Description
This paper inquires into the root causes of global imbalances from an international trade
perspective. The purpose of the paper is to establish a conceptual framework that links financial
market governance, international trade and financial market integration, and to derive implications for
the global financial crisis
Journal of Financial Economic Policy
Global imbalances and a trade-finance-nexus
Andreas Kern Christian Fahrholz
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To cite this document:
Andreas Kern Christian Fahrholz, (2009),"Global imbalances and a trade-finance-nexus", J ournal of
Financial Economic Policy, Vol. 1 Iss 3 pp. 206 - 226
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Dilip K. Das, (2010),"Financial globalization: a macroeconomic angle", J ournal of Financial Economic
Policy, Vol. 2 Iss 4 pp. 307-325http://dx.doi.org/10.1108/17576381011100847
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Global imbalances and a
trade-?nance-nexus
Andreas Kern
Jean Monnet Centre of Excellence, Freie Universitaet Berlin,
Berlin, Germany, and
Christian Fahrholz
Friedrich-Schiller-University Jena, Jena, Germany
Abstract
Purpose – This paper inquires into the root causes of global imbalances from an international trade
perspective. The purpose of the paper is to establish a conceptual framework that links ?nancial
market governance, international trade and ?nancial market integration, and to derive implications for
the global ?nancial crisis.
Design/methodology/approach – In order to analyze global imbalances, the paper draws on a
theoretical Heckscher-Ohlin-Samuelson international trade model, in which it compares two open
economies, solely differing in their ?nancial market governance structures. Building on these ?ndings,
the paper extends the analysis to the role of ?nancial market frictions in propagating global
imbalances into excessive lending in high-income economies.
Findings – To that extent, it argues that global imbalances are due to impasses in international
production. This paper argues that countries seeking to suppress real appreciation have engaged in
?nancial repression, which has, via ?nancial globalization, translated into excessive expansion of
?nancial service sectors in ?exible market economies.
Research limitations/implications – In order to derive a tractable framework, the abstract from
inter-temporal aspects and from an in-depth analysis of ?nancial modelling issues. Owing to the static
nature of the set-up, the analytic link between global imbalances and the global ?nancial crisis is intuitive.
Practical implications – Given that differences in national ?nancial market governance in?uence
the direction of international capital and trade ?ows, it argues for more international policy
coordination in preventing future crisis.
Originality/value – The unique feature of the contribution is that it links ?nancial market
governance and international trade to international ?nancial market integration in a tractable
theoretical framework.
Keywords Financial markets, Governance, World economy, Trade balances
Paper type General review
1. Introduction
Many analysts agree that the resolution of the current ?nancial crisis depends upon its
causes. Some debates in the public sphere have identi?ed the greed of ?nancial investors
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1757-6385.htm
JEL classi?cations – E22, E44, F11, F36, F41
The authors want to thank all their colleagues for inspiring discussions and interchange during
the writing process. For their invaluable research assistance, the authors want to express their
gratitude to Julian Bo¨rner, Cordelia Friesendorf, Tillmann Immisch, Jocelyn Ng and Maximilian
Weingartner. The authors are particularly grateful to the anonymous referees who helped further
streamline the review paper. It goes without saying all remaining errors are solely the authors’
fault.
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pp. 206-226
qEmerald Group Publishing Limited
1757-6385
DOI 10.1108/17576380911041700
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as the original sin. In sharp contrast to such a scapegoat approach, some academic
researchers have highlighted the fact that ?nancial intermediation has been subject to
sensible policy decisions directed towards deregulation of ?nancial markets (Spaventa,
2008). Particularly, dysfunctional central banking policies, especially in the US in terms
of too lax monetary policies, have been identi?ed in the recent academic literature for
having aggravated economic performance. Having decreased interest rates to
historically low rates in response to a bursting dot.com-bubble, the US central bank’s
interventions have rather resulted in throwing increasing amounts of money down the
drain. According to this view, the global savings glut is particularly due to overly
relaxed monetary policies in the USA since the beginning of the new century (Boeri and
Guiso, 2008). In this context, however, an enquiry into the fundamental causes of the
global savings glut and subsequent global imbalances has been far less developed. This
especially applies to export-oriented economies which may be at the heart of global
imbalances (Lane and Milesi-Ferretti, 2005; Eichengreen, 2008). In this paper, we argue
that global imbalances are the result of politically induced distortions in international
production and specialization.
We set forth that, in particular ?nancial repression in emerging market economies has
put the chains on real wages and real exchange rates, respectively, spurring economic
growth in the short-term not only within the emerging economies themselves but also in
mature economies (Montiel and Serve´n, 2008; Rodrik, 2008). Consequently, rather
controlledeconomies have concentratedonexportinglabor-intensive production, whichin
the presence of command economy style distortions has been re?ected in a remarkable
savings glut. To cope with distorted competition in international production – due to
suppressed upward pressures in real wages abroad – few options exist for more mature
economies: possible reactions of rather ?exible market economies comprise of lowering
real wages and/or pushing ahead with the marginal product of other factors, such as
capital or land. As depressing real and correspondingly nominal wages vary considerably
is not a viable option for rather ?exible market economies. Spurring the marginal product
of capital and land have thus been the only appropriate reaction to distorted international
competition. Academic researchers have already scrutinized the in?uence that relative
price and terms of trade distortions, due to labor-market rigidities, exert on other global
competitors (Krugman, 1995a). However, the causal relationship between ?nancial
repression and excessively labor-intensive production in restrained economies on one
hand, and severe distortions inproduction specializationinmarket economies onthe other
hand have not been prominently discussed in the academic literature so far. We develop a
line of theoretical arguments alongside a Heckscher-Ohlin-Samuelson (HOS) model and
demonstrate theoretically, why ?nancial repression in large real appreciation controlling
economies has substantially contributed to an increase in ?nancial market activities and a
corresponding increase in the marginal product of capital in mature market economies.
According to our line of argument, suppressing real appreciation in rapidly growing
economies results in the production of high-net saving surpluses, i.e. an export of real
appreciation pressures and severe global imbalances, which are at the heart of the present
?nancial crisis.
The remainder of the discussion surveys the relevant literature on the global
imbalances and a corresponding global savings glut in Section 2. Subsequently, in
Section 3, we develop a theoretical framework comprising a stylized HOS-model with
?nancial repression. Section 4 brie?y delineates the perils of ?nancial market
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imperfections that may further exacerbate global imbalances due to their pro-cyclical
impact on economic formation. Finally, Section 5 summarizes key insights from the
analysis and sketches policy implications.
2. Review of the literature
There exists a vast amount of literature on the interdependencies of relative prices in a
two-country world. Explaining trade relations inthe world froma factor endowment and
production side perspective lies at the heart of the HOS-model. Krugman (1995a), for
instance, examined the impact of a trade shock on a minimum wage constrained Europe
and a ?exible-wage America, concludingthat it would raise unemployment inthe former
and reduce wages in the latter. His study, on a theoretical plane, belongs to earlier works
of comparative studies. That is to saythat he examines one countryat one time. As Davis
(1998) shows however the results might change dramatically if a global perspective
is added to the discussion, in which Europe and America exist in the same world. In this
respect, the latter author argues that engaging in trade between a ?exible-wage America
and a rigid-wage Europe also raises wage levels in the former economy. Most notably,
the author posits the “insulation hypothesis,” according to which wage rigidities in
Europe completely insulate the American economy from new market entries by
low-skilled “Southern” labor. Our analysis aims at identifying a related argument
towards the root causes of the present ?nancial crisis.
Authors, such as Boeri and Guiso (2008) argue that the crisis has its origin in Alan
Greenspan’s low-interest rate policy (former President of the US Federal Reserve Board),
which injected enormous amounts of liquidity into the global ?nancial system. Contrary
to this argument, Ioannidou et al. (2008) have shown that despite the theoretical appeal
and widespread resonance of this argument, the empirical evidence is not suf?cient to
support a robust link between monetary policy and bank risk-taking. Bearing this in
mind, we emphasize that global imbalances, due to distortions in relative prices and
terms of trade, lie at the heart of the problem.
The idea of identifying global imbalances as the origin of ?nancial crises is not new.
Many authors have identi?ed differences in the level of ?nancial development and
subsequent reserve hoardings in countries like China as being responsible for global
imbalances (Aizenman, 2007; Rajan, 2008). As McKinnon and Schnabl (2008) argue,
despite massive efforts by the People’s Bank of China to sterilize the monetary
consequences of the reserve buildup, China has become an in?ationary force on
American and Europeanprice levels. According to these authors, this observation canbe
attributed to China’s excess liquidity spilling over into the world economy. Following
Tyers (2008), any change in policies directed at savings, dividends, ?scal expansion, and
privatization would raise China’s apparent production costs relative to foreign
investment and would retard investment. Therefore, instead of ?owing out to ?nance
China’s trade surplus, the People’s Bank of China has used its liquidity to accumulate
large amounts of foreign exchange, mainly in the form of US treasury bonds (Freytag,
2008; McKinnon and Schnabl, 2008). This fact indicates that, inline with Davis’
argument, national factor market institutions matter as they profoundly affect global
patterns of output, employment and wages (Davis, 1996). This however poses a serious
weakness to China, as it could contribute to a misallocation of resources for investment
(Barnett and Brooks, 2006). According to the latter authors’ argument, the drivers of
?xed asset investment have been real estate, manufacturing, and infrastructure.
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Focusing more on the internal effects of Chinese ?nancial repression, Lardy (2008)
argues that ?nancial repression, de?ned here as low or negative real return on deposits,
has seriously distorted the structure of demand. While the decline in real interest rates
has reduced the costs of maintaining an undervalued exchange rate, increasing
in?ation has eroded household consumption in gross domestic product (Lardy, 2008).
Although this observation runs seemingly counter to our argumentation, we concur
with Prasad and Rajan (2006, p. 332) that “?nancial system repression has meant that
there are few alternatives to funneling these savings into deposits in the state-owned
banking system.” In this regard, prevailing implicit deposit insurance schemes have
increased the willingness of households to hold bank deposits, despite the weakness of
the banking system. Nevertheless, the main channel of private savings can be traced to
an over-competitive export sector and thus be tracked on the production side of the
economy. From this perspective, savings are generated in the form of ?rm pro?ts,
which are additionally supported from policies preventing a real appreciation of the
domestic currency (Aizenman, 2007). Therefore, distorted relative prices stemming
from ?nancial repression are leading to “excess savings” in the economy.
At the same time, US consumption has been a major driving force behind the growth
of global demand (Obstfeld and Rogoff, 2004). While the US personal saving rates have
been very low, driven by an unsustainable rise of house prices and historically
low-interest rates, growth in China has been accompanied by a rocketing household
saving ratio (Modigliani and Cao, 2004). Although the current account surplus and the
massive excess liquidity have come at the expense of investment and consumption, the
imbalances have bene?ted the Chinese economy as well (Eichengreen and Park, 2006). In
addition, a rapid integration of the international ?nancial system has enabled these
imbalances to persist (Obstfeld and Rogoff, 2004; Lane and Milesi-Ferretti, 2008).
Differences in ?nancial market developments have led more advanced ?nancial markets
to accumulate foreign liabilities in a gradual, long-lasting process (Mendoza et al., 2008).
This clearly differs from the standard view that mature industrial countries should be
exporting capital to poor developing countries due to a relatively higher marginal
product of capital. Gruber and Kamin (2005) highlight that per capita income, relative
growth rates, ?scal balances, demographic variables, and economic openness cannot
account for the global pattern of current account imbalances. Our argument is, therefore,
that for example China’s concentration on labor-intensive production and the according
export of goods and capital via the terms of trade, have forced the USAand other ?exible
market economies to focus on capital-intensive production and subsequently lead to a
surge in borrowing[1]. In this regard, globalized ?nancial markets have allowed China to
sustain USA demand by exporting its “excess savings,” speci?cally for the most part to
the said US economy.
3. Theoretical framework
The aim of this theoretical analysis is to develop a global-trade model between two
groups of countries, i.e. ?exible market economies on one hand and a group of
non-mature economies controlling real appreciation on the other hand. This theoretical
framework may then reveal the root causes of the present ?nancial crisis.
