The New Global Savings Glut and the Politics of Imbalances

Neil Irwin:

But it’s not just the United States and Japan. Name a country with three elements—a stable political system, a credible central bank to call its own, and a free flow of capital across its borders—and it has, right now, extraordinarily low interest rates. That’s true for Canada and Australia (10 year yields of 1.85 percent and 3.36 percent), of Switzerland and Sweden (0.55 percent and 1.6 percent). Britain, certainly (1.94 percent), but even some countries that don’t technically fit our classification because they lack their own central bank (Germany at 1.42 percent and France at 1.99 percent. That would be the same France that The Economist, in a cover story last month, called “the ticking time bomb at the heart of Europe.”).  

So what is going on? Interest rates are, essentially, the relative price of money today versus its value in the future. And investors are saying that they don’t need very much compensation to delay their spending for the future, as long as they can feel secure that they will get their money back and that the money they get back will be worth roughly what they put in. 

To put it a different way, around the world there are all sorts of savers—pension funds, wealthy individuals in emerging nations, governments that want to ensure they have reserves put aside in case there were to be a run on their currency—for whom the goal is not so much to get a big yield on their savings, but rather to ensure that they will get their money back when they need it.

I may have more to say about this over the coming weeks as I'm writing a book chapter related to the topic, but for now let me just mention that this isn't only about the domestic factors that Irwin describes. It is also related to broader developments in the global economy in recent decades. The only development model which has sustained success is export biased: emerging economies export resources and consumer goods to developed countries. Second, the opening up of global trade has increased reliance on comparative advantage, thus benefiting the owners of the abundant factor of production. Third, the decline in capital controls have allowed financial flows to increase markedly. These three factors have led to a world where trade flows constitute 60% of global GDP, international financial balance sheets are 150% of global GDP ($100 trillion), and income inequality has increased markedly.

But it also means that the global economy is fundamentally imbalanced: developing countries must run persistent current account surpluses, while developed countries must run persistent current account deficits. These must be offset by financial transactions: developed countries essentially hand over IOUs to developing countries. And this process must be indefinite; or, rather, they must continue until the whole world has reached roughly equivalent levels of development, until a new political system makes the export-biased development model impossible (restrictions on trade and/or capital movement), or until the imbalances reach a tipping point and a crisis ensues.

The question is what deficit governments should do in this environment. Irwin suggests that they should take advantage of cheap finance to make domestic investments in infrastructure and education. Another option is to try to reduce the probability of a future (domestic) crisis by balancing the books. In the 1990s they largely chose the latter, which ended up leading to crises in the developing world as imbalances unwound. In the 2000s they chose the latter, which ended up leading to crises in the developed world as imbalances fueled asset price bubbles in real estate and sovereign debt.

The story of the 2010s will be how these imbalances are managed.

Global Imbalances FOTD

By “Northern European,” I mean the 6 countries on the list above that lie between Switzerland and Norway. They have a $455 billion [current account] surplus, as compared to China’s $303 billion.

More here.

Will US Equity Values Decline Because of Demographics?

The SanFran Fed has published a research note on the value of US equities (with accompanying graph, above) that has attracted a fair bit of attention. Some key bits:

This evidence suggests that U.S. equity values are closely related to the age distribution of the population. Since demographic trends are largely predictable, we can forecast the path that the P/E ratio is likely to follow in the next few decades based on the predicted M/O ratio. ...

Despite theoretical ambiguities, U.S. equity values have been closely related to demographic trends in the past half century. There has been a tight correlation between population dependency ratios, such as the M/O ratio, and the P/E ratio of the U.S. stock market. In the context of the impending retirement of baby boomers over the next two decades, this correlation portends poorly for equity values. Moreover, the demographic changes related to the retirement of the baby boom generation are well known. This suggests that market participants may anticipate that equities will perform poorly in the future, an expectation that can potentially depress current stock prices. In that sense, these demographic shifts may present headwinds today for the stock market’s recovery from the financial crisis.

What this is basically saying is that stock market prices (relative to firm income per share) have tracked US demographics relatively closely over the past few decades. This is bad news for those invested in US equities because the US population is getting older, which means that there is likely to be more people seeking to sell equity investments to fund retirement than people looking to buy. If the supply of equities for sale shifts right, and the number of people with enough wealth to demand equities shifts left, then the price of equities is likely to fall. That's what the "model generated" portion of the graph above is showing.

But I don't buy it. As Ryan Avent notes, demographic trends are no secret, yet if supply is going to outstrip demand when retirees liquidate their equity portfolios the markets don't seem to have internalized the expectation.

