Financial crash, commodity prices, and global imbalances.

The current financial crisis has its origins in global asset scarcity, which led to large capital flows toward the United States and to the creation of asset bubbles that eventually burst. In its first phase the crash exacerbated the shortage of assets in the world economy, which triggered a partial re-creation of the bubble in commodities markets, and oil markets in particular. This bubble in turn led to an increase in petrodollars seeking financial assets in the United States, which became a source of stability for the U.S. external balance. The second phase of the crisis is more conventional and began to emerge in the summer of 2008, when it became apparent that the financial crisis would permeate the real economy and sharply slow global growth. This slowdown worked to reverse the tight commodity market conditions required for a bubble to develop, ultimately destroying the commodity bubble.

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In this paper we argue that the persistent global imbalances of recent decades, the subprime crisis, and the volatile oil and asset prices that followed it are tightly interconnected. All stem from a global environment where sound and liquid financial assets are in scarce supply.

Our story goes as follows: Global asset scarcity led to large capital flows toward the United States and to the creation of asset bubbles that eventually burst. The crash in the real estate market was particularly complex from the point of view of asset shortages, since it compromised the whole financial sector and, by so doing, closed many of the alternative saving vehicles. Thus, in its first phase, the crisis exacerbated the shortage of assets in the world economy, which triggered a partial re-creation of the bubble in commodities, and in oil markets in particular. Rising oil prices in turn led to an increase in petrodollars seeking financial assets in the United States. In contrast to the typical, destabilizing role played by capital outflows during financial crises, petrodollar flows became a stabilizing factor for the U.S. economy. The second phase of the crisis is more conventional and began to emerge during the summer of 2008. It became apparent then that the financial crisis would permeate the real economy and sharply slow global growth. This slowdown worked to reverse the tight commodity market conditions required for a bubble to develop, ultimately destroying the commodity bubble.

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We now develop some of these steps, starting from the underlying structural force fueling U.S. asset appreciation. Figure 1 displays the main patterns of global imbalances since 1990 as revealed in the current accounts of the United States, Europe and Japan (combined), emerging Asia, and the oil-producing economies, all relative to world GDP. The facts are well known: Starting in 1991 the U.S. current account deficit worsened continuously, reaching 6.4 percent of U.S. GDP in the fourth quarter of 2005, then falling back to 5 percent of GDP by early 2008. The current account surpluses that were the counterpart of the U.S. deficits initially emerged in Japan and Europe and were bolstered by surpluses in emerging Asia and the commodity-producing countries after 1997.

In a previous paper we showed how this buildup in global imbalances could be understood as the consequence of asymmetries in financial development and growth prospects across different regions of the world. (1) In particular, we argued that the emerging market crises at the end of the 1990s, the subsequent rapid growth of China and other East Asian economies, and the associated rise in commodity prices in recent years reoriented capital flows from emerging markets toward the United States. In effect, emerging markets and commodity producers in need of sound and liquid financial instruments to store their newfound wealth turned to the U.S. financial markets, which were perceived as uniquely positioned to provide these instruments. (2)