Saturday, March 13, 2010

Global savings glut and trade deficits

One of the most widely circulated explanations for the sub-prime mortgage bubble has been the "savings glut" in emerging economies (in the aftermath of the 1997-98 currency crisis, these economies are expected to have increased their savings), which is alleged to have financed the massive resource mis-allocations within the developed economies. Such mis-allocations in these economies were manifested in the form of trade deficits (and consumption booms) and asset bubbles. Disentangling the relative causal effects of these trends has been difficult.

In an NBER working paper, David Laibson and Johanna Mollerstrom (and here) show that global savings rates did not show a robust upward trend during the period (1996-2006) (in fact it actually declined) nor was there an investment boom in the countries that imported capital.

They argue that these capital flows from emerging economies coincided with asset bubbles (in equity markets and then real estate markets) in developed economies (they do not examine the reasons why the asset bubbles got inflated in the first place) and contributed to amplifying them. The asset bubbles in turn created a wealth effect and triggered off a consumption boom, which in turn boosted imports and widended trade deficits. In other words, the capital imports were consumed and not invested.

They find that the asset bubble framework quantitatively explains the large current account defcit of the US (peaking at 6%) and the modest increase in investment during the same period (less than 2% of GDP). In their sample of 18 OECD countries and China, they find that movements in home prices alone explain half of the variation in trade deficits.

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