Most of these reserves were accumulated by countries more or less explicitly targeting the US dollar and accumulating US liabilities. The resulting capital flow financed the US trade and current account deficits. But a trade deficit is contractionary: for any given level of domestic demand, it lowers domestic output. Thus, the US needed to expand domestic demand, in order to offset the contractionary effect of the external deficits. Some groups within the economy needed to spend more than their incomes. The most important such group turned out to be households. Thus the growth in US household indebtedness that led to today’s “credit crunch” is a direct result of the global imbalances.
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