More importantly, it's not clear to me that US demographic trends are the most relevant variable going forward. Capital is more internationalized now than at any point in history, and there are many more people in the global middle class than ever before, a trend that is expected to continue over the next 2-3 decades. For many of these people investing in US equities will be attractive, especially if the prices are low. Let's also remember that the US runs a very large current account deficit and is likely to continue doing so for the foreseeable future. That will have to be offset with financial transactions, and equities are one way to do that.

The authors mention the possibility of increased foreign ownership in passing, but it doesn't factor into their methodology. I think it probably should.

Some Politics of U.S. "Hooliganism"

Paul Krugman sends us to Vlad "the Destroyer" Putin:

“Look at their trade balance, their debt, and budget. They turn on the printing press and flood the entire dollar zone — in other words, the whole world — with government bonds. There is no way we will act this way anytime soon. We don’t have the luxury of such hooliganism,” he said.

As Krugman notes, it takes two to tango. A big reason the U.S. has such a large trade deficit is because emerging markets have undervalued their currencies relative to the dollar*. And the big reason the U.S. has engaged in so much monetary stimulus is to boost employment, some of which would could have happened through the nominal exchange rate if so many other countries weren't actively managing their currencies. But adjustment still needs to happen, so now we're seeing pressures on the real exchange rate rather than the nominal exchange rate. In other words, inflation in emerging economies will rise until things become more into balance. And now Russia, and China, and Brazil, and others are complaining about the inflationary pressures that U.S. monetary policy is putting on their economies. But they can't have it both ways: while the U.S. economy is depressed, adjustment has to coming through the nominal exchange rate or the real exchange rate.

This isn't hooliganism. This is using monetary policy in textbook ways. As it happens, U.S. monetary policy has a great effect on external economies, which is why Putin calls the whole world the "dollar zone", but let's be clear: those countries want the U.S. to pursue less expansionary monetary policy so they can free-ride on it. It's fine for them to have that preference, and as I've argued before, I think the U.S. should allow some free-riding. But the U.S. government has citizens to satisfy as well, so those countries can't very well expect the U.S. to pursue a contractionary policies while the economy is so weak.

Krugman explains this as "capital wants to go South". I actually don't think that's right. I think capital "wants" to go North: witness the flight to safety, the historically low U.S. bond rates, the fact that the S&P downgrade warning had no effect on those rates, the rallying U.S. equity markets. Look at how developed countries increased their holdings in U.S. banks immediately following the banking crisis (clear in the animation here).

There's nothing preventing capital flight from the U.S., and yet that hasn't happened. Likely because while the U.S. has some problems, compared to many other large economies they are manageable. They aren't trying to stave off the collapse of a currency union, or a nuclear meltdown, or all the things China has to deal with. There's a high demand for safe, liquid assets, and the U.S. public and private sectors can provide more of those anyone else. The U.S. is at the center of the global financial network, which appears to behave in some ways according to a preferential attachment decision rule. Remember the Leontief paradox: factor-price equalization is not always the norm.

The U.S. government, on the other hand, wants some capital to go South. In other words, it doesn't want deflation, and it does want some dollar depreciation to boost employment via exports. The South, on the other hand, doesn't want capital inflows. Brazil has put currency controls in place, China has a closed capital account and fixed exchange rates, etc. The U.S. is trying to force adjustment through the real exchange rate, meaning higher inflation in exporting economies with managed exchange rates. These choices are political, not responsive to some economic natural laws.

*There's a lot of moving pieces here: budget deficits are a result of tax cuts + spending hikes (Medicare Part D plus wars), and then the recession. This also feeds into the national accounts. And while that is an accounting identity, not a behavioral relationship, I don't think it's a stretch to say that deficit spending is encouraged by low borrowing costs. Indeed this is what the Keynesians are arguing now, and it's one reason why Dick Cheney said that "deficits don't matter". During Bretton Woods II, there's been a huge rightward shift in the supply curve of funds available for the U.S. (either as sovereign, or as businesses and individuals) to borrow. When that happens, we'd expect the quantity demanded and thus equilibrium debt levels of the U.S. to also go up.

Speculative Conjecture on Regulation and Crisis

Finally someone else is writing about the politics of financial regulation, so you know I'm all over this one. Riffing off of Reinhart & Rogoff (R&R) at The Monkey Cage, David Andrew Singer asks how we could know whether this time is different:

Financial crises happen regularly throughout history; indeed, R&R's analysis makes the enduring pattern of boom and bust perfectly clear. However, the book explains very little about the patterns it presents. The authors "select on the dependent variable" by examining only cases of countries in crisis, and as a result they are unable to make causal inferences. Are large capital inflows the root cause of the current financial crisis, and did they cause earlier crises throughout history? With no variation in the dependent variable, we cannot discern whether the alleged macroeconomic triggers are the real culprits, or whether other factors are at work. Examinations of past financial crises tell us little about whether or when current account deficits lead to financial instability, or about the political and institutional factors that might militate against systemic market failures.

