Nouriel Roubini's Global Economics Blog: May 2005 Archives

リンク: Nouriel Roubini's Global Economics Blog: May 2005 Archives.

In the classic Kurosawa film Rashomon, a heinous crime is perpetrated in a forest. This crime is reported by four witnesses, each giving his or her own point of view. Who is telling the truth? Who is lying and what is truth? Which version of the story, if any, is the real truth about what happened in the forest?

Today, the large global imbalances are a similar heinous event that requires explanation and interpretation. In this contemporary Rashomon drama, the basic facts are known: the US is running large fiscal and current account deficits while the rest of the world is running large current account surpluses. The flow of capital that is financing these US twin deficits is mostly (three quarters or so) coming from foreign central banks - mostly in Asia but not exclusively - that are aggressively intervening to prevent an appreciation of their currencies.

While the basic facts are undisputed, the causes of such imbalances, which country is at fault and the policy solutions to such imbalances are much disputed. Like in Rashomon, every actor in this tale is spinning a different interpretation, blaming someone else for the problem and providing a different policy solution.

So, in this note I would like to present a roadmap of the current Global Imbalances Rashomon debate and discuss five alternative views of this contemporary debate, rather than the four in Rashomon. Putting in logical focus the various interpretations will allow us to understand the specific flaws of the various arguments and, hopefully, direct us to the right interpretation and policy solution. So, here is my take on the five interpretations of the global imbalances.

1. The Deutsche Bank's "Bretton Woods Two" Panglossian View: No need to change fiscal balances, current account balances or exchange rates.

The Deutsche Bank's "Bretton Woods Two" hypothesis has been presented by Dooley, Garber and Folkerts-Landau in a series of five papers (Is it 1958 or 1968? Three Notes on the Longevity of the Revived Bretton Woods System; An Essay on the Revived Bretton Woods System; The Revived Bretton Woods System: The Effects of Periphery Intervention and Reserve Management on Interest Rates & Exchange Rates in Center Countries; Direct Investment, Rising Real Wages and the Absorption of Excess Labor in the Periphery; and The US Current Account Deficit and Economic Development: Collateral for a Total Return Swap ). Their view is one of a Panglossian world where these global imbalances are optimal,and thus they do not require any adjustment either in quantities (fiscal or current account balances) or prices (exchange rates). In this Ricardian cum Tax-Smoothing view of the world, the US fiscal deficit is optimal, not a problem as the US is running some temporary wars. Garber claims that global imbalances are not caused by “US fiscal profligacy”, i.e. the US budget deficits. He presumably views the latest US fiscal deficit as driven by a transitory increase in military (and homeland security) spending related to the "temporary" wars against terrorism, Afghanistan, Iraq and the need to prepare to confront other rogue states (Iran, North Korea, etc). Thus, it is "optimal" to run budget deficits and, thus, current account deficits. Indeed, history and a tax smoothing approach to fiscal policy suggest that, during a transitory war, it is optimal to run fiscal deficits that lead to current account deficits. In this view, the US is borrowing from abroad to provide the global public good of “international security”.

Moreover, in the Deutsche view, China and Asia desire to run current
account surpluses and they will eagerly finance the US for a generation or more as China needs to absorb hundreds of millions of rural workers in the urban sector and Asia loves a mercantilist export-led growth model. Thus, there is no problem to solve and we do not need either an adjustment of quantities (fiscal and current account) nor an adjustment of prices (exchange rate). The world is in its Panglossian optimum and will stay so for the longest time.

The flaws of this Panglossian view are clear and Brad and I have fleshed them out in excess detail in our long paper on the coming demise of the Bretton Woods Two regime. Here only a few reminders.

First, the current war against terrorism and various “rogue states” is not "temporary" and may last a generation instead. Thus, a tax smoothing model implies such semi-permanent spending should be financed by an increase in tax rates, not debt and deficits. Second, most of the worsening of the US fiscal deficit has not been driven by an increase in defense and homeland security spending but rather by a structural fall in revenues; this is a perversion of the tax smoothing logic. Third, a tax smoothing model suggest that, during a transitory increase in spending, tax rates should remain constant (smoothed) not sharply reduced as they have been in 2001.

