Comment: Financial Globalization and Exchange Rates

International Monetary Fund
Published Date:
September 2005
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(Philip R. Lane and Gian Maria Milesi-Ferretti)

Daniel Cohen Ecole normale supérieure

This is a wonderful paper, crisp and full of insights. The core idea is the following: countries are rarely in the corner position of being either strictly debtor or creditor. They are most often simultaneously both. They hold claims on the rest of the world and they are in debt with respect to it.

The most obvious example that comes to mind is the US. It is not only the largest debtor on earth but the largest creditor as well. Over the period 1999-2002 alone, the US has borrowed the equivalent of 31% of its GDP. But over the same period, it also accumulated claims over the rest of the world worth about 15% of GDP.

This pattern is frequent for industrial countries, but is also visible for emerging countries as well. In the case of Korea, for instance, the inflows represent 10% of GDP, the outflows stand at 12% of GDP. In Taiwan, the numbers are 25% of GDP both ways (again from 1999 to 2004).

The benefit of being in and out simultaneously is obvious within any theoretical framework where countries want to diversify their portfolio. For countries which are high in debt and do not cash in the benefits of being on both sides of the fence, this adds to the ills of debt crises.

For countries which do cash in the benefits of being on both sides, the macroeconomics of exchange rate fluctuations become quite interesting. What happens when the exchange rate depreciates? For most industrial countries, the paper shows that the return on foreign assets appears to be almost orthogonal to the exchange rate of the country. What happens on the liability side? The surprising result of the paper is that liabilities appear to follow pretty much the same pattern which implies that “the net valuation impact of exchange rate movements on the net foreign asset position has been limited”.

The exception to this rule is the US. Contrary to other industrialized countries, liabilities are unaffected by currency movements, a fact which quite obviously results from the US borrowing in dollar. But the surprising result is that assets follow almost the same pattern. It all appears to be as if the US was living in a dollar zone, with little implications of exchange rate fluctuations on assets and liabilities. This is not necessarily good news if one counts on the dollar depreciation to solve, through the sheer force of wealth effects, the debt problem of the US.

The only exceptions to the rule that flows are important in and out come from countries which are deep in debt. This is the case of Brazil, for instance, that brought in 17% of GDP over 1999-2004 and brought out -1.4% of GDP (i.e., decumulated over its gross position abroad) over the same period. I would like to suggest here some connection with the work that we have done with Richard Portes. We explore the dynamics of debt for middle income debtors and try to differentiate the role of “risk”, growth, and policies on the pattern of debt accumulation on emerging countries.

We characterize risk through real interest rate, which involves both interest cum spread and deviation of exchange rate to PPP. The bulk of this latter term is quite often enormous. We have decomposed the debt dynamics into the following identity:

  • Increase of the Debt-to-GDP ratio =
  • real interest rate * Debt-to-GDP ratio
  • - Growth rate of the economy * Debt-to-GDP ratio
  • - Primary Surplus/GDP

The real interest rate is the nominal rate (risk free rate + spread) adjusted for the deviation of the exchange rate from PPP. The dynamics are computed up to the year of the debt crisis itself. We present this decomposition below by dividing each of the three terms of the right-hand side by the sum of their absolute values (the sum of absolute value then adds to one). I take here four cases of importance.

Each item expressed as a fraction of the sum of absolute value

The first term is roughly interpreted as a confidence premium, the second term as a measure of the underlying fundamentals and the third term as a measure of the policy choices. We see that in all four cases the countries are heavily burdened by the interest+exchange rates term, which almost entirely cancels the (beneficial) growth factor. The fact that these countries appear to be in the Lane-Milesi-Ferretti corner situation has certainly much to do with it. Countries which are deep in debt and have no precautionary assets are likely to be more vulnerable to confidence shocks. More work is needed to thorough this connection, but at this stage much already has been learnt.

Stanley Fischer Member of the Board, Citigroup, Inc.