The point here is that because R & R only look at crisis periods, and not non-crisis periods, it is impossible to know for sure whether the macro variables are really causing the crisis. For example, even if most crises occur when countries have high current account deficits, there are many periods when countries have high current account deficits and yet do not have financial crises. Looking only at crisis periods, we might conclude that current account deficits cause crises. Looking at all periods, not just crisis periods, we (might) conclude that they do not. Or we might find a conditional effect: rapid depreciations in the current account cause crises, but more gradual depreciations do not. Or maybe levels matter more than changes, or maybe there is an interactive effect between the current account balance and levels of national debt. Etc. This is why research is hard.

But then Singer goes on a harangue:

Despite the challenges of causal inference, many social scientists seem content to attribute the financial crisis to underlying macroeconomic imbalances. In my view, these arguments provide useful cover for financial regulators who might otherwise be held accountable for their rule-making. If systemic failure is the periodic and ineluctable result of global capital cycles, then there is little reason for regulators to enact tougher regulations. Why should central banks and regulatory agencies impose more stringent capital requirements and prohibitions against risky investments? If the roots of the crisis are macro-structural, regulators feel no incentive to alter the rules. How else can we explain why U.S. regulators, when facing the public or their overseers in Congress, speak of recent bank failures as if they were exogenous acts of nature? ...

From a research design perspective, a reasonable way forward is to test hypotheses about the conditional impact of capital inflows on the probability of financial crises in the developed world. The scope and quality of regulation are likely contenders for inclusion in such a model. The cases of Australia and Spain suggest that large capital inflows might be less destabilizing if the banking system faces strict capital requirements and prohibitions against non-traditional banking activities. Other possible conditioning variables include, inter alia, resource endowments, partisanship, and corporate governance.

Singer has done a lot of good research on regulation (as I am trying to do, now), so it makes sense that he thinks it's important. I do too. But as far as I know there is no persuasive research showing that crises are the result of poor or lax regulation either. At least not of the "large-N", quantitative variety. One of the reasons for this is that cross-national time series data on financial regulations are rare and incomplete. But even a cursory look across the past few years of history suggests it's more complicated than that. India was recently regarded as a paragon of financial stability... until it wasn't. In fact, the U.S. had stricter regulations pre-crisis (at least in terms of capital adequacy and leverage) than many other major economies, including Germany and Japan, and it's been the U.S. (and U.K.) pushing for tougher standards in the Basel negotiations.

Despite some harmonization through the Basel Accords, national regulatory standards still vary quite a lot. Nevertheless, the subprime crisis spread throughout the system in ways that make national regulatory standards look largely irrelevant. At least, there's no clear pattern to me. What best predicts exposure to crisis (to me) seems to be how integrated a country is in the international financial system, especially to the U.S. and U.K., and how large the banking sector is relative to GDP. Countries that were very tightly connected and had large financial sectors (e.g. Iceland, Ireland, the U.S. and U.K.) have suffered quite a lot. Those that were less integrated into the system or had smaller financial sectors (e.g. Australia, Brazil) have done better.

Singer mentions Spain as a positive example, which is curious because Spain is in the middle of a banking crisis right now that has already required massive public sector bailouts, and that appears to be intensifying and now is threatening to turn in a sovereign debt crisis. (Which is exactly what R&R would predict, by the bye.) This despite the fact that, as Singer notes, Spain has a relatively strict regulatory structure.

Considering a time series leaves us even more unsure. In the U.S., Glass-Steagall didn't prevent the crises revolving around the Latin American debt, savings and loans, and dot-com bubbles. The Basel Accords obviously didn't do their ostensible job either, either in the 1990s or 2000s. The U.K. had more financial instability before "light touch" than after, until 2008. It's not that crises are exogenous shocks; it's just that the regulatory structure doesn't appear to tell us too much about how susceptible to crisis countries are either. Of course we don't know that for sure, because data limitations have limited our ability to rigorously tests these claims. But it isn't obviously true, even if it is intuitive and intellectually appealing.

