Tuesday, January 4, 2011

Why Imbalances Will Persist, For Awhile At Least

. Tuesday, January 4, 2011

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.


Why Imbalances Will Persist, For Awhile At Least




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