DP6000 | Fear and Market Failure: Global Imbalances and 'Self-insurance'

Publication Date

10/12/2006

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Abstract

Two key issues are examined in an integrated framework: the emergence of global imbalances and the precautionary motive for accumulating reserves. Standard models of general equilibrium would predict modest current account surpluses in the emerging markets if they face higher risk than the US itself. But, with pronounced Loss Aversion in Emerging Markets, their precautionary savings can generate substantial ?global imbalances?, especially if there is an inefficient supply of global ?insurance?. A combination of fear and market failure generates imbalances as a general equilibrium outcome. In principle, lower real interest rates will ensure aggregate demand equals supply at a global level: but disequilibrium may result if the required real interest rate is negative. A precautionary savings glut appears to us to be a temporary phenomenon, however, destined for correction as and when adequate reserve levels are achieved. If the process of correction is triggered by ?Sudden Stop? on capital flows to the US, might this not lead to 'hard landing' that is forecast by several leading macroeconomists? When precautionary saving is combined with financial panic, history offers no guarantee of full employment.