Volume 7, Issue 2, April 2006
The Research Agenda: Pierre-Olivier Gourinchas on Global Imbalances and
Ever since David Hume's (1752) price-specie flow mechanism,
the dynamic process of adjustment of a country's external balance is one
the most pressing --and vexing-- question for international
The modern approach to this issue characterizes the dynamics of external
debt as the result of forward-looking savings decisions by households, and
investment decisions by firms, in market structures of varying degrees of
complexity. As Obstfeld (2001) remarks, "[this approach] provides a
conceptual framework appropriate for thinking about the important and
interrelated policy issues of external balance, external sustainability and
equilibrium real exchange rates". Yet in
most empirical studies, the theory
falls short of explaining the dynamics of the current account. External
adjustment has been the focus of much discussion recently, given the
unprecedented build-up of US external imbalances. The current account
deficits of the United States have steadily grown since the mid 1990s,
reaching 6.4% of GDP in 2005. This represents the largest deficit in world
history in dollar terms. Will such an imbalance be corrected, how and at
Pierre-Olivier Gourinchas is Assistant Professor of Economics at the
University of California, Berkeley. His main lines of research are on
precautionary savings and international financial integration. Gourinchas'
The research agenda I will discuss here today focuses on the historical
role of financial variables in this adjustment process. My first line of
research --with Hélène Rey from Princeton-- shifts the
focus of the analysis
from the current account to the net and gross international investment
positions and the role of valuation effects. My second line of research
--with Ricardo Caballero and Emmanual Farhi from MIT-- discusses the
financial development and emphasizes the global supply of financial assets.
In the following discussion, I consider each in turn.
1. The importance of expected valuation effects
The recent wave of financial globalization came with a sharp increase in
gross cross-holdings of foreign assets and liabilities (see Lane and Milesi-
Ferretti (2006)). Hence, it is quite natural to shift the emphasis to the
determinants of a country's net international investment position (NIIP).
Consider the US. Its NIIP is nothing but a leveraged portfolio, short in
dollar denominated US assets (US equity, corporate and government debt,
inward direct investment etc.) and long in foreign currency denominated
foreign assets (Japanese equity, direct investment in China, UK gilts etc.)
whose value is affected by fluctuations in assets and currency prices. The
upsurge in cross border holdings has therefore opened the door to
potentially large wealth transfers across countries, which may alter net
foreign asset dynamics. These valuation effects are absent, not only from
the standard theory, but also from official statistics since the National
Income and Product Accounts and the Balance of Payment report most items in
the current account at historical cost. Hence official data give a very
approximate and potentially misleading reflection of the change in a
country's true NIIP.
Here is a way to think about the orders of magnitude involved: at the end
of 2004, the Bureau of Economic analysis reports US gross external assets
and liabilities equal respectively to 85% and 107% of US GDP, implying a
NIIP of -22% of GDP. That year, the trade deficit on goods and services
reached 5.3% of GDP. The standard approach suggests that the US will need
to run significant trade surpluses, at some point in the future, to
stabilize its external debt. Part of the adjustment, however, may also come
from lower returns on US assets held by foreigners, relative to the return
on foreign assets held by the US, i.e. a wealth transfer to the US. Since
most US liabilities are denominated in US dollars, and approximately 70% of
US foreign assets are denominated in foreign currencies, this wealth
transfer can take the form of a depreciation of the US dollar. For
instance, consider an unexpected 10% depreciation of the US currency. It
implies, ceteris paribus, a transfer of 5.9% (0.7*0.85*0.1) of GDP from the
rest of the world to the US that would more than cover the trade deficit.
Could it be, then, that movements in currency and asset prices contribute
systematically to the adjustment process and if so, by how much?
One may be tempted to dismiss even the possibility of such predictable
valuation effects. After all, usual interest parity considerations would
rule them out: asset and currency prices should be expected to move in such
direction as to deliver similar returns, when measured in a common
currency. I will return to this important theoretical issue shortly, but I
want to concentrate first on what the data have to say.