It is a great pleasure to participate in this panel, surrounded to left and right by former IMF colleagues, each of whom has moved on to better things – whether inside the Fund or out of it. I will discuss six points, very briefly. First, what are the imbalances about which we worry? Second, do they need to be fixed? Third, how? Fourth, what about the role of China? Fifth, is the US dollar going to have a hard landing and do we need to worry about that? And finally, I would like to talk a bit about currency blocks.

1. The imbalances. Typically people worry about one imbalance, the US current account deficit, which exceeds five percent of GDP. Of course there are corresponding current account surpluses in other countries, though there seems to be less concern about that side of the equation.

Consider date for 2003. The US current account deficit was about 530 billion dollars in 2003. The corresponding surpluses were in Japan ($140 billion) and the rest of East Asia (approximately another $140 billion). The mysterious statistical discrepancy accounted for 120 billion dollars. The remaining counterpart of the US deficit consisted of the surpluses of the EU, Russia, other oil producers, and other countries. Fundamentally, then, over half the US current account deficit was with Japan and East Asia.

2. Do the deficits need to be fixed? There is a certain inconsistency in the way we all talk about current account imbalances. Almost every country prefers to have a current account surplus. Many countries that are quite happy with their surpluses complain that the US is running a large deficit and acting irresponsibly in the global economy.

In the aftermath of the Asian crisis, in which countries with more reserves on the whole surmounted the crisis better, many countries wanted to build up their reserves. These countries were content to run current account surpluses. In the midst of its lengthy recession, Japan has not wanted the yen to appreciate. So it too has been content to run large current account surpluses and build up reserves.

Dooley, Folkerts-Landau and Garber have described this as a new Bretton Woods system, one that will enable the world to absorb the massive supplies of labor in China that are now entering the global economy. The only problem with that argument is that the current level of the US current account deficit is unsustainable. Under reasonable assumptions, the US external debt to GDP ratio will continue rising without limit. That means the process cannot continue.

That is not to say that the US current account deficit has to be reduced to zero. Rather it needs to be reduced to a sustainable level, which would be about 2.5 – 3 percent of GDP. That would still leave room for countries that want to do so to accumulate reserves, and for foreign capital to flow to the United States. Similarly, with China receiving foreign direct investment inflows, it could run a current account deficit.

The question is sometimes raised of whether it is appropriate for the world’s richest economy to run a current account deficit. Shouldn’t capital flow from the rich to the poor countries? If risk-adjusted rates of return in poor countries were higher than those in the United States, capital would flow towards the poor countries until rates of return equalized. However we need also to recognize that individuals want to invest where markets are reasonably liquid, and where they have the assurance that their property rights will be protected. In those respects, individuals from around the world will continue to want to invest in the United States. So it is likely that capital will continue to flow to the United States.

3. How will the adjustment occur? The adjustment can take place either through US exports growing more rapidly than imports as a result of more rapid growth abroad, or through a depreciation of the dollar. It would be bad for the US and for the world economy if the adjustment takes place as a result of slower growth in the US – though the fiscal correction that will be needed in the United States will tend to reduce US growth. If growth rates remain close to potential, i.e. if there is no major recession in the US, the dollar will have to depreciate. And it will have to depreciate primarily against the yen and the renmimbi.

It has often been said by European officials that so far the Euro has borne the main runt of the need to reduce the US current account deficit. They seem to believe that when the Asian currencies appreciate, the Euro will be able to depreciate somewhat against the dollar.

Yusuke Horiguchi, formerly of the IMF, now the chief economist at the Institute for International Finance has made the following argument. It is that the appreciation of the Euro against the dollar will over a period of a few years help adjust that part of the US deficit that is due to US imbalances with Europe. US imbalances with Asia have so far been handled through Asian central bank purchases of reserves. When the Asians allow their exchange rates to adjust, that appreciation will essentially compensate for their former purchases of reserves, and leave the exchange rate of the Euro to a first approximation unaffected.

