The Financial Rebalancing Act

Stop Worrying About the Global Flow of Capital

Courtesy Reuters

The global financial crisis that began in 2007 has only just begun to recede, but economists and policymakers are already considering its future implications. Has the Great Recession introduced a new economic era? Or was it a temporary shock that will eventually correct itself? The answers to these questions will affect a number of vital economic issues, including the relationship between emerging and developed economies, the direction of international trade and capital flows, and the potential for currency wars or other economic conflicts.

Both the recent crisis and the policies that ended it were unprecedented. Compared to other periods of economic turmoil, this crisis was not only unparalleled in scale but also unique in its causes -- among them, many argue, global financial imbalances. Basic economic theory presumes that capital will flow "downhill" from capital-rich developed economies to capital-scarce emerging ones, as investors in the first seek profits in the second. Yet over the past 15 years, capital has, on net, flowed "uphill" from emerging economies to developed ones. Although private capital did travel downhill, as conventional wisdom predicts, it was offset by vast government reserves from emerging countries, chiefly from central banks and sovereign wealth funds, heading uphill. When the recession struck, this unprecedented flow of capital and accumulated reserves suddenly seemed less of a mystery, as emerging markets facing problems began to use the reserves they had accumulated to ride out the economic storm. With that insurance on hand, they defended their currencies, averted capital flight, buffered their financial systems, maintained access to capital markets, and pursued fiscal stimulus programs more successfully than they had during previous episodes of economic turmoil and with greater confidence than some of the developed economies.

Yet although these global imbalances may have helped emerging economies during the financial crisis, many have argued that they also contributed to fueling the financial crisis among developed markets in the first place. The International Monetary Fund (IMF) and the G-20, along with many central banks, finance ministers, and economists,

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