Fourth, and most important, it does not make sense for the US - the only hyperpower in the world - to have most of the financing of its fiscal and current account deficits to come from the country - China - that from a geostrategic point of view is the most significant long-run challenge to the United States. For the first time in history, the contemporary superpower/hegemon is a net debtor, rather than a net creditor, is the largest net borrower, rather than net lender, and is being increasingly financed by its most challenging long run geo-strategic rival.

Thus, even leaving aside all the other reasons why the BW2 regime is fragile and unstable and likely to collapse in the next year or two, an optimal tax smoothing and consumption smoothing approach cannot lead to the conclusion that the US twin deficit are optimal or sustainable. The US is playing a fiscal and current account Ponzi game that clashes with any intertemporal solvency condition found in tax smoothing and consumption smoothing and optimal current account models. And once one agrees that such fiscal and current account imbalances are not sustainable, the Deutsche argument that China should not move its peg and should keep on piling up reserves appears as flawed as well. We will consider below in more details the arguments in favor and against a Chinese/Asian currency move.

2. Ronald McKinnon' View: the US fiscal deficit is the problem but the Chinese/Asian currencies do not need to move.

Ron McKinnon wisely argues that the US fiscal deficit (in significant part driven by an unsustainable cut in tax revenue) is a serious global policy problem; such fiscal deficit is also the source of the current account deficit (McKinnon's views have been presented in a series of papers, here and here and here). He also agrees that such twin deficits are unsustainable and as source of severe global imbalances. Thus, he is in favor of a US fiscal adjustment that will reduce such global imbalances. However, he believes that a Chinese or Asian currency move is inappropriate. The global rebalancing can fully occur, in his view, via "expenditure reduction" policies without the need for the "expenditure switching" effect of changes in nominal and real exchange rates. His view is based, in part, on his long-standing arguments that a regime of global fixed exchange rates among major economies (US, Europe, Japan/Asia) would be ideal. In his view, currency adjustments are destabilizing rather than stabilizing. He blames the US pushing for a revaluation of the Japanese yen in the mid 1980s that, in his view, caused the ensuing bubble and then deflation that plagued Japan in the 1990s. He is concerned that forcing China to move its peg would lead to the same destabilizing deflation that plagued Japan. Thus, in his view, quantities (i.e. global savings-investment imbalances) can be adjusted - and should be adjusted - without destabilizing relative price movements. In his view, the real appreciation that fast productivity growing countries require can be achieved via domestic inflation rather than nominal appreciation.

McKinnon view overstates the role that the Yen appreciation in the late 1980s had in triggering the Japanese real estate bubble and its burst into deflation in the 1990s. Other more structural micro distortions in the allocation of savings to capital explain the bubble of the 1980s and its deflationary bursting in the 1990s. He incorrectly downplays the role that exchange rate movements had in the late 1980s in leading to an orderly global rebalancing where US fiscal contraction cum a US dollar fall led to a gradual shrinkage of the US twin deficits of the early 1980s.

Nominal exchange rate movements had an important role in adjusting equilibrium relative price for a country such a Japan during its 30 year period of high growth since the early 1960s. In 1960, the yen was at 360 to the dollar while today it is closer to 100. In spite of such a sharp long run nominal appreciation Japan has not lost its competitiveness because high productivity growth until the early 1990s allowed Japan to experience an appreciating currency without a loss of competitiveness. Also, Japan grew very fast in the years after the breakdown of the Bretton Wood system in 1971 when the yen started its appreciation. Japan grew rapidly for almost two decades after the time when the yen became flexible and well before the 1990s slump. Thus, it is incorrect to blame flexible exchange rates for the economic stagnation of Japan in the 1990s. Similarly, China has already had a long decade of high productivity growth with essentially fixed nominal exchange rates. Since its equilibrium real exchange rate is appreciated, an orderly adjustment of the actual real exchange rate requires a nominal exchange rate adjustment as well; otherwise the real appreciation will occur via socially and politically disruptive increase in inflation. McKinnon mistakenly downplays the risks of high inflation in China: in the early-mid 1990s when China experienced high inflation the real economy went into a hard landing with growth slowing sharply in the late 1990s.