In deriving our model along the lines of the HOS-model, we broadly follow Davis
(1998) and proceed ina ?ve step course. Ina general equilibriummodel, we ?rst highlight
the in?uence that ?nancial repression, i.e. a lower bound oncapital asset returns, in a real
Global
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appreciation suppressing, non-mature economy exerts on production. In this context, we
show that these ?nancial repression mechanisms have the same effect as an upper
bound on real wages in a closed economy. This symmetry can easily be derived by the
so-called Lerner condition in the discussion on the symmetric nature of export subsidies
and import taxes. Incorporating the central result of the Stolper Samuelson theorem on
factor price equalization (FPE) inour model (Stolper and Samuelson, 1941), we are able to
show that ?nancial repression is conducive to an undervaluation of the real exchange
rate[2]. This portion of the analysis yields that suppressing real appreciation results in
the generation of “excess savings” in the formof “stalled investments” in the non-mature
economy. In the second stage of developing our theoretical arguments, we demonstrate
with the help of simple arithmetic in balance-of-payment matters that the latter savings
push ahead with current account surpluses. Third, in an open economy model with an
integrated equilibrium of international FPE (Dixit and Norman, 1986), this “push” is
depicted in terms of increasing capital-intensity within a mature, ?exible economy in
reaction to ?nancial repression in a non-mature economy. Fourth, a model of
global-trade patterns demonstrates that ?nancial repression in opening-up, non-mature
economies indeed stimulates production as well as savings, which are absorbed and
quasi “pulled out” by the ?exible economy. Finally, we set forth that sti?ing real
appreciation in a non-mature economy takes place in the form of exporting
labor-intensive production towards the mature economy. This is to say that real
appreciation pressures are exported to ?exible market economies. In this respect, one
could think of net saving surpluses and/or capital ?ight to a safe haven (Antras and
Caballero, 2007; Dooley et al., 2007), which are re?ected in large current account
surpluses. Consequently, the ?exible market economy builds up foreign liabilities,
which re?ect a surge in real interest rates above their fundamental level (Gopinath,
2004). Following this line of reasoning, we additionally argue that an economic bubble in
?nancial markets might occur due to insurmountable ?nancial market imperfections
within the ?exible market economy (Allen and Gale, 2000).
The conclusion of our analysis is that both misalignments in balances of payments
and global-trade relations stem from warped relative prices in non-mature economies
seeking real undervaluation. Such catch-up strategies actually rely on exporting real
appreciation pressures to ?exible market economies thus precipitating ?nancial crises
such as the latest turmoil occurring in the USA.
3.1 Setting the stage: autarky
We consider a closed economy, which has two factors of production, i.e. capital and
labor, at its disposal. These factors are available in ?xed supply given by K and
correspondingly L. These input factors are used to produce two goods under an
omnipresent production technology subject to a conventional Cobb-Douglas production
function with constant returns to scale. The economy can produce the good x, which is
capital-intensive, and the labor-intensive good Y. As in the stylized HOS-model set-up,
preferences are homothetic and both goods are used in the economy. We denote w to be
the return to labor, r to represent the return on capital, and P to be the resulting relative
price of x in terms of y. In a fully ?exible economy the competitive cost conditions c
ensure that for each sector the sector price has to equal marginal costs of production:
c
x
ðw; rÞ ¼ P and c
y
ðw; rÞ ¼ 1; ð1Þ
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whereas, P denotes the relative price between capital and labor-intensive goods.
Furthermore, it can be assumed that production takes place ef?ciently and that therefore
the following conditions have to be satis?ed:
K
x
þ K
y
¼ K and L
x
þ L
y
¼ L; ð2Þ
Given Walras’ Law, goods market clearing is ensured by the equality of demand and
supply. In the following paragraphs, we utilize Davis (1998) in establishing three key
relationships. First, we establish the link between the relative endowment and capital
intensity k ¼ K/L and the relative price level P in the fully ?exible economy. Inline with
the Heckscher-Ohlin theorem a rise in capital abundance reduces the relative price of the
capital-intensive good. For the sake of the argument, we propose the following equation
to capture these characteristics of the theorem:
P ¼ f ðkÞ; whereas f
0
ðkÞ , 0: ð3Þ
The latter function implies that the relative price P declines with increasing capital
intensity k in production.
In a second step, we include the Stolper-Samuelson proposition in order to establish a
direct link between factor and relative good prices. Given a speci?c relative factor price,
a rise in the real interest rate can be traced back to a decline in relative good prices in
terms of a labor-intensive good unit y. That is to say that a corresponding reduction in
the produced amount of capital-intensive goods relative to labor-intensive goods may be
due to a change in factor prices, i.e. here the real interest rate. An according change in the
rental rate on capital shifts the economy towards labor-intensive goods production.
Given that the capital-intensive good is x, we can thus derive the following
Stolper-Samuelson condition for the real interest rate depending on the relative price P:
r ¼ gðPÞ; whereas g
0
ðPÞ . 0: ð4Þ
Thus, given the relative capital endowment ratio and capital intensity k of the closed
economy, we can directly determine the equilibrium goods relative price in the ?exible
market economy as well as the resulting real interest rate:
r ¼ gðPÞ ¼ gð f ðkÞÞ: ð5Þ
These equations are thus suf?cient to establish a general equilibriumin goods andfactor
markets. In the following section, we introduce a politically induced market distortion,
i.e. ?nancial repression.
3.2 Financial repression
For the sake of simplicity and taking the Walras’ Law into consideration, we model the
market distortion as a minimum rental rate on capital assets r
*
. r, which is identical
to a form of ?nancial repression with the aim of preventing real appreciation. Our
argument can theoretically be traced in the works of Aghion et al. (2004) and Rodrik
(2008), in which ?nancial repression interms of capital controls and excessive borrowing
constraints prevents a real appreciation (Aghion and Banerjee, 2005). This assumption
is consistent with a stable equilibrium featuring diversi?ed production, if and only if
the relative goods price is P
*
¼ g
21
ðr
*
Þ . P (Figure 1).
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This would be the equilibriumgoods price, if and only if employed factors are in the ratio
k
*
¼ f
21
ðg
21
ðr
*
ÞÞ , k: Accordingly, capital that would have been employed in
production in the case of no ?nancial repression must be off-set in terms of “stalled
investments.” This is equivalent to saying that some portion of capital has been
squeezed out of economic production relative to original factor endowments. This
de-capitalization D
*
occurs in terms of:
D
*
¼ zðk
*
; K; LÞ; whereas z
0
ðk
*
Þ , 0 for all k
*
, k: ð6Þ
Hence, the ?nal quadrant simply depicts a crowding out of capital investments hinging
upon the level r
*
of ?nancial repression.
A ?exible interest rate will always ensure that capital will, at all times, be fully
employed. However, adding politically induced market distortions to the capital market
with a binding minimum on the rental rate of capital, a market clearing via the price
mechanism could potentially not occur. In the following subsection, we show that the
resulting real undervaluation is equivalent to a huge amount of savings.
3.3 Real appreciation controlling: a view from the balance of payments
In order to show that a savings glut results from ?nancial repression and a
corresponding drop in capital intensity amounting to, k
*
we expand our analysis
towards balance-of-payment issues. Although such an approach to balance-of-payment
matters presents an ex post view on the international ?ow of real quantities and
according claims and liabilities, a closer look at balance-of-payment matters prepares
the ground for the subsequent analysis of “excess savings” from the viewpoint of
international trade.
In the previous step, we have shown that ?nancial repression results in distorted
relative factor and good prices at level P
*
. In this respect, relative scarcity of capital is
tightened by not deploying capital in production amounting to D
*
at a level of capital
intensity k
*
, which is identical to an “excessive” savings behavior in the economy. With
r
*
¼ g(ƒ(k
*
)) subject to the endowments Kand L, “stalledinvestments” D
*
represent the
amount of capital de-invested in the economy. In reference to our comparative statics in
Figure 1.
Stolper-Samuelson Heckscher-Ohlin
Stalled investments
z (k*, K, L)
P
k
D
r
k r
f (k) g (P)
Capital market
r* k*
P
P*
D*
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Figure 1, applying identities of the balance of payments yields that D
*
must be
equivalent to “excess savings” in the economy.
In following the line of argument formulated by Freytag (2008) and without
distinguishing private and public consumption, equation (7) portrays domestic
production Y consisting of consumption C, domestic investment I
d
corrected by the
“stalled investments” D
*
and the current account in terms of the difference of exports
and imports (X 2 M). At the same time, equation (8) depicts the use of the present
production Y in terms of consumption C and savings S. In equilibrium overall savings
are identical to domestic investment I
d
corrected by the “stalled investments” D
*
,
foreign portfolio and direct investment abroad I
ƒ
as well as the change in foreign
reserves dR of the central bank (equation (9)):
Y ¼ C þ ðI
d
2D
*
Þ þ ðX 2MÞ ð7Þ
Y ¼ C þ S ð8Þ
S ¼ ðI
d
2D
*
Þ þ I
f
þ dR ð9Þ
I
f
þ dR ¼ ðX 2MÞ and S 2I
d
þ D
*
¼ ðX 2MÞ ð10Þ
The subsequent equations in equation (10) then highlight the fact that capital and
?nancial accounts, i.e. investments abroad and changes in the reserve level (I
ƒ
þ dR)
balance the current account (X 2 M). The latter trade balance must then be identical
with the level of “fundamental savings,” which are not invested in the domestic
economy, plus the “excess savings” due to the de-capitalization in the course of ?nancial
repression in terms of “stalled investments” D
*
.
The basic link between ?nancial repression and excess savings is rather simple: for
competitive ?rms to access ?nancial funds on capital markets at interest rate r
*
, they
need to sell-off their products at least at a relative price P
*
. When ?nancial repression
puts a binding constraint on ?rms, the goods price will only be attained, if the relative
scarcity of capital increases. This will apply only if a suf?ciently large share of capital is
unemployed in production[3].
These equations certainly describe identities that must hold true ex post. From a
viewpoint of the production side, however, we have explained in the previous subsection
on ?nancial repression that the emergence of “stalled investments” results from
distorted relative prices. This discussion on balance-of-payment issues shows that the
“stalled investments” must be identical to “excess savings.”
After having referred to production and balance-of-payment issues, we subsequently
develop an isomorphism between the closed economy with ?nancial repression and a
trading world, in which ?nancial markets are fully liberalized. This investigation
relies on the analysis of Dixit and Norman (1986), which has entered the literature as
the so-called “integrated equilibrium concept.” This concept allows for establishing
conditions under which trade in goods is suf?cient to establish the same world
equilibrium, as occurs in the closed economy setting with both goods and factor
mobility.
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3.4 Open economy model
We nowconsider the world economy consisting of two countries with free trade and zero
transaction costs[4]. The mature Country (A), representing the group of ?exible market
economies, has completely liberalized ?nancial markets, in which the interest on capital
assets is determined freely by market forces (Aghion et al., 2004; for an empirical
assessment see, for instance, Blanchard, 2007). The representative real appreciation
controlling economy (C) has imposed some form of ?nancial market repression to
support their economic development strategies, leading to an upwardly bended
minimum real interest rate r
*
, though still inline with competitive cost conditions (see
above). Let a bar of the variable represent the level of that variable in the integrated
equilibrium. Let index i represent goods and index j Countries A and C. The set of
divisions of world endowment among involved countries inline with the integrated
equilibrium concept can thus be described in the form of FPE set:
FPE ¼
½ðK
A
; L
A
Þ; ðK
C
; L
C
Þ?j’k
ij
$ 0
such that
j
P
k
ij
¼ 1
ðK
C
; L
C
Þ ¼
i
P
k
iC
ð
K
C
L
C
Þ þ ð0; D
*
Þ
ðK
A
; L
A
Þ ¼
i
P
k
iA
ð
K
A
;
L
A
Þ þ ðD
*
; 0Þ
i ¼ x; y j ¼ A; C
8
>
>
>
>
>
>
>
>
>
>
>
>
>
<
>
>
>
>
>
>
>
>
>
>
>
>
>
:
9
>
>
>
>
>
>
>
>
>
>
>
>
>
=
>
>
>
>
>
>
>
>
>
>
>
>
>
;
ð11Þ
These conditions are very intuitive. If the integrated equilibrium is to be replicated, the
global savings glut must be at the same level as in the integrated economy. But “excess
savings” do not arise in liberalized ?nancial markets in Country A. However, the real
appreciation controlling Country C must build-up “excess savings” in D
*
order to comply
with the stipulated r
*
. r, as shown in Figure 1. Beyond this, we only need to satisfy the
conventional restrictions in terms of employed factors. These require that both countries
use the integrated equilibrium techniques (with the capital intensities k
*
x
¼ ðK
*
x
=L
*
x
Þ and
k
*
y
¼ ðK
*
y
=L
*
y
Þ), and that the integrated equilibriumoutput in both sectors can be divided
among the countries. In a stable equilibrium, demand will exactly exhaust employed
factors in the two countries, which exist in the overall reduced ratio k
*
. The FPE set is
shown in Figure 2.
