Wolf, Reisen, DeLong, and Buiter on Global Imbalances

Martin Wolf's economists' forum on global imbalances. It's a bit long, but worth it, e.g. see the DeLong versus Buiter debate at the end:

Global imbalances, Martin Wolf's economists' forum: ...I suggest the discussion needs to be focused around five questions: first, what is actually happening? Second, why has the US developed such large current account deficits? Third, in what sense, if any, are these deficits a matter for concern? Fourth, what is likely to happen and over what time period? Finally, to the extent that they are a concern, what actions should be taken to deal with them and by whom?

Let me outline below what I see as the issues under each of the questions I have listed.

First, what is happening? Over the past fifteen years, the US current account has shifted from balance to a deficit of over 6 per cent of gross domestic product. Over the same period, the US has moved from being a small net debtor to the rest of the world, to one with net liabilities at the end of 2004 of 21.7 per cent of GDP. One of the remarkable features of this story, however, is that US net liabilities have slightly improved, from 23.1 per cent of GDP in 2001, despite ongoing current account deficits averaging 5 per cent of GDP. There are two explanations: dollar devaluation and the appreciation of US-owned foreign assets, in terms of their domestic currencies, at a faster rate than of US dollar liabilities, in dollars. How long will foreigners be prepared to make such generous “gifts” to the US?

Ricardo Hausmann and Frederico Sturzenegger have argued, however, that there is no current account deficit, because the US is exporting “dark matter”. This is shown, they claim, in the continuation of the US surplus on investment income, despite the supposed move into a net liability position. Willem Buiter has responded by arguing - correctly, in my view - that the only dark matter is to be seen in the seignorage on foreign holdings of US currency, which accounts for at most a sixth of the number advanced by Profs Hausmann and Sturzenegger.

Second, why is this pattern of “imblances” emerging? One view is that a savings surplus (or “glut”) has emerged in the rest of the world - defined as a surplus of savings over investment, even at exceptionally low real interest rates. The US is offsetting this surplus, by running a corresponding deficit sufficient to sustain “full employment” or, to use contemporary terminology, “a zero output gap” at home. This need has, in turn, dictated US monetary policy and has led to the high-spending, low-saving household sector we see today.

Another view is that US public and private profligacy is driving the external deficit, to which the rest of the world is adjusting. Under that view, the US should start by adjusting its fiscal position and, some would argue, trying to prick the alleged house price bubble.

Third, are the deficits a source of concern? One view is that if deficits are a concern it can only be because of US fiscal policy or currency manipulation abroad. The latter is easily demonstrated, however, by the scale of the accumulation of foreign currency reserves in recent years: since the end of 2001, global foreign currency reserves have risen by roughly $2 trillion.

An alternative view is that the market itself can make mistakes. Foreigners may be buying more dollar assets than makes sense for them. Again, US households may be taking on more debt and saving less than they would if they had a clearer idea of long-term prospects. If either of these perspectives are correct, the adjustment may be painful and abrupt.

Fourth, a big difference has emerged between those who regard what is happening as sustainable in the medium to long term and those who see it as a short-term phenomenon.

Among the former, one can identify several perspectives. Richard Cooper of Harvard University argues, for example, that the savings surpluses in Japan and parts of Europe are structural, while US savings are adequate. A not dissimilar view comes from Ricardo Caballero of MIT, who argues that foreigners buy US assets because of the failure of their own financial systems to generate financial assets of a suitable quality. Alan Greenspan has expressed comparable views on the impact of the decline in home-country bias on capital flows. Michael Dooley of the University of California at Santa Cruz and colleagues at Deutsche Bank argue that China is using fixed exchange rates as a way of building up an internationally competitive industrial sector, just as Japan and Germany did under Bretton Woods.

The majority of economists who have worked on this topic conclude, however, that present trends cannot continue. A turnaround is required fairly soon if US indebtedness is not to explode.

