Shifts in saving patterns of major industrial countries since the early 1980s have been associated with the emergence of large and persistent external imbalances among these countries.16 An important point of debate among academics and policymakers alike has been whether these imbalances represent a problem and, if so, how they could be dealt with. On the one hand, it is argued that, given the high degree of international capital mobility, national saving and domestic investment need not be closely linked. Thus, to the extent that current account imbalances mainly reflect differential rates of return to investment and differing saving rates across countries, they would not pose a problem. On the other hand, concerns have been raised that large and persistent current account imbalances eventually lead to sudden and unpredictable changes in macroeconomic policies—or in variables such as exchange rates, interest rates, and prices of financial assets—and thereby induce large adjustment costs.
This section examines the merits of the above positions. First, the relationship between financial integration and the international distribution of saving and investment is explored. Subsequently, the discussion focuses on circumstances in which large current account imbalances are associated with existing underlying problems. The related issue of resource transfer between the industrial and developing countries through their aggregate current account imbalances and its relationship to the debt crisis is considered in Part Three.
Saving, Investment, and Current Account Balances
As noted in Section I, there have been marked differences in saving behavior among the major industrial countries in the 1980s. While saving rates have generally declined in the lowsaving countries, they have tended to rise in the highsaving countries. These shifts in saving patterns have been an important cause of the widening in external imbalances among these countries. (The decline in investment in some of the highsaving countries has been the other contributing factor.)
Theoretically, in a world in which financial capital moves freely in search of the highest available returns, countries with a high level of investment need not rely on an equally high domestic saving. In such an environment, the gap between domestic investment and saving can always be financed by foreign saving via a current account deficit. However, in a well-known study, Feldstein and Horioka (1980) demonstrated that the development of internationally open financial markets in the 1970s—evidenced by the reduction or removal of capital controls and the growth of international borrowing—did not lead to a reduction in the very high correlations between domestic saving and investment rates in industrial countries. They interpreted this result to suggest that international capital mobility was much more limited in the 1960s and 1970s than casual observation would have indicated.
The interpretation provided by Feldstein and Horioka has been questioned by a number of other researchers, who have noted that there is substantial alternative evidence pointing to a high degree of capital mobility.17 These studies have suggested at least two alternative explanations. First, even if financial capital is highly mobile, saving and investment may be correlated because of their similar responses to certain types of exogenous disturbances. For example, in the presence of constraints to the mobility of labor and physical capital, an unanticipated productivity increase would boost both domestic saving and investment. Similarly, if an autonomous rise in private saving is associated with a decline in demand for consumer goods the production of which is relatively labor intensive, then one would expect a rise in the marginal product of capital and hence a concomitant rise in domestic investment.18
The second explanation is that fiscal policy may have responded to shifts in the net balance of private saving and investment through offsetting shifts in public sector saving. In other words, governments in the 1960s and 1970s may to some extent have aimed fiscal policy at limiting the magnitude of current account imbalances (see Summers, 1988). Although this hypothesis is difficult to test, there is some evidence to support it indirectly. Notably, correlations between private saving and investment tend to be less close than those between total national saving and total domestic investment. Although there are other possible explanations, this finding is consistent with the hypothesis that policy-induced changes in government saving have offset shifts in the private saving-investment balance (see Bayoumi, 1989).
More recent studies suggest that the close correlation between investment and saving that had prevailed during the 1960s and 1970s began to break down in the early 1980s—see Frankel (1989) and Feldstein and Bacchetta (1989). This breakdown may be attributable to two coincidental events. One is that the pace of financial reform was intensified in the industrial countries in the 1980s, particularly in the high-saving countries such as Japan and the Federal Republic of Germany. As a result, a substantial source of saving was made available in the international capital markets. At the same time, a widening of budget deficits in a number of lowsaving countries, particularly the United States, created excess demand for saving and attracted foreign saving through higher interest rates. These stylized facts help explain the large current account imbalances between the United States, on one side, and Japan and Germany, on the other.
Implications of Current Account Imbalances
Given that shifts in saving behavior have differed among the major industrial countries and that some of these shifts seem to have had large effects on current account balances, the question arises as to whether these effects should continue to be a source of concern. More generally, does the distribution of saving among the major industrial countries matter, or should one be concerned only about the total flow of saving in these countries as a group?
To the extent that shifts in external balances reflect the allocation of saving by private agents seeking the highest available risk-adjusted returns, they would not create a problem. For example, if the high rate of saving in a given country is attributable to demographic factors that are expected to be reversed over time, it would be natural for the country to run a current account surplus for an extended period. By accumulating foreign assets, the country would ensure that it is in a position to finance the subsequent rise in consumption and the corresponding current account deficit. In this case, the country would be illadvised to reduce its surplus by reducing saving—which would lower growth at home and abroad—or by undertaking inefficient domestic investment. Another example would be if domestic investment in a country was more productive, say, owing to its resource endowments, than in other countries. In such a case, it would be desirable for the country to run a current account deficit.
More generally, a current account imbalance could be benign so long as it reflected individuals’ optimizing decisions relating to saving and investment that are made in the absence of significant distortions or rigidities in the system. However, as discussed in the previous section, the level of saving may be too low because of a number of distortions, including a divergence between social and private rates of time discount, tax measures, externalities associated with investment, and excessive government dissaving. In an open economy, such underlying problems could be manifested in a large external imbalance. While the external imbalance itself is not the source of the problem, it does nevertheless allow the country to prolong its nonoptimal behavior. In certain circumstances, the eventual delayed adjustment could inflict a cost on other countries through abrupt changes in financial variables.
For instance, if private saving is too low because of tax or other distortions, the country can sustain its consumption through accumulation of foreign debt. If unchecked, a rapid rise in the ratio of external debt to GNP could eventually create solvency problems and necessitate abrupt and costly adjustment. Alternatively, if tax and other distortions result in an outflow of domestic saving, domestic investment could decline to a suboptimal level. The adverse impact on growth and welfare would be amplified to the extent that there are externalities associated with domestic investment.
The most important source of decline in national saving has been identified to be the decline in government saving. In a closed economy, excessive government dissaving pushes up interest rates and crowds out private investment (to the extent that Ricardian equivalence does not fully hold). In this situation, the corresponding rise in inflation and interest rate is likely to generate domestic pressure on the government to correct its fiscal imbalance. In an open economy, the government can resort to foreign borrowing to alleviate pressures on domestic interest rates. Thus, in a sense, increased access to international capital markets enables the government to postpone a needed adjustment. In the meantime, the resulting increase in the international interest rate imposes a cost on the rest of the world. This situation, however, cannot be sustained indefinitely. Eventually, continued government consumption financed by accumulation of foreign liabilities could undermine market confidence, resulting in sharp movements in exchange and interest rates.
The above considerations suggest that the current account balance does contain useful information about the shifts in saving and investment and can serve as an indicator of whether a country’s economic performance and policies are in need of attention. Having said that, it should be pointed out that, in contrast to other economic objectives such as growth and inflation, the current account, per se, is not an intrinsic policy objective. Any judgment regarding the desirability of a given level of current account imbalances must ultimately rest on the assessment of policies determining the underlying saving and investment patterns. Thus, it is necessary to know the origin of a current account imbalance before assessing whether it is undesirable and, if so, how to correct it.