The first task is to construct accurate measures of a country's NIIP at
market value. In Gourinchas and Rey (2006a), we assemble a quarterly
dataset of the US gross foreign asset and liability positions at market
value since 1952 disaggregated into four broad asset categories (direct
investment, equity, debt and other --mostly bank loans and trade credit),
and compute capital gains and total returns on these global
This exercise delivers a number of important "stylized facts." First, it
is well known that the investment income balance --the balance of
dividends and earnings on direct investment paid to and by the US-- has
remained positive despite mounting net liabilities. What is less well-known
is that the evidence on total return on US external assets and liabilities
is consistent with the evidence on yields: since 1952, the US enjoyed an
average annual excess return on its gross assets of 2.11%. Moreover, this
excess return has increased to 3.32% since the collapse of the Bretton
Woods system of fixed exchange rates. About one third of this excess return
reflects the role of the US as a world financial intermediary, borrowing
mostly in the form of low yield-low risk assets (loans and debt), and
investing in high yield-high risks assets (equity and FDI). The remaining
two thirds arise from return differentials within asset classes. This
reflects mostly the ability of the US to borrow at very low interest rates,
a fact sometimes interpreted as evidence of the "exorbitant priviledge"
the US enjoys from its unique position in the international monetary order,
as the issuer of the world's reserve currency.
Gourinchas and Rey (2005) turn to the question of the international
adjustment process. We cast the analysis in very general terms, relying
simply on a country's intertemporal external constraint and a no-Ponzi
condition, and characterize two adjustment channels. The traditional
"trade channel" links current imbalances to future trade surpluses. The
novel "valuation channel" shows that expected future excess returns on
can also potentially contribute to the process of adjustment. Formally, our
empirical approach builds on Campbell and Shiller (1988), who look at the
adjustment process of the dividend price ratio, or more recently Lettau and
Ludvigson (2001), who look at movements in the consumption-wealth ratio.
Like these papers, we construct a measure of cyclical external imbalances
--akin to the deviation from trend of the ratio of the trade deficit (the
flow) to the NIIP (the stock)-- and relate it to future expected net
growth and excess returns. In contrast with these papers, we allow for slow
moving structural changes in the data, capturing increasing trade and
financial integration. The empirical results indicates that up to 27%
of cyclical external imbalances are eliminated via predictable
adjustments in future returns, and 64% are eliminated via future
improvements in the trade balance, accounting for 91% of the
fluctuations in external imbalances. We then turn the argument on its head:
if the valuation channel is operative, current cyclical imbalances,
properly measured, should predict future excess returns, and possibly
future currency movements. There again, we obtain very strong
predictability results, from 1 to 16 quarters ahead, both in and out of
sample. A global imbalance today strongly predicts future positive excess
return on US external assets and a future depreciation of the U.S. dollar.
This last result is especially striking: the classic paper of Meese and
Rogoff (1983), established that no exchange rate model could significantly
outperform the random walk at short to medium horizons. Our results
decisively overturn their conclusion.
2. Valuation effects: some elements of theory
It is now time to return to the theory. As mentioned above, the empirical
evidence in favor of strong predictable valuation effects is quite
puzzling: why would the rest of the world agree to buy US assets (i.e.
finance the US current account deficit) if these assets are expected to
A successful theory will need two critical ingredients: consumption and
portfolio home biases. The former implies that a stabilization of the
current account must be accompanied by relative price and real exchange
rate movements. The latter requires that domestic and foreign assets are
imperfect substitute and implies that wealth transfers are accompanied by
predictable and partially offsetting exchange rate movements (see Obstfeld
(2004)). The connection between consumption and portfolio home biases is an
active topic of research (see Obstfeld and Rogoff (2000), Coeurdacier
(2005) and Heathcote and Perri (2005)). Under some conditions, home
portfolio bias can emerge as a consequence of the tilt in preferences
toward the home good.
