International Economic Outlook logo 130

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No. 1, March 2010

Global payment imbalances are threatening to derail the economic recovery. Several countries within the eurozone and the United States need to reduce balance-of-payment deficits. Without assistance from countries facing balance-of-payment surpluses, which should be enacting policies to encourage domestic consumption, addressing deficits by tightening budgets may worsen global economic conditions. Unfortunately, there has not yet been sufficient global policy coordination to ameliorate global payment imbalances. Such coordination is badly needed to protect the global economy.

Key points in this Outlook:

• Payment imbalances are threatening to derail the global economic recovery.
• Countries with large deficits, like the United States and Spain, should embrace policies aimed at reducing their deficits.
• Countries facing large surpluses, like China and Germany, should encourage more domestic consumption to help facilitate global payment adjustment.
  

Among the more disturbing failures of the global policy response to the Great Recession has been the lack of policy coordination between the world's major deficit and surplus countries to address the problems arising from the tendency of the United States and the Mediterranean countries to consume more than they produce. This lack of coordination now threatens the incipient and fragile global economic recovery; it also increases the risk that countries around the world might drift toward more protectionist policies and increased currency manipulation that would be inimical to long-run global economic prosperity.

Most analysts recognize that the large U.S. balance-of-payments deficit is at the heart of the global payment-imbalance problem.[1] They fear that the U.S. external deficit will widen in the years ahead due to the unhealthy trajectory of U.S. public finances and China's reluctance to undertake measures to promote domestic consumption. That said, too many analysts tend to overlook the unusually large payment imbalances between the northern and southern member countries of the eurozone, which portend an equally threatening challenge to the global economic outlook. The eurozone imbalances are primarily the result of profligate budget policies in the Mediterranean countries. These twin budget and balance-of-payment imbalances, occurring as they are within a single currency bloc, are likely to prove more challenging to resolve than the corresponding imbalance in the United States.

Acting alone, the United States cannot correct the world's payment-imbalance problem in a manner that can preserve global economic prosperity. Global coordination of economic policies is necessary to ensure an adequate level of global aggregate demand as the United States moves away from being the global economy's primary consumer. A concerted global effort is also required to ease the payment-imbalance difficulties in Europe's Mediterranean countries. To address these global payment-imbalance problems successfully, global policy coordination should involve basic structural policy changes that will boost domestic consumption in the world's major surplus countries, notably China and Germany.

Tensions in the Eurozone

The Great Recession has revealed cracks in the foundations of the eurozone that could have serious implications for the global economic recovery. In the same way that the U.S. consumer has been the primary engine for global demand growth, the Mediterranean and eastern periphery countries in the eurozone have been the main drivers of eurozone demand growth over the past decade. Growth in these countries was fueled by spectacular housing booms in Spain, Ireland, and the Baltic countries, as well as by highly expansionary fiscal policies. Whereas the Maastricht criteria (the criteria countries are supposed to adhere to once they have adopted the euro) require eurozone countries to aim for a budget deficit of 3 percent of gross domestic product (GDP), Greece, Spain, Ireland, and Portugal are all now recording budget deficits at or above 10 percent of GDP.[2]

Many years of lax fiscal policy in the eurozone's noncore member countries have led to an appreciable loss in international competitiveness and the development of fundamental internal and external economic imbalances. Since the 1999 inception of the euro, Spain, Greece, Portugal, and Ireland have all lost more than 25 percentage points in unit labor cost competitiveness relative to Germany (for additional information, see figure 1).[3] At the same time, they have all seen their public-sector deficits and their external current-account deficits widen to double-digit levels relative to GDP.

IEO No. 1 Figure 1

In light of deteriorating economic fundamentals in Ireland and the Mediterranean countries, the credit-rating agencies have started a cycle of credit-rating downgrades for these countries. The agencies have also warned that unless these countries undergo a fundamental change in budget policies, their credit ratings will drop further. At the same time, markets have begun to include in the price of these countries' sovereign bond yields the not-negligible probability that these countries could default on their external sovereign debt payments over the next five years. These considerations demonstrate the importance of taking decisive corrective action within the eurozone (for additional information, see figure 2).

IEO No. 1, March 2010, Figure 2

Correcting the internal and external imbalances of Spain, Greece, Ireland, and Portugal will be a major economic challenge for the eurozone in coming years. This task is complicated because these countries lack their own currencies, which precludes them from resorting to devaluation as a means to restore external balance. Instead, these countries will need to persevere with austere fiscal policies for many years before the internal devaluation needed to restore external sustainability will have materialized. Germany's current very low rate of cost and price inflation implies that for the Mediterranean countries to meaningfully gain competitiveness with respect to Germany, their price and wage levels will actually have to decline. This means that the eurozone's noncore members will have to tolerate painful price and wage deflation for a number of years before they will be able to recover the large losses in cost competitiveness they have recently suffered (for additional information, see figure 3).