The width of the box portrays the world’s endowment of labor, while the height
represents the endowment of capital in the world. For the sake of simplicity, we presume
that under free and costless trade, competitive producers in the two countries face the
same goods prices, have the same technologies, and are at least weakly diversi?ed.
Without ?nancial repression in Country C the vector k
x
illustrates the factor ratio
employed in the sector of capital-intensive production, whereas k
y
represents the
quantities of capital relative to the quantities of labor employed in the production of
labor-intensive goods. The integrated equilibrium point E re?ects comparative
advantages in factor endowments. However, as soon as the real appreciation controlling
Country C resorts to ?nancial repression, “stalled investments” ensue amounting to the
line segment O
c
D
*
. These “stalled investments” are equivalent to unemployed capital in
production, which are substituted by labor and exported in terms of a global savings
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glut via the current account (see above). Under the conditions noted above, international
trade equalizes factor prices between the ?nancially liberalized economy A and the
?nancially repressed economy C. The FPE follows directly from the common
competitive cost conditions (see above). The according distortion in relative factor prices
resulting from ?nancial repression is re?ected in a shift towards a new integrated
equilibrium E
*
. At this point capital intensity in the production of the labor-intensive
good has decreased. Accordingly, the original vector k
x
, for instance, has been altered to
k
*
x
, which is longer and ?atter. The increase in size results fromfactor substitution in the
course of ?nancial repression, whereas the altered slope stems from the change in the
factor ratio of capital to labor. At the same time, capital intensity in the capital-intensive
production within Country A has increased from k
y
to k
*
y
. The actual length and
location of the “bended” vectors k
*
x
and k
*
y
depend particularly on factor substitution
elasticities of the productionfunction ineacheconomy. Inthe face of a global market, free
commodity trade fully equalizes factor prices and thus exports warped relative prices
from real appreciation controllers to ?exible economies. In the following subsection, we
inquire further into the formation of trade patterns distorted by ?nancial repression and
warped relative prices.
3.5 Trade adjustments in the course of ?nancial repression
In this section, we want to demonstrate how economic integration in the form of trading
between a mature, ?exible market economy A and a non-mature, and real appreciation
controlling economy C are impacting on both economies. In particular, we are interested
in investigating how ?nancial repression in one country affects the production in the
other country. For the sake of establishing our basic result, we start with a world in
which Countries A and C would be identical in any relevant economic key variable,
i.e. endowments, technologies, and preferences U. The only distinguishing feature
between both economies is that one economy is characterized by repressed ?nancial
markets, dampening credit/capital demand and accordingly sti?ing real appreciation.
Figure 3 shows the core aspects of the general trade equilibrium.
Figure 2.
O
c
O
A
k
k
*
k
*
x
k
*
y
k
y
k
x
D
*
L
L
K K
E
*
E
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The technological production possibility frontier is common to Countries A and C. In
Country C, to support ?nancial repression and the non-appreciation condition r
*
, the
equilibrium price must be P
*
. The composition of demand is given by a (P). Thus, under
full employment of capital assets and production at prices P
*
, Country C would be at G
and demand at G
0
. This implies an incipient demand for Q, tending to raise P as well as
lowering r below r
*
. However, the incipient fall in the capital rental rate is stanched via
“stalled investments” equivalent to an increase in savings in Country C (see above). In
the HOS-model framework it is particularly the Rybczynski (1955) theorem that deals
with the effects of endowment changes. Thus, at ?xed goods prices, an increase in
the endowment of one factor leads to a more than proportional increase in output in the
sector that uses this factor intensively. At the initial equilibrium price, this would be
expected to create an excess supply of the good that uses the factor intensively, hence,
lowering its equilibrium price. According to the Stolper-Samuelson condition, this
results in a decrease of the return to that factor. However, with one factor price ?xed,
i.e. ?nancial repression and an upward bended rental rate for capital, our result is just
the Rybczynski theoremin reverse. This is to say that output is shifted onto a ?nancially
repressed production possibility frontier towards the original demand line. Therefore,
production in the closed economy C would have to be at point F
*
, at which the
constrained supply exactly matches the demand at prices P
*
. The shift of production in
Country C fromGto F
*
re?ects the expansion of savings, exactly necessary to eliminate
the excess demand for capital-intensive goods (i.e. investment) indicated by the line
segment GG
0
.
Now we consider the case in which Countries A and C are trading freely. In order
to support ?nancial repression at level r
*
, Country C still needs to maintain price P
*
in
equilibrium. Since absorption is at point E
0
due to Country A’s original demand in G
0
,
this would require Country C’s production to be in point E
*
. As demand is homothetic
and production linear, the build-up of “excess savings” in moving from F
*
to E
*
surmounts the pre-existing “excess savings” of the previously closed economy in
Country C. This is to say that in this stylized framework the Country C’s opening of trade
Figure 3.
y
a (P)
G
G'
E
*
F
*
U
A
'
U
A
*
, U
C
*
U
A
,U
C
E'
Q
P
*
P
*
x
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with Country A would even further increase Country C’s “excess savings” in terms of
“stalled investments” andthe ruled-out demandfor capital-intensive goods in Country C,
respectively. The reason is that Country C would be “quasi-forced” to generate the full
integrated amount of savings to sustain at a level r
*
for both economies, which implies a
move from E
0
towards the integrated equilibrium E
*
(Figure 2). In Country A, the
absence of ?nancial market intervention comes at the cost of lower interest rates on
invested capital for investors. However, once trade commenced, the ?exible market
economy of Country A come to share Country C’s high real interest rate because it will
have to share the upward bended real interest rate r
*
. r.
The fact that Country A shares the high-interest rate r
*
under trade follows from the
fact that trade links goods prices, that both countries remain diversi?ed and that
producers still face competitive cost conditions. In effect, trade forces Country C to bear
the burden of “excess savings” to maintain Country C’s comparative advantage and
hinder a real appreciation. However, forcing capital markets in Country A to increase
capital rental rates up to a level r
*
implies that opening to free trade will lead to a
deviation of the capital rental rate fromits economic fundamental value. This would lead
to an over-utilization of capital and increasing capital intensity in Country A’s economy.
An economic bubble emerges at the heart of Country A, which cannot be detected by
simply looking at the fundamentals[5]. In order to illustrate our argument we are going
to establish an import-export framework.
3.6 Transfer of “excess savings”
In the following paragraphs, we highlight the fact that “excess savings” of Country Care
indeed exported to the ?exible market economy in Country A. The previously outlined
balance-of-payments arithmetic has already shown that real appreciation controlling
is achieved by a contraction of capital-intensive good production in terms of “stalled
investments,” fuelling the current account surplus of Country C. However, such
balance-of-payment matters only depict the ex post view on economic formation. This
subsection sets forth, how distorted relative factor and good prices affect the formation
of import-export relations ex ante. A framework of import demand and export supply
between Countries A and C ?lls this niche and buttresses the results gained thus far.
As we have demonstrated, the upward bended real interest constraint r
*
makes
Country C export “excess savings,”, i.e. real (excess) supplies, at a relative price level of
P
*
. The actual export volume not only depends on the level of P
*
, which re?ects various
corresponding levels of “excess savings” but also on the trade ties with Country A.
In Figure 4, we arbitrarily depict some equilibriumpoint Ea non-distorted integrated
equilibrium between Countries A and C. Again, both countries avail themselves of
identical endowments, technology, preferences and are at least weakly diversi?ed. At
the non-distorted equilibrium E trade ?ows between Countries A and C are balanced
inz the long-run, i.e. possible changes in export supply X
s
y
or import demand, for
instance, in the course of some exogenous shocks, are only temporary. At this stage,
export supply X
s
y
on the horizontal axis refers to the positive difference of produced
(denoted by a sub-index p) and domestically used (denoted by a sub-index u) quantities
of labor-intensive goods y. Accordingly, it applies that X
s
y
¼ y
p
2y
u
, whereas the
opposite pertains to an import demand. Since Countries A and C are identical, the
left-hand side of Figure 4 (i.e. Country A) is simply a mirror image of the right-hand side
(Country C), so that we simply depict excess demand in Country A by M
d
y
¼ 2X
s
y
:
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Henceforth, arguing Country C’s perspective, enables us to elaborate on the in?uence
that ?nancial repression in Country C exerts on import-export relations. In this respect,
the country-speci?c (nonetheless identical) relative price levels P on the vertical axis are
of relevance. As we have already argued, a surge in relative price levels results in a
relatively increased production of labor-intensive goods and a contraction of
capital-intensive production, respectively. Therefore, export supply in Country C
results from changes in the differential y
p
–y
u
whereas y
p
rises and y
u
declines in P
according to our previous analysis in the discussion of Figure 3, so that:
X
s
y
¼ hðPÞ; whereas h
0
ðPÞ . 0: ð12Þ
From this starting point, we can now portray the implications of ?nancial repression on
import-export ?ows. The point Gdepicts the outset of ?nancial repression in Country C,
which ultimately breeds the new bended integrated equilibrium E
*
in the course of
opening up to international trade. Graphically, this implies that the constrained export
supplycurve has a horizontal segment GE
*
that corresponds to the Rybczynski segment
of the constrained production possibility frontier. In Figure 4, we depict this along with
Country A’s import demand curve for a case in which countries are otherwise identical.
Because of the mirror-imaging within this two country world the accrued export supply
X
s
y
in Country C is identical with the import demand M
d
y
of Country A (i.e. the line
segment between E
*
and the vertical axis P)[6]. At the same time, the relative price level
P has also adjusted upward towards P
*
in Country A ensuring that the new integrated
equilibrium rental rate on capital will be is at a level of r
*
. r.
Accordingly, we may now argue that the upward bended relative price corresponds
to Country C’s real exchange rate and inversely affects its terms of trade. This is to say
that Country C improves its terms of trade with the help of ?nancial repression. As
indicated in the FPE set (see above), the according “excess savings” amounting to in D
*
Country C (see above) are transferred in terms of an export supply of labor-intensive
goods X
s
y
. At the same time, Country A heavily borrows from Country C and absorbs
these “excess savings,” which, in turn, allows for spurring capital-intensive production
in Country A. From the viewpoint of Country C, this is simply an export of its real
appreciation pressure towards Country A via its downward bended terms of trade.
Figure 4.
M
d
y
P
h
A
(P)
h
C
(P)
h
C
(P
*
)
G
X
s
y
E
h
A
(P
*
)
E
*
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Interestingly, therefore, it is the labor force in Country Cthat bears the burden of internal
economic adjustment to suppressed real appreciation.
One may also think of adding diverging factor endowments between the Countries A
and C in our baseline HOS-model set-up[7]. Assuming, for the moment that Country Ais
relatively well endowed with capital and Country C has a comparative advantage in
labor-intensive production in combination with ?nancial repression, we could establish
a similar result. As this process would not deliver any substantial new insights to the
debate, but rather an additional reinforcement of our results, we do not pursue this
extension to our framework. Instead, we are more concerned about demonstrating, how
?nancial markets in mature economies, such as the USA, might have reacted to these
trade distortions. We are especially interested in linking our theoretical model to the
recent ?nancial crises. For that reason, we subsequently put forth a line of argument on
the role of ?nancial market imperfections in mature and ?exible market economies,
which might have ampli?ed the effect of distorted trade relationships with a group of
non-mature, real appreciation suppressing countries.
