Eastern caution, Western ebullience and global

imbalances

Marcus Miller and Lei Zhang

Warwick University

A decade of global imbalances: the time line

US Housing and Credit

boom

1997/8

East Asian Financial Crises

Global Savings Glut

2007/8

US Subprime Crisis and Credit Crunch

1997-98 East Asian financial crisis followed by:

a Savings Glut in Asia, which we

charaterise as Eastern Caution

a Housing and Credit boom in the US,

described as Western Ebullience

How to capture these psychological traits?

Take them in turn

Eastern Caution

Representative Agent

Heterogeneousagents

Idiosyncratic (micro) shocks N/A

Mendoza et al.(2007)

‘missing markets in EM’

Macroeconomic shocks

Jeanne and Ranciere

(2006,2007)

Mankiw (1986),*

Durdu et al (2007)?

and this paper

‘Eastern Caution’

Shocks and self-insurance

* With concentrated shocks, there is heterogeneity ex post

Concentrated risk and precautionary saving

With log utility, first period consumption in the US and EM will be

1 11

11 g

CR

, 1 1 ** 1

11

g R

CR

where first period endowments are one, g the growth rate of the US

GDP, g* the mean expected growth rate of the EM, R the global gross

real interest rate, the time preference and the utility discount to

allow for uncertainty, the ‘risk premium’.

Difference between these levels of consumption measures the transfer

*1* 211 1

g g RC C T

R

where T the current period transfer of resources to the US.

First period goods market clearing …

*1 2* 2 211 1

g g RC C

R

…determines the global interest rate as

*2 2 *2 2g g g g

R

, without risk.

which implies a resource transfer (for large

enough )

*( ) (1 )0

*(1 )(2 )

g g gT

g g

which corresponds to first period saving in EM.

Some numerical results“Transfer” Real

Interest“Premium”

No risk

(g*=0.04, with π =0)-0.002 1.052 0

Risk, but with no concentration

(g*=0.04, but π >0)

-0.001 1.048 0.004

Concentration

of shock on 25%0.01 1.024 0.052

Tighter concentration

of shock on 22%0.028 0.99 0.12

Note: log utility, g=0.03, g*=0.04, β=0.985, π=0.1, and Δ=0.2.

Note: negative real interest rates may be required for full employment

• With high risk and substantial

precautionary savings, the

equilibrium real interest rate may be

negative, cf. Japan in 1990s.

• If real interest rates bounded below

(because inflation is zero and

nominal interest rates cannot be

negative), one has to revert to

Keynesian economics without full

employment – the paradox of thrift.

• Global rates fell: but not to zero – we

give a reason in part two

A resource transfer induces a rise in the price of non-traded goods

Traded Goods

Non-Traded Goods

N

Np1

T

E

E'

Relative price and exchange rate adjustment:

Obstfeld and Rogoff’s ‘transfer analysis’

With log utility and transfer T, the relative price of the non-traded goods is

)1(1

1 TN

p

in the US

and

)1(1*

1 TN

p

in EM,

where represents the share of traded good in the consumption basket.

If prices are flexible and so is the exchange rate, but the each country

stabilises its aggregate price index, the rise in the value of dollar is:

11

1

TX

T

Example Let there be an international transfer of 5% of GDP to the

US: this will be a twenty percent increase in consumption of traded

goods if the latter are a quarter of total expenditure. So with 1/ 4

and T=0.2 , the formula implies that price stabilisation will require the

value of the dollar to increase by 36.12.01

2.0175.0

X .

(Obstfeld and Rogoff , 2005)

Western Ebullience

A house price bubble?

• US house prices rose by about three quarters in real terms from the mid-nineties to the peak in 2006.

• ‘it is not possible to explain the boom in terms of fundamentals such as rental incomes or construction costs’ Shiller (2008)

• Adrian and Shin (2007): the targeting of VaR induced leverage to rise with asset prices; and the pro-cyclical fluctuation in bank balance sheets meant they were hungry for home loans.

• Foster and Young (2008), Rajan (2008): bank bonuses which ignore tail risk lead to excessive risk taking.

Mr Greenspan confesses

Ex-fed chief admits existence of ‘bubble’ in US housing market

Financial Times, Monday, Sept 17th 2007

One GoodTraded and non-traded

Static N/A

Obstfeld and Rogoff(2005)

‘transfer approach’

Dynamic

Obstfeld and Rogoff(1996) ‘intertemporal

approach’

this paper*

Western Ebullience

Time and transfers

* with over-estimation of the value of future non-traded goods in the US

House price bubble, transfer and real interest rate

Bench mark: no uncertainty, identical preferences and endowments.

Let there be a bubble in the period 2 non-traded good price, so

ˆ (1 )/( )2

p B YN

where B >1 denotes the presence of a bubble.

The aggregate price index in period 2 rises:

1 1ˆ (1/ )(1/ )2

P B YN

.

This will induce an increase of first period absorption by the US, which will drive up global interest rates.

A rise in the future price of non-traded goods

induces a resource transfer

Traded Goods

Non-Traded Goods

N

NEp2

T

E

E'

Np1

Intertemporal allocation, transfer and real interest rate:

effect of bubble B>1.

Euler equation for the US in the presence of the bubble

1'( ) '( )ˆ1 22

Pu C R u C

P

Euler equation for the EM

*1'( *) '( *)*1 2

2

Pu C R u C

P

.

Hence B ˆ2

P , given R and 1

P , 1C and 2

C

0T

* * *, ,1 1 2

C P P R

Log utility: Transfer and real interest rate

(1 )( 1)1 2 (1 )(1 )( 1)

BT

B

1 2 (1 )(1 )( 1)(1 2 )

BR

Both transfer and real interest rate increase B, the size of the bubble.

An example: Let 985.0 , 25.0 , g=g* =0, and 05.1B

(corresponding to a 20% increase in housing cost, if rents are ¼ of

non-tradable expenditure).Then 038.1R and 011.0T , i.e.

compared with the real interest rate of 1.015 in the absence of the

bubble, the real interest rate has increased by about 2 ¼ percentage

points …

enough to keep global rates positive up despite a massive savings glut.

What next? Two scenarios• Great Rebalancing: a smooth transition

as described in Obstfeld and Rogoff(2006) where T=0, the dollar falls and all is well

• House price falls and credit crunch in US check US spending, but

• EMEs feel more secure and reduce the precautionary savings glut

• Alternatively: EMEs still play safe, but it takes an economic recession to rein in US spending. Result is Global Stagnation

Epilogue

• Bernanke’s Barcelona speech in June: argues that the East Asian savings glut, the housing bubble and the credit boom (and oil prices) were all contributing factors to global imbalances.

• Question : should the savings glut be blamed for leading to housing bubble?

• Answer: Well the outcome surely owed a lot to the Greenspan Doctrine of Denial: don’t act until the bubble bursts.

The end