After the Asian Summits of 2010–Global Economic Imbalances: Currencies and Economic Cooperation

Posted: January 11, 2011 in International political economy

In this blog entry, I share the talking points I made at the 5th ASEAN-South Korea Cooperation Forum held in Hua Hin, Thailand, December of last year.

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  • Global economic imbalances have been a key issue in international policy discussions in recent years and most especially in the summits held in the Asian region during the past few months.
  • There is a need to distinguish global imbalance from the concept of an internal (to a country) imbalance, which is typically understood in terms of full employment and the absence of inflationary pressures.  Global imbalances are defined as “external positions of systematically important economies that reflect distortions or entail risks for the global economy” (Bracke, Bussiere, Fidora & Straub 2008/2010).
  • The definition has 3 components:
  1. External positions, encompassing current account positions as well as financial positions—this is apparently crucial in view of financial globalization, which implies that the financial dimension is more than the current account dimension;
  2. Systematically important economies, including both the deficit side (e.g. the United States) and the surplus side (e.g. Asia, oil exporters)—while the notion of systemic importance is not fully clear, it’s still functional since it implies that economies participate in the global goods and financial markets and may have a global impact either because of their size or because of other factors (e.g. Thailand appeared to be systematically important at the onset of the 1997 Asian financial crisis even if it accounted for a very small share of world output [< than 1%]);
  3. Distortions & risks, so as to distinguish imbalanced from balanced positions.  Distortions are deviations from the (heuristic) flexible price or perfect competition world and can be induced by policy choice or private sector decisions.  Risks refer to the macroeconomic and financial implications, both under a scenario of unwinding (risk of disorderly unfolding, as manifested por ejemplo in the financial market turmoil of summer 2007) and under a scenario of further increasing imbalances (risk of a protectionist backlash, exemplified in the limited progress made under the Doha round of trade talks).  The reference to risks and distortions captures the extent to which external positions are imbalanced, as opposed to balanced.
  • In the main, the current situation is not exceptional by historical standards as there have been episodes of global economic imbalances before.  In fact, one can argue that global imbalance is the norm rather than the exception.  An imbalance in one part of of the world is matched by an imbalance of the opposite sign in another.  To be concrete, a nation’s foreign exchange surplus is going to be match by at least one other’s deficit.
  • Bracke et al. identified these previous episodes of global economic imbalances: (a) Under the gold standard (of the late 19th century up to the First World War), trade balance adjustment was typically very slow and difficult/costly for deficit countries—and this triggered a search for a better international monetary system (apart from the dysfunctionality of a limit supply of the precious metal relative to growth of international transactions); (b) In the inter-war period, growing imbalances ended in an unraveling of international free trade and monetary arrangements and added to the growing geo-political tensions in the run-up to World War II: (c) After several decades of economic growth across countries, tensions over external imbalances during the early 1970s (exemplified by the so-called Nixon shock when the US unilaterally abandoned the 35$/ounce of gold fixed rate which underpinned the international monetary system) led to a fundamental overhaul of the international monetary system, marking the end of the Bretton Woods system; (d) In the 1980s, widening current account positions led to intensive international coordination with concrete policy commitments under the Plaza (1985) and Louvre (1987) agreements focused on exchange rates; (e) Elsewhere in the 1980s, many developing countries like Brazil, Mexico, the Philippines were saddled with foreign debt burdens that needed restructuring.  In the process, multi-lateral financial institutions such as the International Monetary Fund and the World Bank gained a better handle in influence macro-economic policy in these countries; and (f) In the 1990s, external imbalances in emerging economies were a key source of concern what with a series of financial crises sweeping across nearly all large emerging economies.
  • Bracke and his colleagues argue that three main features set today’s situation apart from past episodes of imbalances:  (a) the emergence of new players, in particular emerging market economies such as China and India (and to a lesser extent Russia and Brazil); (b) an unprecedented wave of financial globalization, with more integrated global financial markets and increasing opportunities for international portfolio diversification, also characterized by considerable unevenness and asymmetries in the level of financial market development across countries; and (c) the favorable global macroeconomic and financial environment, with record high global growth rates in recent years, low financial market volatility and easy global financing conditions running at least up to the summer of 2007.

