The Global Rebalancing Mirage

Author: Uri Dadush
Originally published by the Carnegie Endowment for International Peace

The slowdown in advanced countries has again placed the spotlight on “rebalancing” global demand. Countries running external deficits are calling on those with surpluses—notably China, Germany, and Japan, and many smaller nations—to pick up the slack in global demand.

A major rebalancing occurred during the worst of the crisis in 2009, but is unlikely to continue; most forecasters expect current account deficits and surpluses to remain in the present, moderate range as the sluggish global recovery consolidates. In most instances, such imbalances are not, by themselves, a problem, as they can be financed and corrected over time.

Nonetheless, the rebalancing dispute rages on, fueling protectionist sentiment and deflecting attention from difficult domestic reforms, which are needed for their own sake and cannot be solved by adjustments in partner countries. The rebalancing mirage lures the thirsty in the wrong direction—one likely to lead to shirked responsibility at home and unnecessary divisions abroad.

Global rebalancing happened and more is unlikely

Global demand underwent a major rebalancing over 2008–2009 as a natural result of the global credit crunch. Because countries with large current account deficits—such as the United States and Spain—also had the biggest housing bubbles and the most extended consumers, they cut spending more than surplus countries did. International negotiations had little to do with these shifts in private demand.

By and large, the rebalancing that has occurred is expected to persist: chastened households in the United States and Spain are saving more, their banks are deleveraging, and governments in debt-impaired Europe are retrenching. At the same time, as Pieter Bottelier reports, China is emphasizing development in its less developed regions, while growing middle-class populations in Asia and other parts of the developing world are buying more goods.

Other considerations make further rebalancing unlikely, however. To start with, concerns about rising government debt, asset price inflation, and excessive credit creation are leading countries with external surpluses to reduce government stimulus as their private demand recovers. Moreover, the crisis has reinforced the tendency in emerging markets to maintain large reserves. Conversely, the corresponding deficits will likely persist as well: in the United States and other deficit countries such as Spain, a private demand recovery is expected to roughly offset the demand-dampening effect of fiscal consolidation.

Current account deficits and surpluses in the 3–5 percent range—where most large countries fall today and will likely remain in the medium term—are not exceptional: they can be, and have historically been, financed comfortably. Market-driven international differences in savings trends and investment opportunities—rather than manipulated currencies or hidden protectionism—may account for these moderate imbalances.

Consider the United States: It has many problems, including a still-low household savings rate and a large fiscal deficit, but also ranks at the top of global competitiveness and business climate rankings, has the world’s largest and deepest financial markets, and holds a reserve currency. Not surprisingly, its domestic investment rate exceeds its low savings rate and it still attracts plenty of foreign investment—the mirror image of its now-modest 3 percent current account deficit. Remarkably, despite being at the epicenter of the crisis when its external deficit rose to twice its current size, the United States remained the safe haven and borrowed at the lowest interest rates in its history.

Domestic imbalances and the importance of developing solutions at home

During the pre-crisis boom, the rebalancing dispute revolved around the sustainability of large imbalances rather than the need to maintain global aggregate demand that drives discussion today. But one thing has not changed: countries will get further by developing remedies to fix their own domestic imbalances than by asking others to adjust.

Assume, for example, that in response to U.S. pressure Chinese leaders could dictate that their country’s savings be reduced immediately by 10 percent of GDP—approximately $500 billion. Even more implausibly, assume further that none of this additional spending could go toward domestic products, and that all of it instead went to imports, immediately making China a larger external deficit nation proportional to its GDP than the United States. If the increase were allocated geographically in proportion to China’s recent import spending, the direct effect on U.S. exports and demand would be only $40 billion—or 0.3 percent of U.S. GDP—equivalent to about one-ninth of U.S. fiscal stimulus measures in 2010.

The rebalancing dispute naturally places a lot of attention on the exchange rate, since it is the only instrument—other than trade measures, which can be challenged in the World Trade Organization—that governments can use directly to affect external imbalances. But both logic and experience show that the nominal exchange rate cannot correct external imbalances unless underlying domestic savings and investment patterns change.

Rather than address the surplus, appreciation in current account surplus countries will only add to deflation until the root causes of the imbalance—such as distortions that encourage domestic savings or depress domestic investment—are addressed; witness Japan over the last year. In the same vein, if the nominal exchange rate is not allowed to appreciate but domestic demand surges—China’s case recently—the external surplus will decline anyway, and wages and inflation will tend to rise.

The real issues

Why, then, does the global rebalancing dispute rage on? To start with, there is a strong mercantilist appeal to asking trade partners to buy more and sell less—one that sits well with powerful special  interests though it may raise prices for the general public. By the same reasoning, surplus countries have strong incentives to resist rebalancing. This tension establishes the conditions for escalating international divisions and protectionist measures.

Most importantly, however, rebalancing garners so much attention because it is the easy way out: it is easier to blame others than to confront one’s own problems.

What problems? Before the crisis, when demand was booming and current accounts were seen as obviously excessive, a list of reforms in deficit countries might have included: increased consumption taxes to boost household savings, higher interest rates and tighter financial regulation, a higher gasoline tax, and elimination of the mortgage tax credit. Now, when the overriding concern is lack of demand, the dilemma is how to encourage it despite rising government debt and policy interest rates near zero.

Tackling these issues is much tougher than calling on trading partners to spend more, even if they face similarly difficult challenges. Conversely, surplus countries prefer to reproach the profligacy of their partners rather than confront the powerful domestic interests that benefit from measures that repress wages and interest rates as well as other producer-friendly incentives. Yet, these—and not external imbalances per se—are the real issues, and they need to be addressed for their own sake.

German surpluses may be the one exception to this general argument because of the plight of the debt-afflicted countries tied to Germany through the euro. Germany’s surplus—which, at 5 percent of GDP, is not extraordinary—is nevertheless uniquely worrisome; Germany’s compressed wages and weak domestic demand have placed great competitive pressure on its euro partners, and could one day threaten the viability of the euro project.

Even mindful of the German exception, however, policy makers should focus their attention on what they need to do at home rather than pursue the rebalancing mirage abroad. Exchange rates and current accounts, which today command political attention, are the outcomes of these much deeper domestic forces.