4. China. It is very difficult to predict when China and Japan will allow their respective exchange rates to adjust. Given that the yen is not pegged, that is easier for Japan to do than for China. Indeed Japan has already stopped intervening, although the exchange rate has not moved much since then. Nonetheless it is safe to predict that Japan will resume intervening if the yen begins to appreciate rapidly.

China is comfortable with its pegged exchange rate at present, and will delay moving so long as inflationary forces in China remain under control. But given China’s desire to reduce overheating, it would be useful to allow some appreciation of the currency, perhaps by adjusting the central rate, pegging to a basket, and gradually opening up a band. In the medium term, China will need to allow for greater exchange rate flexibility if it is to become a major international financial center – as it no doubt wishes to do

5. Hard landing for the dollar? Will the dollar collapse once it starts adjusting, a possibility brought to mind by the Dornbusch overshooting model? The Asian central banks have sufficient reserves to prevent an excessively rapid adjustment of the dollar. Since they will be reluctant to see their currencies appreciate too fast, they will likely intervene to slow any appreciation that begins to get out of hand.

Nonetheless, there is one circumstance in which the dollar could suffer a hard landing. Since the early 1980s there has been a basic confidence in the stability of the United States economy. That has meant that a depreciation of the dollar makes United States assets more attractive to foreigners. If this basic confidence is lost – for instance because of a belief that the fiscal deficit is too large – then the dollar could come under enormous pressure as private investors react to an initial decline of the dollar by expecting that it has further to go. Given the volume of foreign holdings of US assets, the potential outflow could be very large, and would put pressure on the exchange rate that would be too powerful for even the Asian central banks to handle.

Such a scenario would require a sharp reaction from policy, along the lines of the Volcker monetary policy of 1979-81. That would slow the US and the global economies. It is not the most probable outcome, but it is a possible result, dependent in large part on whether investors continue to maintain confidence in the economic policies of the United States.

In appraising the probability of a hard landing, we should recognize that we have been worried about that possibility for a long time, and that it has not so far happened. In addition, we need to recognize the increased capacity of the international financial system to deal with exchange rate movements, in part because of the development of hedging instruments. For instance, the Euro has appreciated about 50 percent against the dollar over the past two years, but the consequences have been manageable.

6. Currency blocs. Asian central banks are already stabilizing their exchange rates relative to the yen and the dollar – and with the renmimbi pegged to the dollar, also against the renmimbi. There appears to be real political momentum behind the idea of an Asian exchange rate arrangement. That will be difficult since in the medium and long term both the yen and the renmimbi will be important Asian currencies.

In one scenario, all of East Asia, including Japan, could eventually agree on the use of a common currency. Alternatively, a common currency could be used on the Asian mainland with the yen continuing its separate existence – along the lines of the Euro and the pound sterling. But all that is a very long way away. And by that time, we could even be moving towards the use of one global currency.

When that happens, current account deficits will not matter, and we will not even know what they are. For instance, we do not pay much attention to payments imbalances among American states. And even in Euroland, it is already possible to run very large current account deficits. For instance, Portugal’s current account deficit in 2000 was 11 percent of GDP. But it will only be in the Keynesian long run, in a system without national currencies, that we will cease to care about national balance of payments deficits.

Global Imbalances and Exchange Rates

Malcolm Knight General Manager, Bank for International Settlements

It is a great pleasure for me to participate in this conference on the occasion of the sixtieth anniversary of Bretton Woods. It is also an honour because the IMF, which was established by the Bretton Woods Conference of 1944, has a long tradition of thinking deeply about the topic of this panel discussion—“global imbalances and exchange rates”. The near-term outlook for global output growth and external adjustment over the next 18 months or so currently appears relatively benign. But over the medium term—that is, roughly the rest of this decade—I believe that global imbalances will pose a major challenge for the achievement of solid output, employment and price performance in many countries. Indeed, with due difference to Deputy Governor Li Ruogu of the People’s Bank of China, who is also present on this panel, I would hazard the view that the ancient Chinese curse—“may you live in interesting times”—is rather appropriate to the subject of this session. From the point of view of global imbalances, I think we certainly are living in “interesting times”.

