What are global imbalances?
Fri 17 Feb 2012 by Infometrics Ltd in International

Hardly a day goes by without the Global Financial Crisis (GFC) making the news – more loans for Greece, debt levels in the UK, slowing economic activity in America, inflation concerns in China and so on.

Why has the GFC continued to have to such negative economic effects?   The blame is often put on factors such as greedy bankers, poor financial regulation, political pressure to expand lending for housing (in the USA), overly generous pensions, a bloated public sector in southern Eurozone countries, and risible tax collection mechanisms (particularly in Greece).   Most of these problems existed for decades before the onset of the GFC.   To be sure they contributed to the current malaise, but there was a far more fundamental cause.

The GFC was preceded by the accumulation of two extremely large global imbalances that had amassed over many years, caused by inappropriate exchange rates.   The first of these was the huge trade surplus amassed by China (assisted by Japan and the Asian tigers) and its mirror image – the American deficit – caused by China’s exchange rate policy which prevented the yuan from appreciating against the dollar.  An exchange rate is the price of one currency relative to another.   (We find Australia expensive because we get only 77 Australian cents for our kiwi dollar, whereas not so long ago it was over 90 cents).   By keeping the price of American dollars high when expressed in yuan, it made importing expensive in China, which discouraged spending by households and encouraged savings.   The other side of this effect was cheap Chinese imports for Americans.   Not surprisingly China accumulated vast trade surpluses (see figure).   

The second major imbalance is a parallel situation within the EU.   A savings glut in Germany, also caused by an over-zealous approach to exporting and saving, reinforced by other northern European countries, found ready demand in the southern European countries with their low real interest rates and increased buying power.   In this case the common Euro currency had (and has) exactly the same effect as a fixed exchange rate – the southern Europeans could not devalue against Germany.   The 'one size fits all’ approach to monetary policy has materialised as a 'one size fits nobody’ monetary policy.

While those nominal exchange rates didn’t change, real exchange rates did.   The real exchange rate is the nominal exchange rate adjusted for differences in relative prices   between countries.   It is the real exchange rate   that determines fundamental international competitiveness.   Low inflation in Germany following a decade of low wage growth, combined with high inflation in southern Europe, made German products more price competitive.

This shift in competitiveness needs to be reversed for the Euroland imbalances to be alleviated. Under freely floating exchange rates Greece, Portugal and Spain could devalue, but this option is not available within the euro mechanism.   Thus the only way for the real exchange rate to fall is by reductions prices and wages, labelled as austerity in the European press.   But this is a very painful way to adjust to imbalances.   An easier way for this to occur would be if Germany allow edits real exchange rate to rise – by raising wage rates and reducing tax rates for example – thereby encouraging imports and domestic consumption, and discouraging exports.

Between the USA and China a similar realignment of real exchange rates is occurring, but by a different mechanism.   Greater currency flexibility from Beijing combined with higher Chinese inflation have reduced the nominal and real value of the dollar against the yuan.   Slowly China’s exports are becoming less competitive in the USA.   The Chinese external surplus has already declined substantially (see figure), attenuating the savings glut.   To further reduce savings China also needs to stop using savings to prop up poorly performing state companies and local government, and introduce more social welfare such as pensions.   These changes would encourage more spending by households.   The American trade deficit would improve and another large global imbalance would be mitigated.

So what are the prospects for the next few years?   Because the USA-China imbalance seems to be correcting faster than the intra-Eurozone imbalance, we can expect the USA to see economic growth before the EU.   Nevertheless a sharp American slow-down in 2012 is likely if fiscal policy is tightened too soon.   Private debt levels are also still too high, though much more sustainable than they were.   

The lesson for the Eurozone is that fixed exchange rates between very dissimilar economies do not work in the long term.   Perhaps the Eurozone needs to split into two currency blocks as the best route back to economic growth for all of its citizens, and to national solvency as well for the southern Europeans.   The global imbalances arose through inflexible relative prices (that is exchange rates); they won’t disappear without relative price adjustment.

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