Gourinchas and Rey (2006b) build on this literature. We consider a
two-country Lucas tree economy with complete markets and preferences for the
home good (see Kollmann (2006) for a related model). Preliminary results
indicate that, in models with perfect risk sharing, external adjustment
operates via strong and unexpected valuation effects, but no predictable
valuation effects. The intuition for that result is the following: in an
endowment economy, efficient risk sharing requires that a country runs a
trade deficit when domestic output is relatively low. To do this, the
planner's allocation generates an unexpected valuation gain that offsets
current and expected future trade deficits. One way to implement this
allocation is for foreigners to hold claims to the domestic tree and vice
versa: under reasonable preference assumptions, the negative domestic shock
lowers the value of domestic equity relative to foreign equity and
generates an unexpected capital loss for foreigners, which turns the
domestic country into a net creditor. In the meantime, the decline in the
relative supply of the home good requires an instant real appreciation,
followed by a subsequent depreciation. Crucially, this expected real
depreciation is offset by expected adjustments in asset returns. Therefore
it does not generate predictable excess returns nor contributes to the
Looking ahead, the next obvious step is to build general equilibrium
models of international portfolio allocation with incomplete
markets. I see this as a major task that will close a much needed gap in
the literature between effectively complete markets models and the special
cases that assume away predictable return or eliminate current account
fluctuations (see, inter alia, Baxter and Crucini (1995), Corsetti and
Pesenti (2001), Heathcote and Perri (2005), Pavlova and Rigobon (2003),
Tille (2005)). One interesting step in that direction is Evans and
Along the way, we are witnessing a renewal of interest in the old
partial-equilibrium portfolio balance literature of Kouri (1982), and more recently
Blanchard Giavazzi and Sa (2005), that generate predictable valuation
effects. In these models interest rates are constant and the exchange rate
performs the dual role of allocating global portfolios between imperfectly
substitutable domestic and foreign assets, and affecting the trade balance
through traditional expenditure switching effects. Whether the insights
from that literature survive in a modern dynamic global portfolio model is
a question of great interest.
3. The global supply of financial assets
Despite extensive debates on the factors behind the current "global
imbalances," few formal structures analyze the joint determination of
capital flows and asset returns. In my view, any successful theory should
address three stylized facts. The first is the well known increase in
current account deficits in the US, offset by surpluses in Europe, Japan
and since 1997, emerging and oil producing countries. The second fact, oft
cited in recent months, is the stubborn decline in long run world real
interest rates. The third fact is the sharp increase in the share of US
assets in the financial portfolio of the rest of the world.
Caballero, Farhi and Gourinchas (2006) develop a stylized model to account
for these three observations. Its key feature is a focus on the ability of
different regions to supply tradable financial assets, and how this impacts
equilibrium world interest rates and global capital flows.
The model is quite standard, except for two features. First, it assumes
that only a fraction of current and future domestic output can be
capitalized into tradable financial claims. The present value of the
remaining share of output constitutes a non-tradable financial asset.
Second, the model is non-ricardian: as in Blanchard (1985) or Weil (1987),
current households do not have full rights over the non-tradable asset:
some of these rights might belong to future unborn generations. In a
ricardian setting, the relative supply of tradable and non-tradable
financial assets is irrelevant: an increase in the share of income
capitalized into tradable assets increases the supply of those assets but
decreases the supply of non-tradable financial assets by the same amount,
and hence raises the demand for tradable financial assets one for one. This
leaves equilibrium allocations and interest rates unchanged. By contrast,
in a non-ricardian setting, an increase in the share of income capitalized
into tradable assets increases the total supply of financial assets and
affects equilibrium allocations.
The fraction of output that can be attached to tradable financial assets
might differ across countries, reflecting different levels of financial
development, of protection of property rights, of intermediation capital or
of any financial friction.
