Although started in the U.S. housing market, the current global financial crisis has its deep international root: the so-called “global imbalances” between the U.S. and emerging economies such as India and China along with Middle Eastern oil-exporting countries and Japan.
The global imbalances are created by two different growth strategies adopted by different countries. While the U.S. economy is largely driven on domestic consumption, emerging economies rely more heavily on exports.
As a result, the U.S. has been running huge current-account deficits over the past decade and the emerging economies have had surplus and accumulated large dollar reserves. To finance its huge current-account deficits, the U.S. has to rely on foreign capital inflows from surplus countries. To put their dollar reserves into use, emerging economies have to reinvest their reserves in America.
Large scales of foreign capital inflows combined with the Fed’s loose monetary policy led to lower interest rates, making housing mortgages and business loans more affordable to American families and small-business owners.
But cheap credit also helped feed the housing bubble. As the U.S. housing market collapsed, both foreign investors and U.S. banks suffered huge losses, and the subprime crisis quickly turned into a global financial crisis.
Fundamentally solving the global crisis requires a global solution. We are not talking about actions such as injecting liquidity to banks by central banks around the world. These temporary solutions can only alleviate the symptom. The remedy for the disease is to eliminate the global imbalances, which requires actions from both sides.
American consumers need to change their consumption habits and do a better job monitoring Washington in order to have the government spending under control. In the meantime, emerging economies need to change their growth strategy from targeting foreign demand to targeting domestic demand.
This global solution is certainly not easy to implement. One the one hand, Americans are unwilling to give up the lifestyle that they have been enjoying. On the other hand, emerging economies are worried about not being able to maintain fast growth.
But if we sit and wait, the next global financial crisis will not be very far from us.
