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Linking External Sector Imbalances and Changing Financial Instability before the 2008 Financial Crisis

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  • John Whalley
  • Manmohan Agarwal
  • Jing Wang
  • Sean Walsh
  • Chen Yan

Abstract

The G20 Framework for Strong, Sustainable and Balanced Growth builds on the claim that growing imbalances before the 2008 Financial Crisis were a major cause of the crisis, and the further claim that reducing imbalances post crisis must be a central part of any effort to prevent a further occurrence. Analytical literature in economics seemingly does not provide satisfactory measures of financial instability, either in individual national economies or in the combined global economy; nor ways of linking imbalance change to either worsening or improving financial (or real) instability and the onset of financial crises. Here we focus on the external sector component of financial instability and link changes in country imbalances to individual economy growth rates in ways when summed across countries produce indices of expected worsening or improving financial instability at different points in time. We compute a variety of such indices for the years immediately before the 2008 Financial Crisis. We use the sum of the absolute value of external sector imbalances across countries (the trade imbalance, or the current account imbalance) as a proportion of the combined GDP of countries and link them in various ways to country growth rates. An increasing measure under an index is an indication of future widening excess demands and supplies over all countries as a group relative to gross world product. This, in turn, is an indication of increasing severity of adjustment problems ahead, and hence expected worsening financial instability. We compute such indices for all G20 countries, and various subsets of countries (G2, G8, G8+5) and examine their behavior over the period 2004-2007. Our results suggest that depending upon the index used and the base date chosen for comparative purposes in determining changes, different implications emerge for the linkage between external sector imbalances, perceived future instability and hence the onset of a financial crisis. The implication we drawn is that the links between imbalances and both the onset and best policy response to the 2008 Financial Crisis asserted by the G20 may be more tenuous than claimed. Indeed no such links were suggested earlier for the 1930s, the Asian Financial Crisis or any other crisis. In turn economies have functioned with larger imbalances relative to GDP than in 2008 for considerable periods of time and with no financial implosion (UK in the pre World War I period; Germany and Australia in the 1990s).

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17645.

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Date of creation: Dec 2011
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Publication status: published as “External Sector Rebalancing and Endogenous Trade Imbalance Models.” Contemporary Economics 6 (4), October 2012, pp. 20-26.
Handle: RePEc:nbr:nberwo:17645

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  1. Mary Amiti & David E. Weinstein, 2009. "Exports and Financial Shocks," NBER Working Papers 15556, National Bureau of Economic Research, Inc.
  2. Jaume Puig & Ken Miyajima & Rebecca McCaughrin & Peter Dattels, 2010. "Can You Map Global Financial Stability?," IMF Working Papers 10/145, International Monetary Fund.
  3. Allen Berger & Leora Klapper & Rima Turk-Ariss, 2009. "Bank Competition and Financial Stability," Journal of Financial Services Research, Springer, Springer, vol. 35(2), pages 99-118, April.
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  6. Jonathan Eaton & Samuel Kortum & Brent Neiman & John Romalis, 2011. "Trade and the Global Recession," NBER Working Papers 16666, National Bureau of Economic Research, Inc.
  7. Chunding Li & John Whalley & Yan Chen, 2010. "Foreign Affiliate Sales and Trade in Both Goods and Services," NBER Working Papers 16273, National Bureau of Economic Research, Inc.
  8. Tobias Adrian & Hyun Song Shin, 2010. "The changing nature of financial intermediation and the financial crisis of 2007-09," Staff Reports, Federal Reserve Bank of New York 439, Federal Reserve Bank of New York.
  9. Jan Kregel, 2008. "Financial Flows and International Imbalances--The Role of Catching-up by Late Industrializing Developing Countries," Economics Working Paper Archive wp_528, Levy Economics Institute.
  10. Karl Whelan, 2010. "Global Imbalances and the Financial Crisis," Working Papers, School Of Economics, University College Dublin 201013, School Of Economics, University College Dublin.
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