So, McKinnon is correct in stressing the important role that US fiscal adjustment can play in supporting an orderly global rebalancing. But his view that such rebalancing does not require any exchange rate adjustment is at odd with over thirty years experience with flexible exchange rates where exchange rate flexibility has helped undoing exchange rate misalignments that do occur from time to time. Adjusting relative prices via nominal exchange rate movements is less costly that trying to adjust such relative price via costly deflation or inflation.

One can also point out that the risks of a deflationary spiral in China are minimal. Currently, in China inflation is increasing, not decreasing, and the actual inflation rate is artificially kept low via various administrative freezes on the price of energy and the price of many public services. So, the risk of deflation via a currency appreciation is minimal. If anything, by appreciating its currency China could successfully control inflationary pressures while providing to its citizens an increase in terms of trade or purchasing power over foreign goods.

Also, the McKinnon concern about the deflationary effect of a Chinese and Asian appreciation on their economies can be turned on its head as a failure to flexibilize the Chinese and Asian currencies may lead to deflation in the US, Europe and Japan. Indeed, if the Chinese/Asian appreciation does not occur via a nominal appreciation and it does not occur via higher inflation in China (as slow growth of Chinese real wages may keep such inflation under control), then the only way in which such real appreciation can occur is through the fall in the price of traded goods in the rest of the world (i.e. a fall in prices in the US, Europe and Japan). Thus, while McKinnon worries about Chinese deflation, he does not consider the possibility that the needed real exchange rate adjustment could occur through a severe and destabilizing deflation in advanced economies. And, as the experience of Japan in the last decade suggests, such deflationary pressure would have severe consequences on the productive sector of the advanced economies.

Thus, a US fiscal adjustment without a change in relative prices (the Chinese/Asian nominal and real exchange rate) will not trigger enough of an expenditure switching effect that is required to reduce the global imbalances. Both are required to have an orderly global rebalancing.

3. The Fed's view (or views): the US current account deficit derives from a "global savings glut" rather than a lack of US savings. US fiscal deficits may be a problem but their reduction may not shrink a US current account deficit whose source is foreign, not domestic. Foreign investors' willingness to finance the US current account deficit will continue for quite a while as this global savings glut is attracted to the high growth and returns of the US.

It is hard to know what the Fed's view on the global imbalances exactly is as, over the last weeks and months, Chairman Greenspan, several Fed Governors (Kohn, Bernanke, Geithner, Ferguson, Yellen, Pianalto to name a few) and the Fed staff have all widely written on the subject. I will take as the Fed view the recent and influential piece by Ben Bernanke on the US current account deficit due to a "global savings glut"; but I acknowledge that 1000 flowers may be blooming at the Fed when it comes to the issue of the global imbalances. That Bernanke speech, together with other recent musings by Ferguson, Kohn and Greenspan may represent the core of the Fed view.

Bernanke has argued that the US current account deficit derives from a "global savings glut" rather than a lack of US savings. US fiscal deficits may be a problem but their reduction may not shrink a US current account deficit whose source is - in his view - foreign, not domestic. Foreign investors' willingness to finance the US current account deficit will continue for quite a while as this global savings glut is attracted to the high growth and returns of the US. But the Chinese/Asian currencies may need to appreciate and the US dollar fall to adjust over time the current account imbalance. A currency move will benefit the US, regardless of US fiscal adjustment, as net exports will sharply increase once the dollar falls. While a fiscal adjustment is not crucial for global rebalancing, in the Fed's view, a fiscal adjustment will occur in the US by default and semi-automatically via the political process.

As a starting point of the critique of the Fed's view, note that the term "global savings glut" - used by Bernanke - is a total misnomer.
The alleged "excess" of foreign savings does not come from a sharp increase in global savings, as the evidence shows that private and especially public savings are falling in most regions (US, Europe, Japan), apart from china. This alleged excess of savings, instead, derives from a lack of real investment that leaves more of the relatively low national savings available for foreign investment (i.e. a current account surplus). In other terms, Bernanke should have referred to a "global investment drought" as the current account surpluses of the rest of the world do not derive from a sharp increase in global savings, but rather by a fall and lack of real investment that went bust in 2000 and has failed to sharply recover so far in most advanced economies and emerging market economies as well. So, the "global savings glut" term is altogether improper and incorrect and leads to the non-sense of the Fed arguing that the US CA deficit is not caused by a US savings drought but by a non-existent "foreign savings glut". Obviously, it is convenient for Bernanke to speak of a global savings glut as that term supports the equally flawed and incorrect view that the US current account deficit is not caused by poor US domestic policies, but rather by exogenous foreign/external factors.