In sum, the current situation has unprecedented features in that, for the first time, emerging economies (China particularly) are actually transferring net savings to advanced economies.

Bracke et al. identified a number of key structural factors (including asymmetric and incomplete financial globalization amidst rapid global economic integration) and cyclical (or macroeconomic policy-induced) factors contributed to the current global imbalances.

i.     Asymmetric and incomplete financial globalization.

  1. Capital market liberalization and integration may generate net capital flows only because countries are vastly different in their levels of financial development and institutional quality.  Economies with more developed financial markets can potentially accumulate foreign liabilities vis-à-vis countries with less developed financial systems in a gradual, long-lasting process, despite higher capital-to-labor ratios.
  2. Financial systems that are developed and well-functioning result in deeper financial markets, allowing lower domestic savings.  Countries with deeper financial markets tend to have lower savings and accumulate net foreign liabilities.  Conversely, countries with shallow financial markets, and therefore, high financial market volatility, may have higher savings (owing to the lack of insurance, for instance) but higher capital outflows (resulting from a desire to seek more secure returns).  Countries with deeper financial markets can invest in high-return assets.  As a result, they may receive positive factor payments even if their net foreign asset position is negative.  Low-income countries with low level of financial development will be worse off in such an environment because their savings may bypass their domestic financial systems and flow to developed countries with highly sophisticated financial markets (at least in the short run).  Financial imperfections can therefore increase savings and the demand for safe assets.
  3. Financial imperfection can also reflect a country’s inability to supply (safe) assets.  If safe assets are not provided in every single region in the world, one should observe capital flows to regions that are able to supply the desired assets.
  4. Why does capital flow from emerging markets mainly to the US and will this flow be sustained forever?  Although most industrial economies are increasingly financially open, they still lag behind the US with regard to financial development. The comparative of the US in generating financial assets is, however, not eternally given and cannot be considered as exogenous.  In fact, policy failures could lead to a questioning of the exceptional position of the US as host of flights to quality and safety.

ii.      The cyclical factors are focused on the US and could be separated to factors that had a potentially cyclical impact on private sector aggregate demand and those that affected public sector demand.

