Sunday, January 29, 2006

Rajan on resolving global imbalances

Perhaps you've been reading news reports lately dealing with the US economy in a ramp-up to the State of the Union Speech. See for example these three from the Washington Post: Savings Rate at Lowest Level Since 1933, Growth in 4th Quarter Reached a 3-Year Low, and Budget Office Expects Deficit to Edge Up.

US politicians seem to have an overly rosy view of the economy and its prospects. Not just the Bush administration, but I think some prominent Dems as well, are saying the US economy is strong enough and expanding well enough to support our current deficit and its expected continuance into the future.

That isn't how Raghuram Rajan, my favorite economist, sees the situation. He says, as he repeatedly has been saying, that the US is exposing itself to great risks in not dealing with the deficit. He recently gave a cogent summary of his arguments for resolving global imbalances:
Perspectives on Global Imbalances
Remarks by Raghuram Rajan, Economic Counsellor and Director of Research Department, the International Monetary Fund
At the Global Financial Imbalances Conference
London, United Kingdom
January 23, 2006



Good morning. Since this will be the first session on global imbalances, I thought I would give you a broad overview. The picture is familiar to most of you. The United States is running a current account deficit approaching 6 1/4 percent of its GDP this year and over 1.5 percent of world GDP. And to finance it, the United States needs to pull in 70 percent of all global capital flows. While the deficit is still increasing, the location of the surplus countries is changing. The current account surpluses of the oil-exporting countries of the Middle East have now surpassed those of emerging Asia, which were already quite high.

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The current situation, I believe, has its roots in a series of crises over the last decade that were caused by excessive investment, such as the Japanese asset bubble, the crises in Emerging Asia and Latin America, and most recently, the IT bubble.

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Investment has fallen off sharply since, with only very cautious recovery.

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This is particularly true of emerging Asia and Japan.

The policy response to the slowdown in investment has differed across countries. In the industrial countries, accommodative policies such as expansionary budgets and low interest rates have led to consumption- or credit-fuelled growth, particularly in Anglo-Saxon countries.

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Government savings have fallen, especially in the U.S. and Japan, and household savings have virtually disappeared in some countries with housing booms.

By contrast, the crises were a wake-up call in a number of emerging market countries. Historically lax policies have been tightened, with some countries running primary fiscal surpluses for the first time, and most bringing down inflation through tight monetary policy.

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With corporations cautious about investing and governments prudent about expenditure—especially given the grandiose projects of the past—exports have led growth and savings have built up. Many emerging markets have run current account surpluses for the first time. In emerging Asia, a corollary has been to build up international reserves.

Some call this a new world order. I see the situation as a temporary but effective response to crisis. It is somewhat misleading to term this situation a "savings glut" for that would imply that countries running current account surpluses should reduce domestic incentives to save. But if the true problem is investment restraint, then a reduction in world savings incentives will engender excessively high real interest rates when the factors holding back investment dissipate. Put differently, I think it is best to see the underlying cause of current account surpluses as inadequate investment rather than excess savings, because the desirable policy response is to improve the investment environment rather than cut back on savings.

The world now needs two kinds of transitions. First, consumption has to give way smoothly to investment, as past excess capacity is worked off and as expansionary policies in industrial countries return to normal. Second, to reduce the current account imbalances that have built up, demand has to shift from countries running deficits to countries running surpluses.

The traditional view is that exchange rate movements will help guide these transitions.

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[In fact] exchange rate depreciation will help shift demand, in general, however, such changes take time. The question is whether financial markets will be patient or force adjustments to occur through sharper price changes—notably exchange rates and asset prices—in a way that is destabilizing to the real economy and financial markets.

The most immediate concern in the current environment is whether foreign investors will continue to buy US assets without hiccups for the time it takes for the real side to adjust?

Overall, the bulk of U.S. assets sold to foreigners are still to the private sector.

Given this, it is worth noting that both foreign direct investment and net purchases of equities by non-residents have declined markedly since 2000. The concern is that financing will become more difficult — with consequences to U.S. interest rates and the exchange rate — precisely when other factors make the United States slow and look an unattractive place to invest, compounding the slowdown.

To summarize then, the global current account imbalances have arisen, in large measure as a temporary and uncoordinated response to crisis rather than as a permanent new (and perverse) international order. Emerging markets have recognized the risks posed by volatile cross-border flows, especially given the fragility of their own financial and corporate systems. They have learnt to fit their investment coat within the domestic savings cloth they have available, even leaving a bit over to finance rich countries. The resulting global liquidity, abetted by accommodative monetary and fiscal policies, has led to credit-fuelled housing and consumption booms in some developed countries, providing the needed global aggregate demand. And most recently, imbalances have been accentuated through the oil price boom and by countries resisting exchange rate appreciation. While the imbalances have been financed easily thus far, we cannot be sanguine about them.

The best case scenario is that demand shifts smoothly from deficit countries to surplus countries, even while aggregate world demand grows—the proverbial soft landing. There are two other possibilities. One is that as monetary and fiscal stimulus is withdrawn, consumption demand from the deficit countries, notably the United States, contracts sharply. Domestic demand from surplus countries does not keep pace, and even falls, because external demand has indirectly been pulling investment — for example, in the case of Germany or China. In this worst case scenario, we get a contraction of global demand, with only moderate correction of current account imbalances. A second possibility is that adjustment is forced by the financial side, because the real side is seen as unlikely to adjust on its own. Investors become unwilling to hold increasing amounts of U.S. financial assets, demand higher interest rates and some exchange rate overshooting, which in turn forces U.S. domestic demand to contract. Again, if this happens abruptly, it could cause a slow down, as well as financial market disruptions. Of course, overlaying all this is the specter of protection that could make things worse.

What can policy makers do to help effect the needed transitions? In developed economies running current account deficits, the policy emphasis should be on removing monetary and fiscal accommodation at a measured pace. The United States has agreed that reducing its fiscal deficit is part of the solution and is committed to reducing the deficit by half by 2009. While the goal is welcome, we believe the measures are not ambitious enough, and some revenue raising measures will have to be contemplated, especially in view of Hurricane Katrina and the Iraq war's effects on broader U.S. government spending.

Perhaps the central concern in the process of withdrawing accommodation has to be about consumption growth in the United States, which has been holding up the world economy. U.S consumption growth has to slow because the negative household savings rate is unsustainable. It will slow, perhaps on the back of slowing house price growth. The worry is that it will slow abruptly, taking away a major support from world demand before other supports are in place.

Let me conclude. The world economy has been resilient in the face of shocks, in part due to improvements in the quality of policy. This has allowed a variety of imbalances to build up. While the imbalances have been financed easily thus far, one concern we have is that if financing dries up, it will do so at the worst possible time for the world economy — when its strongest engine falters.

A second concern has to do with protectionism. It is all too easy for politicians to blame other countries for imbalances — after all, foreigners do not vote. The solution then appears easy. Impose punitive tariffs! Yet as we have seen, the imbalances are a shared responsibility, and no one country will be able to solve it unilaterally, least of all by imposing tariffs. And a tariff here will bring forth a tariff there, potentially harming the entire world economy. We have seen the movie before in the depression of the 1930s and it is frightening. It is to forestall such a descent into autarky that the Fund has been arguing that countries should avoid pointing fingers at each other. If instead countries see the imbalances as a shared responsibility, it will help guide the domestic debate in each country away from the protectionism that may otherwise come naturally. We should recognize that the need of the hour is sensible domestic policy reform.

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