Instead, once we talk more appropriately about a "global investment drought", the issue becomes of whether such drought is permanent. The Fed happens to believe that the world is now in a new long run equilibrium where there is too much capital in the world, and thus the low returns on all sort of assets. In this world of excess capital, the investment drought will remain for a long time and thus, real interest rates will remain low regardless of the US fiscal deficits.

But let flesh out in more detail the flaws of the Fed arguments.

First, as discussed above, data are consistent with a "global investment drought", not a "global savings glut". As a number of studies have clearly shown (and see the excellent Economist article on the global shift away from thrift/savings), the problem in the world economy is not one of a glut of savings but rather a dearth of savings. Large and growing fiscal deficits in the US, Europe and Japan imply negative public savings. Private savings are dismally low in the US while higher - but falling - in Europe and Japan where the private sector is saving in order to compensate for the current and future expected negative public savings. Savings rates are high in China and Asia but investment rates are also high in those regions; so there is no global savings glut. The "global savings glut" is a myth and Bernanke and the Fed know better.

Second, the argument that the US has a large and growing current account deficit because the glut of global savings is chasing the safe and high returns of the US is also incorrect. In the 1990s, when the US current account was driven by an investment boom, net FDI and portfolio equity inflows from abroad to the US were massive, to the tune of about $200 billion a year and financing a large fraction of the US current account deficit. Since 2001, when the US current account deficit has worsened in spite of an investment bust because of the fall in public savings (the fiscal balance going from a 2.5% of GDP surplus to a 3.5% deficit), net FDI and portfolio investment has gone from a $200 b surplus to a $200 b deficit per year in 2003-2004. So, private investors not only are not financing any more the US current account deficit; they are actively pulling out $200 b a year from equity investments in the US. So, the argument that foreign investors are attracted to the US and attracted to US high returns is non-sense: they have been pulling out $200 b a year from equity investments as those investments (as measured by stock market returns) have had average returns that have been negative since 2000 (all US stock indexes today are still well below their 2000 peaks).

Third, the myth of a glut global savings being willingly invested in the US by private investors is also altogether false. In the last two years, three quarters of the US current account deficit has been financed by foreign central banks, not foreign private investors (with 2004 seeing an accumulation of dollar reserves of $500 billion out of a US current account deficit of $660 billion). So, Bernanke (or whoever wrote his speech) got the basic facts wrong and the interpretation even more wrong (and the same holds for the speech by Ferguson presenting variants of the Bernanke view).

Fourth, there are plenty of counterarguments to the Fed view that we live in a world of excess capital, where the returns to many assets are low and thus future investment will remain low and thus maintain the "global savings glut". In a separate and forthcoming paper with Brad Setser, we will discuss the bond market conundrum/puzzle and the other asset markets puzzles (high price ratios, low returns and low spreads). Here, one point should be noted. To maintain the economic growth rate of most of the parts of the world close to potential, investment as a share of GDP needs to increase relative to its low levels of the last few years in US, Europe, Japan, and even most of non-China Asia. For a while after the tech bust and 9/11, private corporations and firms were into cleaning up their balance sheets, reducing excessive leverage and boosting profitability. Now, that process has occurred and firms have the resources to invest more once they get more confident about the path of global growth. So, we do not live in a world with too much capital: certainly in most of the emerging markets there is too little capital, not too much and the move of many emerging market economies to become capital exporters, rather than capital importers, is temporary and driven by the temporary slack of investment after the financial crisis of the 1990s.

Even in advanced economies, the low investment rates of the last 4 years imply that investment is well below what is necessary to sustain potential growth. So, eventually investment rates will rise across the world and this will put pressure on low global savings and thus on long term interest rates and the return on many risky assets.