IEO No. 1, March 2010, Figure 3

Greece's Economic Crisis

Greece's present economic and financial market predicament underlines the difficulties that lie ahead for the eurozone in general and for the eurozone's more vulnerable Mediterranean countries in particular. There can be little question that Greece's public finances are on an unsustainable path: as figure 4 shows, Greece's budget deficit is now close to 13 percent of GDP, more than four times the limit in the Maastricht criteria, and the country's ratio of public debt to GDP is expected to exceed 120 percent by the end of 2010.[4]

IEO No. 1, March 2010, Figure 4

Greece's long-run solvency is further threatened by the country's budget profligacy and years of inappropriately low European Central Bank interest rates, which have led to persistently higher wage and price inflation in Greece than in the rest of the eurozone. The International Monetary Fund estimates that, since adopting the euro in 2001, Greece has lost around 30 percentage points in unit labor competitiveness; this has contributed to a growing external current-account deficit that is now well into the double digits relative to GDP (see figure 5).[5]

IEO No. 1, March 2010, Figure 5

Greece's domestic and external imbalances are so far out of line with a sustainable position that an attempt to correct them within the straightjacket of eurozone membership will necessarily involve many years of painful deflation and deep economic recession. Because it lacks its own currency, the policy options most countries might use in this situation are unavailable to Greece. Greece cannot restore international competitiveness through currency depreciation, nor can it devalue its exchange rate to stimulate exports as a means to offset the negative impact a massive budget consolidation will have on domestic demand. As long as the European Central Bank focuses on maintaining price stability in the eurozone, the only way Greece can regain international competitiveness without currency devaluation is by engineering a 20-30 percent fall in domestic wages and prices over time. This would necessarily involve many years of painfully slow economic growth and high unemployment. It would also have the effect of boosting Greece's public debt-to-GDP ratio to over 150 percent. As difficult as it would be, an attempt by the Greek government to reduce its budget deficit by the 10 percentage points needed to bring the deficit in line with the Maastricht criteria is a surer recipe for a depressed Greek economy and for extraordinarily high unemployment levels likely to stretch for many years. Even assuming that the Greek Keynesian multiplier relationship between public-spending cuts and a decline in GDP might be as low as 1.2--a conservative estimate--cutting public spending by 10 percent of GDP would cause Greece's GDP to contract by 12 percent.

Since Greece collects approximately 35 percent of its GDP in taxes, a decline of 12 percent of GDP would decrease tax revenues by approximately 4 percent of GDP. The net result: Greece's budget balance would have improved by only 6 percent of GDP, necessitating another round of public-spending cuts. Taking this line of reasoning to its logical conclusion, Greece could see a decline in GDP of 15-20 percent before budget spending cuts would enable it to meet the Maastricht criteria.

IEO No. 1, March 2010, Figure 6

It is difficult to believe that Greece's social and political fabric would be able to withstand such a deep recession. It is also difficult to believe that a major Greek recession would not cause a wave of household defaults that would shake the Greek banking system to its very roots. As somber as this scenario is, it is unlikely to come to fruition. Greece's European partners are as fearful of the consequences of a Greek sovereign-debt default as the Greek government is. Not only would a Greek sovereign-debt default deal a major blow to a still-fragile European banking system, but it would also focus the market's full fury on other vulnerable eurozone members like Spain, Ireland, Portugal, and Italy. Armed with this knowledge, the Greek government will exert its leverage to extract a bailout from the European Commission. Despite European official institutions' present huffing and puffing about Greece's lack of policy commitment, they know that when the chips are down the very continuation of the eurozone experiment in its present form is in question.

The U.S. Dollar Problem

Over the past decade, the United States has become the world's main driver of aggregate global demand. As the Asian savings glut progressively became more pronounced, U.S. consumers embarked on a massive spending spree. Until the bursting of the U.S. housing bubble in late 2006, U.S. households financed this spending spree by borrowing heavily against the equity in their homes. In the process, the U.S. household savings rate plummeted from an average 8 percent of household income in the 1990s to virtually zero by 2008.[6]

With the onset of the worst U.S. economic recession in the postwar period, households have begun to repair their highly damaged balance-sheet positions, which has led to a modest rebound in U.S. personal savings. This improvement, however, has been offset by a marked deterioration in the U.S. public savings outlook. According to the nonpartisan U.S. Congressional Budget Office (CBO), the United States will record budget deficits in excess of $1 trillion per year over the next decade.[7] Even when the U.S. economy has fully recovered, the CBO expects the U.S. budget deficit will remain close to 4 percent of GDP. The CBO also projects (based on present policies) that the U.S. public debt-to-GDP ratio will nearly double from 45 percent at present to 85 percent by 2019. This would represent the largest peacetime U.S. public debt buildup in U.S. history.