3.7 An extension to the theoretical framework: ?nancial market imperfections
Without going into excessive formal modeling, we want to explain how these warped
trade patterns have been ampli?ed via ?nancial market imperfections in a ?exible
market economy, such as the USA. Given exported “excess savings” from real
appreciation controlling economies, US ?nancial markets have reacted to these in?ows
in some form of overshooting, which has resulted in a consequent lending boom in the
last years (Dell’Arricia et al., 2008; Mendoza and Terrones, 2008 for a comprehensive
empirical survey). At the empirical end, it is still an open question whether there is a
distortion in fundamentals. Although Caselli and Feyrer (1997) do not ?nd any
differences in the marginal product of physical capital within a sample of 53 countries,
our notion of capital-intensive production rather pertains to the sectoral marginal
productivity, i.e. capital-intensive production also comprises the ?nancial service sector.
In this regard, Cova et al. (2009) referring to the role of productivity differences in the
tradable and non-tradable sector in the presence of ?nancial frictions provide some
empirical evidence for our line or argument. For that reason, as we have argued in earlier
sections, the capital-intensive sector in the USA has disproportionately gained in terms
of a surge in capital asset returns from trade ties with real appreciation suppressing
countries. In addition, we want to highlight the fact that ?nancial market imperfections
in combination with adverse regulatory and banking policies have substantially
contributed to an overreaction in US ?nancial markets to these developments (Acharaya
and Schnabl, 2009).
In order to capture this economic trade-off relationship, capital rent rate movements
have to be linked to the monetaryside of the economy and to ?nancial markets. However,
banks and monetary policy in a simple dichotomous economic framework play a minor
role, as deposits have to equal bonds and loans by de?nition in a stylized macroeconomic
setting (Bernanke and Blinder, 1988). Nevertheless, several empirical and theoretical
assessments point to the fact that the process of monetization in the economy can hardly
be controlled by central banking authorities, as monetization and subsequently
allocation of ?nancial assets is primarily taking place in global ?nancial markets
(Stiglitz and Greenwald, 2003; Rogoff, 2006). In this respect, the credit creation
mechanismof ?nancial intermediaries generates some roomfor maneuvering. This is to
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say that lending booms in the formof rapidly increasing credit to the private sector have
substantially contributed to real money supply shifts, which have been observed in the
US economy[8]. In this respect, the microeconomic structure of ?nancial markets plays a
central role for the ef?cacy of monetary policy. Impending incentive problems and
asymmetric information might lead to substantial deviations of interest rates, which
?nancial intermediaries charge on their creditors and depositors (Stiglitz and Weiss,
1981; Mishkin, 2007). In this context, banks and ?nancial intermediaries demand
collateral to ensure their outstanding credit. In presence of even small changes in
fundamentals due to shifts in the terms of trade, balance sheets of ?rms might improve
rising nominal collateral values and thus affect the lending behavior of banks (Kiyotaki
and Moore, 1997). Given the key result of our model that trade openness between mature
and non-mature economies induces a shift of production towards capital-intensive
production in mature, ?exible market economies, and thus rise cash-?ows and pro?ts of
producers in this sector, collateral lending procedures will lead to an increase in lending
in the mature ?exible market economy. Consequently, an exogenous shock such as a
policy induced distortion of trade relations via ?nancial repression in one country can
amplify real economic distortions via ?nancial market frictions (Gopinath, 2004; Aghion
and Banerjee, 2005). This phenomenon has been introduced into the monetary
economics literature by Bernanke et al. (1999) as the ?nancial accelerator mechanism
(further, Kiyotaki and Moore, 1997; Matsuyama, 2007). In presence of a ?nancial
accelerator, shocks to asset prices are ampli?ed through the balance sheets of companies
and ?nancial intermediaries. Following this line of reasoning perverse incentives on the
sides of borrowers and lenders translate into an overestimation of the net worth of ?rms
and thus ?rms’ capacities to borrow on domestic and foreign capital markets, increase
the overall level of bank credit in the economy (Dell’Arriccia and Marquez, 2006).
However, if the pro?t performance of ?rms cannot be satis?ed, expectations turn sour
and a devaluation of asset prices hits ?nancial markets and thus balance sheets of
creditors (Allen and Gale, 1999; Borio and Lowe, 2002).
In this situation an asset price de?ation might trigger a credit crunch, tipping the
economy into recession (Bernanke et al., 1999). In this regard, even small cyclical
economic upturns (e.g. productivity shocks) can trigger a lending boom, which is
conditional on the severity of ?nancial market frictions and their regulation. Hence,
increasing income levels due to changes in overall productivity can also lead to demand
driven expansions of the economy, which in turn might be ampli?ed via a ?nancial
accelerator. In our model, which we have introduced in previous sections, such an
exogenous shock arises fromdistorted ?nancial markets in real appreciation controlling
economies. In addition, if an according expansionary economic process is ?nanced via
international savings, as has been the case with the US economy, shocks in domestic
productivity might lead to a surge in foreign capital in?ows, impacting the real
exchange rate and thus amplifying business cycle swings (Gopinath, 2004). For that
reason, we are convinced that distorted trade relations in combination with adverse
?nancial market regulation and subsequent banking policies, are at the root of the recent
?nancial turmoil.
4. Conclusions and outlook
As we argued at the start, crisis resolution depends upon crisis causes. However, in
contrast to an isolated monetary approach, we have put forth an analytical framework
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of international trade economics in order to investigate the root causes of recent ?nancial
turmoil in a broader context. We demonstrate howeconomic dynamics in an asymmetric
global economic integration process have contributed to fuelling international liquidity
and thus contributed to an expansion of ?nancial markets in mature, ?exible market
economies beyond their fundamental economic capacity. In this regard, our central
assumption has been that ?nancial repression has been applied in non-mature
economies in order to prevent real appreciation pressures, as well as to stabilize
economic growth processes in these economies (Aghion and Banarajee, 2005; Rodrik,
2008). However, these policy measures have worked as a push factor and a driving force
behind international capital ?ows to mature ?nancial markets. Applying an HOS-model,
we could establish a link between ?nancial repression in real appreciation controlling
economies, and warped relative prices in global production. An astonishing ?nding of
this process is that comparatively low-capital endowed economies engage in ?nancial
repression, and thus produce substantial “stalled investment” (i.e. a de-capitalization
process). From a balance-of-payments perspective these “stalled investments” are
equivalent to “excess savings” exported via the current account. An analysis of FPE in
an integrated global equilibriumalso shows that ?nancial repression in non-mature, real
appreciation suppressing economies results in upward bended capital intensity in the
sector of capital-intensive production in mature economies. At the same time,
labor-intensity increases in the sector of labor-intensive production in non-mature
economies. Inline with existing literature, ?nancial repression may be interpreted as a
device for spurring export-led growth in non-mature economies.
For this reason, we argue that latter non-mature economies are the “producers” of the
global savings glut, which, in turn allows for capital intensi?cation in the sector of
capital-intensive production in mature and thus ?nancially developed and liberalized
economies. The consequent absorption of international liquidity may nevertheless also
re?ect global asset shortages (Caballero et al., 2008) as depicted in the fall of global
capital intensityin the integrated world equilibrium. The combination of boththe saving
glut and a lack of appropriate ?nancial market regulation has been fuelling consumption
and production in these mature economies beyond their fundamental capacities. From
this perspective standard approaches and measures applied in assessing ?nancial and
macroeconomic vulnerabilities must have failed to show signs of overexpansion and
misalignments. In fact, a large current account de?cit in combination with a stable US
dollar exchange rate and increasing labor productivity in the USA in recent years have
rather been persuading policy makers and investors to put trust in the sustainability of
global imbalances. Nevertheless, given the results of our theoretical framework, an
arti?cial contraction of capital-intensive production in real appreciation controlling
economies lies at the heart of the economic expansion of ?nancial industries and
consumption in the USA beyond their fundamental limits.
According to this view from the production side, it becomes apparent that accruing
real misalignments between mature and non-mature economies in a globalized world
constitute a root cause of the current global ?nancial crisis. For that reason, any policy
measure aimed at restoring misaligned economic structures will lead to a freeze of global
imbalances, exposing mature and non-mature economies to substantial economic
vulnerabilities in the near future. Nevertheless, such demand-side oriented measures are
possible instruments which may deliver short-term relief to the global economy. At this
stage, however, escaping costly structural adjustments on the supply side in form of
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industrial cutbacks andrising unemployment will hardly be possible. In order to prevent
a potential collapse of the global economy in the medium to the long run, correcting
structural misalignments should be high on the policy agenda. Hence, ?xing according
structural misalignments on a global scale with the help of international policy
coordination may represent the natural order of things. However, as long as this is not a
viable policy option, potential second-best solutions for mature, ?exible market
economies may comprise imposing trade sanctions on labor-intensive import goods
unilaterally. Although such policies would certainly mitigate the extent of structural
misalignments in the world economy, such measures would also erode the bene?ts of
trade and ?nancial globalization and mark the renaissance of protectionism.
Notes
1. The argument that changes in the terms-of-trade impact on household savings decisions has
been ?rst formulated in the works of Harberger (1950) and Laursen and Meltzer (1950). In this
regard the Harberger-Laursen-Metzler effect describes a positive relationship between changes
in the terms of trade and saving, as a result of consumption smoothing. For a survey of related
literature and a recent theoretical contribution on the relationship between the terms-of-trade
shocks and savings given borrowing constraints see Agenor and Aizenman (2004).
2. Although an economic policy stance building on ?nancial repression has remarkably lost
momentum in the last decades (Fry, 1988; Abiad et al., 2008) for an empirical survey on
related ?nancial matters), there is some empirical evidence that policy measures of a similar
nature have been applied to support a real undervaluation conducive to economic growth
(Prasad and Rajan, 2006; Rodrik, 2008).
3. Looking into labor market wage dynamics would yield a similar result. Imagine the wage
rate would be ?xed at a rate lower than in the competitive scenario, an excess demand for
labor-intensive goods would result in the closed economy setting, which is similar in its very
nature to our “excess savings” results.
4. Again, the technologies and preferences in the two countries are identical to the ones in the
closed economy. The technologies are assumed to be constant returns to scale, while
preferences are homothetic and identical.
5. The attentive reader will be aware that at this stage we would encounter the problem of
Ricardian dynamic effects in reference to the endogeneity of capital (particularly, Baldwin
(1989); further, Krugman (1995b) on “factor content” and factor prices). Please note that the
purpose of this paper is to show that ?nancial repression in non-mature economies results in
real undervaluation. We show that such sti?ing of real appreciation results in exporting
“excess savings” in form of labor-intensive goods (see below). Here, however, we do not enter
into a discussion of the stock-?ow problematic of increasing capital intensity in the
production in mature, ?exible market economies. This issue may be subject to future
research.
6. Actually, this import demand, i.e. a current account de?cit, must be balanced in terms of an
export of liabilities via the capital account.
7. Furthermore, one could think of any extension along the key assumptions of the classical
HOS-model set-up and along the lines of a dynamic international macroeconomic model
(Lane, 2001).
8. For a survey of literature on the credit channel Bernanke and Gertler (1995) and for an
empirical treatment on the US subprime mortgage market Dell’Arricia et al. (2008). For an
open economy exposition of a ?nancial accelerator mechanism Tornell et al. (2004),
Aghion et al. (2004) and more recently Rancie`re et al. (2008).
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International Monetary Fund, Washington, DC, May.
About the authors
Andreas Kern is a Senior Research Assistant at the Jean Monnet Centre of Excellence for
European Integration at the Free University Berlin.
Christian Fahrholz is a Senior Researcher at the Chair for Economic Policy at
the Friedrich-Schiller-University Jena. He is also af?liated with the Graduate Programme
“Global Financial Stability” (Stiftung Geld und Waehrung – Deutsche Bundesbank) at the
Friedrich-Schiller-University and the Zukunftskolleg at the University of Konstanz.