Fifth, arguing, as the Fed does, that a glut of global savings and a permanent dearth of global investment will keep global long rates low and will allow the US to happily finance its twin deficit with little risk is naive at best and reckless at worse. It is amazing how the Fed (or at least some at the Fed) have become blasé about the US current account deficit (see this recent story on the Economist). At least, at the Fed there are those like Tim Geithner that, based on their wide experience dealing with emerging market crises, well realize the unsustainability of the US twin imbalances and the risks of a systemic crisis deriving from such global imbalances.

4. Richard Cooper's View: the current account is sustainable as foreign investors love to invest into safe US assets; also a Chinese currency move is inappropriate as it would seriously hurt China's growth.

Richard Cooper's view is clear from the title his recent Financial Times column: "America's current account deficit is not only sustainable, it is perfectly logical given the world's hunger for investment returns and dollar reserves". That says it all. In addition to the view that he is not concerned about the sustainability of the US current account, he is also against a movement of the Chinese currency, even if for reasons different from those of McKinnon. McKinnon is generally in favor of fixed exchange rates globally and against exchange rate flexibility. Cooper is not opposed in principle to trade adjustments occurring via the nominal exchange rate movements but, in the case of China, he believes that a currency adjustment would not be appropriate. Why? China's fixed rate regime has served China well and further forex accumulation is not such a bad idea given that it guarantees continued high growth (as he says: "Their motives stem purely from their desire to inhibit export-damaging currency appreciations that may well be temporary. This is not a foolish strategy, if not carried to extreme".) In his view, given the fragility of the Chinese financial system, a currency appreciation may severely hurt the Chinese traded/export sector and thus lead to a sharp increase of the non-performing loans of such a sector. Thus, a Chinese currency movement is risky. Moreover, his view is that the US current account is sustainable - actually "logical"- (even if eventually the deficit will have to shrink as a share of GDP to make it sustainable in the long run) as foreigners desire to accumulate US dollar assets, and this factor will keep on supporting the exchange rate value of the US dollar. In his view, it is not the US that borrows from abroad when accumulating public and private external debt. It is rather non-residents who want to invest into US dollar assets.

Let us consider the arguments against the Cooper's view.

First, as in the case of the Bernanke argument, the view that the deficit is due to foreigners wanting to buy high return assets is refuted by the data: net FDI and equity portfolio investments have been negative to the tune of $200 b for the last two years and three quarters of the US twin deficits are financed by central banks, not by private investors. So, enough of this false argument that the US current account is reflective of the US capital account surplus and the desire of the world to buy US assets: foreign private investors have voted with their feet and have not accumulated much net new US dollar assets for the last few years while massively reducing their net holdings of US equity (FDI and equity portfolio): it is mostly official political agents, not private ones, that finance the US fiscal deficit and the US current account deficit. Thus, his argument that the US does not "borrow" from abroad, but rather that the foreigners are willingly "investing" into the US is not supported by the facts.

Second, the argument that China cannot manage a 10-15% revaluation of its currency has little basis. Given the peg of the last few years and the sharp increase in Chinese manufacturing productivity, Chinese tradeable firms' profit margins have been increasing over the years. And the nominal and real appreciation of the Chinese currency relative to the Euro and the other floating currencies has further increased the Chinese exports' profitability. Chinese export firms can manage the effects on their operational balance and their balance sheets of a Yuan appreciation; the risk of severe debt servicing difficulties is minor. Other firms - especially state owned ones and service sector ones - that are not in the tradeable sector have much weaker balance sheets and a lack of profitability; for those firms, a Yuan appreciation would be beneficial as its would reduce the relative profitability of exports and tradeables.

Third, Cooper seems to ignore the systemic problem of a world where global imbalances exist but where a group of countries (Eurozone, UK, Canada, Australia, New Zealand, etc.) has flexible exchange rates and has thus more than contributed to the global rebalancing through a sharp nominal appreciation while another group of countries (China and the rest of Asia) have pegged to the US dollar and have thus, not only not contributed to the global rebalancing, but they have been free riding on the downward movement of the US dollar by depreciating sharply relative to the currencies of the free floating regions. Thus, China and Asia have not contributed so far to the global rebalancing.

