KEY POINTS:
When the economic historians come to write their books on the origins of the current financial crisis we can expect to see chapters with titles like "Bretton Woods II" or "The Conjoined Twins".
In a timely and illuminating paper in the latest Reserve Bank Bulletin one of the bank's economists, Chris Hunt, argues that one of the striking features of the global economy in this decade - the emergence of very large current account imbalances - set us up for the current fall by helping keep credit cheap and encouraging risky behaviour by financial markets.
The term Bretton Woods II alludes to similarities with the arrangements which prevailed for a couple of decades after World War II. The parallels are far from exact but it crucially involves a mutually advantageous (for a while at least) co-dependent relationship between countries running current account deficits and those running surpluses.
It has allowed the latter to concentrate on export-led growth and the former, led by the United States, to import capital and spend more than their economies produce.
The total level of the current account imbalances has more than trebled since the start of the decade to more than US$3 trillion ($4.5 trillion) a year. The US accounts for half of the deficit and China almost a quarter of the surplus side.
At the heart of Bretton Woods II is the currency peg between China, the United States and most of the oil exporters of the Middle East. (But although China has the largest current account surplus, Japan and Germany have large ones too and the yen and the euro float.)
It is counter-intuitive to see trillions of dollars of capital flowing "up hill" from a fast-developing country like China to the richest country of all. Previous periods of substantial current account imbalances have been about capital flowing from rich countries to developing ones.
Chinese savings rates are high partly because limited social safety nets increase the need for precautionary savings.
And it is sometimes argued that the need to export much of those savings reflects the underdeveloped state of China's financial institutions, which still have elements of a command economy and may not be particularly efficient at putting those savings to good use domestically.
"China's export-led development model has been premised on pegging its currency to the US dollar at an undervalued rate in order to generate trade surpluses and accompanying foreign reserves," Hunt says.
The trauma of the Asian crisis 11 years ago encouraged many governments in the region to build up large foreign reserves to counter possible future speculative attacks on their currencies or capital flight.
The flipside has been the willingness, the downright eagerness, of the deficit countries to enjoy a housing and consumption-led boom funded in large measure by imported savings.
The principal mechanisms for this transfer of savings has been the accumulation of reserves by central banks and the recycling of petro-dollars through the sovereign wealth funds of the oil-exporting countries.
Much of it has ended up as holdings of US Government debt (of which there is about US$10 trillion).
So we have ended up with a system which tended to keep the US dollar higher than it might otherwise have been, because much of the primary, net demand for dollars has been to buy not American exports but Chinese exports or oil.
Perhaps more importantly it has tended to keep US interest rates lower than they would otherwise have been. Those low interest rates and the associated housing boom turbocharged household consumption, and not only in the United States.
New Zealand households benefited too as banks tapped offshore credit markets to fund relatively cheap fixed-rate mortgages.
Hunt contends that the global savings glut encouraged the development of new markets and financial instruments designed to generate a return on all that extra liquidity. That includes the runaway growth in securitised debt products like the mortgage-backed securities.
In short it helped inflate the bubble which has now gone so messily pop over all of us.
It has had its drawbacks for the surplus countries as well, especially those which have pegged their currencies to the US dollar.
The People's Bank of China has to buy prodigious quantities of US dollars to prevent its own currency from rising as China's massive current account surpluses imply it should.
This means China is running two risks. One is that the value of its holdings of securities denominated in US dollars will decline as the dollar falls.
But the bigger danger is that the Chinese authorities will be unable to adequately "sterilise" their foreign exchange intervention by mopping up equivalent liquidity within China through debt issuance. To the extent they cannot, it swells their money supply and fuels inflation.
Confronted with inflation pressure at home and a sharply slowing world economy, what will they do?
Moving towards a floating exchange rate for the renminbi would be helpful. It is generally best to have prices that tell you the truth, even if they are prone to exaggeration at times.
The currency peg with the US dollar only means that the real exchange rate adjusts through inflation rates, not that it does not adjust at all.
But it remains to be seen whether policymakers in Beijing draw that conclusion.
The partner in that now dysfunctional co-dependent relationship, the United States, right now is in a sorry state, caught between frozen credit markets on the one hand and self-serving backwoods legislators on the other. In effect it is confronting the absurdity of trying to maintain a position of global hegemony on borrowed money.
So the willingness of emerging economies to pour their surplus savings into the US financial system, via purchases of government debt, must be in question at least in the torrential quantities we have seen for most of the decade.
But the United States still has the capital inflows it needs to fund its current account deficit, which has fallen to about 5 per cent of GDP, despite the significant depreciation of the US dollar.
This reflects the United States' role as a safe haven in times of risk aversion and the apparent desire of many emerging countries to maintain export competitiveness.
Rising risk aversion won't be pleasant for New Zealand.
Adjusted for the size of the economies, our external accounts are worse than the United States', with a current account deficit of 8.4 per cent of GDP (the long-run average is about 5 per cent) and net international liabilities of $160 billion or 90 per cent of GDP.
Unwinding untenable current account deficits involves some combination of a weaker currency and slower economic growth. The more it happens through the exchange rate, the less growth has to suffer.
But given how much of what we consume is imported, a weak kiwi dollar will be no fun for the household sector.
