A balancing act
The authorities need to resolve the problem of global economic imbalances, but first they need to understand why it has come about – if they do not identify the cause, they cannot find the solution. Daniel Ben-Ami looks at the different explanations for the unprecedented global imbalances.
Few doubt that global economic imbalances have played a large role in the financial and economic crisis of the past year. On one side is America, consuming substantially more than it was producing. On the other, East Asia and the Middle East, in effect lending America huge amounts of capital so it could buy their goods. Many, including Stephen Roach of Morgan Stanley, argued even before the onset of crisis gave them the benefit of hindsight, that the set-up was unsustainable.
But exactly what the imbalances mean is another matter. Are they the result of American profligacy or excess savings by Asians? Are they the cause of the current crisis or just an
effect? These questions generate substantial debate.
Of course there are other elements to the crisis. Many commentators attribute great importance to factors such as lax financial regulation and excessive risk taking. But most would see global imbalances as playing an important role. The question is what exactly is the part they play.
On factual questions there is a broad consensus. The scale of imbalances in the world economy is unprecedented. Not only is the world’s largest economy a net capital importer, itself unusual, but it is doing so on a huge scale. The statistics also appear to show that these imbalances have narrowed over the past year. These relatively uncontentious questions are the subject of the first part of this article.
Not many would disagree that the global imbalances are somehow related to the domestic imbalances that are implicated in so much havoc in the global economy. For example, the existence of the American house price bubble and America’s massive capital imports from China were connected.
The debate is about the exact character of uneven relationships. Broadly, there are three ways of looking at them. The first view puts the blame mainly on American profligacy, or what can be called a “money glut” theory. The second places responsibility primarily on excess Asian savings, or what is called a “savings glut”. Finally, a heterodox view puts the emphasis on falling profitability in the West. Each of these views has consequences for whether imbalances are seen as the cause or an effect of global economic problems. The debate on the nature of imbalances will be examined in the second part of the article.
This discussion has enormous consequences for the way the global economic crisis is understood and tackled. Different ways of understanding the crisis suggest different types of solutions.
Imbalances now and then
The best way to understand global imbalances is to start from a simple model then add successive elements to it. That process enables both the key relationships and the complexities of imbalances to be understood.
At the core of the imbalances in the world is the relationship between America and China. In broad terms, America consumes more than it produces while China does the reverse. This expresses itself as a large current account deficit for America and a large trade surplus for China (see graph one). In other words America imports far more from China than it exports, while China exports substantially more than it imports.
But somehow America has to pay for the excess goods and services that it imports. It does not produce enough domestically to fund these purchases. In effect it borrows money from China to pay for the purchase of Chinese goods. One of the main mechanisms for this finance is massive purchases by the Chinese authorities of official American debt.
Therefore, even just looking at these two countries it is possible to identify two large global imbalances. One is in trade where America imports too much relative to its national income and exports too little. Another is in capital flows where China exports far more than might be expected of an economy of its size.
It should already be clear that this relationship is paradoxical and potentially destabilising. It means that China, still a relatively poor country, is subsidising consumption in America, a much richer country. This is what commentators mean when they talk about capital flowing “uphill” or “upstream”. As Martin Wolf, the chief economics commentator for the Financial Times, puts it in his book on Fixing Global Finance: “Capital now flows upstream, from the world’s poor to the richest country of all”.
Such imbalances are also closely linked to the turmoil in the global economy over the past year. Chinese capital flows to America have clearly played some kind of role in keeping American interest rates low and liquidity flowing. These in turn bolstered the house price boom which later turned to bust.
Global imbalances and domestic ones are closely related to each other. And when there is an adjustment to bring them more into balance the consequences can be painful.
The imbalance between America and China has certainly narrowed over the past year of crisis. America’s trade deficit has narrowed as has China’s surplus. Capital Economics, a specialist consultancy, estimates that China’s trade surplus in the second quarter was 60% of the size of a year before in real terms. Although both are far from being in balance they are closer than they were when the crisis began.
Before moving on to the more contentious part of the discussion, it is worth remembering that America and China are at the core of a more complex set of imbalances. Bob Baur, the chief global economist at Principal Global Investors in Des Moines, Iowa, says: “In practice you need to look at many more countries”. Broadly speaking, East Asian countries and commodity producers are running trade surpluses and exporting capital to the West. America, in contrast, is running deficits.
Within Europe the situation is more complex. Overall, the region is broadly in balance but there are substantial imbalances within it. Germany, for example, is a large surplus country while many other European countries, including, Britain and Spain, are running substantial deficits.