I think Singer is correct about his main point: R&R doesn't tell us everything we need to know. There are certainly intervening variables that are important, and strength of regulation may be one of them. In fact, I would be very surprised if regulation had no effect on stability or instability. But we also need to remember that regulations are political creations; there is no ex ante reason to believe that regulatory codes are even primarily intended to promote stability. Regulations affect distribution, and that makes them inherently political rather than technocratic. Indeed, much of the Dodd-Frank reform bill was about either punishing financial institutions, protecting consumers, shuffling regulatory authority, or winding-up failed institutions. Not a whole lot of it really concerned stability, and it didn't say much of anything about capital, liquidity, or leverage.*

Jeffrey Friedman has argued that specific parts of the regulatory code -- those privileging mortgage debt, asset-backed securities, and OECD sovereign debt -- made the system less stable. These parts of the regulatory code had an explicitly political purpose: to encourage home-ownership, especially among the lower classes, and to make access to bond markets incredibly cheap for governments. This ground is ripe for political economists.

Singer concludes with this:

Until we conduct more rigorous tests, social scientists will remain in the uncomfortable position of offering only speculation and conjecture. The availability of hundreds of years of data on previous crises should not give us a false sense of confidence about our capacity to explain. Indeed, we simply do not know whether this time is different or not.

I completely agree. I would argue that this applies equally to claims about the effects of regulation as well which are, as of now, at least as speculative and conjectural.

*Title I concerns financial stability, but mostly reorganizes already-existing regulators and tasks them with monitoring and addressing systemic weaknesses. It doesn't create any substantive new statutory requirements of banks.

Why Imbalances Will Persist, For Awhile At Least

Martin Feldstein is bullish on macroeconomic imbalances, and walks through the relevant savings-over-investment accounting identities (pdf available here). I recommend reading the whole thing, as its short and gives a very good overview of the situation. Basically, what he's saying is that the U.S.' current account deficit can be, and likely will be, shrinking sharply over the coming years, and it may disappear entirely:

Feldstein imagines the U.S. national saving rate rising by 2% of gross domestic product and budget deficits declining to 3% of GDP from 8%, producing a combined saving rise of 7% of GDP.

“These assumptions about private and public saving may be too optimistic but they indicate that closing the U.S. current account deficit is potentially feasible,” he said.

Meanwhile, China is directing more investment internally–spending more on health care, education and housing–as it looks to raise living standards.

“If China reduces its national saving rate from the current 45% of [gross domestic product] to 40% without a corresponding fall in investment, the result would be to shift China from having a current account surplus to a current account balance or even a small deficit,” he said.

If savings increase in the U.S. and investment does not, our current account deficit necessarily narrows. Likewise, if savings shrink in China and investment does not, their current account surplus necessarily narrows. It's as simple as that, and yet the political and economic forces behind those movements are a bit more complex. So as an outline of what is feasible his analysis is correct. As an outline of what is likely I'm not so sure. I do think imbalances will shrink some over the coming years, but probably not as much as Feldstein alleges. Here's why.

It will likely take five or more years for the U.S. to get back to full employment, which means that the public deficit is not likely to shrink to 3% of GDP any time soon. Politicians talk a lot about that, and so do voters, but I haven't seen any real momentum to get it done. In the meantime, as the financial sector strengthens and the real economy stays weak (prompting the Fed to continue to make cash available at low rates), credit will likely become more available more rapidly than incomes rise. When that happens I would expect savings rates to grow less slow or even decline. Moreover, the continuing aging of the population means that more and more of us will be drawing down private (and public) savings rather than building them up.

It's true that China is allowing the RMB to appreciate at 5% a year, and that internal inflation changes the real exchange rate faster than that, but it's not clear how long those two things will persist. If China has its own property bubble that then pops, we may see savings rates there increase or at least hold steady. Or we may see lower growth rates that again cause savings to go up as wealth creation drops. To me, political reform will have to happen in China before major economic reform happens, and that doesn't seem likely over any short time horizon. In any case, China is only one country, so even if the bilateral Sino-U.S. imbalance lessens, U.S. imbalances with other countries might increase. If enough of that happens simultaneously the overall effect is not clear.

Consider Europe. Europe's real exchange rate has depreciated fairly significantly over the past few years, and Germany has benefited from that as an export-oriented economy. Is it likely that the euro will appreciate much over the next few years? It doesn't look that way to me. How about Africa? While not without problems, several African countries have been growing recently, and the medium-run prospects for the region appear to be improving. This development will likely occur by running current account surpluses with Europe and the U.S. Meanwhile, resource-exporters in the Middle East and elsewhere will continue to benefit from increasing demand and will maintain high current account surpluses.

The politics of current account imbalances is clear: there is no coordination now, and as the global economy remains weak there is not likely to be. Everyone wants everyone else to adjust. Eventually this will change, since things cannot persist this way forever. But over the time period Feldstein is talking about I'm not so sure.