Fifth, what should be done? The answer depends on whether there is any reason for concern. If there is, the big question is who starts the process - markets or governments? If the latter, again, who starts - the debtor or the creditors? The likelihood, in practice, is that it is the former who will trigger the change. The greatest disaster, however, would be a tightening in the US, unmatched by expansionary policy elsewhere. The result would probably be a global recession.

It is over to you now.

Martin

 

Your comments by Reisen:

Martin,

at the Lacea 2005 meeting held last year in Paris, I have argued along the following lines:

1. Asian economies have cut back on investment after the Asian financial crisis 1997/98, built up huge official reserves (often invested in US treasuries) and then warmed to ‘exchange-rate protection’.China’s savings and investment rates have exploded to extraordinarily high levels, with savings outstripping investment.
2. Low interest rates that coincide with falling saving rates in the OECD area suggest that the driving force for global 'imbalances'has been an increase in the surplus of savings over investment particularly in emerging Asia and, more recently, in the oil exporting countries.
3. A core model of economic development, the Lewis- Ranis - Fei or surplus labour model might point to an overlooked, but crucial feature: China’s modern sector – and by extension the world economy (!) – faces an unlimited supply of labour at wages not far from the subsistence level.
4. As the value of the marginal product of labour in the modern sector exceeds the wage rate, profits are high, saved and reinvested.
5. China is still miles away from reaching the point where wages would start to converge between the rural and the urban sector. In the quarter century from 1978-2003, urban per capita income has risen much faster than rural income. With employment at ca. 750 million in China and an estimated annual employment growth of 1 percent. over the coming 20 years China’s rural surplus labour will not be exhausted.
6. The rapid export growth of low-skill and labour-intensive manufactures has increased the market competition for these goods and hence exerted a downward pressure on their prices. The saving segments of OECD populations will keep on saving little, thanks to wealth effects as a result of high real estate, bond and stock prices – as long as wages remain depressed and/or unemployment high.
7. So probably more of the same in the next two decades: The Asian producer saves, the OECD consumer issues further debt.

From Helmut Reisen, OECD

by Brad DeLong:

Martin

Let me tackle number 4: "What is likely to happen and over what time period

Japan's central bank is likely to keep buying several hundred billion a year of dollar-denominated assets--it wants to avoid any severe yen appreciation that will threaten exports. China's central bank is likely to do the same: China's State Council wants to preserve full employment at Shanghai at all costs. China's central bank, however, cannot keep borrowing $300 billion worth a year from the good burghers of Shanghai for more than another couple of years. So it will start printing money--and a wave of domestic inflation in China will appreciate the real value of the renminbi even without nominal appreciation. Similarly, Japan's central bank will welcome inflation

The most likely scenario, I think, is that over the next half decade price levels in Asia will rise substantially enough to curb imports into the U.S. and boost exports, and that the U.S. trade deficit will thus shrink back down to sustainable levels without any great macroeconomic upset in the U.S.--as happened in the late 1980s with the unwinding of the trade deficits produced by the policy mistakes of the Reagan era, as happened in the late 1970s with the unwinding of the Middle East's petrodollar surpluses

Of course, large-scale money printing and internal price rises of 50% or so in Asia in the course of a few years may well cause significant macroeconomic upset on the western side of the Pacific

And this is, I think, only the most likely scenario. It is also, I think, the calmest and least distressing

Brad DeLong

by FT Economists Forum:
From Willem Buiter

Martin,

It is strange that opinions on this issue are so far apart. The fundamental inputs required to reach a conclusion are the following: (1) the magnitude of the US net foreign liabilities; (2) the rate of return the US will have to pay in the future on these net external liabilities; (3) the future growth rate of the US economy; (4) the size of the current US external deficit; and (5), the real exchange rate depreciation required to achieve a given reduction in the US external (primary) deficit. Differences in opinions should be reducible to different estimates for these 5 key numbers.