If we look at the adjustment of external current account balances over the past forty years of so, it is only a modest oversimplification to assert that the major swings in global imbalances correspond roughly to each chronological decade. For example, the decade of the 1960s was a period of relatively small current account imbalances, strong growth, and low inflation. To put it another way, that decade was marked by a salubrious environment for external adjustment. In sharp contrast, the decade of the 1970s—at least after the huge oil price increase of 1973-74—as characterised by very large external current account imbalances, stagflation, and weak macroeconomic growth performance.

The decade of the 1980s saw a very large swing in the real exchange rate of the US dollar. The large real appreciation of the dollar from the beginning of the decade through the mid-1980s was associated with a sharp increase in the US current account deficit, and the subsequent large dollar depreciation was marked by a return to rough balance in the US current account over the latter part of the 1980s, especially with the fall in domestic investment that began as the US economy moved into recession towards the end of the decade. The decade of 1990s began with a marked recession in a number of countries, but thereafter it was generally marked by strongly improving fiscal balances in a number of large countries, by monetary policies that were directed at maintaining low and stable inflation, and by relatively small external imbalances. In other words, the past decade was a salubrious one, a bit like the 1960s.

Currently we are experiencing a synchronized upturn in the world economy that has gradually gathered momentum. Does this mean that the first decade of the third millennium will also be one of solid macroeconomic performance, like the 1960s or the 1990s? While I agree that the short-term global outlook is relatively benign, I have major concerns about the longer-term prospects for external adjustment, and for the achievement of solid output and employment performance.

There are a number of reasons for these concerns. First, the current juncture is marked by very large external current account imbalances—particularly the deficit in the United States and the surpluses in Asia, the transition economies, and Latin America. Second, the stance of both fiscal and monetary policies in many countries is currently much more expansionary than is likely to be sustainable over the longer term. Third, partly because industrial production is shifting from regions where the primary input content of industrial production (including energy inputs) is relatively low at the margin to emerging market countries where it is higher, inflationary pressures from energy and other primary product prices are emerging earlier than would typically be the case at this stage in a global economic upturn.

To put things in a nutshell, external adjustment at the global level is likely, over the current decade, to be much more challenging than it was in the 1990s. This challenge comes from the need to adjust major external imbalances at the same time that a number of major emerging market economies, in particular in Asia, are being integrated into the global economy. The first task—moving to a more sustainable pattern of payments balances—is a macroeconomic adjustment issue which will require shifts in macroeconomic policy. But the second task—that of adjusting to large and rapid changes in comparative advantages and trading patterns—will require deep and painful structural adjustments. This challenge will create frictions and structural problems that are largely separate from those of trade imbalances per se. In particular, the increasing supply of goods and services from major emerging economies—and I am not just speaking of China and India, though they are by far the largest examples—will trigger profound changes in production, international trading patterns, and relative prices. In particular, deficit countries will need to shift resources into the production of tradables at a time when the integration of large low-wage economies into the global economy is creating intense competition in international goods markets and is putting strong and sustained downward pressure on unit labour costs all around the globe.

A Comparison of Current Account Cycles

Before I expand on these themes, let me briefly review major current account swings by contrasting recent developments in the external payments position of the US economy – which is almost one fifth of the global economy – with those in the rest of the world. These developments are summarised in the table below.

Changes in Current Account Balances: 1981-2003

a) 1997 – 2003
Country/regionIn billions of US dollarsAs per cent of GDP
United States−421− 3.4
Euro area−42− 0.9
Emerging Asia1303.0
Latin America713.5
Transition economies373.2
Total− 128−0.4
b) 1987 – 1991
Country/regionIn billions of US dollarsAs per cent of GDP
United States1643.5
Euro area− 104− 1.7
Japan− 16− 1.5
c) 1981 – 1987
Country/regionIn billions of US dollarsAs per cent of GDP
United States− 166−3.6
Euro area571.7

The top panel of this table indicates that, over the six-year period 1997-2003, the US current account position deteriorated by over 420 billion dollars, an increase in the US external deficit of some 3.4 percentages of GDP, which brought the level of the external current account deficit to around 5% of GDP by 2003. In dollar terms, the main identified counterparts to this widening US current account deficit are not found in the industrial countries, but in the changes to the current account positions of emerging Asia (plus US$130 billion), Latin America (plus US$70 billion) and the central and eastern European transition economies (plus US$40 billion). Note also that some 30% of the US deficit is unaccounted for.