Interesting US-China Trade Developments

I don't have a whole lot to say about this, except that whenever we discuss increasing the amount of research for green technologies, or consider subsidizing production or consumption of green energy, we almost never consider the fact that those policy tools often violate international trade law. That's not the purpose of this suit, which is intended to protect American steelworkers (again), but it is a very real implication.

I also found this interesting:

The United Steelworkers, which had protested the Chinese wind power fund as part of a larger, 5,800-page trade complaint it filed with the American government on Sept. 9, said the administration’s decision was only a first step in addressing a “vast web of protectionist policies” by Beijing.

5,800 pages? From just one union? Geez.

Here's the statement from the US Trade Representative.

Here's a strong claim (via IELPB) about the misleading way trade statistics are calculated:

A new reasearch paper calculates that because of the way trade statistics are calculated - the full value of an iPhone is considered an export to the U.S. from China by both countries, even though only about 1% of the value was created during the final assembly process in China - just the iPhone alone added almost $2 billion to America's trade deficit with China in 2009. The authors find that if a "value-added approach" was used to calculate trade statistics, the iPhone would have instead generated a $48 million trade surplus for the U.S. in 2009, instead of the $1.9 billion trade deficit reported using the conventional methodology. ...

[I]f trade statistics were adjusted to reflect the actual value contributed to a product by different countries, the size of the U.S. trade deficit with China—$226.88 billion, according to U.S. figures—would be cut in half.

I wouldn't worry so much about the actual numbers, and instead focus on the fact that the trade statistics, like many other common statistics, do not always do a good job of measuring what they are supposed to measure.

Interesting New Research

Monday is the day that the NBER releases its working papers for the week, and sometimes there's some interesting stuff. This week, for example. I haven't had the chance to actually, you know, read any of these papers, but here's a few abstracts that caught my eye:

Why Have Economic Reforms in Mexico Not Generated Growth?

Timothy J. Kehoe, Kim J. Ruhl
NBER Working Paper No. 16580

Following its opening to trade and foreign investment in the mid-1980s, Mexico’s economic growth has been modest at best, particularly in comparison with that of China. Comparing these countries and reviewing the literature, we conclude that the relation between openness and growth is not a simple one. Using standard trade theory, we find that Mexico has gained from trade, and by some measures, more so than China. We sketch out a theory in which developing countries can grow faster than the United States by reforming. As a country becomes richer, this sort of catch-up becomes more difficult. Absent continuing reforms, Chinese growth is likely to slow down sharply, perhaps leaving China at a level less than Mexico’s real GDP per working-age person.

This analysis jives with my priors, and also with a lot of things I've been thinking about lately. One point is that we probably expected too much from Mexico, which never had as much room for development as China or the Asian Tigers. Another is that not all development is the same. China has been able to mobilize large factors of production that were essentially idle a generation or so ago. Mexico was not in the same position. Yet another is that we cannot, and should not, expect China's meteoric rise to continue at pace indefinitely. Michael Pettis wrote a good post on this point recently, drawing the obvious analogy to Japan. Mexico has problems with inequality and the environment, but they pale in comparison to China's. Right now China's state is more consolidated than Mexico's, but we should probably expect it to become more sclerotic over time. Mexico's demographics are also much more favorable for future stable economic performance. Obviously comparing the development record of any two countries is problematic, but we should recognize that Mexico has done fairly well over the past generation, and has a good opportunity for sustained growth in the future.

An ungated version of this paper is available from the Minneapolis Fed here.

Classification, Detection and Consequences of Data Error: Evidence from the Human Development Index

Hendrik Wolff, Howard Chong, Maximilian Auffhammer
NBER Working Paper No. 16572

We measure and examine data error in health, education and income statistics used to construct the Human Development Index. We identify three sources of data error which are due to (i) data updating, (ii) formula revisions and (iii) thresholds to classify a country’s development status. We propose a simple statistical framework to calculate country specific measures of data uncertainty and investigate how data error biases rank assignments. We find that up to 34% of countries are misclassified and, by replicating prior studies, we show that key estimated parameters vary by up to 100% due to data error.

Measurement problems with the HDI have been well-known for a long time, but this is the first paper I've seen that tries to reestimate the index after correcting some of these problems. Also note that the 2010 HDI report uses a new methodology than previous reports. Didn't hear much about that? Perhaps it's because the U.S. moved up to #4 (behind only Norway, Australia, and New Zealand) in 2010, from #13 in 2009. I strongly favor using a variety of well-being measures to rank outcomes in countries; GDP is too crude to be used for everything. But other indices have their own problems, among them measurement errors and the necessity of a "philosophy of weights", i.e. how much importance to give what factors in creating the index. These choices are often motivated by normative concerns. A more open and nuanced discussion of these issues is good.

