Why So Little Focus on the Unwinding of Global Imbalances?

It seems peculiar indeed that a sea change in the world economy, namely, the decline of the international funds flow generally called “global imbalances,” has gotten so little attention.

“Global imbalances” refers to capital flows from high savings countries such as China, Taiwan and Japan, funding current account deficits (meaning consumption) in the US. They have become as fundamental to the operation of the world economy as the Gulf Stream is to the climate, and changes in it would produce a similar level of disruption.

This topic has garnered comparatively little attention in the financial press relative to its importance. There was a sobering discussion by Martin Wolf at the Financial Times recently. But for the most part, the discussion, even by Serious Economists, is on the decline of the dollar, and it seems for the most part to be considered in isolation. An exception that proves the rule is a comment by Paul Krugman (in keeping, on his blog, not in his New York Times column) that points to a recent paper of his that addresses the issue but frames it in terms of a possible “dollar plunge”:

There is little doubt that the dollar must eventually fall from current levels. Trade deficits on the current scale cannot continue forever – and we are all fond of quoting Stein’s Law: ‘If something cannot go on forever, it will stop.’ Closing the trade deficit will require a redistribution of world spending, with a fall in US spending and a rise in spending abroad. One occasionally hears assertions that this redistribution of world spending can lead to the required change in trade deficits without any need for a change in real exchange rates – a view John Williamson once felicitously described as ‘the doctrine of immaculate transfer’. In fact, however, a redistribution of world spending will require a fall in the relative prices of US-produced goods and services, because US spending falls much more heavily than the spending of other countries on those US-produced goods and services. So there must, eventually, be a real depreciation of the dollar. But this depreciation could be gradual, a few percent per year or less. Why should it take the form of a discrete drop?

There has actually been surprisingly little discussion of this question, even in papers that can seem, on a casual reading, to be about the prospects for a dollar plunge. For example, the widely cited work of Obstfeld and Rogoff about dollar adjustment, continued in their 2005 Brookings paper, is often cited as reason for alarm. But their framework is designed to estimate the size of the dollar decline needed to eliminate the current account deficit; it sheds little light on whether that decline will happen quickly, as opposed to a gradual adjustment over the course of a number of years.

The closest any paper in the 2005 Brookings symposium came to addressing that question directly was Edwards (2005), whose view is echoed less clearly in a number of discussions. The basic idea can be summarized as follows: there has been an
upward shift in the proportion of US assets that foreign investors want to hold in their portfolios. As long as foreign investors are still in the process of moving to this new, higher share of dollars in their wealth, their actions generate a large capital flow into the United States. But the capital flows needed to maintain an increased dollar share in portfolios are much smaller than those required to achieve that share. So once the desired holdings of US assets have been achieved, the argument goes, capital flows into the United States will drop off sharply, leading to an abrupt decline in both the current account deficit and in the dollar.

Note that the scenario that Krugman describes above, that foreign investors will reach a target level of dollar holdings and then become much less keen about buying more dollars to keep funding US deficits, leading to a fall of the dollar. That process appears to be underway. As we have noted before (see here and here for examples), foreign central banks, which have been the biggest buyers of the US currency, have begun to diversify away from the greenback.

A post by Michael Pettis on Brad Setser’s blog (which does a very good job on the currency beat) takes a different angle than Krugman: he anticipates that an end of global imbalances will lead to a prolonged economic slowdown, with or without a sharp correction of the dollar:

As I said in an earlier post I believe that the recycling of the US trade deficit has been the main factor underpinning the recent globalization cycle. If so, and when the current cycle ends, if history is any indication the adjustment from the insanely happy days of too much liquidity (with its attendant surge in risk appetite) to a more “normal” level of liquidity will be a very difficult one and can result in significantly reduced global growth lasting many years – especially for those countries that begin the slowdown with the weakest and most rigid financial systems.

In previous cycles, financial systems, which during the good times had evolved into greater risk-taking activity and more-tightly-stretched asset-liability structures, were suddenly caught short by the secular change in risk appetite. In many cases their ability to intermediate the flow of capital slowed considerably, and what followed often involved considerable economic slowdown.

My evidence is largely anecdotal, but it seems to me that those countries with the highest levels of financial risk-taking and the least flexible financial systems were the ones that did most poorly – the United States in the 1930s, with its reliance on thousands of small banks with rigid deposit bases, a weak and inexperienced central bank, and an investment banking industry in shock, of course did among the worst, although there were plenty of other non-financial factors that exacerbated the problem (by the way, it is worth remembering that in 1929 the US had, after several years of very high trade and capital account surpluses, very high levels of reserves, which in the end didn’t help).