Many commentators agree that these changes in relative current account positions are not sustainable over the long term. If they are indeed unsustainable, how will the adjustment take place? What challenges will it present? And what are the policy implications?

These are not easy questions to answer, we are naturally led to look for guidance from past historical episodes. I think the decade of the 1980s presents one. Over 1981-87 the US real effective exchange rate appreciated by some 40%. US fiscal deficits were also large, and US economic growth was strong. The middle panel of the table indicates that the deterioration in the US current account deficit over this period was slightly larger as a percentage of GDP, 3.6 percentage points, than it was over 1997-2003. This deterioration amounted to some US$66 billion, and almost the exact counterpart in dollar terms was a strengthening of the current account positions of just two regions, Europe and Japan.

The bottom panel of the table shows how the US external imbalance of the first half of the 1980s was corrected in the late 1980s and early 1990s. From 1987 to 1991 the US current account position improved by 3.5 percentage points of GDP. It is very interesting that most of this improvement of 164 billion dollars was the counterpart of rising external current account deficits in the same two regions: Europe (US$104 billion) and Japan (US$16 billion). These deficits reflected the strong economic growth that marked the European and Japanese economies at that time.

If we compare this full current account cycle of the 1980s with the uncompleted cycle in recent years we see that during 1997-2002, the US dollar also appreciated strongly and the US current account deteriorated by about the same percentage as had been the case in the early 1980s. The question is—what will happen next? Again, if we look at historical experience in the last full US balance of payments cycle the current account improvement that took place after 1985 was associated with a very large real depreciation of the US dollar, which was quite orderly. Is this relatively orderly and benign adjustment likely to prevail again over the remainder of the first decade after 2000? In order to answer this question it helps to look into the reasons why the US current account deficit rose after 1997. If the causes were similar to those of the 1980s, then the swing in the real exchange rate over the current external adjustment cycle should be associated with an opposite swing in the external current account deficit as a percentage of US GDP.

Graph 2 shows that one reason for the widening US current account deficit over the seven years to 2003 was that cumulative real domestic demand growth in the US was above that in the Euro area by some 15 percentage points and exceeded demand growth in Japan by a cumulative 25 percentage points. The role of relative demand growth in the widening of the US current account imbalance is particularly important given that there is also an asymmetry between US export and import elasticities. US demand for imports is much more income-elastic than foreign demand for US exports. Hence the US current account balance tends to deteriorate even if the US is growing at the same rate as its trading partners.

Graph 1US real effective exchange rate

In terms of relative consumer prices; January 1997 = 100

Source: BIS.

Graph 2Real total domestic demand

1997 Q1= 100

Source: National data.

Graph 3 looks at the widening of the US current account deficit since 1997 from a saving – investment perspective. The rise in the US external deficit and the associated US external borrowing needs of the past seven years can be divided into two phases. In the first phase, over 1997-2000, the US current account deficit essentially reflected a modest decline in net private saving as a percentage of GDP, and a high rate of net private investment associated with a sustained rise in the rate of growth of productivity and improved long-term growth prospects for the US economy. With significant fiscal consolidation during this period, the external current account deficit was financed by sharply rising capital inflows. By contrast, from 2001 onwards there was a sharp decline to a lower level of net private investment, but at the same time tax reductions and rising government expenditures led to a very marked shift from fiscal surplus to a large fiscal deficit.

Graph 3US saving and investment

As a percentage of GDP

1Defined as gross saving less gross investment.

Source: US Bureau of Economic Analysis (SCB table 5.1).