U.S. external accounts are on an unsustainable path primarily due to the consistently weak performance of U.S. savings over the past decade. By 2006, the U.S. external current-account deficit reached a postwar high of $800 billion, the equivalent of 6 percent of GDP (see figure 7).[8] Although the U.S. external current-account deficit has narrowed significantly since the onset of the global recession, that deficit is expected to widen again to an unsustainable level once the economic recovery gains traction.

IEO No. 1, March 2010, Figure 7

The dramatic shift in the U.S. external debt position is another clear indication of the precarious state of U.S. external finances. The United States has gone from the world's largest creditor country in the mid-1990s to the world's largest debtor country today. Foreign holdings now exceed 50 percent of the total U.S. public debt, and the United States is becoming increasingly dependent on foreigners to finance the bloated U.S. budget deficit. Credit-rating agencies are now warning that the U.S. government could lose its AAA rating unless it adopts policies to put U.S. public finances on a more sustainable path.

An Asian Savings Glut

The massive buildup of large payment surpluses in the Asian emerging-market economies and, to a lesser extent, in the Organization of the Petroleum Exporting Countries has exacerbated the U.S. payment deficit. Chastened by their traumatic experience during the 1998 Asian economic crisis, most Asian emerging-market economies have relied upon highly disciplined budget policies, while simultaneously intervening in their currency markets to promote export-led growth. This combination of policies has resulted in persistently large Asian current-account surpluses and the accumulation of massive international reserve positions.

China is the most egregious example of an Asian economy that has stubbornly pursued export-led growth in apparent disregard for how such a strategy affects its main trade partners. Propelled by a domestic savings rate close to 50 percent of GDP, China's external current-account surplus peaked near 12 percent of GDP on the eve of the global recession. (For additional information, see figure 8.) At the same time, its international reserves have been increasing at an annual rate of around $400 billion, giving China over $2.2 trillion in international reserves by the end of 2009--the highest level in the world by far.

IEO No. 1, March 2010, Figure 8

Despite China's unusually strong external position, it has chosen to peg its currency to a depreciating U.S. dollar since June 2008; this policy has added to its unfair competitive advantage. Many mainstream economic analysts, including those at the Peterson Institute for International Economics, find that the Chinese currency is undervalued by between 15 and 30 percent.[9] More disturbing, China is stubbornly resisting requests that it take measures to increase domestic consumption, which appears to be a necessary condition for restoring global payment balance.

The highly skewed distribution of global international reserve holdings is a further indication of global external imbalances. Asian countries, including Japan, presently hold over 80 percent of the world's international reserves and a similar proportion of U.S. dollar-denominated public-debt instruments. Any significant shift in the composition of those reserves has the potential to create disorderly international financial market conditions.

Toward a Coordinated Solution

Any coordinated policy effort aimed at reducing today's large payment imbalances in a manner that will not disrupt the global economic recovery must rest on two basic planks. First, policies must be aimed at securing a better alignment of the major global exchange rates than we have today. Exchange-rate policies should encourage countries with large external deficits to shift resources toward the export sector, while countries with large external surpluses should use exchange-rate policy to shift resources away from the export sector and toward domestic demand. Second, a coordinated policy response must involve basic changes of demand-management policies in both deficit and surplus countries. Deficit countries should put in place more austere budget policies that would make room for the shift of resources toward the export sector. Surplus countries should adopt budget policies and structural reforms aimed at increasing their domestic demand by an amount sufficient to offset the decline in domestic demand in deficit countries. Sadly, the G20 has yet to coordinate global demand policy along these lines.

Improving Major Countries' Currency Alignment

A sizable and welcome secular depreciation in the U.S. dollar since 2000 should help in the adjustment process (for additional information, see figure 9). That secular decline was interrupted by the depth of the global financial crisis in late 2008 and early 2009 that saw a massive flight to the relative safety of U.S. Treasury bonds. Since March 2009, however, the secular decline of the dollar has resumed as global risk appetite has begun to increase and as the U.S. dollar has come to be increasingly used as the vehicle for trade. Most analysts, including those at the Peterson Institute of International Economics, estimate that the dollar will approach its long-run equilibrium level if it depreciates by approximately 10 percentage points more on an effective basis.[10]

IEO No. 1, March 2010, Figure 9

Unfortunately, a large part of the decline of the U.S. dollar has been against the euro rather than against the Asian currencies of the emerging-market economies. This is a problem since the eurozone overall is in approximate current-account balance. It is also not helpful because a stronger euro will require an even greater internal devaluation for Spain, Ireland, Greece, and Portugal.

