such as inﬂation targeting and norms for ﬁscal balance), there are also considerable differences. First, under the gold standard, countries of new settlement—the emerging markets of the time—ran current account deﬁcits, while the major European economies ran surpluses. In the current era, there is no such delineation: some major economies run persistent deﬁcits, some persistent surpluses, and the same is true of emerging-market economies. 5 POLICY DISCUSSION PAPERS NUMBER 13, JANUARY 2006 Second, before 1914, gross capital ﬂows were much smaller than they are today, and gross asset and liability positions were very close to net positions, in contrast to today, where most major industrial countries are either major creditors or debtors. The earlier pattern reﬂects the prevalence of longterm investment by the core countries in the countries of new settlement.The substantial growth of two-way ﬂows between advanced countries since 1980 has been associated with both international ﬁnancial diversiﬁcation and intertemporal consumption smoothing. Third, the adjustment mechanism is different. The historical record shows that adjustment to the signiﬁcant and persistent external imbalances in the pre-1914 era occurred largely through the Humean price-specie-ﬂow mechanism of the classical gold standard. In contrast, the global economy is now on a managed ﬂoating exchange rate regime, and instead of gold ﬂows, the brunt of the external adjustment occurs through changes in the exchange rate and international reserves, along with relative price movements, short-term capital ﬂows, and valuation effects (Obstfeld 2004). Finally, in the pre–1914 era, Great Britain was the dominant country. Its currency, the pound, served as the international medium of exchange and as a key reserve asset. Great Britain ran considerable current account surpluses throughout the period. By contrast, the United States is the dominant economy today and the dollar is the key currency, but the United States has been running persistent current account deﬁcits. Further Lessons from History: Some Bad Outcomes History also gives two other, not-so-rosy scenarios of global imbalances and how they were adjusted to: the interwar gold exchange standard and the Bretton Woods system. The Interwar Adjustment World War I ended the classical gold standard as all of the belligerents except the U.S. abandoned gold convertibility. Private capital ﬂows also ceased.After the war, by 1926, the major countries returned to a variant of the gold standard, the gold exchange standard in which members held most of their international reserves in dollars, sterling, and francs, and the U.S., Great Britain, and France held gold. But the interwar gold exchange standard had serious ﬂaws, which prevented smooth adjustments to the imbalances that built up (Meltzer 2003, Eichengreen 1992).The key problem was that the major countries returned to gold at misaligned real exchange rates.All the belligerents had serious inﬂations during the war, and the restoration of the original gold parities involved deﬂation and recession. As it turned out, Britain restored parity at $4.86 with an overvalued real exchange rate while France and Germany each greatly devalued their currencies and restored parities at undervalued real levels (see ﬁgure 7). Although the United States never left the gold standard during the war, U.S. prices did not return to the prewar level, so that the country’s postwar real exchange rate was also undervalued. This misalignment meant that the United States, France, and Germany tended to run current account surpluses while Britain, its empire, and the countries economically linked to it ran deﬁcits. Under the gold standard, this meant that gold tended to ﬂow toward the surplus countries. Also, under the gold standard rules, both creditors and debtors were supposed to adjust to the imbalances—creditors by allowing domestic price levels to rise, debtors by deﬂation. As it turned out, both the United States and France continuously sterilized their gold ﬂows and prevented adjustment (Meltzer 2003). As a consequence, they imposed deﬂationary pressure on Britain and on the rest of the world. Another important difference between the classical and interwar gold standards that impaired the adjustment mechanism in the latter was the lack of credibility in the member countries’ adherence to 6 FEDERAL RESERVE BANK OF CLEVELAND gold convertibility. Unlike in the earlier period, markets had limited conﬁdence that countries would always put external balance considerations before domestic policy concerns (Eichengreen 1992). This meant that short-term capital movements could be destabilizing. In the end, the system collapsed after 1929 in the face of the Great Depression. Speculative attacks against countries that used expansionary monetary policy to alleviate banking panics and to stabilize the real economy forced country after country to abandon the gold standard (Eichengreen 1992).This was not the case for the United States however; it had adequate gold reserves to withstand speculative attacks (Bordo, Choudhri, and Schwartz 2002). The United States left the gold standard in 1933 as part of Roosevelt’s policy package to reﬂate the U.S. economy (Meltzer 2003). The Bretton Woods Adjustment Under the post–World War II Bretton Woods system, a distant variant of the gold standard, the United States was the dominant country, with the largest gold reserves (Bordo 1993). Under Bretton Woods’ rules, the United States had to peg the dollar to gold at $35.00 per ounce, and the rest of the world pegged to the dollar.The rest of the world used dollars as international reserves, and the dollar served as the international medium of exchange.The United States was also supposed to follow stable monetary and ﬁscal policies. During the period 1959–1971, when the system fully operated (most