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This article has been cited by:
1. Christian Fahrholz, Andreas Freytag. 2011. Whither the TARGET2 System? Taking a Glance at the Real
Economic Facets of the Euro-Area Debt Crisis. Applied Economics Quarterly 57, 15-25. [CrossRef]
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doc_265833173.pdf
This paper inquires into the root causes of global imbalances from an international trade
perspective. The purpose of the paper is to establish a conceptual framework that links financial
market governance, international trade and financial market integration, and to derive implications for
the global financial crisis
Journal of Financial Economic Policy
Global imbalances and a trade-finance-nexus
Andreas Kern Christian Fahrholz
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Andreas Kern Christian Fahrholz, (2009),"Global imbalances and a trade-finance-nexus", J ournal of
Financial Economic Policy, Vol. 1 Iss 3 pp. 206 - 226
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Global imbalances and a
trade-?nance-nexus
Andreas Kern
Jean Monnet Centre of Excellence, Freie Universitaet Berlin,
Berlin, Germany, and
Christian Fahrholz
Friedrich-Schiller-University Jena, Jena, Germany
Abstract
Purpose – This paper inquires into the root causes of global imbalances from an international trade
perspective. The purpose of the paper is to establish a conceptual framework that links ?nancial
market governance, international trade and ?nancial market integration, and to derive implications for
the global ?nancial crisis.
Design/methodology/approach – In order to analyze global imbalances, the paper draws on a
theoretical Heckscher-Ohlin-Samuelson international trade model, in which it compares two open
economies, solely differing in their ?nancial market governance structures. Building on these ?ndings,
the paper extends the analysis to the role of ?nancial market frictions in propagating global
imbalances into excessive lending in high-income economies.
Findings – To that extent, it argues that global imbalances are due to impasses in international
production. This paper argues that countries seeking to suppress real appreciation have engaged in
?nancial repression, which has, via ?nancial globalization, translated into excessive expansion of
?nancial service sectors in ?exible market economies.
Research limitations/implications – In order to derive a tractable framework, the abstract from
inter-temporal aspects and from an in-depth analysis of ?nancial modelling issues. Owing to the static
nature of the set-up, the analytic link between global imbalances and the global ?nancial crisis is intuitive.
Practical implications – Given that differences in national ?nancial market governance in?uence
the direction of international capital and trade ?ows, it argues for more international policy
coordination in preventing future crisis.
Originality/value – The unique feature of the contribution is that it links ?nancial market
governance and international trade to international ?nancial market integration in a tractable
theoretical framework.
Keywords Financial markets, Governance, World economy, Trade balances
Paper type General review
1. Introduction
Many analysts agree that the resolution of the current ?nancial crisis depends upon its
causes. Some debates in the public sphere have identi?ed the greed of ?nancial investors
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1757-6385.htm
JEL classi?cations – E22, E44, F11, F36, F41
The authors want to thank all their colleagues for inspiring discussions and interchange during
the writing process. For their invaluable research assistance, the authors want to express their
gratitude to Julian Bo¨rner, Cordelia Friesendorf, Tillmann Immisch, Jocelyn Ng and Maximilian
Weingartner. The authors are particularly grateful to the anonymous referees who helped further
streamline the review paper. It goes without saying all remaining errors are solely the authors’
fault.
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pp. 206-226
qEmerald Group Publishing Limited
1757-6385
DOI 10.1108/17576380911041700
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as the original sin. In sharp contrast to such a scapegoat approach, some academic
researchers have highlighted the fact that ?nancial intermediation has been subject to
sensible policy decisions directed towards deregulation of ?nancial markets (Spaventa,
2008). Particularly, dysfunctional central banking policies, especially in the US in terms
of too lax monetary policies, have been identi?ed in the recent academic literature for
having aggravated economic performance. Having decreased interest rates to
historically low rates in response to a bursting dot.com-bubble, the US central bank’s
interventions have rather resulted in throwing increasing amounts of money down the
drain. According to this view, the global savings glut is particularly due to overly
relaxed monetary policies in the USA since the beginning of the new century (Boeri and
Guiso, 2008). In this context, however, an enquiry into the fundamental causes of the
global savings glut and subsequent global imbalances has been far less developed. This
especially applies to export-oriented economies which may be at the heart of global
imbalances (Lane and Milesi-Ferretti, 2005; Eichengreen, 2008). In this paper, we argue
that global imbalances are the result of politically induced distortions in international
production and specialization.
We set forth that, in particular ?nancial repression in emerging market economies has
put the chains on real wages and real exchange rates, respectively, spurring economic
growth in the short-term not only within the emerging economies themselves but also in
mature economies (Montiel and Serve´n, 2008; Rodrik, 2008). Consequently, rather
controlledeconomies have concentratedonexportinglabor-intensive production, whichin
the presence of command economy style distortions has been re?ected in a remarkable
savings glut. To cope with distorted competition in international production – due to
suppressed upward pressures in real wages abroad – few options exist for more mature
economies: possible reactions of rather ?exible market economies comprise of lowering
real wages and/or pushing ahead with the marginal product of other factors, such as
capital or land. As depressing real and correspondingly nominal wages vary considerably
is not a viable option for rather ?exible market economies. Spurring the marginal product
of capital and land have thus been the only appropriate reaction to distorted international
competition. Academic researchers have already scrutinized the in?uence that relative
price and terms of trade distortions, due to labor-market rigidities, exert on other global
competitors (Krugman, 1995a). However, the causal relationship between ?nancial
repression and excessively labor-intensive production in restrained economies on one
hand, and severe distortions inproduction specializationinmarket economies onthe other
hand have not been prominently discussed in the academic literature so far. We develop a
line of theoretical arguments alongside a Heckscher-Ohlin-Samuelson (HOS) model and
demonstrate theoretically, why ?nancial repression in large real appreciation controlling
economies has substantially contributed to an increase in ?nancial market activities and a
corresponding increase in the marginal product of capital in mature market economies.
According to our line of argument, suppressing real appreciation in rapidly growing
economies results in the production of high-net saving surpluses, i.e. an export of real
appreciation pressures and severe global imbalances, which are at the heart of the present
?nancial crisis.
The remainder of the discussion surveys the relevant literature on the global
imbalances and a corresponding global savings glut in Section 2. Subsequently, in
Section 3, we develop a theoretical framework comprising a stylized HOS-model with
?nancial repression. Section 4 brie?y delineates the perils of ?nancial market
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imperfections that may further exacerbate global imbalances due to their pro-cyclical
impact on economic formation. Finally, Section 5 summarizes key insights from the
analysis and sketches policy implications.
2. Review of the literature
There exists a vast amount of literature on the interdependencies of relative prices in a
two-country world. Explaining trade relations inthe world froma factor endowment and
production side perspective lies at the heart of the HOS-model. Krugman (1995a), for
instance, examined the impact of a trade shock on a minimum wage constrained Europe
and a ?exible-wage America, concludingthat it would raise unemployment inthe former
and reduce wages in the latter. His study, on a theoretical plane, belongs to earlier works
of comparative studies. That is to saythat he examines one countryat one time. As Davis
(1998) shows however the results might change dramatically if a global perspective
is added to the discussion, in which Europe and America exist in the same world. In this
respect, the latter author argues that engaging in trade between a ?exible-wage America
and a rigid-wage Europe also raises wage levels in the former economy. Most notably,
the author posits the “insulation hypothesis,” according to which wage rigidities in
Europe completely insulate the American economy from new market entries by
low-skilled “Southern” labor. Our analysis aims at identifying a related argument
towards the root causes of the present ?nancial crisis.
Authors, such as Boeri and Guiso (2008) argue that the crisis has its origin in Alan
Greenspan’s low-interest rate policy (former President of the US Federal Reserve Board),
which injected enormous amounts of liquidity into the global ?nancial system. Contrary
to this argument, Ioannidou et al. (2008) have shown that despite the theoretical appeal
and widespread resonance of this argument, the empirical evidence is not suf?cient to
support a robust link between monetary policy and bank risk-taking. Bearing this in
mind, we emphasize that global imbalances, due to distortions in relative prices and
terms of trade, lie at the heart of the problem.
The idea of identifying global imbalances as the origin of ?nancial crises is not new.
Many authors have identi?ed differences in the level of ?nancial development and
subsequent reserve hoardings in countries like China as being responsible for global
imbalances (Aizenman, 2007; Rajan, 2008). As McKinnon and Schnabl (2008) argue,
despite massive efforts by the People’s Bank of China to sterilize the monetary
consequences of the reserve buildup, China has become an in?ationary force on
American and Europeanprice levels. According to these authors, this observation canbe
attributed to China’s excess liquidity spilling over into the world economy. Following
Tyers (2008), any change in policies directed at savings, dividends, ?scal expansion, and
privatization would raise China’s apparent production costs relative to foreign
investment and would retard investment. Therefore, instead of ?owing out to ?nance
China’s trade surplus, the People’s Bank of China has used its liquidity to accumulate
large amounts of foreign exchange, mainly in the form of US treasury bonds (Freytag,
2008; McKinnon and Schnabl, 2008). This fact indicates that, inline with Davis’
argument, national factor market institutions matter as they profoundly affect global
patterns of output, employment and wages (Davis, 1996). This however poses a serious
weakness to China, as it could contribute to a misallocation of resources for investment
(Barnett and Brooks, 2006). According to the latter authors’ argument, the drivers of
?xed asset investment have been real estate, manufacturing, and infrastructure.
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Focusing more on the internal effects of Chinese ?nancial repression, Lardy (2008)
argues that ?nancial repression, de?ned here as low or negative real return on deposits,
has seriously distorted the structure of demand. While the decline in real interest rates
has reduced the costs of maintaining an undervalued exchange rate, increasing
in?ation has eroded household consumption in gross domestic product (Lardy, 2008).
Although this observation runs seemingly counter to our argumentation, we concur
with Prasad and Rajan (2006, p. 332) that “?nancial system repression has meant that
there are few alternatives to funneling these savings into deposits in the state-owned
banking system.” In this regard, prevailing implicit deposit insurance schemes have
increased the willingness of households to hold bank deposits, despite the weakness of
the banking system. Nevertheless, the main channel of private savings can be traced to
an over-competitive export sector and thus be tracked on the production side of the
economy. From this perspective, savings are generated in the form of ?rm pro?ts,
which are additionally supported from policies preventing a real appreciation of the
domestic currency (Aizenman, 2007). Therefore, distorted relative prices stemming
from ?nancial repression are leading to “excess savings” in the economy.
At the same time, US consumption has been a major driving force behind the growth
of global demand (Obstfeld and Rogoff, 2004). While the US personal saving rates have
been very low, driven by an unsustainable rise of house prices and historically
low-interest rates, growth in China has been accompanied by a rocketing household
saving ratio (Modigliani and Cao, 2004). Although the current account surplus and the
massive excess liquidity have come at the expense of investment and consumption, the
imbalances have bene?ted the Chinese economy as well (Eichengreen and Park, 2006). In
addition, a rapid integration of the international ?nancial system has enabled these
imbalances to persist (Obstfeld and Rogoff, 2004; Lane and Milesi-Ferretti, 2008).
Differences in ?nancial market developments have led more advanced ?nancial markets
to accumulate foreign liabilities in a gradual, long-lasting process (Mendoza et al., 2008).
This clearly differs from the standard view that mature industrial countries should be
exporting capital to poor developing countries due to a relatively higher marginal
product of capital. Gruber and Kamin (2005) highlight that per capita income, relative
growth rates, ?scal balances, demographic variables, and economic openness cannot
account for the global pattern of current account imbalances. Our argument is, therefore,
that for example China’s concentration on labor-intensive production and the according
export of goods and capital via the terms of trade, have forced the USAand other ?exible
market economies to focus on capital-intensive production and subsequently lead to a
surge in borrowing[1]. In this regard, globalized ?nancial markets have allowed China to
sustain USA demand by exporting its “excess savings,” speci?cally for the most part to
the said US economy.
3. Theoretical framework
The aim of this theoretical analysis is to develop a global-trade model between two
groups of countries, i.e. ?exible market economies on one hand and a group of
non-mature economies controlling real appreciation on the other hand. This theoretical
framework may then reveal the root causes of the present ?nancial crisis.
