Global imbalances vs flight to quality risks - different stories

One of the key arguments for the global crisis has been the global imbalance story. The large current account deficits of the US helped to create an unstable system. The global imbalance story is based on the emerging market events of the last two decades where current account deficit could not be financed through a "sudden stop" in the economy. Developed countries still need to be on guard if they have large current account imbalances because a change in funding sentiment will create a crisis.

The safe asset shortage story states that the lack of capital market developments in many emerging market countries which limited the risk free assets available to investors including central banks created demand for safe assets in the US. Yes, there were imbalances that would correct if there was not a demand for safe assets by those running surpluses. The strong demand for triple-A rated assets fueled the creation of securitized assets. The strong demand meant that investment bankers could find active buyers for what they created. The story is consistent with many of the empirical facts that we have prior to the crisis.

The crisis came but it did not take the form that the global imbalance story-tellers were expecting. The crisis would come because a sudden stop of investor demand would force the dollar lower and and drive interest rates higher. This would require more savings in the US. The higher rates would also attract more savings. The crisis would be a collapse in the status quo of dollar funding by the rest of the world in current account surpluses.

The reality is that the crisis led to a dollar shortage and a scramble for safer assets. There was nor sudden stop. The current account improved because of a slowdown in buying as US consumers began their deleverage but there was no asset pricing crisis against US assets. The demand for safe assets changed from triple-A rated ABS to Treasuries but there was still a strong demand for dollar assets.

Our current understanding of how the global financial system still needs significant adjustment the global imbalance story may still be relevant but needs further refinement.