Since August 2007, the global economy has been subject to a sharp and adverse financial shock, with re-pricing of risk and higher cost of funds. This article argues that this shock is a consequence of an unsustainable period of global economic growth involving very large external imbalances. These imbalances – large current account surpluses in many emerging markets matched by current account deficits (CADs) in a number of advanced economies – contributed to an unsustainable cheapening of credit and increased risk-seeking behaviour by financial markets. The development of the imbalances can be explained by financial underdevelopment in many emerging markets, together with particular savings and investment dynamics across the surplus and deficit countries. These factors established ‘Bretton Woods II’, a global macro-financial dynamic that tied the deficit and surplus economies together in a co-dependent relationship. The current credit crisis appears to mark the limits of this relationship. However, the precise nature of any subsequent adjustment in global imbalances is not immediately clear.
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