Treasury secretary Paulson commented that the root cause of the credit crisis was the global imbalance around the world. This is a story which has been discussed in international finance circles for years. The flow of funds into the US created the bubble as the risk premium for asset was pushed lower from the large flow of funds. The flow imbalance showed up in the current account deficit.
The international finance argument is that the imbalances between saver and debtor countries led to the large current account dislocations. If these dislocations get too large, there is greater likelihood of a sudden stop in the currency market in order to correct the imbalance. The large current account deficit countries like the US will have to see a dollar decline in order to help bring the deficit imbalance back to equilibrium. Once the current account reaches, and extreme there will be a sudden stop as the global financial markets realize the unsustained nature of the deficit.
This global imbalance story is a theme that will continue to drive thinking for the next few years regardless of what happens with the world economic slowdown. It is good to review this story within the context of the two major imbalance paradigms. The traditional view or global threat story focuses on the imbalance as a monetary and fiscal dislocation which can become a significant dollar and rate funding problem because the current account deficit is unsustainable. The new paradigm of global imbalances states that it is a consequence of economic and fundamental globalization. It will not lead to a sudden stop in the dollar to current the current account deficit because the imbalance is structural and will not go away easily. The answer to this imbalance problem and how we choose to deal with it will be a key to how the global growth problem is solved.
The new paradigm states that the current account deficit may get larger without any adverse impact because of the long-term economic imbalances that are unrelated to short-term economic issues. For example, one view of the imbalance issue is that there is a less of savings problem to begin with. The savings rate as measured by the difference between income and consumption is low which would suggest that investment has to be funded from abroad, but saving in the US is not measured properly in the first place. The US does not account for savings in the form of durable goods purchased, education, R&D, and wealth effects unrelated to current income. Currently, we are seeing an increased in measured savings but in reality it is a change in the composition of savings as durable goods purchases decrease and dollar savings increase. Our actual savings rate is closer to 19% well above the number thrown out as less than 5% of income. Hence, the current account deficit could be related to other issues not the fact that the savings rate is low.
The savings argument as a long-term issue can be extended by the fact that the difference in savings rates across countries is related to demographic. As a country’s population ages, there is greater savings relative to countries that are younger. The increased savings in Japan, China, and Europe are matched by rapidly aging population which means that they will have excess savings versus, say the US, which has a younger population. The excess savings in an open global market will seek that place where it can be easily invested which means the US. Under this case, the current account deficit should be looked at through a lens of benign neglect. This capital movement is a natural part of the flow of capital between those places that have excess savings because of demographics. This is a process that cannot be changed and should not be altered through some policies to adjust the dollar at this time. This does not mean the problem should be ignored, but higher current account deficits could be sustained in the US because of the longer-term aging imbalance problem.
The new paradigm has also offered what some have called the Bretton Woods II story as another alternative which can explain a long and sustained imbalance. This story states that exchange rates have been kept low by many developed countries to foster exports. These exports were financed by the producer countries through investing profits back to the consumer countries. Emerging market money flowed back to the US to finance the trade deficit form the goods produced in those countries.
In this scenario, each group got what it wanted, yet this may be the dangerous story for 2009. At this point there is less desire to continue this process by both parties but it will not be easy for any one group to decide to get off this wild ride. Exporters have to worry about lay-offs in their countries so there is little incentive to allow exchange rates to appreciate to offset the long-term imbalances. The consuming countries have been delevering but the pain of pulling back consumption is real. However, if the consumer countries try to change the mix of goods sold from imports to domestic consumption, there could be a spiral of actions which harm all parties. One way for the change in consumption mix to occur is through tariffs on imports which could lead to the savings-export countries to cut back their investments in the US. This breakdown of the new order could be the envisioned sudden stop; however, we will have some signs of this type of direction before there is a crisis.
The third story for the sustainability of the current account deficit is the exorbitant privilege argument which states that the high return on foreign assets the US receives offsets the cost of the financing as measured by the interest income on the liabilities of the US assets bought by foreigners. The US finance at low rates while receiving higher long-term foreign equity returns. This process has allowed the current account deficit to grow and stay in equilibrium because the returns have been higher than normal. The US as a reserve currency has been able to finance at a lower rate than what has been the case for other countries. This may continue given the lower rate in the US for the short-run, but there may be a growing awareness of the investment shortfall from holding Treasuries. Additionally, many of the foreign investments by the US which have been more in equities have fallen sharply from the global decline. If these declines are sustained, then the privilege gained by the US will be diminished.
The capital flow argument is that the US is able to sustain the current account deficits because it has the most liquid markets in the world as well as the best legal and regulatory environment for investors. Given these liquid deep markets with strong investor protections, there will be a natural movement to the US as the rest of the world gains excess savings. Foreign countries do not have the deep liquid markets to allow for the protection of savings. Unfortunately, this will be put to the test in the next year. Changing the rules of investors so they are less protected will have negative impact on the perceived value for the holding US assets.
While we are believers in the new paradigm arguments, these arguments will be put to the test in the next year which could mean mounting pressure on the dollar as the delevering story ends. Key issues to watch for: (1) a change in the market environment which makes the US less investor friendly; (2) growing discussion of tariffs which will cut imports and cause a capital retaliation; (3) increased comments of currency manipulation about some countries which have been net exports; (4) sustained poor equity markets which reduces the gains from foreign investments by the US. None of these issues are new, but there will be renewed focus on these key policy issues which will feedback on the current account deficit issue.
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