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Sunday, January 14, 2007

Structural Drivers of Global Macroeconomic Imbalances

by Claus Vistesen : Copenhagen

Here at Global Economy Matters we we are going to emphasize that any analysis at the individual country-economy level needs to incorporate and take into account the global economic context. In this post I will try to outline one important conceptualization of the global economy as it is being widely debated at the moment amongst global economic analysts. I am speaking here of the phenomenon known as global macroeconomic imbalances and in terms of a brief description the visualization offered below from a recent IMF paper on the subject is good starting point.

global.imbalances.jpg *

Essentially, the concept of global macroeconomic balances is a proxy for the imbalance in the external balances in-and-between the world's major regions. More specifically, as can be seen from the figure the concept basically juxtaposes the US as an economy running a large current account deficit with other parts of the world running external surpluses or very small deficits. Apart from the actual description of this the most interesting task is to look at the economic dynamics and structural drivers behind these imbalances and it is here, as they say, that the plot thickens.

What are the dynamics and structural drivers of global imbalances?

1. Bretton Woods II

Perhaps the most widely cited explanation for the global imbalances at the moment is the notion of Bretton Woods II. This discourse which is excellently developed by Brad Setser from RGE directs its focus towards the US current account deficit on the one side and the dual dollar peg of Asia (most notably China) and Petro exporters on the other side. The empirical foundation for this analysis is very strong. Consequently, the US current account deficit seems indeed, at least to some degree, to be extensively mirrored in a very large and growing Chinese surplus as well as a joint surpluses being run by the petro exporters. This also brings us to the actual mechanism driving the global imbalances. As such, the main drivers become the surplus nations' fixed exchange rate policy, and the subsequent sterilization of the capital inflows associated with the huge external surpluses. More specifically, this mechanism works through the accumulation of reserves in dollars to keep a de-facto dollar peg by China's and the petro exporter's central banks. Finally, this also brings us to one of the major components in any re-balancing process where a gradual loosening of, for example, the RMB's value against the dollar would help smooth out the imbalances as the bilateral trade relationship of the two biggest economies in the world would correct to the fundamentals in a floating currency regime or as Brad Setser likes to point out: 'relative prices matter.'

2. A Savings Glut

It is of course difficult to seperate the explanations and discourses entirely here. However, where the proponents of Bretton Woods II discourse focus their attention somewhat narrowly on the triangle relationship between the US on one side and China and the Petroexporters on the other, the saving glut thesis attempts to look at global saving dynamics as a driver of global imbalances. The main point of this thesis is an attempt to reconcile the situation of low global real interest rates with the US's ability to continue borrowing ever larger amounts of capital from non-US sources (i.e. the ability to sustain a growing external deficit). Consequently, a growing US current account deficit then becomes a counter-result to the abundance of foreign thrift and as such the main research question becomes the scrutiny of the reasons for the glut in savings and whether this will persist in the future. This clearly also allows for the incorporation of a Bretton Woods II type scenario but crucially it also sets the scene for a broader analysis and conceptualization of the global economy. Another important aspect here involves examining the role of Europe and Japan and asking whether (and to what extent) these two global entities can contribute to global rebalancing, and if so what form (how far and how fast) this will take?

3. Demographics

The idea that demographics should have something to say in terms of explaning and conceptualizing global imbalances follows directly and intuitively from the saving glut thesis referred to above. As such, one of the fundamental pillars in the saving glut thesis is indeed how demographics on a global scale represent a driver of thrift. In fact, a 2005 survey from The Economist on the global economy and more specifically on the savings glut itself (see also the link above) gives a very good initial description of the role of demographics. The survey links the phenomenon of global ageing to the economic theory of life-cycle operationalized specifically in Franco Modigliani's life-cycle hypothesis in order to argue that, at least, one of the factors driving the state of global savings is demographics. I personally think this is a very important point and as such I am also inclined to take the explanation one step further. The main underlying point is that demographics in fact have a lot to do with international capital flows and crucially that this demands we take a very close look at the dynamics of investment and savings in individual domestic economies. A tantalising question then becomes what in fact determines whether a country is running a surplus or deficit on the external balances and crucially whether in fact global macroeconomic imbalances are a proxy for global demographic imbalances? This also brings into question the whole idea and nature of a rebalancing process.

The three points above pretty much sums up the range of views on global macroeconomic imbalances as the debate is packaged today albeit with my own personal gripe that demographics are not often not given sufficient importance at the time of setting up the problem

As can readily be seen seen a lot still remains to be done, as the phenomenon is still hardly a well understood one, and one of the roles of contributors here at GEM will be to follow this issue and debate closely and build on what has already been achieved. My argument here is also based on the important implicit assumption that we cannot and should not seek to present a mono-causal explanation for the phenomenon. The issue and related dynamics are far too complex to be available for encapsulation in one single explanation, but rather we should be trying to weight and and determine the relative importance all the relevant factors which are associated with the hypotheses being advanced. Finally, it is perhaps already clear that I believe demographics represent one of the most important (and normally ill-explored) cornerstones here. As such, I am somewhat driven by my own personal intuitions and as we move along I will among other things dig deeper and explain why I think what I do. However, I can assure you that there are other views present amongst the contributors at GEM which will give mine and others' belief in demographics due challenge and counterbalance. The key point would be that this phenomenon is relatively new, and no-one has all the answers or a monopoly on truth, which is why it is so important that everything is explicitly debated. The need for just this debate is, at the end of the day, the principal reason why this new forum has been created.

* Figure 1 - p. 49. IMF paper on Europe and Global Imbalances, 22/9-2006 - (linked above).