Graph 4 shows that net long-term private capital inflows into the United States, which rose sharply from 1998 to 2000, financed the rising current account deficit. Nevertheless, although net long-term private inflows remained fairly high thereafter, in the second phase after 2001, the role of official foreign exchange purchases became much more important in financing the continuing rise in US current account deficits.

Graph 4Current account and long-term capital in the United States

In billions of US dollars

Source: US Bureau of Economic Analysis.

With this historical perspective, I return to the question of what the global adjustment process might look like going forward. More specifically, will it look like the latter half of the 1980s? From the first quarter of 1985 to the end of 1987, the US dollar depreciated by exactly the same amount (40%) as it had previously appreciated in the five years to 1985. In other words, it depreciated to about its 1980 level and remained there for the next four years. In addition to the lagged effects of the sharp depreciation of the dollar that began in 1986, the main features of the improvement in the US external account position were the marked strengthening of activity in Japan and Europe in the late 1980s. As a result of these factors, the US current account began to improve late in 1987, reaching a surplus in 1991 (see graph 5).

Graph 5US current account and domestic saving-investment balances

As a percentage of GDP

Source: US Bureau of Economic Analysis.

The four panels of graph 6 consider how the present level of the US real exchange rate and external current account may look relative to the exchange rate/current account cycle that took place in the 1980s. In these graphs the vertical line is the year of the peak in the real exchange rate of the US dollar during each decade-long exchange rate/current account cycle (1985 for the cycle of the 1980s and 2001 for the current (uncompleted) US current account cycle). As shown in the south-west panel of this graph, the pattern of current account deterioration in the five years preceding the exchange rate peak and in the two years following it is about the same thus far in the current cycle as it was in the 1980s. However, the current account imbalance is about 1.5% points of GDP worse than it was at the peak of the previous cycle.

Graph 6Current and previous cycle in the United States

1In terms of relative consumer prices; peak year = 100.

2 General government cyclically adjusted financial balance, as a percentage of potential GDP (OECD definition).

3 As a percentage of GDP.

4 US gap less rest-of-OECD gap; in real terms.

5 Defined by a peak in the real effective exchange rate; current and previous peak: 2001 and 1985 respectively.

Sources: National data; OECD; BIS.

As the top left-hand panel of graph 6 indicates, the real effective appreciation of the US dollar was slightly smaller over the five years preceding the exchange-rate peak this time around than it was in the 1980s. The adjustment in the 1980s involved a complete turnaround in the real effective rate of the dollar. By contrast, in the current cycle the decline in the real effective rate of the dollar up to June 2004 has been only a fraction of the preceding appreciation This may give pause to those who think that, since its peak two years ago, the US dollar has depreciated enough to adjust the current US position.

Of even more concern is the difference in the US structural fiscal position over the two cycles. As the top right-hand panel shows, the structural fiscal position in the 1980s basically deteriorated steadily prior to the maximum-deficit point of the cycle before improving slightly thereafter. Thus the current account effects of the exchange rate depreciation over 1985-87 were not strongly offset by changes in the fiscal position. In contrast, the US fiscal position was improving until 2001. In the two years since then it has deteriorated to a level that is almost the same as the fiscal position two years after the peak of the previous cycle. This weak fiscal position is likely to offset the positive adjustment effects of future US dollar depreciation, suggesting that the dollar may have to fall by more this time around unless active measures of fiscal restraint are taken.

The lower right-hand panel looks at relative demand patterns in the two episodes of US current account change. Whereas demand in the rest of the world was strengthening relative to US demand after the US cyclical peak had been reached in the mid-1980s, thereby reinforcing the strengthening of the US current account, the demand gap between the United States and the rest of the world has been essentially zero during the current cycle.

Adjustment Challenges Today

History never repeats itself exactly. The experience of the US external current account cycle that took place during the 1980s suggests that the adjustment to reduce a very large US current account deficit can take place without cataclysmic disruptions, (not least because the United States is at the centre of the international monetary system and can borrow in its own currency). But this experience also suggests that, especially in the absence of fiscal consolidation, the current account adjustment is likely to require a rather large depreciation of the dollar’s real effective exchange rate, that the adjustment process will take a number of years, and that it will be marked by relatively lacklustre economic growth performance.