In deriving our model along the lines of the HOS-model, we broadly follow Davis
(1998) and proceed ina ?ve step course. Ina general equilibriummodel, we ?rst highlight
the in?uence that ?nancial repression, i.e. a lower bound oncapital asset returns, in a real
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appreciation suppressing, non-mature economy exerts on production. In this context, we
show that these ?nancial repression mechanisms have the same effect as an upper
bound on real wages in a closed economy. This symmetry can easily be derived by the
so-called Lerner condition in the discussion on the symmetric nature of export subsidies
and import taxes. Incorporating the central result of the Stolper Samuelson theorem on
factor price equalization (FPE) inour model (Stolper and Samuelson, 1941), we are able to
show that ?nancial repression is conducive to an undervaluation of the real exchange
rate[2]. This portion of the analysis yields that suppressing real appreciation results in
the generation of “excess savings” in the formof “stalled investments” in the non-mature
economy. In the second stage of developing our theoretical arguments, we demonstrate
with the help of simple arithmetic in balance-of-payment matters that the latter savings
push ahead with current account surpluses. Third, in an open economy model with an
integrated equilibrium of international FPE (Dixit and Norman, 1986), this “push” is
depicted in terms of increasing capital-intensity within a mature, ?exible economy in
reaction to ?nancial repression in a non-mature economy. Fourth, a model of
global-trade patterns demonstrates that ?nancial repression in opening-up, non-mature
economies indeed stimulates production as well as savings, which are absorbed and
quasi “pulled out” by the ?exible economy. Finally, we set forth that sti?ing real
appreciation in a non-mature economy takes place in the form of exporting
labor-intensive production towards the mature economy. This is to say that real
appreciation pressures are exported to ?exible market economies. In this respect, one
could think of net saving surpluses and/or capital ?ight to a safe haven (Antras and
Caballero, 2007; Dooley et al., 2007), which are re?ected in large current account
surpluses. Consequently, the ?exible market economy builds up foreign liabilities,
which re?ect a surge in real interest rates above their fundamental level (Gopinath,
2004). Following this line of reasoning, we additionally argue that an economic bubble in
?nancial markets might occur due to insurmountable ?nancial market imperfections
within the ?exible market economy (Allen and Gale, 2000).
The conclusion of our analysis is that both misalignments in balances of payments
and global-trade relations stem from warped relative prices in non-mature economies
seeking real undervaluation. Such catch-up strategies actually rely on exporting real
appreciation pressures to ?exible market economies thus precipitating ?nancial crises
such as the latest turmoil occurring in the USA.
3.1 Setting the stage: autarky
We consider a closed economy, which has two factors of production, i.e. capital and
labor, at its disposal. These factors are available in ?xed supply given by K and
correspondingly L. These input factors are used to produce two goods under an
omnipresent production technology subject to a conventional Cobb-Douglas production
function with constant returns to scale. The economy can produce the good x, which is
capital-intensive, and the labor-intensive good Y. As in the stylized HOS-model set-up,
preferences are homothetic and both goods are used in the economy. We denote w to be
the return to labor, r to represent the return on capital, and P to be the resulting relative
price of x in terms of y. In a fully ?exible economy the competitive cost conditions c
ensure that for each sector the sector price has to equal marginal costs of production:
c
x
ðw; rÞ ¼ P and c
y
ðw; rÞ ¼ 1; ð1Þ
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whereas, P denotes the relative price between capital and labor-intensive goods.
Furthermore, it can be assumed that production takes place ef?ciently and that therefore
the following conditions have to be satis?ed:
K
x
þ K
y
¼ K and L
x
þ L
y
¼ L; ð2Þ
Given Walras’ Law, goods market clearing is ensured by the equality of demand and
supply. In the following paragraphs, we utilize Davis (1998) in establishing three key
relationships. First, we establish the link between the relative endowment and capital
intensity k ¼ K/L and the relative price level P in the fully ?exible economy. Inline with
the Heckscher-Ohlin theorem a rise in capital abundance reduces the relative price of the
capital-intensive good. For the sake of the argument, we propose the following equation
to capture these characteristics of the theorem:
P ¼ f ðkÞ; whereas f
0
ðkÞ , 0: ð3Þ
The latter function implies that the relative price P declines with increasing capital
intensity k in production.
In a second step, we include the Stolper-Samuelson proposition in order to establish a
direct link between factor and relative good prices. Given a speci?c relative factor price,
a rise in the real interest rate can be traced back to a decline in relative good prices in
terms of a labor-intensive good unit y. That is to say that a corresponding reduction in
the produced amount of capital-intensive goods relative to labor-intensive goods may be
due to a change in factor prices, i.e. here the real interest rate. An according change in the
rental rate on capital shifts the economy towards labor-intensive goods production.
Given that the capital-intensive good is x, we can thus derive the following
Stolper-Samuelson condition for the real interest rate depending on the relative price P:
r ¼ gðPÞ; whereas g
0
ðPÞ . 0: ð4Þ
Thus, given the relative capital endowment ratio and capital intensity k of the closed
economy, we can directly determine the equilibrium goods relative price in the ?exible
market economy as well as the resulting real interest rate:
r ¼ gðPÞ ¼ gð f ðkÞÞ: ð5Þ
These equations are thus suf?cient to establish a general equilibriumin goods andfactor
markets. In the following section, we introduce a politically induced market distortion,
i.e. ?nancial repression.
3.2 Financial repression
For the sake of simplicity and taking the Walras’ Law into consideration, we model the
market distortion as a minimum rental rate on capital assets r
*
. r, which is identical
to a form of ?nancial repression with the aim of preventing real appreciation. Our
argument can theoretically be traced in the works of Aghion et al. (2004) and Rodrik
(2008), in which ?nancial repression interms of capital controls and excessive borrowing
constraints prevents a real appreciation (Aghion and Banerjee, 2005). This assumption
is consistent with a stable equilibrium featuring diversi?ed production, if and only if
the relative goods price is P
*
¼ g
21
ðr
*
Þ . P (Figure 1).
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This would be the equilibriumgoods price, if and only if employed factors are in the ratio
k
*
¼ f
21
ðg
21
ðr
*
ÞÞ , k: Accordingly, capital that would have been employed in
production in the case of no ?nancial repression must be off-set in terms of “stalled
investments.” This is equivalent to saying that some portion of capital has been
squeezed out of economic production relative to original factor endowments. This
de-capitalization D
*
occurs in terms of:
D
*
¼ zðk
*
; K; LÞ; whereas z
0
ðk
*
Þ , 0 for all k
*
, k: ð6Þ
Hence, the ?nal quadrant simply depicts a crowding out of capital investments hinging
upon the level r
*
of ?nancial repression.
A ?exible interest rate will always ensure that capital will, at all times, be fully
employed. However, adding politically induced market distortions to the capital market
with a binding minimum on the rental rate of capital, a market clearing via the price
mechanism could potentially not occur. In the following subsection, we show that the
resulting real undervaluation is equivalent to a huge amount of savings.
3.3 Real appreciation controlling: a view from the balance of payments
In order to show that a savings glut results from ?nancial repression and a
corresponding drop in capital intensity amounting to, k
*
we expand our analysis
towards balance-of-payment issues. Although such an approach to balance-of-payment
matters presents an ex post view on the international ?ow of real quantities and
according claims and liabilities, a closer look at balance-of-payment matters prepares
the ground for the subsequent analysis of “excess savings” from the viewpoint of
international trade.
In the previous step, we have shown that ?nancial repression results in distorted
relative factor and good prices at level P
*
. In this respect, relative scarcity of capital is
tightened by not deploying capital in production amounting to D
*
at a level of capital
intensity k
*
, which is identical to an “excessive” savings behavior in the economy. With
r
*
¼ g(ƒ(k
*
)) subject to the endowments Kand L, “stalledinvestments” D
*
represent the
amount of capital de-invested in the economy. In reference to our comparative statics in
Figure 1.
Stolper-Samuelson Heckscher-Ohlin
Stalled investments
z (k*, K, L)
P
k
D
r
k r
f (k) g (P)
Capital market
r* k*
P
P*
D*
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*
must be
equivalent to “excess savings” in the economy.
In following the line of argument formulated by Freytag (2008) and without
distinguishing private and public consumption, equation (7) portrays domestic
production Y consisting of consumption C, domestic investment I
d
corrected by the
“stalled investments” D
*
and the current account in terms of the difference of exports
and imports (X 2 M). At the same time, equation (8) depicts the use of the present
production Y in terms of consumption C and savings S. In equilibrium overall savings
are identical to domestic investment I
d
corrected by the “stalled investments” D
*
,
foreign portfolio and direct investment abroad I
ƒ
as well as the change in foreign
reserves dR of the central bank (equation (9)):
Y ¼ C þ ðI
d
2D
*
Þ þ ðX 2MÞ ð7Þ
Y ¼ C þ S ð8Þ
S ¼ ðI
d
2D
*
Þ þ I
f
þ dR ð9Þ
I
f
þ dR ¼ ðX 2MÞ and S 2I
d
þ D
*
¼ ðX 2MÞ ð10Þ
The subsequent equations in equation (10) then highlight the fact that capital and
?nancial accounts, i.e. investments abroad and changes in the reserve level (I
ƒ
þ dR)
balance the current account (X 2 M). The latter trade balance must then be identical
with the level of “fundamental savings,” which are not invested in the domestic
economy, plus the “excess savings” due to the de-capitalization in the course of ?nancial
repression in terms of “stalled investments” D
*
.
The basic link between ?nancial repression and excess savings is rather simple: for
competitive ?rms to access ?nancial funds on capital markets at interest rate r
*
, they
need to sell-off their products at least at a relative price P
*
. When ?nancial repression
puts a binding constraint on ?rms, the goods price will only be attained, if the relative
scarcity of capital increases. This will apply only if a suf?ciently large share of capital is
unemployed in production[3].
These equations certainly describe identities that must hold true ex post. From a
viewpoint of the production side, however, we have explained in the previous subsection
on ?nancial repression that the emergence of “stalled investments” results from
distorted relative prices. This discussion on balance-of-payment issues shows that the
“stalled investments” must be identical to “excess savings.”
After having referred to production and balance-of-payment issues, we subsequently
develop an isomorphism between the closed economy with ?nancial repression and a
trading world, in which ?nancial markets are fully liberalized. This investigation
relies on the analysis of Dixit and Norman (1986), which has entered the literature as
the so-called “integrated equilibrium concept.” This concept allows for establishing
conditions under which trade in goods is suf?cient to establish the same world
equilibrium, as occurs in the closed economy setting with both goods and factor
mobility.
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3.4 Open economy model
We nowconsider the world economy consisting of two countries with free trade and zero
transaction costs[4]. The mature Country (A), representing the group of ?exible market
economies, has completely liberalized ?nancial markets, in which the interest on capital
assets is determined freely by market forces (Aghion et al., 2004; for an empirical
assessment see, for instance, Blanchard, 2007). The representative real appreciation
controlling economy (C) has imposed some form of ?nancial market repression to
support their economic development strategies, leading to an upwardly bended
minimum real interest rate r
*
, though still inline with competitive cost conditions (see
above). Let a bar of the variable represent the level of that variable in the integrated
equilibrium. Let index i represent goods and index j Countries A and C. The set of
divisions of world endowment among involved countries inline with the integrated
equilibrium concept can thus be described in the form of FPE set:
FPE ¼
½ðK
A
; L
A
Þ; ðK
C
; L
C
Þ?j’k
ij
$ 0
such that
j
P
k
ij
¼ 1
ðK
C
; L
C
Þ ¼
i
P
k
iC
ð
K
C
L
C
Þ þ ð0; D
*
Þ
ðK
A
; L
A
Þ ¼
i
P
k
iA
ð
K
A
;
L
A
Þ þ ðD
*
; 0Þ
i ¼ x; y j ¼ A; C
8
>
>
>
>
>
>
>
>
>
>
>
>
>
<
>
>
>
>
>
>
>
>
>
>
>
>
>
:
9
>
>
>
>
>
>
>
>
>
>
>
>
>
=
>
>
>
>
>
>
>
>
>
>
>
>
>
;
ð11Þ
These conditions are very intuitive. If the integrated equilibrium is to be replicated, the
global savings glut must be at the same level as in the integrated economy. But “excess
savings” do not arise in liberalized ?nancial markets in Country A. However, the real
appreciation controlling Country C must build-up “excess savings” in D
*
order to comply
with the stipulated r
*
. r, as shown in Figure 1. Beyond this, we only need to satisfy the
conventional restrictions in terms of employed factors. These require that both countries
use the integrated equilibrium techniques (with the capital intensities k
*
x
¼ ðK
*
x
=L
*
x
Þ and
k
*
y
¼ ðK
*
y
=L
*
y
Þ), and that the integrated equilibriumoutput in both sectors can be divided
among the countries. In a stable equilibrium, demand will exactly exhaust employed
factors in the two countries, which exist in the overall reduced ratio k
*
. The FPE set is
shown in Figure 2.