An overriding requirement for the restoration of global payment balance is a significant appreciation of the Chinese currency to redress China's outsized external current-account surplus. Past experience with currency appreciations suggests that Chinese currency should be appreciated in a steplike manner since a policy of gradual currency appreciation would make the Chinese currency a one-way bet in the financial markets. China's June 2008 decision to peg the Chinese currency against a depreciating U.S. dollar is regrettable because it points the Chinese currency in precisely the wrong direction (for additional information, see figure 10).

IEO No. 1, March 2010, Figure 10

Toward a Better Global Demand Balance

The present lack of U.S. policy to place public finances on a more sustainable footing darkens the prospects for any early resolution of the global payment-imbalance problem. Indeed, far from addressing this issue, the Obama administration seems to be compounding the budget quagmire by cavalierly embarking on ambitious expenditure programs, most notably health care reform, without raising taxes to fund those programs. On February 23, 2010, the White House pegged the cost of its health care reform initiative at $950 billion over ten years.[11] The market is almost certain to question whether the United States is trying to inflate its way out of its public-debt problem.

The fragility of the present U.S. recovery argues against withdrawing U.S. fiscal stimulus prematurely, but it is not too early for U.S. authorities to outline a credible medium-term program for regaining budget sustainability. Nor is it too early for the United States to make credible and binding policy commitments to attain medium-term budget sustainability in a manner that might allay growing market fears about the U.S. long-run public-finance outlook. Any serious commitment toward medium-term budget sustainability was conspicuously absent in the administration's 2011 budget proposal.

To maintain an adequate level of global aggregate demand as the United States undertakes medium-term budget consolidation, surplus countries, most notably China and Germany, must adopt policies that include basic structural reforms to promote domestic consumption. In this context, it is regrettable that China directed a major component of its 2009 fiscal and monetary policy stimulus toward increasing investment rather than promoting domestic consumption. Those policies will exacerbate the world's excess supply problem when investment projects come online later this year.

Similarly, far from helping maintain an adequate level of global aggregate demand, Germany is embarking on a program of budget consolidation aimed at securing medium-term budget balance. Beyond the global consequences of such a policy, Germany's move toward more restrained budget policy will make it more difficult for Europe's Mediterranean countries and for its Eastern European periphery to redress their severe macroeconomic imbalances.

Conclusion

The extraordinarily accommodative U.S. and European monetary policy stances since March 2009 have enabled a sense of calm to return to global financial markets. It is important that this calm does not now breed complacency among global policymakers with respect to today's large global payment imbalances. Left unattended, these imbalances could set the stage for a renewed bout of global economic and financial-market instability that could abort the current global economic recovery.

Desmond Lachman (dlachman@aei.org) is a resident fellow at AEI.

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Notes

1. See, for example, Maurice Obstfeld and Kenneth Rogoff, "Global Imbalances and the Financial Crisis: Products of Common Causes" (Asia Economic Policy Conference, Federal Reserve Bank of San Francisco, Santa Barbara, CA, October 2009).

2. International Monetary Fund (IMF), Regional Economic Outlook: Europe; Securing Recovery (Washington, DC: IMF, October 2009), available at www.imf.org/external/pubs/ft/reo/2009/EUR/ eng/ereo1009.htm (accessed February 9, 2010).

3. Ibid.

4. Organisation for Economic Co-operation and Development (OECD), "OECD Economic Outlook No. 86," November 2009, available at www.oecd.org/document/18/0,3343,en_2649_3 4109_20347538_1_1_1_37443,00.html (accessed March 5, 2010).

5. IMF, "Greece: 2009 Article IV Consultation--Staff Report; Staff Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Greece," IMF Country Report, no. 09/244, August 2009, available at www.imf.org/external/pubs/ft/scr/2009/ cr09244.pdf (accessed March 3, 2010).

6. Executive Office of the President, Council of Economic Advisers, Preparing the Workers of Today for the Jobs of Tomorrow (Washington, DC, July 2009), available at www.whitehouse.gov/ assets/documents/Jobs_of_the_Future.pdf (accessed March 3, 2010).

7. Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2010 to 2020, 111th Cong., 2d sess., no. 4095 (Washington, DC, January 2010), available at www.cbo. gov/ftpdocs/108xx/doc10871/01-26-Outlook.pdf (accessed March 3, 2010).

8. Board of Governors of the Federal Reserve System, Monetary Policy Report to the Congress, 111th Cong., 1st sess. (Washington, DC, July 21, 2009), available at www.federalreserve.gov/monetarypolicy/ files/20090721_mprfullreport.pdf (accessed March 3, 2010).

9. Morris Goldstein and Nicholas Lardy, The Future of China's Exchange Rate Policy (Washington, DC: Peterson Institute for International Economics, July 2009).

10. Fred Bergsten, "The Dollar and the Deficit," Foreign Affairs, November 2009.

11. Patricia Zengerle, "Obama Unveils His US$950B Health Plan," Reuters, February 23, 2010.