Moreover, there are aspects of the current situation that were not present last time and that could make the future adjustment process more challenging. A first key consideration is the impact of emerging Asia. Future adjustment of global imbalances will require that the key current account deficit country (the US) shifts resources into the production of tradables in the face of intense competition in world markets for goods and services coming from China, India and the other emerging market countries. This was a far less important factor in the 1980s balance of payments cycle. The so-called “Newly Industrialised Countries” that entered the world trading system in the 1980s accounted for less than 2% of the world’s population. By contrast, India and China alone have one third of the world’s population. The result is a huge labour force, much of which is educated, and much of which is currently underemployed. This is likely to put strong downward pressure on unit labour costs in all developed countries for many years and exacerbate the problem of shifting resources to tradables as the US economy endeavours to adjust.

It seems to me that this observation has two implications. First, for the United States, the real effective exchange rate is likely to have to depreciate more than it did in the 1980s, in order to produce the required shift into tradables in a fiercely competitive world goods market. It goes without saying that this correction will be even larger if fiscal adjustment in the US is delayed. Second, for all developed countries, even if productivity growth remains at current levels, real wage growth will tend to be slower than it has been in the past. This in turn suggests weak consumption growth in the developed world, so that the adjustment is likely to be characterised by larger than normal output gaps and weaker output growth.

The second challenging aspect of today’s adjustment process is that the next adjustment could also be more stagflationary than the 1980s adjustment. I have already noted that this time, primary commodity prices have risen more, and at an earlier stage in the upswing, than was the case in the 1980s. This rise in costs risks creating stagflationary effects. Indeed, I believe that if goods production is shifting to countries which, at the margin, have a higher input of commodities per unit of output, the effects will be stagflationary even if the second—round effects of prices on wages are much weaker than they were in the 70s and 80s.

In the late 1980s, the reduction of the large US current account deficit was also made easier by the fact that aggregate demand in Europe and Japan was accelerating. This time, as I have already suggested, slower wage growth will result in weaker growth of domestic consumption. Finally, the negative wealth effects of the global adjustment process will be much larger than they were in the 1980s. The large US current account deficits of the last few years mean that residents of the rest of the world are now holding a larger stock of dollar-denominated financial assets, currently estimated at some US$9 trillion. A depreciation of the US dollar that was of similar magnitude to that which occurred from 1985 to 1987 would reduce the real value of these assets by some 40%. Like the other effects, such a reduction in wealth would also tend to weaken demand and economic activity. And these effects could be very large.

Policy Implications

Going forward, therefore, the risks in the global adjustment process lean towards a marked weakening of growth performance. How should national economic authorities respond to achieve smooth adjustment of global imbalances to sustainable levels? I do not think the answer lies in monetary policy. Monetary policies are currently very expansionary in a number of key industrial countries. In order to avoid exacerbating the inflationary side of a possible stagflation, monetary policy in the key currency countries/regions must shift to a more neutral stance. But in order to avoid overshooting of exchange rates among the key currencies, the timing of this withdrawal of monetary stimulus will have to be consistent across key currency zones. The precept for the coordination among monetary policy makers over the next several years must be: “first, do no harm”. By contrast, fiscal adjustments could, in principle, assist the external adjustment process. Most obviously, active policy measures to reduce the fiscal deficit in the US to a sustainable level would contribute to a smoother adjustment of a global external imbalance.

But these adjustments, even if they are vigorous and in the right direction, may not appear to yield much in terms of output and employment improvements as key emerging economies that have low unit labour costs in an ever-broadening range of industrial sectors are becoming more and more prominent in the international market place. Viewed in this light, the adjustments needed for the US to achieve sustainable fiscal and current account deficits may be large. The first decade of the twenty first century may indeed be “interesting times.”

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