Ebook Global Imbalances and Exorbritant Privilege
The last several decades have witnessed a spectacular increase in cross-border “two-way” gross capital flows, as documented, among others, by Gourinchas & Rey (2005) and Lane & Milesi-Ferretti (2005). To illustrate the magnitude of these flows, Tille (2008) points out that at the end of 2006, gross assets and liabilities of the United States comprised 115 and 131 % of GDP, compared to only 36 and 34 % two decades ago. This opens the door to the new external adjustment mechanisms that work through short-term capital gains and losses on the gross cross-country asset positions (the so-called “valuation effects”), and makes the traditional NIPA measure of the current account balance an outdated indicator of the change in country’s net foreign asset position.
At the same time, it can make one highly suspicious of the conclusions about the sustainability of the country’s external position reached through the traditional intertemporal models of the current account that assume perfect certainty and external imbalances that are financed through trade in only one asset real bonds.
This has lead to a renewed interest in developing and solving general equilibrium models of international portfolio choice with incomplete markets that would allow one to analyze the determinants of the national portfolios and their effect on the external adjustment mechanism. Several recent papers (which we discuss in more detail in the following section) have attempted to accomplish this. Most of them use some version of linear and higher-order approximation around some fixed point in a state space to obtain the model solution. We take a different route, and adapt a method developed in a series of papers by Judd, Kubler and Schmedders to analyzing the international portfolio choice problem.
As an application of this method, we show that by changing the payoff structure of the internationally traded bonds, we can account for the following intriguing feature of the international portfolio composition of the United States. Gourinchas & Rey (2005) observe that “the US balance sheet resembles increasingly one of a venture capitalist with high return risky investments on the asset side”, while “its liabilities have remained dominated by bank loans, trade credit and debt, i.e. low yield safe assets”, and that “its leverage ratio has increased sizeably over time”. This evidence is corroborated by Obsfeld (2004), who states that for the United States, “the striking change since the early 1980s is the sharp growth in foreign portfolio equity holdings”, while on the liabilities’ side, “the most dramatic percentage increase has been in the share of U.S. bonds held by foreigners”.
Similar observations are made by Higgins, Tille & Klitgaard (2007), Tille (2005), Mendoza, Quadrini & Rios-Rull (2008) and Obsfled & Rogoff (2005). We try to relate this to the “exorbitant” privilege that the United States has enjoyed as the issuer of the international currency, and thus being in the center of the world financial system. Gourinchas & Rey (2005) point out that, as the issuer of international currency, the United States can denominate their entire stock of liabilities in dollars, shifting the exchange rate exposure to the rest of the world. In their opinion, “this key characteristic of the external balance sheet of the US, shared to some extend by other developed countries, is instrumental in the stabilization of external accounts of these countries”. Obsfled & Rogoff (2005) claim that “A major reason why foreigners hold relatively more U.S. bonds than vice-versa is that the U.S. dollar remains the world’s main reserve currency”.
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