The end of financial globalization 3.0?

Posted by on 24 February 2009

Over the past decade, China and other emerging markets accumulated foreign currency reserves to insure against the economic and political vagaries of financial globalization. They were wise to do so. Countries with larger reserves are weathering the current storm relatively better than those who have bought less insurance. Yet while purchasing insurance policy might have been sensible from the perspective of each individual country, collectively these currency interventions prepared the ground for the global crisis: emerging markets – most notably China – helped to create the macroeconomic backdrop for the current financial crisis by subsidizing interest rates and consumption in the United States. Niall Ferguson and I coined the term "Chimerica" to describe this historically unique financial symbiosis that had developed between China and America.


The paradox of reserve accumulation is that attempts to make individual economies safer have contributed to macroeconomic imbalances and the mispricing of financial risk on a global level. It is possible that this paradox could mark the end of yet another attempt to make the world safe for global finance, just as the Asian crisis marked the end financial globalization 2.0 (NB: financial globalization 1.0 took place in the late 19th century). Financial globalization 2.0 started in the 1980s and lasted to 1997/98. It was based on the idea that removing restrictions on capital account transactions would enable emerging markets to tap into the pool of global savings and import much-needed capital for development. Market forces would allocate capital efficiently to its most productive uses across the globe. Financial globalization 2.0 ended painfully with the Asian crisis when it became clear that private capital flows were volatile and could seriously complicate economic management in difficult times. Moreover, during the crisis some emerging markets' governments had to go on a humiliating trip to Washington to ask the IMF for emergency financing. Unsurprisingly, governments in the developing world decided that they wanted to avoid finding themselves in the same situation again.


What followed was financial globalization 3.0. Emerging markets heeded Martin Feldstein's advice and took out an insurance policy against the vagaries of financial globalization.[2] By running current account surpluses, intervening in foreign exchange markets and building up currency reserves Asian and other emerging economies were sustaining export led growth and buying insurance against future financial instability. These policies turned developing markets into net capital exporters to the developed world, mainly to the US. Between 1990 and 1998 – during what I have termed financial globalization 2.0 – emerging and developing economies (according to the IMF classification) were running an average current account deficit of about 1.7% of their GDP. Between 1999 and 2008 – during financial globalization 3.0 – this deficit turned into a surplus of 2.5% of GDP.[3]Just like its predecessor, financial globalization 3.0 seemed a success story for a while, generating financial stability and high rates of economic growth. Yet the accumulation of large war chests of foreign reserves through currency intervention carried negative externalities. The arrangement opened up a Pandora's box of financial distortions that eventually came to haunt the global economy. The glut of savings from emerging markets has been a key factor in the decline in US and global real-long term interest rates – despite the parallel decline in US savings.[4] Lower interest rates in turn have enabled American households to increase consumption levels and worsened the imbalance between savings and investment. And because foreign savings were predominantly channeled through government (or central bank) hands into safe assets such as treasuries, private investors turned elsewhere to look for higher yields. This led to a more general re-pricing of financial risks and unleashed the ingenuity of financial engineers to develop new financial products for the low interest rate world – such as securitized debt instruments.[5]


Individual policies meant to insure against financial instability and sustain export-led growth have collectively distorted global interest rates, helped to sustain excess demand and contributed to the mispricing of financial risks. Moreover, it is unlikely that emerging markets' behavior will change. From the perspective of emerging markets, the academic debate whether reserve levels have grown excessive has been answered almost over night in the current crisis.[6] It is clear to policy-makers from Buenos Aires to Budapest and Beijing that there is no such thing as too many reserves in a world of volatile capital flows. Emerging markets are as unlikely today as at any point during the past decade to embrace the instability of global capital flows and accept large swings in exchange rates.


Have we therefore come to a crossroads for financial globalization 3.0? There were good economic reasons to doubt that a financial globalization model premised on large scale capital flows from poor to rich economies was a fundamentally smart idea. Moreover, the past years have shown that capital outflows from emerging markets, including China’s reserves accumulation within the constellation we called Chimerica, have themselves contributed to the build-up of macroeconomic imbalances and financial risks that brought the global economy to its knees. After the dust has settled, members of the economics profession will have to think hard what the right policy advice drawn from financial globalizations 2.0 and 3.0 should look like. Neither model has passed the practice test with flying colors. 


Moritz Schularick, 
Visiting scholar at the University of Cambridge and Assistant Professor of economics and economic history at the Free University of Berlin



Bernanke, Ben (2007) "Global Imbalances: Recent Developments and Prospects", Bundesbank Lecture, Berlin, September 11, 2007
Dooley, Michael, David Folkerts-Landau and Peter Garber "Bretton Woods II Still Defines the International Monetary System", Deutsche Bank Global Markets Research, February 11, 2009
Economic Report of the President (2009), Washington D.C., January 2009
Ferguson, Niall and Moritz Schularick (2007) "Chimerica and the Global Asset Market Boom", International Finance 10(3)
Hunt, Chris (2008) "Financial Turmoil and Global Imbalances - the End of Bretton Woods II?", Reserve Bank of New Zealand Bulletin, Volume 71 No. 3, September 2008

International Monetary Fund (2009), World Economic Outlook Database, January 2009
Jeanne, Olivier (2007) " International Reserves in Emerging Market Countries: Too Much of a Good Thing?", Brookings Papers on Economic Activity 1:2007
Kose, Ayhan, Eswar Prasad, Kenneth Rogoff, and Shang-Jin Wei1 (2006) "Financial Globalization: A Reappraisal", IMF Working Paper 06/189, August 2006
Obstfeld, Maurice, Jay Shambaugh and Alan Taylor (2008) "Financial Instability, Reserves, and Central Bank Swap Lines in the Panic of 2008", Paper presented at the ASSA Meetings, January 2009
Rodrik, Dani and Arvind Subramanian (2008) "Why Did Financial Globalization Disappoint?", Harvard University, Draft.
Schularick, Moritz and Thomas Steger (forthcoming) " Financial Integration, Investment, and Economic Growth. Evidence From Two Eras of Financial Globalization", Review of Economics and Statistics
Setser, Brad (2009) "Debating the global roots of the current crisis", Weblog on, January 28, 2009
Stiglitz, Joseph, Making Globalization Work, London: Penguin Books
Summers, Lawrence (2006) "Reflections on Global Account Imbalances and Emerging Markets Reserve Accumulation", Speech at the Reserve Bank of India, March 24, 2006
Wolf, Martin (2009), Fixing Global Finance, New Haven: Yale University Press

[2] Feldstein (1999)
[3] Data from the IMF (2009)
[4] See Bernanke (2007) and the discussion in Hunt (2008). The drop in savings in the US (relative to desired investment) should have led to an increase in real-long term interest rates. A similar argument can be made on the global level where increased returns on capital coincided with a lower cost of capital (Ferguson and Schularick, 2007).
[5] Economic Report of the President (2009); see also Hunt (2008)
[6] See the contributions by Summers (2006), Stiglitz (2006) and Jeanne (2007)