The G20: putting Europe at the centre of the global debate
Global Imbalances
The large and persistent current-account deficits run by the United States from the second half of the 1990s have generated widespread concerns about the sustainability of current macroeconomic imbalances at the global level and the risk of disorderly adjustment and slowdown in macroeconomic activity. We review the current debate and discusses the implications of global adjustment for European macroeconomic developments and policy-making.
Currently, large external deficits in the US are matched by large surpluses in Japan, Asian emerging markets, oil-producing countries and a few European countries. However, the euro area as a whole is close to external balance.
The composition of external financing of the US deficit changed significantly after 2000 with a falling share of private capital inflows (accounting for 90 percent of total inflows in 1997–1999, but for only 40 percent in 2003–2004) and an increasing share of public inflows. A further dimension of current global imbalances concerns the high level of international reserves held in dollar assets. At the same time, there has been a strong expansion of cross-border holdings of financial instruments, which have doubled since 1990 from about 60 percent of world GDP to above 120 percent now.
Though the US current account deficit is large in terms of US GDP, it is small relative to the stock of US foreign gross assets. The US typically borrows from international markets by issuing dollar-denominated assets but lends abroad mostly by acquiring equities and foreign-currency denominated bonds. Therefore, dollar depreciation leaves the dollar value of US liabilities unaffected but raises the dollar value of US assets and improves the US net foreign asset position.
There are a number of views on the causes of current imbalances, with quite different implications for the need for corrective policy measures.
A widespread view attributes the persistent US current account imbalances to low US national savings. Private savings in the US have been trending downward for some time and US public savings have also deteriorated markedly since 2000. Some studies suggest that the impact of fiscal consolidation in the US on external trade is limited in the short run, but greater fiscal discipline would certainly help reduce imbalances in a longer-term perspective.
A second view of the US external deficits argues that they are essentially driven by expectation of high future growth. This view has two important policy implications. First, it is not appropriate to talk about “imbalances”, as trade flows are in fact balanced in an intertemporal perspective. Second, significant dollar depreciation in real terms may not be required for some time and should therefore not be expected. However, current expectations about high US growth in the future may be too optimistic. If and when expectations are revised downwards, restoring US external balance would then require a sharp correction of spending plans, possibly implying large movements in exchange rates and relative prices.
A third view of US current account deficits argues that the deficits are a mirror image of a “saving glut” in the rest of the world. A variant of this view is that there is an “investment drought” outside the US. This view offers a potential explanation of the simultaneous occurrence of low real interest rates and low investment. According to this argument, one may expect interest rates to rise as soon as investment picks up again.
A fourth view suggests that a desire for “exported growth” and a build-up of currency reserves in Asian emerging markets have substantially contributed to the current global imbalances. In particular, imbalances are due to China’s exchange rate policy and its strong influence on the policies of the other emerging markets in the region. China’s formal abandonment of the inflexible peg against the US dollar has not led to any significant appreciation of the renminbi so far. However, given the internal consequences of distorted relative prices, due to an artificially low exchange rate and the threat of protectionist measures by the US, one should expect some noticeable correction in the near future.
Predictions of further sizeable depreciation of the dollar in real effective (multilateral) terms emphasis’ the need for a fall in the relative price of US non-tradable, which is tantamount to a reduction in US income relative to the rest of the world. According to some studies, the required real rate of depreciation of the dollar might be quite large, depending on several factors that ultimately affect the elasticity of substitution between traded and nontraded goods in the US and between US and foreign traded goods, as well as on the impact on the level of economic activity. Many studies suggest that adjustment could necessitate a protracted period of real dollar weakness. According to the consensus view, the most important policy contribution to adjustment should come from a reduction in the US fiscal deficits. Without any fiscal rebalancing in the US, a reduction in Asian saving, possibly associated with a slowdown or reversal in reserve accumulation, increases the risks of financial strain in the global currency and asset markets. Looking at the adjustment of global imbalances from a “euro” viewpoint, there may or may not be further dollar depreciation vis-à-vis the euro. However, correcting the US current account deficit in any case requires an improvement in US net exports, and Europe is likely to experience a drop in external demand with negative effects on European growth.
It is possible that the resolution of current imbalances will proceed relatively smoothly. However, it is also possible that the current build-up of imbalances will be followed by one of the “hard landing” scenarios. Suppose that there is a disorderly adjustment with strong relative price and exchange rate movements and financial turmoil across markets. In this scenario, it is highly plausible that European financial and non-financial firms would suffer from strong deterioration of their balance sheets and liquidity shortages.
This scenario would call for European monetary and supervisory authorities to stress test their institutional framework. If the financial crisis is moderate, the euro system may be able to contain it. However, if the financial crisis is sufficiently severe, monetary authorities may face difficult tradeoffs between financial stability and price stability. Governments may then have to shoulder large fiscal costs to stave off a serious financial crisis. This would rise important issues regarding the distribution of fiscal costs across countries those policies to mitigate a serious crisis would entail. In this scenario, the relatively weak public finances in many European countries are an aggravating factor, as they would imply undue constraints on emergency financing in the case of a crisis. Increasing the fiscal room of manoeuvres in a possible future financial crisis adds a strong precautionary motive for stronger fiscal discipline now.
Even if European monetary authorities were successful in fighting financial contagion and other undesired effects of liquidity shortages in the event of a worldwide financial crisis in the context of an unwinding of global imbalances, the euro area would still in such a situation face a severe aggregate demand problem. It would be difficult to deal with this problem under the current framework for monetary and fiscal policy. Perhaps the most important risk for Europe associated with global imbalances is to become exposed to a severe downturn without having access to effective policy instruments to stabilize the economy.