The model considers what happens when regions that are good asset suppliers
experience a sustained growth slowdown (continental Western Europe and
Japan in the early 1990s), or when the quality, or acceptance of financial
assets deteriorates (emerging Asia and Russia after the Asian crisis). In
both cases, the global supply of financial assets declines. This depresses
global interest rates, generates persistent capital flows into the US and
an offsetting current account deficit. From the good's market perspective,
global declines in the supply of financial assets abroad increases the
value of US financial assets, hence US wealth when portfolio are not
perfectly diversified. This increases consumption and leads to a trade
We extend the basic structure along two dimensions. First we allow for
domestic and foreign direct investment. Direct investment generates
intermediation rents for the US (as documented in Gourinchas and Rey
(2006a)) that further relax the US external constraint and finances
permanent trade deficits. Second, we introduce heterogeneous goods to
discuss real exchange rate determination. The exchange rate patterns
generated by the expanded model are consistent with the data, while leaving
the broader pattern of capital flows and global returns largely unchanged.
In the short run, under the assumption of home consumption bias, the
increase in US wealth translates into higher relative demand for US goods
and a real exchange rate appreciation. In the long run, we find that the
real exchange rate depreciates only moderately.
This line of research highlights the role of financial factors for current
imbalances. It indicates that the current configuration of asymmetries is
likely to continue until the conditions for the initial imbalances are
reversed (higher growth among asset suppliers, Europe and Japan, or
financial development among asset demanders, emerging Asia). Along that
path, the US may build large net external liabilities. Of course, such
leverage is risky. Our framework emphasizes that these risks do not arise
unavoidably from the current situation.
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Cycles and the Asset
Structure of Foreign Trade
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and Expectations of Future Dividends and Discount Factors
, vol. 1, pp. 195-227.
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," Quarterly Journal of Economics
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," NBER working paper 11155.
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"From World Banker
to World Venture Capitalist: US External Adjustment and
the Exorbitant Privilege
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diversification puzzle is not as bad as you think
," mimeo, NYU Stern
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EconomicDynamics Interviews David Levine on Experimental Economics
David Levine is the Armen Alchian Professor of
Economic Theory at the University of California, Los Angeles.
He is interested in the study of intellectual property and endogenous
growth in dynamic general equilibrium models, the endogenous formation of
preferences, institutions and social norms, learning in games, and the
application of game theory to experimental economics. He will
be the next president of the Society for Economic Dynamics. Levine's RePEc/IDEAS entry
EconomicDynamics: In your 1998 Review of Economic Dynamics article, the most cited so far in
this journal, you show that one can easily account for the altruistic and
spiteful behavior in dynamic experimental games. How did this article
influence subsequent experiments and the relevant literature?
David Levine: There were several elements of that paper: as you indicate, it examines
altruism and spite in experimental games. One finding is that altruism and
spite cannot be explained as a static phenomenon, but rather arises
dynamically as actions by players trigger feelings of altruism and spite
their opponents. However, it is apparent to anyone with a modicum of sense
that players in these experiments have altruism and spite, and many papers
making this point and proposing various models appeared before I wrote on
the subject - Rabin in particular was a leader. There were two innovative
elements of the paper. First, it proposed a particular signalling model of
altruism and spite. While this approach has not overrun the profession,
there is some very beautiful recent work by Gul and Pesendorfer taking an
axiomatic approach to interpersonal preferences, of which I am pleased
my rather ad hoc model turns out to be a special case of. However, I think
the main element of the paper that was significant was the effort to do
quantitative theory - that is,
to follow the calibration methodology of looking for a small number of
behavioral parameters - in this case measuring attitudes towards other
players - that are the same across many different data sets. This
methodology has been used with great success by Fehr and Schmidt - who
their own model of altruism and spite ("inequality aversion"), and who have
done a great many clever experiments giving players opportunities to
and reward each other.
In which areas do you see this kind of economic behavior to have an
impact? In other words, for which questions may the responses
be significantly influenced by this behavior?