An ungated pdf is here.

Financial Crises, Credit Booms, and External Imbalances: 140 Years of Lessons

Òscar Jordà, Moritz Schularick, Alan M. Taylor
NBER Working Paper No. 16567

Do external imbalances increase the risk of financial crises? In this paper, we study the experience of 14 developed countries over 140 years (1870-2008). We exploit our long-run dataset in a number of different ways. First, we apply new statistical tools to describe the temporal and spatial patterns of crises and identify five episodes of global financial instability in the past 140 years. Second, we study the macroeconomic dynamics before crises and show that credit growth tends to be elevated and natural interest rates depressed in the run-up to global financial crises. Third, we show that recessions associated with crises lead to deeper recessions and stronger turnarounds in imbalances than during normal recessions. Finally, we ask if external imbalances help predict financial crises. Our overall result is that credit growth emerges as the single best predictor of financial instability, but the correlation between lending booms and current account imbalances has grown much tighter in recent decades.

Thomas may find this one interesting. I have a feeling that when I read it I'll be asking for a political explanation for the growth in credit and imbalances pre-crisis. I'll reserve more substantive comment until I've had a better chance to look it over.

An ungated pdf is here.

Balancing Act

Just to piggy-back off of Dr. Oatley's post below. Geithner wants to cap current account surpluses or deficits at 4% of GDP. What effect would that have? Well, U.S. GDP is roughly $14tn. 4% of that is $560bn. In other words, a persistent 4% deficit in the current account is still quite large. Large enough that during most periods the U.S. was well within that boundary, though not during the mid-2000s. As the picture above shows, only in the last few years has the U.S.'s balance of payments been that sharply out of balance. (Note: that is nominal yearly data.)

What's interesting to me about the G20 kicking around these types of proposals are the distributional implications:

Representatives of the world’s largest economies, meeting in South Korea, reached tentative agreement early Saturday on the need to rein in trade imbalances, as part of an American-brokered compromise on calming exchange-rate tensions that have threatened to disrupt the uneven global recovery.

The Obama administration on Friday urged the other economic powers that make up the Group of 20 to agree to curb persistent surpluses and deficits that could contribute to the next financial crisis.

The proposal, which included a numerical limit, was backed by South Korea and quickly drew support from Britain, Canada and Australia. But it met with resistance from Germany and ambivalence from Japan, both major export countries. China, whose currency battle with the United States has threatened to derail the process of global economic cooperation, did not formally weigh in.

So after a marathon negotiating session that stretched into the predawn hours Saturday, the G-20 representatives agreed on the goal of “reducing excessive imbalances” — without a specified limit — and called on the International Monetary Fund to examine the causes of “persistently large imbalances.” The draft statement, to be ratified later Saturday, will also call on countries to “refrain from competitive devaluation” of their currencies, officials said. ...

Four countries have current-account surpluses exceeding 4 percent: Saudi Arabia (6.7 percent), Germany (6.1 percent), China (4.7 percent) and Russia (4.7 percent.) But under the American proposal, countries like Russia and Saudi Arabia that are “structurally large exporters of raw materials” would be exempt from the 4 percent limit, so the pressure would have fallen on China and Germany.

Two G-20 countries have current-account deficits larger than 4 percent: Turkey (5.2 percent) and South Africa (4.3 percent). The United States is next, at 3.2 percent.

A lot of stuff in here. First note that, once again, the expansion of the G7 to the G20 seems to have made it practically impossible to reach meaningful agreements with actionable language. How to reduce these imbalances? Umm... How much should they be reduced? No hard limit. What is the consequence of not reducing imbalances? None that I can see.

Of course the most important thing is who is reducing imbalances. As Dr. Oatley noted, it doesn't matter what countries like Turkey and South Africa do. Nor Russia or Saudi Arabia. It only matters what the U.S., China, and Germany do. The U.S. is under the proposed 4% limit, so is it any surprise that that is the level Geithner picked? It's the number that directly targets China and Germany, and to a lesser-extent Japan. The U.S. is trying to make China, Germany, and Japan pay for international macroeconomic adjustment. No wonder that those countries immediately rejected a firm requirement.