I start from the following premises: (a) Past US current account deficits have not been massively overstated through a failure to record US exports of 'Dark Matter' (see my Goldman Sachs Global Economics Paper No: 136 "Dark Matter or Cold Fusion" at http://www.nber.org/~wbuiter/dark.pdf for the details); (b) the US is a net external debtor, but the existence of a stock seigniorage Dark Matter (US currency held abroad) of between 1.7% and 4.3% of GDP in 2004 means that the true net external liabilities are likely to be just under 20% of GDP rather than just over it; (c) recent recorded current account deficits of just over 5% of GDP in 2005 and around 6.5% of GDP in 2005 are not seriously over-stated.

To be sustainable, the value of net external US liabilities cannot exceed the present value of current and future US primary surpluses. The US primary surplus is its current account surplus excluding net foreign investment income - effectively the trade balance surplus plus net current transfer payments to the US. The US has run primary deficits every year since 1982, except of a small primary surplus in 1991. In recent years, with net foreign factor income a small positive number, the US has run primary deficits just slightly smaller than the steadily growing current account deficits. That is the bad news.

The (prima facie) good news is that if the rate of return on the US net external debt is low enough, the future primary external surpluses the US will have to generate to ensure external sustainability and solvency, need not be large. Assuming that primary surpluses can grow in line with GDP, the key factor determining the future net external transfers the US will have to make is the gap between the real rate of return on its net external liabilities and the growth rate of US real GDP. US real GDP grew at an annual rate of 2.9% over the period 1986-1995, and at 3.4 percent between 1996 and 2004. Looking forward, a trend growth rate of 3.0 percent does not appear wildly optimistic.

What about the future real rate of return on net foreign liabilities? Ten-year nominal interest rates on Treasury bonds are around 4.5 percent. The real yields on index-linked US government 10-year and 30-year bonds hover around 2.0 percent. If 2.0 percent is indeed the rate of return the US will pay on its net external liabilities in the future, we have a true ‘don’t worry, be happy’ scenario. With the real cost of external borrowing below the growth rate of the real economy, any net external debt stock is sustainable.

Therefore, those who, like myself, argue that there is something to worry about must argue either that the future growth of US real GDP will be much less than its historical average over the last two decades, or that the rate of return that will be paid on US net external liabilities in the future will be significantly above the level of current US sovereign borrowing rates (at all maturities). My money is on future returns being higher than current sovereign borrowing rates. There are two reasons for this. First, sovereign borrowing rates everywhere are more likely to rise than to fall going forward. Without being in the UK league (where 50 year index-linked gilts yielded all of 0.35% at the end of January 2006), US long-term real rates appear low today. Second, foreign purchasers of US assets will continue to purchase private assets as well as US government securities. Between 1982 and 2004, the stock of Foreign Direct Investment in the US increased (at market value) from $130bn to $2,687bn. Expected returns on FDI and on portfolio equity in the US can be expected to exceed the return on long-term government debt.

That said, it is not easy to rationalize a long-term real rate of return much over 4.0%. With a 4.0% long-run real rate of return and a 3.0% long-run growth rate of real GDP, an average future long-run primary surplus of 0.2 percent of GDP suffices to make a current net external debt burden of 20% of GDP sustainable. From a 2005 primary deficit of over 6.0 percent of GDP, this means a permanent reduction in the US primary deficit of just over 6.0 percent of GDP. That is a big number. The number gets bigger the longer the reduction in the primary deficit is postponed.

The required six percent of GDP increase in the balance of US saving over US investment will be economically and politically painful. If US capital formation is cut significantly, future growth prospects will be diminished. If private and public consumption are cut, political heads will roll.

Policy measures or other shocks that raise US saving relative to US capital formation are likely to be associated with a decline in every measure of the US real exchange rate; the relative price of non-traded goods to traded goods will fall in the US and so will the relative price of US exports to US imports. How large these real depreciations will be to support a six percent of GDP reduction in the primary external deficit depends on the responsiveness of demand and supply to changes in these key relative prices. With the US still a relative closed economy as regards trade in goods and services (exports plus imports amounted to 25% of GDP in 2004), standard export and import price elasticities (say, 2 for the sum of the export and import price elasticities) give large numbers for the real exchange rate depreciation required to achieve a sustainable US external position. The numbers just given imply a 25 percent real depreciation for the dollar.