The width of the box portrays the world’s endowment of labor, while the height
represents the endowment of capital in the world. For the sake of simplicity, we presume
that under free and costless trade, competitive producers in the two countries face the
same goods prices, have the same technologies, and are at least weakly diversi?ed.
Without ?nancial repression in Country C the vector k
x
illustrates the factor ratio
employed in the sector of capital-intensive production, whereas k
y
represents the
quantities of capital relative to the quantities of labor employed in the production of
labor-intensive goods. The integrated equilibrium point E re?ects comparative
advantages in factor endowments. However, as soon as the real appreciation controlling
Country C resorts to ?nancial repression, “stalled investments” ensue amounting to the
line segment O
c
D
*
. These “stalled investments” are equivalent to unemployed capital in
production, which are substituted by labor and exported in terms of a global savings
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glut via the current account (see above). Under the conditions noted above, international
trade equalizes factor prices between the ?nancially liberalized economy A and the
?nancially repressed economy C. The FPE follows directly from the common
competitive cost conditions (see above). The according distortion in relative factor prices
resulting from ?nancial repression is re?ected in a shift towards a new integrated
equilibrium E
*
. At this point capital intensity in the production of the labor-intensive
good has decreased. Accordingly, the original vector k
x
, for instance, has been altered to
k
*
x
, which is longer and ?atter. The increase in size results fromfactor substitution in the
course of ?nancial repression, whereas the altered slope stems from the change in the
factor ratio of capital to labor. At the same time, capital intensity in the capital-intensive
production within Country A has increased from k
y
to k
*
y
. The actual length and
location of the “bended” vectors k
*
x
and k
*
y
depend particularly on factor substitution
elasticities of the productionfunction ineacheconomy. Inthe face of a global market, free
commodity trade fully equalizes factor prices and thus exports warped relative prices
from real appreciation controllers to ?exible economies. In the following subsection, we
inquire further into the formation of trade patterns distorted by ?nancial repression and
warped relative prices.
3.5 Trade adjustments in the course of ?nancial repression
In this section, we want to demonstrate how economic integration in the form of trading
between a mature, ?exible market economy A and a non-mature, and real appreciation
controlling economy C are impacting on both economies. In particular, we are interested
in investigating how ?nancial repression in one country affects the production in the
other country. For the sake of establishing our basic result, we start with a world in
which Countries A and C would be identical in any relevant economic key variable,
i.e. endowments, technologies, and preferences U. The only distinguishing feature
between both economies is that one economy is characterized by repressed ?nancial
markets, dampening credit/capital demand and accordingly sti?ing real appreciation.
Figure 3 shows the core aspects of the general trade equilibrium.
Figure 2.
O
c
O
A
k
k
*
k
*
x
k
*
y
k
y
k
x
D
*
L
L
K K
E
*
E
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The technological production possibility frontier is common to Countries A and C. In
Country C, to support ?nancial repression and the non-appreciation condition r
*
, the
equilibrium price must be P
*
. The composition of demand is given by a (P). Thus, under
full employment of capital assets and production at prices P
*
, Country C would be at G
and demand at G
0
. This implies an incipient demand for Q, tending to raise P as well as
lowering r below r
*
. However, the incipient fall in the capital rental rate is stanched via
“stalled investments” equivalent to an increase in savings in Country C (see above). In
the HOS-model framework it is particularly the Rybczynski (1955) theorem that deals
with the effects of endowment changes. Thus, at ?xed goods prices, an increase in
the endowment of one factor leads to a more than proportional increase in output in the
sector that uses this factor intensively. At the initial equilibrium price, this would be
expected to create an excess supply of the good that uses the factor intensively, hence,
lowering its equilibrium price. According to the Stolper-Samuelson condition, this
results in a decrease of the return to that factor. However, with one factor price ?xed,
i.e. ?nancial repression and an upward bended rental rate for capital, our result is just
the Rybczynski theoremin reverse. This is to say that output is shifted onto a ?nancially
repressed production possibility frontier towards the original demand line. Therefore,
production in the closed economy C would have to be at point F
*
, at which the
constrained supply exactly matches the demand at prices P
*
. The shift of production in
Country C fromGto F
*
re?ects the expansion of savings, exactly necessary to eliminate
the excess demand for capital-intensive goods (i.e. investment) indicated by the line
segment GG
0
.
Now we consider the case in which Countries A and C are trading freely. In order
to support ?nancial repression at level r
*
, Country C still needs to maintain price P
*
in
equilibrium. Since absorption is at point E
0
due to Country A’s original demand in G
0
,
this would require Country C’s production to be in point E
*
. As demand is homothetic
and production linear, the build-up of “excess savings” in moving from F
*
to E
*
surmounts the pre-existing “excess savings” of the previously closed economy in
Country C. This is to say that in this stylized framework the Country C’s opening of trade
Figure 3.
y
a (P)
G
G'
E
*
F
*
U
A
'
U
A
*
, U
C
*
U
A
,U
C
E'
Q
P
*
P
*
x
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with Country A would even further increase Country C’s “excess savings” in terms of
“stalled investments” andthe ruled-out demandfor capital-intensive goods in Country C,
respectively. The reason is that Country C would be “quasi-forced” to generate the full
integrated amount of savings to sustain at a level r
*
for both economies, which implies a
move from E
0
towards the integrated equilibrium E
*
(Figure 2). In Country A, the
absence of ?nancial market intervention comes at the cost of lower interest rates on
invested capital for investors. However, once trade commenced, the ?exible market
economy of Country A come to share Country C’s high real interest rate because it will
have to share the upward bended real interest rate r
*
. r.
The fact that Country A shares the high-interest rate r
*
under trade follows from the
fact that trade links goods prices, that both countries remain diversi?ed and that
producers still face competitive cost conditions. In effect, trade forces Country C to bear
the burden of “excess savings” to maintain Country C’s comparative advantage and
hinder a real appreciation. However, forcing capital markets in Country A to increase
capital rental rates up to a level r
*
implies that opening to free trade will lead to a
deviation of the capital rental rate fromits economic fundamental value. This would lead
to an over-utilization of capital and increasing capital intensity in Country A’s economy.
An economic bubble emerges at the heart of Country A, which cannot be detected by
simply looking at the fundamentals[5]. In order to illustrate our argument we are going
to establish an import-export framework.
3.6 Transfer of “excess savings”
In the following paragraphs, we highlight the fact that “excess savings” of Country Care
indeed exported to the ?exible market economy in Country A. The previously outlined
balance-of-payments arithmetic has already shown that real appreciation controlling
is achieved by a contraction of capital-intensive good production in terms of “stalled
investments,” fuelling the current account surplus of Country C. However, such
balance-of-payment matters only depict the ex post view on economic formation. This
subsection sets forth, how distorted relative factor and good prices affect the formation
of import-export relations ex ante. A framework of import demand and export supply
between Countries A and C ?lls this niche and buttresses the results gained thus far.
As we have demonstrated, the upward bended real interest constraint r
*
makes
Country C export “excess savings,”, i.e. real (excess) supplies, at a relative price level of
P
*
. The actual export volume not only depends on the level of P
*
, which re?ects various
corresponding levels of “excess savings” but also on the trade ties with Country A.
In Figure 4, we arbitrarily depict some equilibriumpoint Ea non-distorted integrated
equilibrium between Countries A and C. Again, both countries avail themselves of
identical endowments, technology, preferences and are at least weakly diversi?ed. At
the non-distorted equilibrium E trade ?ows between Countries A and C are balanced
inz the long-run, i.e. possible changes in export supply X
s
y
or import demand, for
instance, in the course of some exogenous shocks, are only temporary. At this stage,
export supply X
s
y
on the horizontal axis refers to the positive difference of produced
(denoted by a sub-index p) and domestically used (denoted by a sub-index u) quantities
of labor-intensive goods y. Accordingly, it applies that X
s
y
¼ y
p
2y
u
, whereas the
opposite pertains to an import demand. Since Countries A and C are identical, the
left-hand side of Figure 4 (i.e. Country A) is simply a mirror image of the right-hand side
(Country C), so that we simply depict excess demand in Country A by M
d
y
¼ 2X
s
y
:
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Henceforth, arguing Country C’s perspective, enables us to elaborate on the in?uence
that ?nancial repression in Country C exerts on import-export relations. In this respect,
the country-speci?c (nonetheless identical) relative price levels P on the vertical axis are
of relevance. As we have already argued, a surge in relative price levels results in a
relatively increased production of labor-intensive goods and a contraction of
capital-intensive production, respectively. Therefore, export supply in Country C
results from changes in the differential y
p
–y
u
whereas y
p
rises and y
u
declines in P
according to our previous analysis in the discussion of Figure 3, so that:
X
s
y
¼ hðPÞ; whereas h
0
ðPÞ . 0: ð12Þ
From this starting point, we can now portray the implications of ?nancial repression on
import-export ?ows. The point Gdepicts the outset of ?nancial repression in Country C,
which ultimately breeds the new bended integrated equilibrium E
*
in the course of
opening up to international trade. Graphically, this implies that the constrained export
supplycurve has a horizontal segment GE
*
that corresponds to the Rybczynski segment
of the constrained production possibility frontier. In Figure 4, we depict this along with
Country A’s import demand curve for a case in which countries are otherwise identical.
Because of the mirror-imaging within this two country world the accrued export supply
X
s
y
in Country C is identical with the import demand M
d
y
of Country A (i.e. the line
segment between E
*
and the vertical axis P)[6]. At the same time, the relative price level
P has also adjusted upward towards P
*
in Country A ensuring that the new integrated
equilibrium rental rate on capital will be is at a level of r
*
. r.
Accordingly, we may now argue that the upward bended relative price corresponds
to Country C’s real exchange rate and inversely affects its terms of trade. This is to say
that Country C improves its terms of trade with the help of ?nancial repression. As
indicated in the FPE set (see above), the according “excess savings” amounting to in D
*
Country C (see above) are transferred in terms of an export supply of labor-intensive
goods X
s
y
. At the same time, Country A heavily borrows from Country C and absorbs
these “excess savings,” which, in turn, allows for spurring capital-intensive production
in Country A. From the viewpoint of Country C, this is simply an export of its real
appreciation pressure towards Country A via its downward bended terms of trade.
Figure 4.
M
d
y
P
h
A
(P)
h
C
(P)
h
C
(P
*
)
G
X
s
y
E
h
A
(P
*
)
E
*
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Interestingly, therefore, it is the labor force in Country Cthat bears the burden of internal
economic adjustment to suppressed real appreciation.
One may also think of adding diverging factor endowments between the Countries A
and C in our baseline HOS-model set-up[7]. Assuming, for the moment that Country Ais
relatively well endowed with capital and Country C has a comparative advantage in
labor-intensive production in combination with ?nancial repression, we could establish
a similar result. As this process would not deliver any substantial new insights to the
debate, but rather an additional reinforcement of our results, we do not pursue this
extension to our framework. Instead, we are more concerned about demonstrating, how
?nancial markets in mature economies, such as the USA, might have reacted to these
trade distortions. We are especially interested in linking our theoretical model to the
recent ?nancial crises. For that reason, we subsequently put forth a line of argument on
the role of ?nancial market imperfections in mature and ?exible market economies,
which might have ampli?ed the effect of distorted trade relationships with a group of
non-mature, real appreciation suppressing countries.
