The following is the first in a series of articles analyzing the major problems that the G20 leaders should tackle to stabilize the global financial markets and rebalance the world economy. -- Ed. By Ryou Jai-won Balance means a state of equilibrium in which there is no tendency to have a fall. While something in balance looks good, something out of balance gives us a feeling of anxiety and tension. The balance between debits and credits is no exception. That is why global imbalances, i.e., surplus or deficit in international transactions among major countries, particularly in trade of goods and services, may well cause instability in the global economy. The protagonist in the drama of global imbalances is the United States. The U.S. current account deficit has continued to deteriorate since the early 1990s, amounting to 6 percent of gross domestic product in 2006. Given the U.S. role as the spender and borrower of last resort in the global economy, it is no wonder that the U.S. current account deficit is a mirror image of the global imbalances. The antagonists include China, the world`s manufacturing powerhouse, and a group of oil exporting countries in the Middle East. Because Europe`s current account is almost balanced as a whole, the adjustment of the U.S. current account cannot be considered separately from a reduction in the surpluses of emerging East Asian and Middle Eastern economies. There have been vigorous discussions on the sustainability of global imbalances. Pessimists like Paul Krugman, who won the Nobel Prize in 2008, warned that the U.S. current account deficit could not be sustained forever and that an abrupt adjustment process beginning with a dollar crisis would jeopardize international financial stability and stable economic growth. On the other hand, optimists like Richard Cooper at Harvard University insisted that excess saving (reflecting demographic change) in Europe and East Asia would be invested in the United States, financing the current account deficit in the foreseeable future. In the middle of the global financial crisis, the problem of global imbalances seems to have been resolved to some extent. However, it remains to be seen what happens to those imbalances once the global economy bounces up. According the IMF`s prediction, global imbalances will linger well after recovery. The issue of regaining global balance is expected to be the focus of hot debates at the coming G20 summit meeting in Seoul, particularly between China and the United States. Surprisingly enough, there are many Western economists who blame the East Asian countries for the U.S. current deficit. It was Ben Bernanke, professor of economics at Princeton University and the current chairman of the U.S. Federal Reserve, who popularized the global savings glut hypothesis. In his famous Homer Jones Lecture in 2004, he claimed that a significant increase in the global supply of saving was responsible for both the increase in the U.S. current account deficit and the relatively low level of long-term real interest rates in the world. In the same context, Martin Wolf, the renowned columnist of the Financial Times, insisted that the inability or unwillingness of East Asian and Middle East economies to absorb surplus savings made the United States a superpower of global borrowing. In his 2009 bestseller, Fixing Global Finance, he went further to conclude that global imbalances led to the U.S. subprime crisis and eventually the global financial crisis. Should balancing in the U.S. current account come at the cost of surplus in the East Asian countries? Do Asian countries need to replace the United States as a driver of global growth by giving up their export-oriented growth strategy and relying more on domestic spending? Will the U.S. dollar substantially depreciate in the process of correcting global imbalances? In order to answer these questions, we should examine first what caused the global imbalances, asking how extensive national savings and the current account surplus in East Asia are linked to the global imbalances. Stylized facts about the U.S. current account deficit In retrospect, running a current account deficit has been a chronic phenomenon for the United States. As shown in Figure 1, the deficit amounted to 3 percent of GDP in the mid-1980s. To help facilitate the U.S. adjustment of the significant external imbalance, the Group of Five countries (France, Germany, Japan, the U.S. and the U.K.) agreed to depreciate the U.S. dollar with respect to the Japanese yen and the German mark. As a result of coordinated intervention and associated policy changes that followed the so-called Plaza Agreement of September 1985, the value of the U.S. dollar against the yen declined by 35 percent through August 1986. Thanks to the depreciation of the dollar, the U.S. current account balance began to improve and turned to a surplus in 1991. But it was only a year later that it began to worsen again. The size of current account deficit continued to grow, reaching 6 percent of GDP in 2006. Since 2007, the current account deficit began to shrink and recorded 3 percent of GDP in 2009. However, it remains questionable whether the deficit will continue to narrow to a more manageable level. Figure 1-The U.S. current and capital account balances Note: CABY=current account balance/GDP(%) KABY=capital account balance/GDP(%) Source: IMF, International Financial Statistics, CD-ROM, 2009. Many believe that the effect of strong dollar is indispensable to explaining global imbalances. Figure 2 shows the effective exchange rate of the U.S. dollar. Effective exchange rate refers to the weighted average of a country`s currency relative to currencies of major countries. An increase in the value means an appreciation of the dollar. Both the nominal and real values (adjusted for the effects of inflation) of the U.S. dollar peaked in 1985 and began to fall after the Plaza Agreement. However, the value of the U.S. dollar began to appreciate in 1995, before starting to depreciate again in 2003. The depreciation of the U.S. dollar discontinued because of the global financial crisis. As the immediate impact of the crisis dissipated, the value of the dollar resumed its declining trend.
