Chapter

CHAPTER 9. Comment on “Global Imbalances: In Midstream?”

Author(s):
Il SaKong, and Olivier Blanchard
Published Date:
July 2010
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Author(s)
Charles Bean

This is an important contribution to the literature on global imbalances, which has been bedevilled hitherto by much muddy thinking. Blanchard and Milesi-Ferretti begin by making the important point that current account imbalances need not be “bad.” In particular, they may be warranted by: international savings differences resulting from different rates of time preference; differences in investment prospects across countries; and differences in financial markets, in particular the relative supply of high-quality and liquid assets. But Blanchard and Milesi-Ferretti also note that imbalances can arise through distortions, in which cases the imbalances are indeed “bad” in nature. For instance, high household savings may reflect inadequate household insurance, while high corporate savings may reflect defective financial intermediation from lenders to borrowers. Moreover, even if the source of imbalances is “good,” they may interact with other distortions to create inefficient outcomes or generate risks.

Blanchard and Milesi-Ferretti list a lot of the usual suspects, but three other “bad” imbalances relevant to recent experience are worth noting. First, the imbalances, even if “good” in source, may be badly financed. The current crisis was characterized by a plethora of distorted incentives in advanced country financial markets, including an incentive to shift loans off-balance-sheet in order to circumvent capital requirements; employment contracts that encouraged excessive risk taking; an incentive to excessive loan origination when those loans are to be securitized and sold; and ratings agencies that acted in the originator’s interest rather than the investor. In addition, we saw the creation of complex securities that were hard to value in stressed conditions. Even if the imbalances were “good” in source, their interaction with these distortions heightened risks and made them “bad” in impact.

Second, and somewhat relatedly, Blanchard and Milesi-Ferretti put a relative shortage of high quality assets in their list of “good” imbalances. But Ricardo Caballero has argued that such asset shortages lie behind the serial bubbles seen in financial markets in recent years.

Finally, investors are prone to focus on interest differentials and underplay exchange rate risk. The result has been that international capital flows have been susceptible to a “carry trade” in which investors borrow in low interest rate jurisdictions in order to invest in countries with higher rates. But these carry-trade flows have proved to be volatile, resulting in excessive exchange rate and asset price movements, as well as compromising monetary independence.

In the second part of their paper, Blanchard and Milesi-Ferretti break the era since 1996 into three roughly equal periods. The authors argue that the imbalances were largely “good” during 1996–2000 and reflected differences in perceived investment opportunities (even though the assessment of U.S. prospects was in reality somewhat overoptimistic). According to them, the picture was more mixed during 2001–04, with an unsustainable fall in U.S. saving, especially that of the public sector (“bad”), matched by higher savings in some of the surplus countries that appeared rational (“good”). Finally, the 2005–08 period is characterized by predominantly “bad” imbalances: the financial excesses were associated with unjustified falls in savings across a number of advanced economies—my earlier point is relevant here—coupled with a widening in the Chinese surplus (though the authors rather pull their punches on whether this was “good” or “bad” in nature).

I broadly concur with this narrative, and in particular with the point that numerous factors generated the current account imbalances. But I do have a slightly different take on the final period. Blanchard and Milesi-Ferretti characterize the imbalances as driven by events in financial markets, but not driving them. I see things as being more of a two-way street, with relatively high Asian savings seeking a safe home depressing long-term real interest rates and, together with overly loose U.S. monetary policy, stoking up a leveraged “search for yield.”

The final part of their paper takes us up to the present and casts an eye at what the future might hold. As they note, we have seen some narrowing in the global current account imbalances, reflecting both the relative cyclical impact of the financial crisis, as well as more stimulatory policies in surplus countries. The question is whether they will continue to narrow, whether this is as far as it goes, or whether the narrowing will prove to be merely temporary, reversing as global growth resumes. Blanchard and Milesi-Ferretti argue that some of the narrowing reflects the rise in private savings in the deficit countries and is likely to persist; that seems reasonable.

The key question is, however, not whether the imbalances narrow. Rather it is whether the narrowing is consistent with the attainment of full employment in all countries on a sustainable basis. In order to achieve this, a reallocation of global demand from the deficit countries to the surplus economies is necessary. And to achieve the associated sectoral reallocation of resources, one would expect that to be accompanied by an appreciation of the surplus countries’ real exchange rates. That is essentially Blanchard and Milesi-Ferretti’s Scenario 1.

However, it is not clear that the necessary adjustment in the real exchange rate will be permitted to occur. Full employment in all regions, the elimination of the imbalances, and unchanged real exchange rates represent a mutually inconsistent triad. So what might happen if real exchange rates remain unchanged? Blanchard and Milesi-Ferretti identify two particular alternatives. Scenario 2 is essentially a return to the status quo ante. Scenario 3 involves excess supply in the deficit countries, full employment in the surplus countries, and some narrowing of imbalances by virtue of the underemployment in the former; this is broadly similar to the picture painted in the latest World Economic Outlook. I have grave doubts, however, that it is a viable political equilibrium. Sustained weak growth and high unemployment in the United States, accompanied by an ongoing current account deficit, is very likely to prompt the introduction of protectionist measures there. At best, that might result in an appreciation in the shadow real exchange rate of the surplus countries. But there is also the prospect of retaliation and a more generalized trade war, repeating the errors of the 1930s.

The welfare properties of the various distortions that promote international imbalances are touched on only implicitly by Blanchard and Milesi-Ferretti; they would have been worth bringing into sharper relief. Many of the domestic distortions impinge primarily on the welfare of the home country: for instance, the lack of a household safety net in China. In such a case, the home country has an incentive to undertake reform, so this sounds like a no-brainer. But such first-best solutions are not necessary easily achievable. If they were, then they would probably have taken place already.

The imbalances that are trickiest to deal with, however, are those that generate negative externalities for other countries. When we see such an externality in other areas of economics, we usually recommend the introduction of a suitable tax/subsidy on the externality, or else look to the losers to pay the generators of the externality to alter their behavior. It is hard to see this sort of solution working in an international economic context.1 At present, the G-20 are relying on peer pressure working through the Framework for Strong, Sustainable, and Balanced Growth. It is an open question whether this will succeed where the multilateral effort undertaken by the IMF ahead of the crisis did not. But the stakes are high. And a question for the longer term is whether this will need to be superseded by an international monetary system that builds in more explicit incentives for both deficit and surplus countries to moderate unsustainable current account imbalances.

Though it looks like we may be about to see something similar introduced to finance global action against carbon emissions.

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