One of the most popular explanations for the huge global imbalances emphasises the importance of developments in the West. It is also known as the money glut theory. Although there are different versions of the argument they can be broadly grouped together under this heading.
Money glut theorists point to low interest rates in the West as a key determinant of imbalances. For example, America’s Federal Reserve is widely criticised for keeping interest rates so low for so long earlier this decade. Such laxness played, in the view of money glut theorists, an important role in encouraging excess American consumption and the development of a housing bubble.
Some go even further and criticise American profligacy. Such thinkers emphasise the fact that Americans were consuming too much relative to what they produced. The authorities should have taken a tougher line in keeping the two in balance. Their failure to do so, it is argued, played a key role in creating the basis for the economic crisis.
Andy Xie, an independent economist based in Shanghai, argues that low American interest rates were a
key part of the problem. Laxness by the authorities was, in his view, immensely damaging, “Central banks cranked up the money supply and that led to the bubble,” he says.
However, he argues that pegged interest rates in developing countries also played a pernicious role. These made it more difficult for economic adjustments to take place through the mechanism of changing exchange rates. As a result imbalances reached the stage where they became dangerous.
Until 2005 the most popular explanation for imbalances emphasised lax American monetary policy and profligacy. But then Ben Bernanke, the Fed chairman, gave a speech in which he flipped the argument on its head. It was not laxness by western central banks that was the fundamental problem in relation to global imbalances. On the contrary, it was Asian excess savings.
According to this argument the real damage in the world economy is being done by Asians who produce far more than they consume. As a result they are building up savings which are finding their way into western capital markets where they are doing immense damage. It was pressure from Asian savings which, according to this theory, kept American interest rates relatively low.
Bernanke did not originate the argument, it had been proposed a year earlier by Charles Dumas, an economist at Lombard Street Research. But given Bernanke’s senior position in the global financial hierarchy, the fact that he took it up played a key role in popularising the argument.
It should be clear that Bernanke’s argument is self-serving. It presents a world in which the Fed was basically doing things right and the onus for global adjustment lies with Asia. But the fact that it is self serving does not necessarily mean it is wrong. Many independent economists have taken up the argument.
For example, Julian Jessop, the chief international economist at Capital Economics, puts the emphasis on surplus savings from Asia and the oil producing countries. He says he does not believe the western authorities particularly wanted to see large imbalances.
There are several other factors that seem to support the savings glut thesis. An important one is the low long-term interest rates in America. This is what Alan Greenspan, then chairman of the Fed, called a “conundrum” in a February 2005 testimony to congress (available at: http://www.federalreserve.gov/Boarddocs/hh/2005/february/testimony.htm )
If America really was being profligate, it might be expected that high interest rates would be needed to attract foreign capital. But this does not seem to be the case.
Another supporting factor is the existence of currency pegs in Asia including China. These seem to be part of a deliberate policy by Asian countries to keep their currencies relatively weak to help bolster their exports to America. For many this would seem to support the view that there is an Asian savings glut.
It is also worth noting that the core of the Chinese savings story relates to state owned enterprises rather than personal savings. Chinese households are large savers but, as Martin Wolf points out in his book, state enterprises are larger. “The Chinese government told state enterprises to become profitable, and they have done what they were told,” he says.
Although the savings glut theory of imbalances is currently the most popular, followed by the money glut, there are alternatives. One of the most interesting is put forward by Michael Howell, the head of research at Crossbordercapital, who focuses on falling profitability in the West relative to Asia.
Howell argues that global imbalances are a symptom of western weakness. “The root goes back to a global power shift,” he says. “Global imbalances are a result of the problem, not a cause of the problem,” says.
To support his argument he points to low levels of capital investment in the West relative to Asia (see graph four). In the West capital spending is not much more than at replacement levels. It is just about enough to replace worn machinery, but it is not sufficient to provide the basis for strong growth in the future. This is in contrast to Asia where capital investment is strong and there is a long term trend towards relatively strong economic growth.
“Broadly, there is a crisis of low profitability and bad bank liability”, he says.
However, Andrew Milligan, the head of global strategy at Standard Life Investments, disputes this thesis. “Companies in the West have outsourced their manufacturing to the global emerging markets, hence investment / GDP ratios are lower, but they still retain control of the profits flow,” he says. “They own the factories or they benefit from cheaper production so enhancing their profits”.
In the real world the distinctions between the different outlooks are not as clear-cut as the three neat divisions suggest. For example, many commentators argue that the savings glut theory is broadly right while acknowledging that the American authorities have made policy errors. But it is nevertheless useful to distinguish between three approaches as each of them suggests different policy conclusions.
If America profligacy is the problem it is easy to draw the conclusion that the American authorities need to take a tighter grip on monetary policy.