Meanwhile, Justin Fox notes that Keynes proposed something very similar during the Bretton Woods discussions:

Not impossible-to-enforce targets, but a system with incentives built in that would have made big trade imbalances unattractive to both sides. There’s that little matter of creating a new global currency and getting everybody to accept it, but this was at the tail end of World War II. If the U.S. had decreed that the International Clearing Union was a go, the International Clearing Union would have been a go. But at the time, the U.S. ran big trade surpluses and assumed it would do so forever. Its delegates at the Bretton Woods meetings were vehemently opposed. So the idea went nowhere.

Imagine that! Powerful governments decided not to pursue actions that went against their domestic interests. Who could have foreseen it?

The same dynamics are still at play even if some of the roles have reversed, so asking the IMF to investigate causes is a waste of time. China, Germany, and Japan have strong domestic political incentives to pursue policies that generate large current account surpluses. Their political survival depends on continued economic growth, and their economies are so structured that growth has to come largely from exports. The IMF will surely highlight the policies that lead to these outcomes, including exchange rate machinations, but it won't matter because they won't address the underlying political processes that generate the policies in the first place. Even if leaders wanted to bite the bullet and reverse these policies, their domestic constituents wouldn't allow it.

If the U.S. wants to address this issue, it's going to take much more than a vaguely-worded G20 communique. It will have to build a large constituency of other large economies. It will have to find a way to appease Germany and Japan while isolating China. It will have to massively boost domestic savings. And it will have to push a binding agreement through the IMF or WTO. That's a very tall order right now, and I don't see how they can pull it off. As the NYT article linked above notes:

Desmond Lachman, a former I.M.F. official now at the American Enterprise Institute in Washington, praised Mr. Geithner’s message. “It’s a constructive and imaginative proposal and it broadens the discussion away from an exclusive focus on currency to the wider set of policies needed to bring balance about,” he said. “But if you don’t have the Germans and the Chinese, this isn’t going to go very far.”

He added: “They want the U.S. to reduce its deficits, but they don’t want to reduce their surpluses.”

And vice versa.

Brad DeLong Wrote Something Important in 2005

And it remains important today. I'll quote the conclusion, but it has no power unless you read the whole thing. Please do.

It was very interesting. And very disturbing. Brilliant economists, thinking hard, unable to reach even the beginnings of analytical agreement about how to model the distribution of possible futures.

Quote of the Day

This from a report [large pdf] published in 1990 by Larry Summers, David Cutler, James Poterba, and Loise Sheiner:

“For about 15 years, the United States runs current account deficits, so that more than 6 percent of U.S. assets are owned by foreigners in 2010. High saving for the subsequent 15 years results in current account surpluses and reduces foreign capital ownership to 3.5 percent. Past 2020, however, with the rapid increase in the number of elderly, the United States again runs current account deficits, so that in the steady state almost 9 percent of U.S. assets are owned by foreigners.”

Well that explains much of the past 20 years, doesn't it? Via A Fistful of Euros, who adds:

So, if we don’t do something, and do something now, to stop median ages rising too rapidly, then more crises are guaranteed, and the next round will make this crisis will seem like, now how do they put it, oh yes, a picnic.

Who Adjusts, II

Update (Back date?): This post by Brad Setser nicely links the current mess to the broader current imbalance and exchange rate arrangements in Asia.

Somehow I missed Paulson's last trip to China in connection with the Strategic Economic Dialogue. While achieving little, it did reveal a bit of information about how the Chinese government is thinking about the global recession and global imbalances. When asked about the appropriate policy response, Zhou Xiaochuan, governor of China's central bank, said "The United States should speed up domestic adjustment, raise its savings rate and reduce its trade and fiscal deficits." (HT to Kaylan).

Discouraging but not surprising news, really. Discouraging because adjusting global current account imbalance is less painful if China expands than if the US contracts. Thus, the Chinese position implies a more-painful-than-necessary adjustment path. Unsurprising because China's position reflects its interests as a large creditor. As Wang Qishan, China's deputy prime minister, put it, the United States should stabilize its economy as soon as possible to "ensure the safety of China's assets and investments in the U.S." This sounds somewhat like the advice another large country often offers emerging market governments, though that country rarely is so brash as to admit that the advice is offered to safeguard American assets.

The IHT article also contains a terrific non sequitur: "During his campaign for president, Barack Obama often accused China of manipulating its currency, but ... his choice for Treasury secretary, Timothy Geithner, has lived in China and speaks Mandarin."

Who Adjusts?

