“Domestic or global imbalances? Rising inequality and the fall in the US current account” by Tobias Broer
This paper shows how the rise in individual income risk in the US since the 1980s could help explain the fall in its foreign asset position. The key to this result is endogenous financial deepening in an open economy where individuals can default on contracts, at the price of exclusion from financial trade. More volatile income makes default less attractive, and thus allows higher borrowing against future income. In a closed economy, this improves consumption smoothing across volatile income realisations (Krueger and Perri 2006). My theoretical results show how, in an open economy, relaxed default constraints from higher risk decrease stationary demand for aggregate consumption and assets with potentially no effect on consumption insurance, determined by world interest rates. In a quantitative two country general equilibrium analysis, the observed rise in US individual risk in the US strongly lowers its foreign asset demand. This is reinforced by a precautionary savings glut" from increased income volatility in an emerging economy, calibrated to the evolution of individual inequality in China, where the absence of insurance markets leaves no room for financial deepening.