DL: It is easier to answer the opposite question: where does altruism and
not have important economic consequences? I think there is fairly
agreement about this: in competitive environments, interpersonal
do not play much role, because there is little scope for harming or
other people. Setting too high a price for your good doesn't harm your
customer because they can easily find another seller to sell to them at
competitive price. Similarly, you don't help or harm your competitors who
are able to sell pretty much what they want at the competitive price no
matter what you do. Setting too low a price helps your customer of course
but you are just transferring value to them on a 1-1 basis, and while the
evidence is that people are willing to be altruistic when the gains to the
other party are greater than the cost to themselves, they are less willing
to do so when the gains and the costs are equal. There is plenty of
that in competitive environments the competitive model - with selfish
preferences - does quite well; this is the thrust of the first
economics literature by Plott, Smith and many others. This idea is also
reflected in an earlier literature - particularly by Gary Becker -
out that racial discrimination and other related interpersonal preferences
do not thrive in a competitive environment.
It should also be emphasized that while some strangers in the lab playing
anonymously do behave altruistically and spitefully, the majority behave
selfishly. In non-competitive environments, some games are relatively
to the introduction of some players with deviant preferences; others are
not. Centipede grab-a-dollar type games, of the type studied by McKelvey
Palfrey, are very sensitive to players willingness to give money away in
final period. Even more economically important are finitely repeated
games. Here a little bit of non-selfish play - willingness to reward an
the last round - goes a long way. It is pretty well established both in
laboratory and out that a long finite horizon can induce quite a bit of
cooperation. I think it is pretty likely a consequence of preferences on
part of some people that care mildly about other players.
In practice I think a lot of institutions rely pretty heavily on a mild
degree of altruism by most people, and a lot of spite by a few. The
system - the rule of law - depends in my view quite heavily on this.
the desire for revenge, many fewer crimes would be reported. Bear in mind
that there is an important public goods aspect to reporting crimes. If
relatively neutral witnesses didn't have a mild preference for telling the
truth and "seeing justice done" it is hard to see how the system could
function particularly well.
ED: In game theory, the frequent multiplicity of Nash equilibria is dealt with
by refinements that sometimes are quite ad hoc. In which sense are
refinements in preferences such as the ones discussed above not subject to
DL: I'm not entirely sure of the analogy - the problem of multiplicity is that
the theory is inadequate; it does not have enough predictive power. The
problem with preferences is that the theory - at least using selfish
preferences - is wrong. But the issue of being ad hoc is certainly
in both cases.
A great deal of work on preferences that are altruistic and spiteful is ad
hoc; and some of it does not stand up well to scrutiny as a result. The
problem I see is that preferences that are an ad hoc solution to one
at the same time lead to nonsense results, or contradict existing theory
setting where existing theory does quite well. It isn't enough to show
a particular model of altruism and spite solves some particular problem.
has to be shown also that (1) it remains consistent with existing theory
domains where existing theory already works and (2) that is works across a
broad variety of different problems where altruism and spite exist.
Moreover, most preference puzzles are quantitative not qualitative, so I
think the scope for theories showing that particular modifications to
preferences shifts things in the right direction to explain one particular
anomaly are not all that useful at this stage. My paper used an ad hoc
description of preferences, but tried to bring some of this discipline to
bear. Fehr and Schmidt's work has also been aimed at providing broad
I also think that axiomatic theory of the type being conducted by Gul and
Pesendorfer is an important antidote to the ad hoc approach - it is a good
thing, in my view, that the type of preferences I examined satisfy the
Gul-Pesendorfer axiom system. The reason that the axiomatic approach is so
important is that it gives us a much broader understanding of what
preferences are like, what domains they are consistent with selfish
preferences over, and some general reassurance that they do not have
and undesirable features. It is not easy, given a particular functional
form, to see transparently what implications that function has in all
settings - that is, what axioms it might satisfy and violate. The
approach also enables us to know which variations on preferences are
"reasonable" in the sense of satisfying the same set of axioms, while
limiting the range of solutions we look for. How difficult would economics
be, for example, if for the most part we did not think that preferences
Becker, Gary S. (1971): The Economics of Discrimination
pages. University of Chicago Press.