Figure 2 - Nominal and real effective exchange rates of the U.S. dollar Note: NOMMAJOR=Nominal Major Currencies Dollar Index REALMAJOR=Price adjusted Major Currencies Dollar Index Source: Federal Reserve Board (www.federalreserve.org) Compared with the trend in the current account balance, the U.S. dollar exchange rate fluctuations do not appear to be simple. According to national income accounting, a current account deficit is an outcome of insufficient private savings relative to investments or government deficits, irrespective of the level of the exchange rate. Due to bubbles in equity and real estate markets, domestic investment in the United States was active, recording 17.1 percent of GDP in the fourth quarter of 2008. Moreover, private consumption has remained strong at around 70 percent of GDP since 2001. In contrast, the U.S. personal savings rate continued to decrease since the mid-1980s, amounting to 1.2 percent in the first quarter of 2008. In addition, the fiscal balance (taxes minus expenditures) has been recording a deficit except for the short period between 1997 and 2001, substantially worsening after the Iraq war. To sum up, the U.S. current account reflects structural factors concerning consumption-saving behavior both in private and public sectors. Testing the global savings glut hypothesis Then, what is the role of the global savings glut in global imbalances? Capital flows from surplus countries to the United States became evident after the currency crises in East Asia in 1997, followed by similar crises in Russia and Brazil in 1998. With an increase in investor preference for safer assets, which the United States offered, the U.S. interest rates began to fall in the early 2000s, while capital inflows to the United States picked up. As a result, the U.S. dollar substantially appreciated despite the worsening U.S. current account deficit. Moreover, the insufficient U.S. national savings could be compensated by high savings on the part of the U.S. trading partners. That is why many pointed out savings glut of some East Asian countries as the major cause of the U.S. current account deficit. However, the causality between the two is not clear. Moreover, this criticism does not answer the related question: Why do these emerging market economies try to accumulate foreign reserves denominated in the U.S. dollar? In order to evaluate the validity of the global savings glut hypothesis, it is necessary to figure out the relative importance of domestic factors such as fiscal deficits or over-consumption and external factors such as East Asia`s savings. To do this, I have set up a simple model based on the modern portfolio balance approach explaining the dynamics of exchange rate movements in the process of interaction with capital and current accounts. It consists of U.S. variables (real GDP, interest rate, current account balance, capital account balance, nominal exchange rate and national savings), along with the savings of East Asian countries (China, Japan and Korea). The sample period is set to the first quarter of 1991 and the fourth quarter of 2007. Due to rapid progress in computing technology, it is not difficult to analyze the relationships between these variables with a personal computer. However, it is important to remember that empirical findings are not immune from many annoying problems including the specifications of the model, definition of the variables and sample periods of analysis. Despite these shortcomings, my empirical analysis shows that the U.S. current account deficit maintained since the early 1990s is mainly driven by the domestic factors such as a decrease in the U.S. national savings and an increase in money supply growth. Contrary to the global savings glut hypothesis, the East Asian national savings do not appear to produce a significant effect on the U.S. current account deficit. If we use the East Asian exports instead of East Asian national savings, the result is not much different. Therefore, it appears too farfetched to insist that too much saving in East Asia and the resulting increase in net exports are the main cause of the U.S. current account deficit. On the other hand, an increase in the U.S. money supply growth produces a significant effect on the U.S. current account deficit. This finding seems to support the view that a lax monetary policy pursued since 2001 has aggravated the current account deficit. Another interesting result is that the U.S. current account was not very sensitive to changes in the exchange rate. This finding implies that correcting the global imbalances by means of depreciating the U.S. dollar alone is hardly possible unless changes are also made in structural and other macroeconomic factors. Despite the growing interest in exit strategies, it will not be easy to stop expansionary aggregate demand policy. Therefore, a successful resolution of the global imbalances seems hardly plausible in the foreseeable future. Epilogue Global imbalances have many important implications. Here I would like to discuss the confidence problem of the dollar within the context of global imbalances. To be specific, there are two critical questions: (i) the possibility of a free falling dollar and (ii) the feasibility of achieving global balances in a more orderly manner. First, when and how much the dollar will eventually depreciate depends on the strength of the confidence international investors have in the dollar as the key reserve currency. Before the crisis, many had suggested that the dollar would not depreciate because official capital outflows from Asian emerging market countries would continue as they have accumulated reserve asset claims on the center country. However, Professor Barry Eichengreen at the University of California at Berkeley warned that the U.S. current account deficit would cause the dollar to depreciate against major currencies. The recent exchange rate movements support the view that the dollar may well depreciate substantially in the long run. Regarding the second issue, we know the answer better. In order to resolve global imbalances, the U.S. should increase its savings rate, reduce fiscal deficit and tighten its money supply. As a means of coping with the global imbalances, the East Asian countries, particularly China, are often asked to spend more and save less. It is true that global rebalancing of demand is needed in order to restore sustained growth of the global economy and an increase in the domestic demand in the surplus countries such as China and Japan may be helpful in rectifying global imbalances. However, it appears to be insufficient per se.
