Global economic imbalances

One of the most important and immediate causes of the real estate bubble is the US and a lot of other economies, was low interest rates for remarkably long period of time. While there have been several reasons cited for this phenomenon, the most plausible answer seems to be the global economic imbalances starting in the 90’s. Both the theory and the practice of these imbalances is fairly intricate & a very recent economic development.  

Theory of Economic Imbalances

In a closed economy with zero mobile capital, the income levels are fine tuned to domestic demand. Any sudden decrease or increase in this demand or supply alters the incomes of all participants in the economy and establishes a new equilibrium.

Without capital flows, it’s impossible to have a current account deficit or surplus. In this case, the exports and the imports are merely terminologies to describe overseas flow of goods. For all other purposes, the exporters and importers in the faraway country are another element of the domestic economy itself.

Even with capital flows, there is an upper limit on the time for which a country can have trade deficit- since with each year, the capital flows from deficit country to surplus country. There has to be a way of getting the capital back for the next round of deficit.  Thos is the famous imbalance described above in which the capital does flow back from Asia to the US as a credit. Till here, fluid currencies are not required.

Even with gold standard currencies, a country can have sustained deficits if the surplus country is willing to lend money to the deficit country (the mechanism of this can be detailed) – the question is why would it do that?

The Asian attempt to hold the dollar already versus their currencies was a strategy in effect to enforce the gold standard on the dollar. In purchasing dollars to prop it, the Asians did two things – one was to lend money to US to fund its deficit & two, was to  signal the US that it would print more dollars if it wished and that dollar would still be held in a  certain value range by them.

The Asians were propping up the dollar to ensure that the Americans have something to pay with for their imports of Asian goods .Why did Asians need American consumers? Were they an easy target than domestic?

Source : Anatomy of froth