  1. Widening US current account deficits have been accompanied by a fall in household net savings (reflected in the rise of private consumption).  The rise in US private consumption has been one of the triggers for the observed unbalanced path of global demand.
    1. Productivity-driven changes in US permanent income and the rise in household wealth reflecting a surge in asset prices are the usual explanations for the rapid growth of US private consumption.
    2. These two factors have fundamentally different implications for widening current account deficits. Productivity-driven permanent income changes may imply that current account balances are an equilibrium response of rational agents to changes in the economic environment.  However, American consumption growth driven by fluctuations in asset prices could give rise to a boom-bust cycle.  As the current account is usually a countercyclical variable, a revision of consumer and investor expectations and a corresponding drop in asset prices could trigger a sudden unwinding of the US current account deficit.
    3. Much of the relevant literature argues that there is a negative relationship between a fiscal deficit and a trade balance though there are dissenting opinions.  However, even if the immediate impact of fiscal policy on the trade balance may still be disputed, budget deficits might jeopardize a country’s ability to meet its future obligations.  In theory, the limited response of the trade balance to changes in the fiscal position is usually driven by a fall in investment.  However, this lowers the potential economic growth rate, endangering the country’s ability to repay its future debts.
    4. Financial market developments since the summer of 2007—a global re-pricing of risk—were a clear manifestation of existing global economic imbalances and should have started a more determined adjustment process.  However, with structural drivers remaining largely in place, especially the attractiveness of US financial assets as a safe haven for investors across the world, a decisive adjustment in external imbalances remained relatively unlikely.
  2. Earlier this morning, we heard Simon Tay of the Singapore Institute of International Affairs (SIIA)  refer to a “wounded America”—“still powerful but … weakened economically, politically and in ‘soft power’.”  Nonetheless, the US plays a key role to global economic recovery even as it has a lot to do with the current economic malaise.
    1. Great structural changes in world trade and finance occur quickly. The 1945-2010 era of relatively open trade, capital movements and foreign exchange markets is being destroyed by a predatory financial opportunism that is breaking the world economy into two spheres: a dollar sphere in which central banks in Europe, Japan and many OPEC and Third World countries hold their reserves the form of U.S. Treasury debt of declining foreign-exchange value; and a BRICSA-centered sphere, led by China, India, Brazil, Russia and South Africa (the last addition is complement of University of Cape Town sociology professor Ari Sitas), reaching out to include Turkey and Iran, most of Asia, and major raw materials exporters that are running trade surpluses.
    2. What is reversing trends that seemed irreversible for the past 65 years is the manner in which the United States has dealt with its bad-debt crisis. The Federal Reserve and Treasury are seeking to inflate the economy out of debt with an explosion of bank liquidity and credit – which means yet more debt. This is occurring largely at other countries’ expense, in a way that is flooding the global economy with electronic “keyboard” bank credit while the U.S. balance-of-payments deficit widens and U.S.  official debt soars beyond any foreseeable means to pay. The dollar’s exchange rate is plunging, and U.S. money managers themselves are leading a capital flight out of the domestic economy to buy up foreign currencies and bonds, gold and other raw materials, stocks and entire companies with cheap dollar credit.
    3. This outflow from the dollar is not the kind of capital that takes the form of tangible investment in plant and equipment, buildings, research and development. It is not a creation of assets as much as the creation of debt, and its multiplication by mirroring, credit insurance, default swaps and an array of computerized forward trades. The global financial system has decoupled from trade and investment, taking on a life of its own.
    4. In fact, financial conquest is seeking today what military conquest did in times past: control of land and basic infrastructure, industry and mining, banking systems and even government finances to extract the economic surplus as interest and tollbooth-type economic rent charges. U.S. officials euphemize this policy as “quantitative easing” or QE.  The Federal Reserve is flooding the banking system with so much liquidity that Treasury bills now yield less than 1%, and banks can draw freely on Fed credit. Japanese banks have seen yen borrowing rates fall to 0.25 percent.
    5. This policy is based on the wrong-headed idea that if the Fed provides liquidity, banks will take the opportunity to lend out credit at a markup, “earning their way out of debt” – inflating the economy in the process.
  3. What really needs to be done?  If the conventional view on global imbalances is based on a few basic propositions: that (i) they are the ultimate cause of the financial crisis, and (ii) mainly the result of overspending in the US and currency manipulation in China; then (iii) the overall policy objective should be to rebalance which requires that deficit countries should save more and surplus countries less, and (iv) that exchange rate flexibility should be enhanced. Traditionally, overspending used to be blamed on government budget deficits, so the policy prescription would call for reduced government spending. But since the crisis, regulatory failure appears to have emerged as a new culprit. Financial regulation failed to detect and stop excessive credit growth which in turn made it possible for US households to over-consume.  Now that financial reform legislation has supposedly fixed that problem in the US, attention appears to have shifted onto global imbalances and exchange rate flexibility.
    1. However, what is not discussed as much is the downside of raising savings to rebalance in the midst of an anemic recovery. Economists often talk from both sides of their mouths to deal with the problem: Spending should be raised in the short run to revive growth when in a slump, but needs to be curtailed in the long run when the economy recovers. But, the short run fix takes us further away from the long run objective and it is never clearly spelled out how one goes from the former to the latter without tripping along the way.
    2. It is possible that the conventional view suffers from an even deeper problem, for it assumes a world that no longer exists. It implicitly presupposes an international economy consisting of distinct national economies with their own separate systems of financial intermediation tied to one another mainly through trade. But, in a world of free capital flows why should the net demand for national currencies and thus the market determination of exchange rates depend solely on trade balances?  The conventional view would only make sense in a world where financial assets are traded mainly to move goods; where central banks control credit growth and where the current account rules the roost. Of course, none of this is consistent anymore with the increasingly transnational world we inhabit, a world that is interconnected through financial flows and global production networks; one where the notion of global financial intermediation is no longer an empty supposition.
  4. Remedying current economic imbalances is the objective of various summits held in Asia over the second half of the current year.  There is really a need for cooperation and coordinated policy actions to place the world economy on a more secure path to economic recovery and eventually to high growth, job creation, and financial stability.  While my new friend, Dr. Heenam CHOI from South Korea will make his own presentation on global economic imbalances especially from the G-20 perspective, allow me to say a few words with respect to the recently-concluded G-20 summit held in South Korea.
    1. To my mind, the said summit was principally designed to resolve differences between the US and China.  The US has long claimed that by almost all measures China’s currency is purposefully grossly undervalued and with an undervalued currency, as the argument goes, China is distorting global financial flows in its favor.  On the flipside, China and other emerging economies such as Brazil are angry at the Fed’s decision to pump $600 billion into the American economy in early November 2010 claiming the move would flood developing countries with cheap, speculative dollars and thus weaken local economies.