This still leaves open a number of key questions. (1) When will these required reductions in the primary deficit have to start if the markets are to keep their faith in the ability and willingness of the US private and public sectors eventually to reduce their financial deficits to sustainable levels? My guess is not immediately, but probably before the next decade. (2) Will the depreciation in the real exchange rate come through a depreciation of the nominal exchange rate or through US inflation below that in the rest of the world? My strong prior is: mainly through the nominal exchange rate. (3) Will this be an orderly process or will it be accompanied by nominal exchange rate overshooting and other manifestations of financial market neuroses? My view is that everything is possible but that not everything is likely. Asset markets will no doubt over-react..

Best, Willem Buiter

by Brad DeLong:

Dear Willem--

Why is it your strong prior that adjustment will be accomplished mainly through a shift in the nominal exchange rate rather than through differential inflation, especially in Asia?

Both Japan's and China's central banks will at some point face the choice between (a) going to their respective governments and saying that the low-yen or low-renminbi policy is over, and (b) printing the money to buy one more month's worth of dollar-asset supply and postponing their unpleasant meeting with the cabinet or the state council for an extra month.

It is a very brave--and very unusual--central bank head to abandon an effective nominal exchange rate target and let the exchange rate swing free before dire necessity. And in this case there will never be any dire necessity--neither China or Japan will run out of reserves to support their currencies because it is not their currencies they are supporting...

by FT Forum - Willem Buiter:

Dear Brad,

These are the reasons I expect the forthcoming real depreciation of the US dollar to come mainly through a depreciation of the nominal effective exchange rate of the US dollar rather than through differential inflation.

* With Bernanke at the helm of the Fed, the US rate of CPI inflation will not be much below 2 percent per annum for the foreseeable future. He will not go in for serious, sustained inflation.
* The ECB and the UK will amble along at around two percent per annum CPI inflation until the cows come home.
* In Japan, the odds on the BoJ targeting (let alone achieving) an inflation rate much in excess of the US inflation rate over an appreciable period of time is negligible. The same holds for South Korea, Taiwan and India.
* That leaves the great unknown, the People’s Republic of China. It has probably the least independent Central Bank in the known universe. Part of the political leadership is economically literate/sophisticated, but there remain a large number of Neanderthals in influential economic policy positions. The authoritarian/totalitarian nature of the regime makes decision making opaque and hard to predict. It is therefore certainly possible that it will become increasingly difficulty to sterilise the continuing huge inflows of foreign exchange reserves and that this will give a major boost to monetary growth and to the expansion of credit to enterprises and households. Should that happen, there would no doubt be attempts to use command and control methods, including price controls, to suppress the resulting inflationary pressures. Such methods will fail (watch Nestor Kirschner in Argentina), and open inflation will roar along.
* Such a scenario is possible, but unlikely. It is much more likely that the renminbi will be allowed to appreciate, possibly quite sharply, vis-à-vis the US dollar. This could happen as early as 2007 and certainly before the beginning of the next decade. The gradual liberalisation of the capital account of the PRC means that the attractiveness of a nominal exchange rate target is steadily diminishing. When push comes to shove, most policy makers will opt for stability of the internal value of the currency over the stability of its external value. With a more liberal capital account, that choice becomes a no-brainer. For a largish economy, with an openish capital account, there is only one workable exchange rate regime - a float, possibly a dirty one.
* Whatever happens to Chinese inflation or to the bilateral exchange rate of the renminbi and the US dollar, the Chinese currency currently has a weight in the US dollar's effective (trade-weighted) exchange rate, as measured by the Fed's broad index for the US dollar, of just over 10 percent. The renminbi is therefore an interesting but not overwhelmingly important piece of the US dollar effective exchange rate puzzle.