Monday, November 24, 2014

Bretton Woods III

SINGAPORE – Many analysts and observers believe that the global imbalances that characterized the world economy in the years before the 2008 crisis have substantially dissipated. But, while it is true that China’s current-account surpluses and America’s deficits have somewhat moderated since then, have the imbalances really been corrected? More important, can the post-crisis global economy enjoy both growth and balance?

To answer these questions, it is important to understand the imbalances’ underlying dynamics. An economy’s current account is the difference between its investment rate and its savings rate. In 2007, the United States had a savings rate of 14.6% of GDP, but an investment rate of 19.6%, generating a current-account deficit. By contrast, China had a fixed investment rate of 41.7% of GDP and a savings rate of 51.9%, reflected in a large surplus.

Since 2007, the US current-account deficit has narrowed, but not because of a higher savings rate. Rather, the external deficit has been squeezed by a collapse in investment activity, while America’s overall savings rate has fallen below 13% of GDP, owing to worsening government finances. Meanwhile, China’s savings rate remains stubbornly high. The surplus has narrowed because investment has been ramped up even higher, to roughly 49% of GDP. In other words, the Americans save even less today than they did before the crisis erupted, and the Chinese invest even more.

Any future recovery in the US economy will almost certainly trigger a revival in investment activity. American businesses have postponed much-needed capital spending and, with American airports and bridges in appalling condition by developed-country standards, investment in infrastructure is crucial as well. Indeed, it is very likely that reviving growth will lead to larger current-account deficits, even if the savings rate improves and domestic energy production curtails oil and gas imports.

China has the opposite problem. In order to sustain growth, it needs to continue to invest half of its $9 trillion annual GDP – no easy task for a country that already has brand new highways and airports. In fact, over the next decade, as China attempts to move up the value chain into services and adjusts to a shrinking workforce, its investment requirements will shrink – and its investment rate will fall sharply.

Of course, China’s savings rate will also decline, but Japan’s experience since the 1980’s demonstrates how a sharp fall in investment can generate large and persistent current-account surpluses, even when the savings rate is falling and the currency is appreciating. Indeed, a stronger currency can paradoxically feed external surpluses, while discouraging investment in export-oriented industries.

The implication is that the post-crisis global economy will not be characterized by balance, but by a return to large macroeconomic imbalances. But, although many economists will consider this problematic, history shows that symbiotic imbalances have characterized virtually all periods of global economic expansion.

The Roman Empire ran a persistent trade deficit with India for centuries. Although the resulting outflow of gold caused monetary debasement in the Roman Empire, Indo-Roman trade remained the backbone of the global economy.

Similarly, Spain ran persistent deficits in the sixteenth and seventeenth centuries, paid for by Andean silver. The resulting flood of liquidity caused a global boom that benefited economies from Elizabethan England to Mughal India. And 1870-1913, another period of rapid growth and globalization, was not characterized by balance; it was funded by the United Kingdom, acting as the world’s “bank.”

In the last 60 years, the US has underpinned global growth by running persistent current-account deficits. Under the Bretton Woods system, the US ran deficits that enabled war-torn Europe and Japan to rebuild. In return, Europe funded the US deficits.

The system broke down when European countries, particularly France, decided to stop funding those deficits. But the economic model persisted, with Asian economies stepping in to finance the US deficits, while using the US market to grow rapidly. China is the latest and largest beneficiary of the economic model dubbed “Bretton Woods II.”

Clearly, periods of global growth are almost always characterized by symbiotic imbalances. But, while each of these episodes was characterized by macroeconomic distortions caused by the imbalances, they lasted for years, or even decades. So, the real question is what the next generation of symbiotic imbalances will look like.

It is likely that China will soon return to running very large current-account surpluses – potentially large enough to fund the US, with plenty left over for the rest of the world. As this capital cascades through the global financial system, it will re-inflate the economy.

In the “Bretton Woods III” system, China will transform from “factory to the world” to “investor to the world.” Like all imbalanced systems, it will have its distortions, but the arrangement could last for many years.

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    1. Portrait of Pingfan Hong

      CommentedPingfan Hong

      It is superficial to focus on the imbalances cross countries. There is nothing wrong in a diverse world where some countries have higher savings than others and thus lead to imbalances in the current accounts across countries.

      What caused the subprime mortgage crisis in the US was not simply the flows of Chinese savings to the US, but the way the US used these savings from China: instead of using the funds in productive sector, particularly in infrastructure, the US used the borrowings from China to below up the housing bubble. Imbalances across countries, when they become too large, say 6% of GDP as in the case of the US in 2006, are indeed warning signs of instability, but they are not the direct cause of the crisis. In an integrated global economy, imbalances across countries at certain level are benign and mutually beneficial for all the countries involved.

      In order to attain a robust global growth and maintain a stable world economy, policies should be focused on the underlying macroeconomic policies and financial regulation at both national levels, rather than on the imbalances per se.

    2. CommentedProcyon Mukherjee

      Sanjeev, when I go through the last Federal Reserve Release dated 6th December 2012, on page-17 under 'derivation of measures of Personal Savings', in the FOF concept, the figures for personal savings rate is given starting from the year 2008 to the last quarter of 2012 and the rates range from the high of 14% to the low of 5.1%, while the gross savings on page 15 gives the range from $1800 Billion to $2000 Billion for the same period. There is a very high correlation of the savings rate and gross savings, with the personal, corporate and Federal debt, the last one rising at a compounded annual rate of above 5%, while the personal debt has been coming down. Page 15 makes it clear that it is the non-financial corporate sector which made bulk of the increase in investment ($200 Billion increase from 2008 to 2012), while the rest have virtually made no additional contribution, while the gross government investment has actually come down by the same proportion.

      On comparison of savings rate with China, Project Syndicate article by Robert Shiller on August 25th 2006, makes it abundantly clear why China continues to save several times higher.