5. The Roubini and Setser (and consensus view): global rebalancing requires both US fiscal adjustment (and private savings increase) and a Chinese/Asian currency appreciation.

I refer to our view as the "consensus view" as a large number of authoritative commentators have expressed serious concerns about the U.S. "twin deficits," the sustainability of the U.S. public and external debt accumulation and the risks deriving from the reliance on foreign central bank financing of these twin imbalances. Similar concerns and alarms have been expressed in academic, policy, press/media and Wall Street circles by Rubin, Sinai and Orszag, Summers (and here, too), Peterson, Roach, Gross, Bergsten, the IMF (also, here), the World Bank, Rogoff and Obstfeld (plus this), Eichengreen, Wolf and Volcker, just to cite a few.

As we have argued before, orderly global rebalancing requires both "expenditure switching" via a Chinese/Asian appreciation relative to the US dollar and other floating currencies and, at the same time, "expenditure reduction" via a meaningful reduction of the US fiscal deficit that will require some increases in taxes.

A Chinese/Asian currency appreciation will lead to a reduction of the rate of forex intervention by such central banks. Thus, reduced Chinese/Asian forex intervention would lead to a soft landing and orderly adjustment if the U.S. fiscal deficit is reduced in tandem as the Asian currencies appreciate: In that case, the reduced supply in financing of the US deficits from Asia is matched by reduced demand for fiscal financing by the US. Then, the US the dollar can gradually fall without sharp effects on U.S. long-term interest rates: thus, "expenditure switching" via real depreciation would lead to an improved trade balance via fiscal "expenditure reduction," an orderly rebalancing that maintains U.S. and global growth. Also, as Brad Setser and I have argued in our recent China Trip Report paper, China would benefit from an appreciation of its currency for domestic - internal balance - purposes separately from the contribution of such an appreciation to the orderly global rebalancing.

But if the reduced foreign financing occurs without a parallel reduction in the U.S. fiscal deficit (in part via tax increases), then we are in hard-landing scenario, where the reduced supply of financing hits a still-persistent demand for fiscal deficit financing. In that case, not only the dollar does sharply fall, but long-term interest rates shoot up sharply, prices of risky assets (housing, equities, high-yield debt) fall sharply, a systemic crisis occurs and we risk a U.S. and global economic slowdown, if not an outright recession, as sharply higher real rates and negative wealth effect reduce private consumption and investment. In that scenario, the trade deficit will shrink in a disorderly and recessionary way for the U.S. and global economies.

Thus, to all of those we say that we do not have to worry about the US fiscal deficit or we do not have to worry about the US current account deficit or that we do not need a Chinese/Asian currency movement, one can reply: you are incorrect as an orderly global adjustment requires both a US fiscal deficit reduction and an Asian currency adjustment. Currency adjustment in China and Asia without a parallel US fiscal deficit contraction will lead to a hard landing triggered by higher US long term interest rates. A US fiscal adjustment without a change in relative prices (the Chinese/Asian nominal and real exchange rate) will not trigger enough of an expenditure switching effect that is required to reduce global imbalances.

Conclusion

In the film Rashomon, each story and interpretation given by the various characters is self-serving, and all these stories are mutually contradictory. At the end the viewer is left completely unable to determine the truth of the events, what really happened and who is to be blamed.

Hopefully, this note has brought some clarity on the causes and appropriate solutions of the current global imbalances. Some interpretations are highly self-serving, others conceptually and empirically flawed, other altogether Panglossian. There is an emerging consensus view on the multiple causes of these global imbalances and the need for a cooperative solution that requires each major region of the world to do its part. The main obstacle and problem is that the fiscal policy stalemate in Washington: the administration and the Republican Congress live in the delusional dream that the fiscal deficit can be meaningfully reduced without any tax increase (and actually via aggressive and reckless moves to make all the tax cuts permanent). Such reckless policy stance makes the probability of an orderly rebalancing smaller and increases the chances that the global rebalancing will be disorderly and occur through a hard landing of the US and the global economy.