Global Imbalances from the Historical Perspective by Marcela Veselkova Central European University Department of International Relations and European Studies Dissertation submitted in partial fulfillment of the requirement for the degree of Doctor of Philosophy in Political Science Supervisor: Julius Horvath CEU eTD Collection Word count: 88101 Budapest, October 2010 DECLARATION I hereby declare that no parts of the thesis have been submitted to no other institution different from CEU towards a degree. To my knowledge nor does the thesis contains unreferenced material or ideas from other authors. Marcela Veselkova …………………….. CEU eTD Collection ii Abstract This dissertation examines the global imbalances from the historical perspective. The main aim is to examine the factors that determine the current account balances. To this end, this dissertation relies on the combination of the historical narrative and econometric analysis. The former traces changes in the current account imbalances and their reflex influence exerted on the course of economic and political events. The latter determines the short- and medium-run determinants of the current account balances in two eras of globalization. The results of Chapter 5 suggest that the transitory shocks to income are the main source of variation in the trade balance, whereas the permanent shocks to income determine the changes in the income Thus, in the short-run it is possible to increase the current account balance by fiscal or monetary tightening. Chapter 6 investigates the determinants of the current account balances for 14 countries in the period of 1865-1913 and 107 countries for the period of 1970-2007. The comparison has yielded several similarities. In both periods, the excess saving was redistributed to relatively rich countries with developed financial markets, high quality institutions and high proportion of dependent persons in the population. Second, the results suggest that the global savings glut and the twin deficits hypothesis are not mutually exclusive. But whereas the former holds for both eras of globalization and both developed and developing countries, the latter holds only in the short-run in the pre-War period and for developing countries in the period of 1970-2007. CEU eTD Collection iii Acknowledgments My greatest thanks go to my supervisor, Julius Horvath, who inspired me to conduct the research on global imbalances and provided me with very helpful suggestions for the improvement of earlier drafts of this dissertation. I have enjoyed working with him immensely. I am indebted also to László Csaba and Béla Greskovits, who – together with Julius – sparked my interest in the field of international political economy. I would like to thank my second reader, Michael Merlingen for his comments and Erin Jenne for her useful suggestions at an early stage of this dissertation. I thank my audiences at departmental seminars, the 2 nd Graduate Network Conference in Budapest 2008, and the 5 th CEU Graduate Conference in Social Sciences in 2009. I am grateful to Alan Taylor, Jeffrey Williamson, Niall Ferguson, Moritz Schularick, and Banca d’Italia, who kindly provided the data. I acknowledge financial support from the Central European University, the CEU Doctoral Fellowship, and Yehuda Elkana, Rector’s Write-Up Grant. Lastly my parents and my sister have helped me in this adventure in more ways than I can list. CEU eTD Collection iv INTRODUCTION 1 CHAPTER 1 – GLOBAL IMBALANCES UNDER PAX BRITANNICA 5 1.1 Political and Economic Background 5 1.2 Financial markets in the pre-War Great Britain 14 1.3 Regional Distribution of Capital 20 1.3.1 United States 21 1.3.2 Canada 23 1.3.3 Argentina 25 1.3.4 Australia 27 1.3.5 India 30 1.3.6 South Africa 31 1.3.7 Brazil 32 1.3.8 Russia 33 1.4 Conclusion 35 CHAPTER 2 – GLOBAL IMBALANCES, 1914-1945 38 2.1 Political and Economic Background 38 2.2 British-American Financial Relations during the War 40 2.3 War Debts 49 2.4 Reparations 51 2.5 Private Capital Flows 60 2.6 Policy Response 67 CEU eTD Collection 2.7 Conclusion 70 CHAPTER 3 – GLOBAL IMBALANCES UNDER THE BRETTON WOODS SYSTEM, 1945-1970 72 3.1 Political and Economic Background 72 v 3.2 U.S. Financial Aid 73 3.3 Balance-of-Payments Disequilibria 80 3.4 Policy Response 83 3.5 Impact of the Bretton Woods on the Integration of Capital Markets 93 3.6 Conclusion 97 CHAPTER 4 – GLOBAL IMBALANCES IN THE POST-BRETTON- WOODS PERIOD 100 4.1 Petrodollar Recycling 100 4.2 United States and Japan 105 4.3 Developing World 128 4.4 Global Imbalances 135 4.4.1 China 139 4.4.1.1 Solution to Trilemma 142 4.4.1.2 Macroeconomic considerations 145 4.4.1.3 Microeconomic considerations 149 4.4.2 Other Economies Financing U.S. Current Account Deficit 151 4.4.3 The United States 154 4.5 Conclusion 158 CHAPTER 5 – INCOME SHOCKS TO TRADE BALANCE UNDER THE GOLD STANDARD 161 5.1 Introduction 161 CEU eTD Collection 5.2 Demand and Supply Shocks under Gold Standard 163 5.3 Data, Methodology and Results 169 5.4 The United