How will these global current-account imbalances correct: gradual adjustment or sudden shock?
High levels of current-account surpluses in those countries which are manufacturing exports and producing resources and correspondingly high levels of current-account deficits in the consumer-driven importing economies cannot be sustained indefinitely. Borrowing such a high proportion of income must eventually be curtailed. But there has been considerable room for difference of opinion on how and when this would happen and whether the correction, when it eventually came, would be a gradual and relatively smooth adjustment of incomes and patterns of trade or a jarringly painful forced contraction of expenditure.
To explain what is involved, it is worth recounting the views of some leading economists in 2006, before the financial crisis erupted (for me, as a card-carrying economist holding a London School of Economics Ph.D. this is a natural reference point). The media characterizes economists as being unable to agree about anything. Disagreement on economic issues among professionals is as natural as it is among non-specialists. When policy advice depends on forecasts – which are always uncertain – and on different political standpoints and judgements, then economists do indeed express a wide range of views.
What is striking about this issue is that back in 2006 leading economists, from a wide range of different standpoints, were expressing very much the same views about the world current-account imbalances. They all agreed that the level of savings by exporters of resources and manufactures and correspondingly large borrowing by the importing countries, could not be sustained indefinitely. The reason is simple arithmetic. A country, even a large and great country like the United States, is in the same position as an individual; it cannot keep borrowing 5 per cent of its income forever, spending $105 for every $100 it actually earns.
There were arguments about the statistics. Some, for example, believed that there is hidden income on US overseas assets and that when this is included the deficit looks a little smaller. But almost no one disputed that eventually income and expenditure in the United States and other deficit countries would have to adjust, through some combination of reduced spending on imported goods and services and higher domestic production, to bring total expenditure more into line with total income.
Where there were disagreements was on how this adjustment would come about and how quickly, and on what policy measures might be needed to deal with it. Some were pessimistic about this adjustment process, anticipating what was commonly labelled as a ‘hard landing’. To take one example, Paul Krugman, Professor of Economics at Princeton University and an op-ed writer for the New York Times, wrote on several occasions about the possibility of an abrupt slowdown in US consumption and house prices and a potentially sharp dislocation in exchange and interest rates.2 He was concerned about both the sustainability of consumption and the role of international investors. Household consumption – which accounts for around 70 per cent of all US expenditure – might slow sharply, triggering a sharp decline in national output. There could also be a collapse of confidence by overseas investors, leading them to switch out of dollars into other currencies, and triggering a massive correction to the dollar exchange rate, far more than was required for adjustment of the external deficit, and leading to rising inflation and a major reduction in business confidence and private-sector investment.
Other commentators stressed the ability of the market to self-correct, arguing that households and taxpayers are not entirely short-sighted and would recognize when they, or government on their behalf, are spending beyond their incomes, and then gradually take steps either to reduce expenditures or to increase incomes. Savings, in other words, can be expected to rise gradually to bridge the gap. Market prices will also adjust to encourage this correction, so that we can expect to see a lower dollar exchange rate, at least against the Chinese renminbi and the Japanese yen. These will lead to higher US savings and to greater export growth, and to a slowdown in consumer borrowing and the growth of imports.
Many economists held these views. One elegant statement is to be found in a 2006 paper by the respected economists Guillermo Calvo and Ernesto Talvi.3 They contest Krugman’s argument that reduced investment in the United States by the Chinese government would lead to a sharp fall in US economic activity, arguing instead that the export of savings by surplus economies is unlikely to come to a sudden sharp halt; but they do acknowledge the possibility that a sharp correction in US housing markets could lead to a slowdown in US consumer spending.
It is now clear that the adjustment of the world’s structural currentaccount imbalances is clearly not going to be smooth. But the shock is not one of those identified by Krugman or indeed by any other economic commentator before early 2007. We have not so far seen a complete collapse in household consumption in the deficit countries. Nor have we seen an uncontrolled collapse of exchange rates and withdrawal of foreign capital from the United States, the United Kingdom and other borrowing countries. What has instead happened is an entirely unanticipated major and long-lasting dislocation to credit markets and bank funding.
As a result, far from a gradual adjustment of the world’s current-account balances, we now seem to be heading towards a much sharper correction through a massive contraction of credit, leading to falling household and business expenditure. If this happens it will create a cumulative downward spiral in world economic activity.
Tags: account imbalance