Stop obsessing about global imbalances

Uri Dadush, Vera Eidelman

Global imbalances and their effects on the global economy are much discussed. This column says that discussing global imbalances is popular because it is the easy way out. It says that policymakers should target the illness rather than the symptoms by reforming their domestic economies and focusing on sustainable growth.

The idea of “rebalancing” global demand – increasing demand in trade-surplus countries so as to lessen the world’s dependence on demand growth in the US and other trade-deficit countries – is once again in the spotlight. It was the focus of the G20 Finance Ministers Meeting in Paris and continues to be fountain of frustration for many policymakers and commentators.

But this emphasis is misguided. Most imbalances are not a problem in and of themselves and, in fact, many have fallen substantially since the crisis began. In theory, negotiations on trade imbalances enable countries to conduct international policy coordination but, in practice, reducing them has become an end in itself. Leaders have become embroiled in what feels like – but isn’t – a zero-sum game. Endless discussions about imbalance “indicators” have mainly succeeded in stoking currency tensions and protectionist sentiment.

Most importantly, debates around imbalances divert attention from what is really needed – domestic reform in the major economies, beginning with the US, which has driven the process.

Rebalancing during the crisis

The global credit crunch naturally led to a large rebalancing of global demand. Deficit countries such as the US and Spain had the biggest housing bubbles and most extended consumers prior to the crisis, and they experienced greater reductions in demand over 2008-2009 than did current-account surplus countries. International negotiations had little to do with the shift.

By and large, that rebalancing is expected to persist. Chastened households in the US, Spain, and Greece are saving more. Their banks are deleveraging, and many of their governments are retrenching – or will need to retrench. Meanwhile China is appreciating its real exchange rate at a 10% annual clip, and its new five-year plan emphasises domestic demand.

Table 1. Current-account balance, selected countries (% GDP)

2008 2009 2010 2011 (f) US -4.7 -2.7 -3.2 -2.6 China 9.6 6.0 4.7 5.1 Germany 6.7 4.9 6.1 5.8 Japan 3.2 2.8 3.1 2.3

Source: IMF.

Further rebalancing in the short term is unlikely, however. Faced with large output gaps and high unemployment, external deficit countries are now looking to revitalise domestic demand, while China and many other surplus countries are overheating.

Is rebalancing always good?

Current-account deficits and surpluses in the 3%-5% of GDP range – where most large countries fall today and will likely remain in the medium term – are not exceptional. Historically, they have been financed comfortably and adjusted to over time. In addition, these imbalances – and the international capital flows that mirror them – reflect mainly market-driven differences in savings trends and investment opportunities and are not primarily the result of manipulated currencies or hidden protectionism.

Consider the US. Its household savings rate is extraordinarily low and its fiscal deficit is huge, yet it ranks among the highest in the world in competitiveness, governance, and business climate scores. Moreover, it has the world’s deepest financial markets and holds the reserve currency. With such a low savings rate and favourable investment climate, it is hardly surprising that the US attracts as much foreign investment (the mirror image of its current-account deficit) as it does.

Now consider China. Its competitiveness, governance, and business-climate rankings are mediocre. Its capital markets are underdeveloped and its currency is not freely convertible. But its national savings rate is the highest in the world. Not surprisingly, despite its high investment rate, it generates excess savings, which are invested abroad and form the counterpart to China’s current-account surplus.

Viewed from this perspective, the imbalances are simply reflections of underlying domestic conditions and are only bad if they are clearly unsustainable – not the case today – or if something is amiss in the underlying domestic conditions. If the latter is the case, however, countries must act on those domestic conditions and not the imbalances directly. Acting on the symptom does not cure the disease and, in this case, can only make it worse by, for example, penalising trade (James 2010).