members had current account convertibility), the United States ran persistent current account and trade surpluses and also engaged in considerable foreign investment.The overall balance of payments was generally in deﬁcit and the rest of the world absorbed dollar claims (see ﬁgure 8). At the same time it is argued that the principal continental European countries and Japan kept their real exchange rates deliberately undervalued in order to foster export-driven growth in their economies (Dooley et al. 2002).This policy meant that they kept accumulating dollars, which they sterilized, just as the United States and France had during the interwar period. It has been argued that during this period, the United States acted as ﬁnancial intermediary to the rest of the world, importing short-term capital (dollar claims) and exporting long-term capital (McKinnon 1969). From 1961 to 1967, Europe and Japan’s holding of dollar claims convertible into gold kept increasing relative to gold holdings in the United States, suggesting the possibility of a run on the dollar (see ﬁgure 9). FIGURE 7 REAL EXCHANGE RATES (CPI) U.S. dollar/U.K. pound U.S. dollar/French franc $0.03 $5.40 $5.20 $0.02 United States $5.00 $0.02 $4.80 $4.60 France $0.01 $4.40 $0.01 $4.20 $0.00 $4.00 1924 1925 1926 1927 1928 1929 1930 1931 Note: The dollar–pound parity in 1925 was $4.86, and the dollar–franc parity in 1927 was $0.0392. Source: Bordo et al. 2001. 7 POLICY DISCUSSION PAPERS NUMBER 13, JANUARY 2006 McKinnon (1969), Meltzer (1991), and others have argued that the system could have continued for an extended period as a de facto dollar standard. However, two factors led to the collapse of the Bretton Woods system. First, the French resented the United States’“exorbitant privilege” of not having to adjust to its payments imbalances because it was the principal reserve country.They wanted a return to a pure gold standard, and to facilitate this outcome, they converted their outstanding dollar claims into gold. Second, the United States began to follow inﬂationary monetary and ﬁscal policies beginning in 1965—to ﬁnance the Vietnam War and the Great Society. The expansionary policies increased both the U.S. payments deﬁcit and European central bank reserves, as the United States exported its inﬂation abroad.As a consequence, the Europeans began converting their dollar claims into gold, threatening U.S. gold reserves.The system collapsed when Richard Nixon closed the gold window in August 1971. It has been argued that a reincarnated Bretton Woods system exists today. China, possibly India, and other countries are seen as deliberately running an undervalued peg against the dollar to encourage export-driven growth the way Europe and Japan did 40 years ago (Dooley et al. 2002).The central banks of these countries willingly accumulate dollar assets consequent upon their current FIGURE 8 BALANCE OF PAYMENTS: UNITED STATES, 1950–1971 (MILLIONS OF U.S. DOLLARS) 8,000 Current account 4,000 0 Long-term capital –4,000 Short-term capital –8,000 –12,000 Change in reserves –16,000 –20,000 1950 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 SOURCE: Bordo (1993). FIGURE 9 MONETARY GOLD AND DOLLAR HOLDINGS: THE UNITED STATES AND THE REST OF THE WORLD, 1945–1971 (BILLIONS OF U.S. DOLLARS) 70 60 50 External dollar liabilities 40 U.S. monetary gold stock 30 Rest of the world monetary gold stock 20 10 External dollar liabilities held by monetary authorities 0 1945 47 49 51 53 55 SOURCE: Bordo (1993). 8 57 59 61 63 65 67 69 71 FEDERAL RESERVE BANK OF CLEVELAND account surpluses. Dooley et al. argue that such a relationship could persist for as long as a decade to allow China to absorb its 200 million surplus agricultural workers into the manufacturing sector. Others argue that the reincarnated system will not last for 10 years but will collapse much sooner because, unlike the Europeans in the 1960s, Asian central banks do not have a stable cartel (Eichengreen 2004). Furthermore, in the Bretton Woods era, there were no good substitutes for the dollar as the world’s reserve asset (the pound was a reserve asset, but it was weak), but today we have the euro. They predict the system will collapse quickly. What Will Happen? We have illustrated three historical episodes of external imbalances and their adjustment.Two ended in a collapse.The third worked remarkably well. Which episode is more relevant to today’s environment? My bet is a benign outcome, like that of the prewar gold standard era. In today’s world, the underlying fundamental of globalization and the basic strength of the U.S. economy—which will continue to underpin the dollar as a reserve asset—suggest that adjustment to the present set of imbalances will be gradual, and, when all is said and done, the experience will be viewed as similar to what happened in the late 1980s. 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Obstfeld, Maurice, and Kenneth Rogoff. “The Unsustainable Current Account Position Revisited,” National Bureau of Economic Research Working Paper, no. 10869 (October 2004). Obstfeld, Maurice, and Alan Taylor. Global Capital Markets: Integration, Crisis and Growth. Cambridge: Cambridge University Press, 2004. Gourinchas, Pierre-Olivier, and Helene Rey. “International Financial Adjustment” National Bureau of Economic Research Working Paper, no. 11155 (2005). Triner, Gail, and Kirsten Wandschneider. “International Capital and the Brazilian Encilhamento, 1889–1892: An Early Example of Contagion among Emerging Markets.” Financial History Review (2005). 10 pd papers Presorted Standard FEDERAL RESERVE BANK OF CLEVELAND RESEARCH DEPARTMENT P.O. BOX 6387 U.S. Postage Paid Cleveland, OH Permit no. 385 CLEVELAND, OHIO 44101 Return Service Requested: Please send corrected mailing label to the Federal Reserve Bank of Cleveland, Research Department, P.O. Box 6387, Cleveland, Ohio 44101.