More on Global Imbalances

As I noted yesterday (see here and here), Bank of Canada Governor* David Dodge recently decried the global imbalances, with the US spending so much and saving so little while others (China, in particular) are saving so much and investing so much in the US. His concern is that when, not if, the asset bubble in the US fizzles, the ensuing slowdown in the US could drag down the rest of the world with it.

These global imbalances have been acknowledged by economists for quite some time. Some are concerned by them, but not all. Last May, Nourieli Roubini wrote a nice summary of the views. Here are brief excerpts of what he wrote:

[T]he 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.

...[H]ere 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.

[L]eaving 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.

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

... 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.

... 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...

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.

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.

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.

Please note that the above quotations are excerpts; his arguments and explanations are much more detailed. Please note, too, that his piece was written before the Chinese currency revaluation occurred.
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*Query: should I be writing "gubnor"?