Fear and Market Failure:

global Imbalances as symptoms of

‘self insurance’?

Marcus Miller* and Lei Zhang

*visiting IADB Research Department

The story so far…

• Yesterday we heard many ideas from Nouriel Roubini, the economist who Jeffrey Sachs once said had the highest ‘velocity of ideas’ in Economics, a novel concept which Jeffrey defined as follows:

the velocity of ideas = (sentence/min) x (ideas/sentence) = ideas per min!

• In case you missed some of what he said, we provide a summary in Table 1.

• We also summarise David Backus’s position in a Fisher diagram.

No exchange rate problem

Some dollar overvaluation

Unsustainable overvaluation

No imbalance of demand

Backus et al.

Hausmann and S:

“Dark Matter”

Some demand imbalance

Richard Cooper, Caballero er al:

“Constrained equilibrium”

Dooley, Garber and F-L: “Bretton Woods II”

Obstfeld and Rogoff:

“The Transfer Problem”

Unsustainable demand imbalance

Roubini and Setse

Martin Wolf

Eichengreen and Park

“Hard Landing?”

Table 1. Global imbalances and the dollar: various views.

A

B

B’

A’

C1, Y1

C2, Y2

Econ 101: David Backus’s view in a Fisher diagram. Q: Which is USA – A or B?

Stiglitz: Making Globalization Work p.248,

• “The East Asian countries that constitute the class of ’97 have boosted their reserves in part because they want to make sure that they won’t need to borrow from the IMF again.

• Others who saw their neighbours suffer, came to the same conclusion: it is imperative to have enough reserves to withstand the worst of the world’s vicissitudes.”

The basic structure of our 2 x 2 x 2 model

or

DGSE* made easy

g

Grad Econ 101: Global risk-sharing: EM buys “safety”.

Benchmark case – and effect of increasing risk.

With Complete Markets increased risk in emerging markets has almost no effect on interest rate or Global Imbalances…

and the effects are not much greater in the ‘bonds only’ case.

σ Risk World interest rates US deficit / EM savings

3% 4.5% 0%

12% 4.2% 0.2%

Introducing Loss Aversion

Assume that utility falls very sharply if consumption in period 2 is below the reference level achieved in period 1: a strong form of loss aversion.

Then one finds:

Proposition 1: With loss aversion, if risk in EM is small ( ) and there is Insurance, no added savings is required: equilibrium prices and allocation are the same as before.

Proposition 2: If risk is large ( ), simple risk sharing is not sufficient to ensure that consumption in the bad state remains above the reference level for EM: EM increase savings as a substitute for high cost insurance.

Proposition 3: The resulting global equilibrium is ‘as if’ there is more patience in EM, together with an increasing fear of the bad state.

2g

2g

Effect of Loss Aversion in EM:

it’s ‘as if’ its time preference has fallen and pessimism

has increased

US

C1

A

C

B

E

Insurance

BondsFDI

qh/ql

y1

Savings

Lowstate

EMHigh state

Fisher diagram again: Loss Aversion and Precautionary Saving

Low state

Mean outcomeEy2

First period

yL

y1

Precautionary saving

C

Second period

1+r

g

Savings and real interest rates with loss aversion and no insurance.

Note: For Jeanne and Ranciere (2006) of 10% might lead to imbalances of about 5%.

Conclusion

With complete markets, loss aversion (‘fear’) involves only minor global imbalances.

With incomplete markets (i.e. ‘market failure’), fear leads to major global imbalances with very low interest rates - maybe even negative.

But if real interest rates cannot go negative, the global economy can fall into a Liquidity Trap.

Caveat: our model does not include Sudden Stops.