Funny how the world works. I was talking (or at least trying to) about contemporary global imbalances in class today, with a particular focus on the question of the relative merits of adjustment via contraction in the US and adjustment via expansion in the surplus countries, especially China. Reading the FT tonight I come across Martin Wolf's nice summation:

"Countries with large external surpluses import demand from the rest of the world. In a deep recession, this is a “beggar-my-neighbour” policy. It makes impossible the necessary combination of global rebalancing with sustained aggregate demand. John Maynard Keynes argued just this when negotiating the post-second world war order.

In short, if the world economy is to get through this crisis in reasonable shape, creditworthy surplus countries must expand domestic demand relative to potential output. How they achieve this outcome is up to them. But only in this way can the deficit countries realistically hope to avoid spending themselves into bankruptcy."

Of course, pointing out what ought to happen to get the world economy through this crisis in reasonable shape does not mean it will in fact happen. I am particularly skeptical about China's willingness to embrace this path. "Asked whether China might pursue economic policies aimed at saving the world, Mr. Lou said that the country’s leaders had a narrower focus. “China can only save herself..."

G20 and Global Imbalances

It is nice when world governments act so quickly to illustrate the processes we discuss in class. Last Thursday we focused on macroeconomic policy coordination as a solution to global current account imbalances. The Group of 20 met this weekend in South Africa and agreed the following:

"We also agreed that an orderly unwinding of global imbalances, while sustaining global growth, is a shared responsibility involving: steps to boost national saving in the United States, including continued fiscal consolidation; further progress on growth-enhancing reforms in Europe; further structural reforms and fiscal consolidation in Japan; reforms to boost domestic demand in emerging Asia, together with greater exchange rate flexibility in a number of surplus countries; and increased spending consistent with absorptive capacity and macroeconomic stability in oil-producing countries."

Krugman on the Dollar and Current Account Adjustment

I do like it when Paul Krugman uses his platform to talk about the things he knows best, in this case, current account adjustment and the falling dollar. It also is not everyday that one sees a public discussion about the savings-investment gap, so it's worth checking out for that reason alone..

Krugman has written two recent blog posts on this topic, one that emphasizes the need for a depreciating dollar in conjunction with rising savings, and another on the reasons for the dollar's current slide. The basic message is that current account adjustment without recession requires a rise in savings and a fall in the dollar. He elaborates these views in greater detail in a recent Economic Policy article (a shorter piece apparently derived from this by Robert Baldwin is also available).

The US Current Account Deficit

Monday's New York Times carries a story headlined "Rising Exports Putting Dent in Trade Gap." It essentially mis-represents the most recent Census Bureau report on the US current account. The Times is optimistic...

"As a result, it now looks as if the huge trade deficit, which swelled to a record $765.3 billion last year, could gradually decrease. The trade gap widened in March, mostly because of higher prices for imported oil, but the vast disparity between what Americans import and export is expected to narrow, which would allow trade to contribute to economic growth in the United States for the first time in more than a decade."

Hold on, the trade deficit grew? Doesn't the headline say that the trade gap is dented? Apparently, rising exports would have dented the gap were it not for the even faster growth of imports. Fortunately, however, the Times assures us, March is just a temporary aberration that reflects the fact that the goods we import and can't do without (oil) rose in price in February. So, I guess as long as we can reduce the world oil price, we should be okay moving forward and we can expect rising exports to dent our trade gap pretty soon.

The bigger problem is that the story mistakes a micro effect, that a weaker dollar helps US exporters and import-competing producers, for a macro effect--that the weaker dollar will reduce imports and increase exports enough to balance the current account. The story cites the most optimistic economist on this question--C. Fred Bergsten--to the effect that a 1 percent depreciation of the dollar improves the current account by $20 billion.

And Bergsten is very optimistic about the sensitivity of the trade balance to the exchange rate. According to the most recent IMF World Economic Outlook, "typical estimates from the standard econometric models of the U.S. economy suggest that narrowing the ratio of current account deficit to GDP by a percentage point would require a real depreciation ranging from 10 percent to 20 percent." The re-analysis the IMF reports cuts this range by half (5 to 1o percent). Bergsten's guess is essentially the IMF's 5 percent estimate--the lowest boundary of a single study. One might more reasonably pick a point somewhere in the middle of the more numerous studies (15 percent) or even at the point where the new and the typical studies agree (10 percent devaluation for each 1 percent desired correction). In short, Bergsten is an extreme exchange rate optimistic unrepresentative of the broader research community.

Sadly, stories such as this are a big part of why we are incapable of informed public discussion about our current trade position. If our most important paper of record can't report responsibly and accurately, how can we expect an informed public debate? Instead, we imagine that we can find simple solutions; we look for villains (China, Japan, ...) and think that higher tariffs will somehow solve the problem. All the while, we fail to talk about the real cause of the imbalance: we don't save.