Imbalances Can’t Go on Forever

The world economy continues to look strong despite recent hiccups in international capital markets and the recalcitrance of high oil prices. It's almost certain that for the third year in a row world output will grow around 5%, with record low inflation worldwide. Yet economists are increasingly worried about the possibility of a serious economic setback, if not this year then sometime in the not-so-distant future. The culprit at the root of the latest bouts of insomnia and divided opinions torturing my fellow members of the dismal profession is the situation dubbed "global imbalances."

If present trends hold, the U.S. current account deficit – which reflects the country's excess of expenditure over income – could reach $900 billion in 2006, or 6.8% of GDP. This will be the highest deficit ever registered by the U.S. economy. It's being financed by the equally unprecedented surpluses being run by other economies, most notably – but not exclusively – those in the Asia Pacific region.

The benign version of the global-imbalances story posits that higher productivity in the U.S. has given Americans both a revaluation of their assets and an expectation of higher future income, which has encouraged them to spend more and save much less than before. At the same time, the phenomenon of higher productivity has made the U.S. a more attractive place for other countries to invest their current account surpluses, the result of their greater propensity to save, export and accumulate foreign exchange reserves. From this perspective the current state of affairs is simply one more of the many favorable consequences of financial globalization, which allows resources to move swiftly to where expected returns are more attractive.

Other analysts, however, question this happy tale. They perceive global imbalances to be the result of faulty fiscal, monetary, exchange-rate and structural policies of the countries contributing to them. For example, some point to American profligacy, triggered by both lax fiscal and monetary policies, as a chief suspect. Others believe that currency manipulation by East Asian countries, particularly China, is mostly to blame. And then there are those who see the reluctance of some of the major European countries to reform their economies as being part of the problem.

At first glance all of the above perceptions seem to be competing explanations of the causes of global imbalances. But they aren't. As Barry Eichengreen of the University of California, Berkeley has lucidly argued, none of them can individually account for the imbalances, but each provides elements of truth that add up to the larger story. Eichengreen grants that because of its flexibility, which leads to higher profitability, the American economy continues to attract the savings garnered by some of the other major economies. But he also makes clear that the decline in the share of U.S. investment financed out of U.S. savings has gone beyond what is warranted by the higher profitability of the U.S. economy. He also believes a substantial part of the problem is that Asian countries, in order to propel their economic growth, rely on undervalued exchange rates to stimulate exports instead of relying on increased domestic consumption.

Even adherents to the benign interpretation of global imbalances don't believe things can continue indefinitely as they are. If the present inertia could conceivably be sustained, the U.S. would owe foreigners more than 50% of its GDP by the end of the decade and much more than 100% ten years beyond that. You don't need to be a paranoid nationalist to figure out that this trend will somehow stop. Of course, it would be in nobody's interest if it were changed by a sudden interruption of capital inflows into the U.S., dramatic changes in exchange rates and sharp jumps in interest rates, which would eventually be followed by a worldwide recession. Yet this will be the most likely outcome if nothing is done or if the burden of any adjustment is imposed on one player alone.

Unfortunately for politicians in the countries that bear responsibility for the global imbalances, discussion of the issue has degenerated into a blame game, at times charged with nasty rhetoric and proposals that, if adopted, would be counterproductive, particularly those calling for less-open markets for international trade and investment. People playing the game – not only in the U.S. but also in Asia and Europe – would like to see other countries, not theirs, make adjustments to fix the imbalances before a serious global financial crisis unfolds. But I'm afraid that's what's coming if they just keep playing this useless game.

Synchronization Is Best

The formula for avoiding the lose-lose scenario has been in the policy arsenal for a long time, though it's been seldom practiced: collective and coordinated action in order to smooth the adjustment and make it less costly for every participant. Disorderly and traumatic correction can be avoided if every pertinent country commits and honors its part in a coordinated plan. Asians and Europeans would be required to implement expansionary policies grounded in stronger macroeconomic fundamentals. The U.S. would need to address its fiscal deficit seriously. All would have to synchronize their monetary policies in order to realign their exchange rates. Admittedly, even when collective action is in all countries' self-interest, it is typically resisted and hard to achieve. Consequently, it has yet to be seen whether the recent mandate given the IMF – to undertake multilateral consultations with a view toward narrowing the global imbalances while maintaining global economic growth – reflects enlightened responsibility by the major players or is merely one more trick on their part to deflect responsibility.