Flying Lopsided

While trade surpluses and foreign reserves balloon across Asian and oil-exporting countries, a gaping trade and current account deficit yawns in the US. Will the unwinding of this imbalance send the world economy into a tailspin? The European Economic Advisory Group urges the EU to upgrade its monetary policy instruments in case it might.

Many theses have been put forth to explain, or explain away, the gaping US current account deficit. There is a huge amount of invisible US foreign wealth, say some, that dwarfs its foreign debts. A sort of dark matter that makes itself evident by its effects—the $36-billion income it earned the US in 2004, or the persistency of low interest rates, for instance—rather than by mere figures in an account. Thus, the deficit does not even exist.

Others shift the blame for the sea of red ink to a global saving glut. In other words, Americans are not spending themselves to oblivion; it is the rest of the world that is saving too much, instead of buying US goods and services.

Still others point an accusing finger at China and other countries, which allegedly derive an unfair advantage in the global marketplace from their undervalued currencies.

Be it as that may, the generally accepted accounting practices show a gargantuan current account deficit in the US, topping $2.5 trillion at the end of 2004. This makes markets—and most economists—jittery: a disorderly adjustment of this imbalance can send the global economy into a spin. This looming risk prompted the European Economic Advisory Group at CESifo to address the matter in depth in their latest report on the European economy*, just released in London, Brussels and Munich.

The big question is the sustainability of such large and persistent current account deficits, evident since the mid 1990s. At present, these deficits are matched by large surpluses in Japan, Asian emerging markets, oil-exporting countries and even a few European nations. The euro area as a whole, however, is close to external balance.

The composition of external financing of the US deficit has changed significantly since 2000, with private capital inflows falling from 90 percent to 40 percent and public inflows increasing accordingly. A further dimension of current global imbalances is 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, doubling since 1990 from about 60 percent of world GDP to above 120 percent now.

Although 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, thus improving the US net foreign asset position.

There are a number of views on the causes of current imbalances, with rather different implications regarding 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. While some studies suggest that the impact of fiscal consolidation in the US on external trade will be limited in the short run, greater fiscal discipline would certainly help reduce imbalances in a longer-term perspective.

A second view argues that the US external deficits are essentially driven by expectations 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 inter-temporal perspective. Second, a 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 the 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 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 for 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 “export-led 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 peg against the US dollar has not led to any significant appreciation of its currency so far. A noticeable correction, however, should be expected in the near future.

Predictions of a further sizeable depreciation of the dollar in real terms emphasise the need for a fall in the relative price of US non-tradables, 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 non-traded 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, which would make Europe experience a drop in external demand and, consequently, reduce its economic growth.

With luck, the resolution of current imbalances may proceed relatively smoothly. However, it is also possible that a “hard landing” occurs. If the financial crisis is moderate, the euro system may be able to contain it. If the financial crisis is sufficiently severe, however, monetary authorities may face difficult trade-offs between financial stability and price stability. Governments may then have to shoulder large fiscal costs to stave off a serious financial crisis.

This would raise important issues regarding the distribution across countries of the resulting fiscal burdens. The relatively weak public finances in many European countries are an aggravating factor, adding 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 a disorderly unravelling of global imbalances, the euro area would still face a severe aggregate demand problem. It would be difficult to deal with this problem within the current framework for monetary and fiscal policy. Perhaps the most important risk for Europe in this regard is to become exposed to a severe downturn without having access to effective policy instruments to stabilise the economy. The time to set up such instruments is now.

*Report on the European Economy 2006, Chapter 5, by the European Economic Advisory Group at CESifo. EEAG comprises eight renowned economists from eight European countries. Further info at www.cesifo-group.de/eeag