Benoit, Jean-Pierre, and Vijay Krishna (1985): "Finitely
, vol. 53(4), pp. 905-922.
Dal Bó, Pedro (2005): "Cooperation
under the Shadow of the Future:
infinitely repeated games
", American Economic Review
Fehr, Ernst, and Klaus M. Schmidt (1999): "A Theory
Competition, and Cooperation
", Quarterly Journal of Economics
114(3), pp. 817-868.
Gul, Faruk, and Wolfgang Pesendorfer (2005): "The
Canonical Type Space for Interdependent
," mimeo, Princeton University.
Levine, David K. (1998): "Modeling
Altruism and Spitefulness in
," Review of
, vol. 1, pp. 593-622.
McKelvey, R. and Thomas Palfrey (1992): "An
experimental study of the centipede game
, vol. 60, pp. 803-836.
Plott, Charles R., and Vernon L. Smith (1978): "An
Experimental Examination of
," Review of Economic Studies
Rabin, Matthew (1993): "Incorporating
Fairness into Game Theory and
, vol. 83, pp. 1281-1302.
Roy Radner (1980): "Collusive behavior in noncooperative
of oligopolies with
long but finite lives." Journal of Economic Theory
vol. 22, pp. 136-154.
Smith, Vernon L. (1962): "An experimental study of
competitive market behavior", Journal of
, vol. 70, pp. 111-137.
Review: Singelton's Empirical Dynamic Asset Pricing
Empirical Dynamic Asset Pricing
by Kenneth Singleton
This book is at the intersection of modern time series and modern asset
pricing theory, two fields that are by themselves already challenging for
all graduate students. For those how have mastered the basics, Ken
Singleton gives us the ultimate treatise of empirical asset pricing.
The book is structured such that it can be read in different ways: there
are purely econometric chapters, only a few of which are required reading
for the rest, followed by chapters that cover dynamic asset pricing
theory, focussing on pricing kernels, linear and consumption-based models,
each first covering theory, then empirical methods that can test them. The
last part of the book treats no-arbitrage models in the same way. The
author does not just present models and methods, but also likes to discuss
results, both from his own, well-known research (with updates) and from
the current frontier. Thus it is possible to teach with this book either
empirical methods, asset pricing theory itself, or a combination of both.
This book is not an easy read, and thus clearly destined to teach the
advanced PhD student or serve as a reference to the researcher. But it is
sure to become a classic work in this field. It has all the necessary
ingredients: a systematic and thorough coverage of the relevant topics,
both the seminal and the latest, and an author who is a pioneer of the
"Empirical Dynamic Asset Pricing" is published by Princeton University
Review: Bertola, Foellmi and Zweimüller's Income Distribution in Macroeconomic Models
Income Distribution in Macroeconomic Models
by Giuseppe Bertola,
Reto Foellmi and Josef Zweimüller
There is a renewed interest in distributional issues in macroeconomics in responses to challenges in the social security system in many countries and concerns about the link between growth and inequality. This textbook fills a gap especially in the analysis of the growth model. There are various kinds of inequalities and the text tries to address all of them mostly with closed-form solutions: inequality in the remuneration of factors, inequality in the distribution of individual income and wealth, and inequality in the product mix.
This textbook does not attempt to be at the very cutting edge of research. Rather it tries to show how one can extend the representative agent model in interesting ways, i.e. how aggregates may influence distributional indicators or vice-versa. Results are generally of analytic nature and focus on key insights.It starts with the neoclassical growth model, gradually making it more complex by endogenising more variables, adding uncertainty in income or lifetimes, introducing market imperfections, market power and multiple goods. The analysis is complemented by numerous exercices and each chapter is concluded by a literature review of extensions.
While this book is probably not appropriate for a standalone graduate macroeconomics class, it can certainly complement one or serve as the basis for a second course. Researchers should also find the book useful to refresh their intuition or to discover new avenues.
"Income Distribution in Macroeconomic Models" is published by Princeton
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