Martin Wolf's Exchange

Update: Read Martin’s final response to readers’ comments.

The question I wish to pose for the next two weeks is whether it is possible for countries to accept large net inflows of capital from abroad, without ending up in crisis. If not, how do we manage a world of capital mobility?

This may seem a rather abstract problem. But I find it among the most important of all challenges confronting the world economy. It is the principal topic of my recent book, Fixing Global Finance (of which an updated edition has recently appeared). The view I have derived from the last three decades of experience is that it is almost an iron rule that, whenever countries run really large and sustained current account deficits (more than 5 per cent of GDP, or so), they end up in financial crisis. Carmen Reinhart and Kenneth Rogoff provide strong support for this view in their recent masterpiece, This Time is Different (Princeton University Press).

That is what happened to the Latin American countries in the debt crisis that erupted in 1982 and to the Asian countries in the crisis that erupted in 1997. It is also what happened in the current financial crisis, whose epicentre has been in countries that ran large current account deficits, notably, the US, Spain, UK and a number of countries in central and eastern Europe. Meanwhile surplus countries were affected indirectly, via losses of export markets and of the value of their assets held abroad.

Why is running current account deficits so dangerous? There are four reasons: first, it often means unsustainable asset price bubbles in the capital-importing country; second, it means unsustainable build-ups of debt in the private and public sectors of the capital-importing economy; third, it often means an unsustainable expansion of the financial system, characterized by excessive leverage and excessive build-ups of risky assets financed by supposedly risk-free liabilities; finally, it also often means a build-up of currency mismatches within the economy, particularly in the financial system, which makes the economy extremely vulnerable to currency collapses.

Mindful of these risks many emerging market economies have tried to insulate themselves, by keeping exchange rates down and recycling current account surpluses. This is one of the reasons that the crisis erupted this time in developed countries. Even the US was not immune. Though it has no problem of currency mismatches and little difficulty in financing external deficits, the financial system was damaged by the implosion of the bubble economy. Of course, as I have argued in previous columns, a similar problem exists within the eurozone, between the surplus and deficit countries. The absence of currency risk merely means that the stresses have emerged as credit risk.

So where do we go from here? The markets, partly driven by cheap money in the developed countries, are now trying to push emerging economies into current account deficit. The latter, in turn, are resisting. Should they continue to do so? After all, this is not costless. By resisting currency appreciation, emerging economies risk higher inflation, instead. On the other hand, emerging countries are right to be concerned about the longer-run consequences of large current account deficits. At the same time, it might ultimately be very disruptive to see huge current account deficits and financial excesses re-emerge in the US.

What, then, are the policy options for taming these extremes? A new global monetary regime? Capital controls? What other ideas do people have?

Martin Wolf responds to readers’ comments:

I don’t feel that many people have attempted to answer my question. Maybe, they didn’t think it was very interesting. One person who did was @ Dave Levy. I am not sure I fully understood his formulation. But there are two general points to be made on external deficits and debt.

The fact that the eurozone is in balance is irrelevant if the surplus countries are unwilling to finance the deficit countries. The current crisis shows they are unwilling to do so. So current account imbalances do matter inside the eurozone, as I have argued on many occasions.

A single currency area with internal capital controls is a very peculiar animal indeed. I would argue that this is an abandonment of the single-currency concept altogether.

There was no way the Greek situation could have been kept quiet in current circumstances. They are on an explosive path. A huge primary fiscal deficit, huge debt levels, a huge current account deficit and real interest rates well above the long-term growth rate are simply an unmanageable combination.

I believe Greece would not be able to borrow now on terms that were available even a few weeks ago. It would have been interesting to see what would have happened in the very near future if the bail-out package had not been offered.

Without official external assistance, Greece would now default.

The right way of thinking about most of what has happened in the last decade is that policy decisions about exchange rates and trade caused the net capital flows, rather than the other way around.