3.7 An extension to the theoretical framework: ?nancial market imperfections
Without going into excessive formal modeling, we want to explain how these warped
trade patterns have been ampli?ed via ?nancial market imperfections in a ?exible
market economy, such as the USA. Given exported “excess savings” from real
appreciation controlling economies, US ?nancial markets have reacted to these in?ows
in some form of overshooting, which has resulted in a consequent lending boom in the
last years (Dell’Arricia et al., 2008; Mendoza and Terrones, 2008 for a comprehensive
empirical survey). At the empirical end, it is still an open question whether there is a
distortion in fundamentals. Although Caselli and Feyrer (1997) do not ?nd any
differences in the marginal product of physical capital within a sample of 53 countries,
our notion of capital-intensive production rather pertains to the sectoral marginal
productivity, i.e. capital-intensive production also comprises the ?nancial service sector.
In this regard, Cova et al. (2009) referring to the role of productivity differences in the
tradable and non-tradable sector in the presence of ?nancial frictions provide some
empirical evidence for our line or argument. For that reason, as we have argued in earlier
sections, the capital-intensive sector in the USA has disproportionately gained in terms
of a surge in capital asset returns from trade ties with real appreciation suppressing
countries. In addition, we want to highlight the fact that ?nancial market imperfections
in combination with adverse regulatory and banking policies have substantially
contributed to an overreaction in US ?nancial markets to these developments (Acharaya
and Schnabl, 2009).
In order to capture this economic trade-off relationship, capital rent rate movements
have to be linked to the monetaryside of the economy and to ?nancial markets. However,
banks and monetary policy in a simple dichotomous economic framework play a minor
role, as deposits have to equal bonds and loans by de?nition in a stylized macroeconomic
setting (Bernanke and Blinder, 1988). Nevertheless, several empirical and theoretical
assessments point to the fact that the process of monetization in the economy can hardly
be controlled by central banking authorities, as monetization and subsequently
allocation of ?nancial assets is primarily taking place in global ?nancial markets
(Stiglitz and Greenwald, 2003; Rogoff, 2006). In this respect, the credit creation
mechanismof ?nancial intermediaries generates some roomfor maneuvering. This is to
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say that lending booms in the formof rapidly increasing credit to the private sector have
substantially contributed to real money supply shifts, which have been observed in the
US economy[8]. In this respect, the microeconomic structure of ?nancial markets plays a
central role for the ef?cacy of monetary policy. Impending incentive problems and
asymmetric information might lead to substantial deviations of interest rates, which
?nancial intermediaries charge on their creditors and depositors (Stiglitz and Weiss,
1981; Mishkin, 2007). In this context, banks and ?nancial intermediaries demand
collateral to ensure their outstanding credit. In presence of even small changes in
fundamentals due to shifts in the terms of trade, balance sheets of ?rms might improve
rising nominal collateral values and thus affect the lending behavior of banks (Kiyotaki
and Moore, 1997). Given the key result of our model that trade openness between mature
and non-mature economies induces a shift of production towards capital-intensive
production in mature, ?exible market economies, and thus rise cash-?ows and pro?ts of
producers in this sector, collateral lending procedures will lead to an increase in lending
in the mature ?exible market economy. Consequently, an exogenous shock such as a
policy induced distortion of trade relations via ?nancial repression in one country can
amplify real economic distortions via ?nancial market frictions (Gopinath, 2004; Aghion
and Banerjee, 2005). This phenomenon has been introduced into the monetary
economics literature by Bernanke et al. (1999) as the ?nancial accelerator mechanism
(further, Kiyotaki and Moore, 1997; Matsuyama, 2007). In presence of a ?nancial
accelerator, shocks to asset prices are ampli?ed through the balance sheets of companies
and ?nancial intermediaries. Following this line of reasoning perverse incentives on the
sides of borrowers and lenders translate into an overestimation of the net worth of ?rms
and thus ?rms’ capacities to borrow on domestic and foreign capital markets, increase
the overall level of bank credit in the economy (Dell’Arriccia and Marquez, 2006).
However, if the pro?t performance of ?rms cannot be satis?ed, expectations turn sour
and a devaluation of asset prices hits ?nancial markets and thus balance sheets of
creditors (Allen and Gale, 1999; Borio and Lowe, 2002).
In this situation an asset price de?ation might trigger a credit crunch, tipping the
economy into recession (Bernanke et al., 1999). In this regard, even small cyclical
economic upturns (e.g. productivity shocks) can trigger a lending boom, which is
conditional on the severity of ?nancial market frictions and their regulation. Hence,
increasing income levels due to changes in overall productivity can also lead to demand
driven expansions of the economy, which in turn might be ampli?ed via a ?nancial
accelerator. In our model, which we have introduced in previous sections, such an
exogenous shock arises fromdistorted ?nancial markets in real appreciation controlling
economies. In addition, if an according expansionary economic process is ?nanced via
international savings, as has been the case with the US economy, shocks in domestic
productivity might lead to a surge in foreign capital in?ows, impacting the real
exchange rate and thus amplifying business cycle swings (Gopinath, 2004). For that
reason, we are convinced that distorted trade relations in combination with adverse
?nancial market regulation and subsequent banking policies, are at the root of the recent
?nancial turmoil.
4. Conclusions and outlook
As we argued at the start, crisis resolution depends upon crisis causes. However, in
contrast to an isolated monetary approach, we have put forth an analytical framework
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of international trade economics in order to investigate the root causes of recent ?nancial
turmoil in a broader context. We demonstrate howeconomic dynamics in an asymmetric
global economic integration process have contributed to fuelling international liquidity
and thus contributed to an expansion of ?nancial markets in mature, ?exible market
economies beyond their fundamental economic capacity. In this regard, our central
assumption has been that ?nancial repression has been applied in non-mature
economies in order to prevent real appreciation pressures, as well as to stabilize
economic growth processes in these economies (Aghion and Banarajee, 2005; Rodrik,
2008). However, these policy measures have worked as a push factor and a driving force
behind international capital ?ows to mature ?nancial markets. Applying an HOS-model,
we could establish a link between ?nancial repression in real appreciation controlling
economies, and warped relative prices in global production. An astonishing ?nding of
this process is that comparatively low-capital endowed economies engage in ?nancial
repression, and thus produce substantial “stalled investment” (i.e. a de-capitalization
process). From a balance-of-payments perspective these “stalled investments” are
equivalent to “excess savings” exported via the current account. An analysis of FPE in
an integrated global equilibriumalso shows that ?nancial repression in non-mature, real
appreciation suppressing economies results in upward bended capital intensity in the
sector of capital-intensive production in mature economies. At the same time,
labor-intensity increases in the sector of labor-intensive production in non-mature
economies. Inline with existing literature, ?nancial repression may be interpreted as a
device for spurring export-led growth in non-mature economies.
For this reason, we argue that latter non-mature economies are the “producers” of the
global savings glut, which, in turn allows for capital intensi?cation in the sector of
capital-intensive production in mature and thus ?nancially developed and liberalized
economies. The consequent absorption of international liquidity may nevertheless also
re?ect global asset shortages (Caballero et al., 2008) as depicted in the fall of global
capital intensityin the integrated world equilibrium. The combination of boththe saving
glut and a lack of appropriate ?nancial market regulation has been fuelling consumption
and production in these mature economies beyond their fundamental capacities. From
this perspective standard approaches and measures applied in assessing ?nancial and
macroeconomic vulnerabilities must have failed to show signs of overexpansion and
misalignments. In fact, a large current account de?cit in combination with a stable US
dollar exchange rate and increasing labor productivity in the USA in recent years have
rather been persuading policy makers and investors to put trust in the sustainability of
global imbalances. Nevertheless, given the results of our theoretical framework, an
arti?cial contraction of capital-intensive production in real appreciation controlling
economies lies at the heart of the economic expansion of ?nancial industries and
consumption in the USA beyond their fundamental limits.
According to this view from the production side, it becomes apparent that accruing
real misalignments between mature and non-mature economies in a globalized world
constitute a root cause of the current global ?nancial crisis. For that reason, any policy
measure aimed at restoring misaligned economic structures will lead to a freeze of global
imbalances, exposing mature and non-mature economies to substantial economic
vulnerabilities in the near future. Nevertheless, such demand-side oriented measures are
possible instruments which may deliver short-term relief to the global economy. At this
stage, however, escaping costly structural adjustments on the supply side in form of
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industrial cutbacks andrising unemployment will hardly be possible. In order to prevent
a potential collapse of the global economy in the medium to the long run, correcting
structural misalignments should be high on the policy agenda. Hence, ?xing according
structural misalignments on a global scale with the help of international policy
coordination may represent the natural order of things. However, as long as this is not a
viable policy option, potential second-best solutions for mature, ?exible market
economies may comprise imposing trade sanctions on labor-intensive import goods
unilaterally. Although such policies would certainly mitigate the extent of structural
misalignments in the world economy, such measures would also erode the bene?ts of
trade and ?nancial globalization and mark the renaissance of protectionism.
Notes
1. The argument that changes in the terms-of-trade impact on household savings decisions has
been ?rst formulated in the works of Harberger (1950) and Laursen and Meltzer (1950). In this
regard the Harberger-Laursen-Metzler effect describes a positive relationship between changes
in the terms of trade and saving, as a result of consumption smoothing. For a survey of related
literature and a recent theoretical contribution on the relationship between the terms-of-trade
shocks and savings given borrowing constraints see Agenor and Aizenman (2004).
2. Although an economic policy stance building on ?nancial repression has remarkably lost
momentum in the last decades (Fry, 1988; Abiad et al., 2008) for an empirical survey on
related ?nancial matters), there is some empirical evidence that policy measures of a similar
nature have been applied to support a real undervaluation conducive to economic growth
(Prasad and Rajan, 2006; Rodrik, 2008).
3. Looking into labor market wage dynamics would yield a similar result. Imagine the wage
rate would be ?xed at a rate lower than in the competitive scenario, an excess demand for
labor-intensive goods would result in the closed economy setting, which is similar in its very
nature to our “excess savings” results.
4. Again, the technologies and preferences in the two countries are identical to the ones in the
closed economy. The technologies are assumed to be constant returns to scale, while
preferences are homothetic and identical.
5. The attentive reader will be aware that at this stage we would encounter the problem of
Ricardian dynamic effects in reference to the endogeneity of capital (particularly, Baldwin
(1989); further, Krugman (1995b) on “factor content” and factor prices). Please note that the
purpose of this paper is to show that ?nancial repression in non-mature economies results in
real undervaluation. We show that such sti?ing of real appreciation results in exporting
“excess savings” in form of labor-intensive goods (see below). Here, however, we do not enter
into a discussion of the stock-?ow problematic of increasing capital intensity in the
production in mature, ?exible market economies. This issue may be subject to future
research.
6. Actually, this import demand, i.e. a current account de?cit, must be balanced in terms of an
export of liabilities via the capital account.
7. Furthermore, one could think of any extension along the key assumptions of the classical
HOS-model set-up and along the lines of a dynamic international macroeconomic model
(Lane, 2001).
8. For a survey of literature on the credit channel Bernanke and Gertler (1995) and for an
empirical treatment on the US subprime mortgage market Dell’Arricia et al. (2008). For an
open economy exposition of a ?nancial accelerator mechanism Tornell et al. (2004),
Aghion et al. (2004) and more recently Rancie`re et al. (2008).
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About the authors
Andreas Kern is a Senior Research Assistant at the Jean Monnet Centre of Excellence for
European Integration at the Free University Berlin.
Christian Fahrholz is a Senior Researcher at the Chair for Economic Policy at
the Friedrich-Schiller-University Jena. He is also af?liated with the Graduate Programme
“Global Financial Stability” (Stiftung Geld und Waehrung – Deutsche Bundesbank) at the
Friedrich-Schiller-University and the Zukunftskolleg at the University of Konstanz.
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This article has been cited by:
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