No international fix

Can countries rely on adjustments in their trading partners instead of enacting their own reforms? The answer is no. Imagine, for example, that China suddenly reduces its savings by 10% of GDP (approximately $500 billion) and spends all of this on imports, thereby becoming a larger external-deficit nation, proportional to its GDP, than the US is today. Assuming the new spending reflects current patterns, this massive shift would add just $40 billion to the demand for US exports – equivalent to a 9% reduction in the US current-account deficit and 0.3% of US GDP. In other words, asking Chinese policymakers to reduce the US current-account deficit is like asking the tail to wag the dog.

Similarly, insisting that China reduce its currency intervention will (if accompanied by more rapid growth) help China increase its income and consumption, but will have little effect on the external balance of most countries (see Ali and Dadush 2010). Moreover, because China’s revaluation would raise the price of its exports, it would almost certainly widen the deficits of countries that import significantly more from China than they export there, such as Italy and the US (Ikenson 2010), and could even raise their domestic inflation (Auer 2011).

The real issues are domestic

Why then does the global rebalancing dispute persist? Mainly because it is the easy way out. Blaming others is easier than confronting domestic problems and the constituencies that oppose change. But such a course will fail to sustain global growth.

To sustain global growth, change must start with the three countries at the heart of the dispute – the US, China, and Germany – and the needed changes are only indirectly linked to current-account deficits and surpluses.

The US is now growing at a solid pace and it should cease seeking more demand from its trading partners, most of which are either overheating or, in the case of the European periphery, need to retrench. Rather than focus on external demand (-3% of GDP), US policy should concentrate on how it can grow its domestic demand (103% of GDP) sustainably. The overwhelming priority now is to put in place a plan to reduce its fiscal deficit and remove a host of tax incentives that artificially depress its household savings.

China, meanwhile, needs to encourage more investment in its backward regions and to remove artificial incentives that favour its corporate sector at the expense of consumers. These include low dividend requirements for state companies and artificially low interest rates on consumer deposits. A better social safety net, financed by reductions in government surpluses, could also encourage private consumption. A gradual real appreciation of the renminbi (say 20% over three years), would – with these other measures – help boost incomes and encourage spending while helping to contain inflationary pressures, even if it does not necessarily do much for its trading partners.

Germany – with its large sway in Europe and solid fiscal and external positions – needs to help the fiscal and competitive adjustment in the Eurozone’s periphery as part of the euro rescue operation. Insofar as German wages and consumption are allowed to rise faster, the deflation needed in the periphery will be shallower and shorter and the need for expensive rescue operations will decrease.

Conclusion

It may surprise the reader that these reforms may or may not reduce global imbalances.

Fiscal consolidation in the US may, for example, increase not just savings but also confidence and investment there, leaving the modest current-account deficit little changed.

Currency appreciation and increased wages may lead not only to increased consumption but also reduced investment in China, having little effect on the trade surplus.

But if countries do not enact these reforms, the most significant adverse consequences will be domestic – a possible fiscal crisis in the US; an unsustainable and unbalanced growth model in China; and a potential disaster in the Eurozone.

Moreover, if confidence in the US and the Eurozone fails to recover (and especially if they continue to rely on very expansionary monetary policies), the stage may be set for another speculative boom-bust cycle, especially in rapidly growing emerging markets. Another crisis and surge in unemployment will lead to more currency tensions and possibly a wave of protectionism.

Thus, instead of obsessing over global imbalances, hard-working officials at the G20 and IMF would be well advised to “speak truth to power” and insist that leaders place domestic reforms and sustained growth at the centre of their discussions.

References

Ali S and U Dadush (2010). “Who gains from a renminbi revaluation?”, VoxEU.org, 9 December.

Auer R (2011), “What the renminbi means for American inflation”, VoxEU.org, 21 February.

Ikenson, D (2010), “Appreciate This: Chinese Currency Rise Will Have a Negligible Effect on the Trade Deficit”, Free Trade Bulletin No. 41, Centre for Trade Policy Studies, Cato Institute, 24 March.

James, H (2010), “The history of tackling current account imbalances”, in Stijn Claessens, Simon J Evenett, and Bernard Hoekman, Rebalancing the Global Econom