Sunday, June 29, 2008

The story so far - economic history of this decade

Here is a parable. The context first. Prosperonia is the largest and most developed economy in Planet Economia. Its currency is the de-facto currency of Economia and the major share of international trade is denominated this currency. It has a financial system that incentivizes debt over savings, which in turn complements its consumers voracious appetite for consumption, which has been magnified by the "wealth effect" arising from a recent boom in its asset markets.

Emergonia is a diverse country with a few large and many smaller states, a recent history of exchange rate crisis, and a culture that incentivizes thrift and savings over consumption. Incidentally, Emergonia produces what the consumers in Prosperonia want and does so at very cheap prices, thereby further fuelling Propseronian consumers desires.

The Emergonian government makes it more favorable for its exporters by keeping currency exchange rates artificially tied at lower than market rates to that of Prosperonia. A massive foreign exchange surplus builds up and in the absence of a mature and developed financial system, the Central Bank of Emergonia invests its burgeoning surpluses in the safer and liquid assets of Prosperonian government.

The result - a massive import boom ensues and Prosperonia builds up a huge and unsutainable current account deficit. Emergonian savings and surpluses end up financing the Prosperonian consumers. Interest rates fall to historic lows and the easily available credit fuels financial market distortions and bubbles. Then the chickens come home to roost and the bubble bursts, tanking the real economy of Prosperonia to a recession. The Prosperonian currency falls against the Emergonian currency, forcing the Emergonian Central Bank to intervene and accumulate even more of the Prosperonian currency, thereby further adding to the bulging forex surplus.

Then the Economian economy experiences a supply side shock and commodity prices rise uncontrolled. Being the premier economy in Economia, and a large proportion of global trade in commodities being denominated in the currency of Prosperonia, the weakness of the Prosperonian currency adds to the upward pressure on the commodity prices. The rising commodity prices in turn drive up inflationary pressures in Emergonia, and this starts adversely affecting their predominantly poor population.

Now, replace Prosperonia with the United States, Emergonia with the emerging economies of Asia, and Economia with our own Earth, and we have covered the major part of the economic history of the world in the first decade of the new millennium!

Update 1
The Economist has this excellent summary of the global economic imbalances that have driven us to the present crisis.

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