They should be prepared to restrict consumption growth in America, even if it leads to a painful readjustment process. An alternative approach, although less commonly propagated, would emphasise the need to generate more long-term dynamic growth in America. This would be an alternative to a boom based largely on credit.
In contrast, the savings glut thesis puts the onus on the Asian countries, and other capital exporting countries to readjust – that probably helps explain why it is so popular in American and British circles. A logical conclusion from this premise is that such countries should allow their currencies to float freely if they are currently pegged. It also suggests that they should bolster domestic demand so that the world economy can come closer to balance.
The falling profitability thesis suggests radically different conclusions. If low profitability in the West is the problem, it follows that the solution is to raise profitability. In the current environment this probably means a radical restructuring with decrepit, unprofitable businesses encouraged to declare themselves bankrupt.
But the political costs of following such a path are likely to be high. It suggests allowing many more firms to fail and a large increase in unemployment. Supporters of such measures would normally argue that acceptance of short-term pain would create the basis for more vibrant long-term growth in the future.
The debate about global imbalances is far from over. As long as they are so large, they are likely to remain a source of tension in the global economy. The authorities will no doubt attempt to go down what appears to them to be the easiest path in resolving such imbalances. But if their understanding of the situation is wrong, they are unlikely to move towards resolving it and they could easily make it worse.
One of the main concerns raised over the past year is whether the world will enter a phase of deglobalisation. Exactly what this would entail is unclear since the term “globalisation” is used to mean several different things. But in broad terms it can be taken to mean a decline in the integration of the global economy.
As far back as January 2009 Gordon Brown warned of the threat of deglobalisation in a speech on the global economic crisis (available at: http://www.number10.gov.uk/Page18153 ): “as the downturn spreads across the world we are for the first time seeing cross-border flows growing more slowly than domestic flows and we are seeing banks favouring their domestic lending over foreign lending.”
It was a time when many countries were aggressively taking action to stabilise their own banking systems. Therefore there seemed to be a substantial risk that protectionist pressures could result.
But deglobalisation can mean more than the intensification of protectionism. The past year has seen a reversal, at least temporarily, of the trend to the internationalisation of trade and capital flows. Trade has declined more sharply than economic output and many forms of capital flow have decreased sharply too (see graphs two and three).
Whether this trend is decisive enough to be said to constitute deglobalisation is open to debate. For Andrew Milligan, the head global strategy at Standard Life Investments, it does, at least up to a point.
He points to protectionist pressures and argues: “The pendulum hasn’t moved vary far but it has moved”. However, he argues there are also pressures to find international solutions to the crisis.
Andy Xie, an independent economist based in Shanghai, takes a different view. “Deglobalisation is extremely difficult in the age of the internet,” he says. Given that information is freely available worldwide it is hard to see globalisation being reversed.
Julian Jessop, the chief international economist at Capital Economics, takes a similar view to Xie. For him “globalisation is a structural shift”, therefore it is hard to see it being reversed.
Bob Baur, the chief global economist at Principal Global Investors in Des Moines, Iowa, takes a midway position. He acknowledges that the short term lack of credit has had a heavy impact on international trade. He also argues there is a form of “stealth protectionism” with countries taking subtle protectionist measures in defence of their own economies. But he is hopeful that the trend will be reversed as the crisis subsides.
However, it should be remembered that actions and words tend to be particularly contradictory in this area. It is typical for governments to favour international cooperation on the one hand while implementing protectionist measures on the other.
So Gordon Brown was willing to warn of the dangers of protectionism in his January speech. But the government is also putting pressure on banks to lend to British businesses – a clear example of favouring one country’s firms over others.
Ben Bernanke, “The Global Savings Glut and the US Current Account Deficit”. 2005 speech in which the chairman of the Federal Reserve blamed global imbalances on Asians saving too much. Available at: http://www.federalreserve.gov/boarddocs/speeches/2005/200503102/
Richard Duncan, The Dollar Crisis: Causes, Consequences, Cures, Wiley 2003. A version of the money glut
Charles Dumas and Diane Choyleva. The Bill from the China Shop, Profile 2006. Another account of the Asian savings glut. The original idea was put forward by Dumas before Bernanke raised it.
International Monetary Fund. “Decoupling the train? Spillovers and Cycles in the Global Economy”. Chapter four of the World Economic Outlook, April 2007. Available at: http://www.imf.org/external/pubs/ft/weo/2007/01/
Martin Wolf, Fixing Global Finance: How to curb financial crises in the 21st century. Yale 2009. An account of global imbalances by a veteran Financial Times commentator.
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