States, 1957-2010 175 5.5 Conclusion 179 vi CHAPTER 6 – GLOBAL IMBALANCES FROM THE HISTORICAL PERSPECTIVE 181 6.1 Introduction 181 6.2 Theoretical issues 183 6.3 The medium-term determinants of the current account balance, 1865- 1913 192 6.3.1 General model 194 6.3.2 Robustness tests 203 6.4 Medium-term Determinants of the Current Account Balance, 1970-2007 206 6.4.1 Estimation results 206 6.4.2 Robustness Tests 219 6.5. Conclusions and policy recommendations 221 CONCLUSION 225 APPENDICES 229 A: APPENDIX TO CHAPTER 1 229 B. APPENDIX TO CHAPTER 6 232 REFERENCE LIST 298 CEU eTD Collection vii List of Tables Table 4.1: Net Capital Flows in Five Asian Economies 134 Table 4.2: Saving/Investment Balances as a percentage of GDP 138 Table 5.1: Variance Decomposition, 1850-1913 171 Table 5.2: Variance decomposition from structural factorization, United States, 1957 – 2010 176 Table 5.3: Variance decomposition from structural factorization, United States, 1971 – 2010 177 Table 6.1: Current Account Regressions, 1865-1913 197 Table 6.2: Savings regressions, 1865-1913 198 Table 6.3: Investment regressions, 1865-1913 199 Table 6.4: Effect of POLITY2 on INVESTMENT conditional on M2GDP 201 Table 6.5: Effect of M2GDP on INVESTMENT conditional on POLITY2 201 Table 6.6: Current account regressions, 1970-2007 208 Table 6.7: Savings regressions, 1970-2007 209 Table 6.8: Investment regressions, 1970-2007 210 Table 6.9: Current account regressions (developed countries) 215 Table 6.10: CA Regressions, developing countries excluding Africa 218 CEU eTD Collection viii List of Figures Figure 4.1: Current accounts in selected countries and regions, 2000-2008 136 Figure 5.2: Impulse Responses, 1865-1913 173 Figure 5.2: Accumulated responses, United States, 1957-2010 178 Figure 5.3: Accumulated responses, United States, 1971-2010 179 CEU eTD Collection ix INTRODUCTION Global imbalances are not a new phenomenon. Throughout the modern history, significant imbalances affected both politics and economic fortunes of countries. However, the past decade witnessed an unprecedented reversal in the current account financing. The current account deficit of the world’s largest economy, the United States, reached the low of astonishing 803.5 billion USD or 6 percent of GDP in 2006 (WEO 2009). This deficit was mirrored by the growing current account surpluses in East Asian and oil-exporting countries. Thus, emerging economies transferred net savings to advanced economies. The current debate surrounding the global imbalances typically contrasts two views: the twin deficits hypothesis and the global savings glut hypothesis. The former draws a link between the U.S. current account deficit and the growing U.S. budget deficit, which represents a decrease in the public savings (Sachs and Roubini 1987, Ueda 1988, Roubini 2006, Ito 2009). This argument draws on intertemporal models of the current account, which suggest that the government budget deficits induce current account deficits by redistributing income from future to present generations (Obstfeld and Rogoff 1998). In contrast stands the global savings glut hypothesis, according to which the excess of savings in developing countries combined with their underdeveloped financial markets directs these excess savings to the United States, whose deep and liquid financial markets are able to absorb it (Bernanke 2005; Blanchard et al. 2005; Caballero et al. 2006, 2008, 2009; Gruber and Kamin 2005; Legg et al. 2007; Prasad et al. 2006; Smaghi 2008). Thus, the two hypotheses yield different CEU eTD Collection policy recommendations. According to the twin deficits hypothesis, the burden of adjustment rests on the United States and involves the cost of fiscal tightening. On the other hand, the global savings glut hypothesis suggests that it is the emerging countries that are able to trigger 1 the global imbalances adjustment through the policies aimed at the financial market development and capital account liberalization. This dissertation contributes to this debate by examining the determinants of external balances from the historical perspective. I adopt the New Comparative Economic History approach, which “reflects a belief that economic processes can best be understood by systematically comparing experiences across time, regions, and, above all, countries (Hatton, O’Rourke and Taylor 2007, 1).” This approach is motivated by the belief that history can inform current debates by focusing on long-term rather than short-term trends (ibid, 2). The dissertation consists of three interconnected parts. First part seeks to provide a comprehensive account of the global imbalances for nearly two centuries. The first four chapters therefore trace changes in the current account imbalances and their financial dimension, as captured by gross and net international capital flows and the build-up of international investment positions, and analyze the reflex influence that the global imbalances exerted on the course of economic and political events.