i.      “Those US dollars end up going abroad like a tsunami and for these developing countries it’s very difficult to contain that pressure,” according to Mauricio Cardenas of the Brookings Institute.  He continues: “So the dollars are intended to reactivate the economy in the US but end up overseas and that, of course, is a problem for these developing countries where these dollars cause abjection of local currencies.”

ii.      A Brazilian economist opined that the Fed’s decision will ultimately mean developing countries will have less money they can put away in reserves.  “To the extent the US wants to reduce its balance of payments deficits, it will be like reducing everybody else’ capacity to accumulate reserves.”  Brazil and other emergency country-members of the G20 liked the accumulation of reserves as that was one of the key reasons how they could defend themselves from the economic crisis without the crisis becoming a BOP nightmare.

iii.      The G20 summit ended with a bland statement declaring that the group will monitor development for signs of countries artificially deflating their currencies gained a lukewarm welcome from critics who said the group had papered over the cracks of a problem that could jeopardize recovery from the economic crisis.  In particular, the G20 leaders were unable to agree on how to identify when global imbalances pose a threat to economic stability, merely committing themselves to a discussion of a range of indicators in the first half of 2011.

iv.      While G20 tightened its unity in response to the crisis two years ago, the variable-speed recovery since then has fragmented the group.  Slow-growing or slowly-recovering economies have kept interest rates at record lows to kickstart growth while big emerging markets have come roaring back so fast that many are worried about overheating.

v.      Agreement in the recent G20 summit was undermined in the opinion of some observers by US premature and very public advocacy of limits to deficits—a proposal opposed by the surplus economies—particularly China and Germany.  While the group sought to revive the moribund Doha trade talks, which collapsed in disarray in 2008 with India strongly resisting US attempts to open its economy to US exports, it has offered no sense of how to resolve tensions between rich and poor nations that sank the Doha talks.

vi.      Nonetheless, several cooperative gains can be cited.  In September, the G20 made the historic breakthrough to grant a greater voice to developing nations in the International Monetary Fund, reflecting a shift of global power to emerging heavyweights such as China and India.  Earlier G20 meetings have helped establish tougher regulations on the amount of core capital banks should hold under the so-called Basel III accord.  And lastly, while the failure of the US and South Korea to finalize a landmark trade agreement during the G20 summit last month, its recent approval is a good sign of international cooperation.

  • It was my purpose to simply offer some talking points as inputs to a subsequent discussion and I’m afraid I spent too much time discussing theoretical issues.  However, I could not help myself.  A review of the summits held in recent months reminded me of the realist-liberal debate in IR/IPE theory regarding the prospects of international cooperation.  This review indicates that serious difficulties stand in the way of much-need international cooperation so the world economy can effect a decisive recovery.  However, even as obstacles have impeded progress, gains can still be made.  The intellectual and practical challenge for all of us is to find ways and means to push cooperation despite strong temptations to beggar-thy-neighbor.
  • Thanks for your kind attention.  I would also like to thank the organizers, especially Thitinan, for inviting me and making possible my first attendance of an ASEAN-Korea Cooperation Forum in such a beautiful and significant locale—Hua Hin, Thailand. Good day, ladies and gentlemen.
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