Problems of Global ImbalancesChina / Asian countries have built up large accumulation of US assets. It means they take a close interest in the strength / prospects of the dollar. If the dollar weakened it could lead to a capital flight from US, further undermining the dollar. On the other hand, you could argue since foreign investors hold so many US assets, they don't want to see the dollar drop sharply.
Cost of debt repayments could rise. At the moment, the US government can finance its national debt at low interest rates. However, if demand for holding dollars dried up, it would find the cost of servicing national debt would rise.
Encouraged low quality loans. The global savings glut artificially reduced interest rates encouraging high levels of borrowing and low saving. It was one factor behind the development of low quality loans such as sub-prime mortgages. It was argued that because there was so much demand for US securities, there were willing buyers for these toxic mortgage bundles which later caused so many problems.
The UK suffered from being the world's reserve currency upto the start of the first world war. After the first world war they rejoined the gold standard but suffered deflation as they struggled to meet the old exchange rate. There was much concern whether UK could meet its old exchange rate requirements.
A recent IMF report argued that the global imbalances were not the primary cause of the recent financial crisis. The IMF argued it was regulatory failure which caused this crisis. The global imbalances only perhaps increased its magnitude. Of course, not everyone agrees with the IMF. The Economist points out that it was the IMF who arguably encouraged global imbalances through their intervention in the South East Asian crisis in 1977 so it is not surprising they blame something else. IMF blame regulatory failure not global imbalances at Economist
Some argue that the global imbalances were an important contributory factor.
Improving Global ImbalancesOne benefit of the financial crisis may be to start shifting these global imbalances.
- Already the US current account deficit has fallen as consumers seek to increase their saving rates and reduce their dependence on debt (often dubious mortgage backed debt)
- Other countries such as China, Japan and Germany which relied on export have been hit very hard by the fall in US led demand. They are realising that relying on exports to be the mainstay of growth is just as unbalanced as relying on consumer led borrowing.
- China, Japan and Germany will be forced to look at ways to boost domestic demand to offset the fall in external demand. As I have said previously, it is countries like Germany and China who can benefit most from expansionary Keynesian policies because of the high levels of consumer spending.
- Also, it is likely that the Dollar will have a declining share of the world's global reserves. This would be a good thing as it would place less stress / focus on the US economy. But, on the other hand it could mean in the medium / long term the US is faced with higher interest rates and therefore higher costs of servicing debt. It will mean lower growth, at least, in short term, but, if it helps contribute to a more stable global economy it may be worth it in the long run.