. second, china can take advantage of the lessons learned by others during the asian crisis, when many countries experienced that small reserves in a period of economic turbulence can be hazardous. third, china requires substantial savings to prepare for the future needs of an ageing population. the export surplus combined with high domestic investment may be a sound savings strategy. nonetheless, changes in china ’ s policy are no doubt on their way. an appreciation in real terms seems inevitable, potentially through higher domestic cost and price pressures. there are already clear indications of this. western economies, however, should not primarily be looking to remedy their own trade deficits via china ’ s exchange rate policy. the imbalances in the us and europe are the result of countries living beyond their means. deficit countries must come to grips with their own problems. capital flows and real interest rates as a mirror image of the trade imbalances, capital has flowed from emerging economies to rich countries. normally, capital flows to the highest returns. this would imply that capital is transferred from countries with a large capital stock and inadequate savings to countries where the stock of capital is small and there are opportunities for profitable investment. in that case, capital should rather have flowed to emerging economies, and not the reverse, as we have witnessed in recent years. chart : saving and investment as a share of gdp looking back on the financial crisis, the question may be raised whether international capital markets have been able to cope effectively with large capital flows. a large savings surplus in asia has sought investment opportunities in rich countries. this has been possible, not because of high investment demand, but because of the sharp decline in saving in advanced economies. the high level of saving in asia has been the driving force and is the reason for the decline in long - term real interest rates. chart : us long - term interest rates the effect of global imbalances on long - term interest rates set the stage for the financial crisis. in the us, as shown in the chart, interest rates had shown a persistent downward trend. low interest rates induced investors to seek new investment opportunities in the search for higher returns. expected return rises with an increase in risk. a strong appetite for risk combined with financial innovation resulted in an underpricing of risk in financial markets, while low interest rates led households, enterprises and governments to overestimate their own ability to pay. combined with weak regulation and inadequate supervision of the financial sector, these were some of the root causes of the financial crisis.

##s ”. in such an environment, traditional checks and balances may become inadequate and easily lead to excessive risk 4. we have seen numerous examples where periods of exuberance were accommodated by the financial system, reflected by increasing leverage and asset price inflation, followed by a correction. without any doubt, the best example in dutch financial history is the tulip mania, which took place around 1635. this episode is especially known for its incredible price increases. at the peak, 14 thousand guilders were paid for a single tulip bulb – more than a workman earned in his entire life those days. less known is that the speculative bubble was largely driven by financial innovation. in the years before the tulip mania, new financial markets evolved in the netherlands, including a stock exchange and futures markets. sophisticated trading techniques were developed, allowing short selling and the use of put and call options. derivative contracts allowed massive trading in tulips that were not even planted yet – a genuine financial innovation at the time. many investors did not realise that these new instruments were inflating a speculative bubble on an unprecedented scale and lost all their money when the market collapsed after two years. the tulip mania illustrates how imbalances can develop when previous constraints are lifted – in this case by new financial tools allowing investors to take large speculative positions. but it also illustrates the role of naive optimism and even greed. 5. misguided incentives are often also at the root of growing imbalances, because of conflicting micro and macro perspectives. this is because at the micro level, market participants tend to take the environment in which they operate as given, for instance prices and the behaviour of other market participants. but factors that are considered exogenous at the micro level may become endogenous for the financial system as a whole. at the macro level, this easily leads to fallacies of composition. for example, for an individual investor, increasing leverage is a way to boost returns. but if everybody does this, without sufficient profitable investment opportunities, it can only be counterproductive by reducing long - term yields and raising risks. pro - cyclicality 6. a closely related issue is the financial system ’ s inherent pro - cyclicality. we all know that with a favourable economic outlook and upbeat financial markets, balance sheets look strong for both financial firms and their counterparts in the real economy. in such an environment, it is understandable that banks ’ lending criteria become looser and, for instance, pension contributions are