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Taken from todays Australian Financial Review
How to balance the books
Dec 10
Stephen Grenville
Just about everyone agrees that the United States' current account deficit, running at more than 5 per cent of gross domestic product, is unsustainable. If something cannot go on forever, at some point it will have to stop. The questions, then, are when and how?
The slippage of the US dollar may give some clue as to the "when" - the adjustment process is under way. The "how" is more complex and uncertain.
Three factors are relevant here. Most of the focus is on the first of these - the exchange rate. But with the US having a floating exchange rate, how did it get into this unsustainable position if the exchange rate was doing its job of clearing the market? To answer this question we need to look at the second factor: capital flows.
As long as foreigners were willing to fund the current account deficit, it could be sustained (in the same way that the Australian current account deficit has been routinely and consistently funded). As the deficit grew during the 1990s, foreigners saw opportunities for profitable investment in the US, buoyed by the golden promise of the tech boom and rising productivity and company profits. When these flows faded with the bursting of the tech bubble, they were replaced by official flows, as foreign governments willingly bought dollars to replenish their reserves and, often enough, to stop their own currencies suffering inconvenient appreciation. But, as US Federal Reserve chairman Alan Greenspan put it in his customary oblique way: "A diminished appetite for adding to dollar balances must occur at some point." This is likely to be a sharply defined tipping point.
The third factor in the equation is the underlying savings-investment balance. Once the adjustment is under way, this balance offers a useful focus on how it will play out, as it is the exact counterpart of the current account: if the deficit has to be reduced, say, to balance, then the US either has to reduce its investment by 5 per cent of GDP or increase its savings by that amount, or some combination of the two. Foreign countries have to shift towards deficit, to make room for the US shift towards surplus. The savings-investment imbalance in the US can be readily identified - it reflects a budget deficit running at 4 per cent of GDP and an abysmally low private savings rate. But if the US bites the bullet on the budget (a big ask for an administration with a proclivity to give tax breaks to the big end of town), this will slow demand and hence growth. This is where a fall in the US dollar might help, by boosting demand for exports and switching demand from imports to domestic production. But the exchange rate has to move a fair way (and stay there for some time) for it to have a significant effect. And all this has to happen in a context where the US policy makers insist that they have a "strong dollar" policy.
Maybe this isn't too difficult in practice: the US dollar slides, policy makers reiterate their in-principle beliefs in a strong dollar, no one even whispers the words "benign neglect" and the exchange rate does its job over time, ideally without overshooting.
The exchange rate is only one element in the adjustment. The sequence might best be seen like this: some "hard pounding" gets the budget deficit down; this softens domestic demand, but the weakness can be compensated for by letting the dollar fall, encouraging net exports and improving the current account. This is, however, a game of pass the parcel. For every dollar of improvement in the US current account deficit, some other country's position has to move the other way, inhibiting growth. The textbook answer might be to lower interest rates or ease fiscal policy globally. But there is not much capacity to do this in the major countries, with interest rates already low and fiscal positions constrained by big public debt.
This, perhaps, explains why so much attention is focused on China: it seems to be a "suitable case" where adjustment may not be too painful. Indeed, it is probably in China's interest to appreciate the yuan substantially (maintaining a fixed rate and capital controls), spilling some excessive domestic demand into imports, reducing the pressures for tariff increases overseas and (if the rate is changed enough) taking away the one-way bet that is encouraging unhelpful speculative capital inflows. But even if China shifts from surplus to balance quickly, it amounts to less than $US50 billion - not even one tenth of the US deficit.
Some of the other Asian countries might follow China's example without too much persuasion (keeping their intra-Asian competitiveness in the process). But the big-dollar surpluses are elsewhere - first, in Japan, which is tentatively creeping out of a 14-year slump, and not at all happy to see its exchange rate move to the levels that would make a real difference quickly. Japan has been the most vigorous of the interveners, buying more dollars in the first quarter of this year than China did in the whole of last year.
Looking for other big-dollar surpluses, another obvious candidate is Germany, estimated by the International Monetary Fund to run a surplus of 4.4 per cent of GDP this year. But it has much the same problem as Japan, reluctant to see its already weak growth compromised by discouraging exports. Already the appreciation in the euro has been described by the head of the European Central Bank as "brutal". So there won't be any eager starters for the adjustment process in Europe.
All that said, we have been here (or somewhere like this) before. The US ran a current account deficit of almost 4 per cent of GDP in the mid-1980s, accompanied by a run-up in the value of the dollar. The adjustment involved letting the dollar slide by some 30per cent, accompanied by budget tightening to improve the savings rate. The downward shift in the dollar was orchestrated in a rather haphazard way by policy co-ordination between the major nations - most notably in the Plaza Accord of 1985, which confirmed the direction of the dollar, followed by the Louvre Accord of 1987, aimed at preventing the dollar slide from becoming a rout. In time - a couple of years - the adjustment was achieved, without inhibiting world growth. Why not simply repeat this?
One missing element now is international policy co-ordination. It's hard to know how the 1980s adjustment would have played out without co-ordination: sceptics abound, and perhaps the outcome would have been much the same. The US is always ambivalent about policy co-ordination, still retaining faith in "the magic of the market". It's certainly true that most of the exchange rate intervention took the form of exhortation and incantation, rather than actual currency intervention.
But large shifts were achieved without disruption, not only for the dollar but for the yen as well. The process of policy co-ordination gives the opportunity for trade-off bargains between the parties, and these bargains are best made behind closed doors rather than through high-profile public pressure.
Co-ordination provides a certain amount of mutual reinforcement to instil the courage to do the job, and international pressure can be used as an excuse to take the unpalatable measures needed (for example, more structural reform in Germany and Japan). The lags in adjustment are long (in the 1980s the US current account continued to worsen for two years after the dollar began its slide), and co-ordination can help the parties hold their nerve and avoid protectionist measures.
Co-ordination might help avoid a repeat of the fate that befell Japan after the Plaza agreement: a sharply appreciated exchange rate dampened growth, which led to interest rates being held too low for too long, allowing an asset-price bubble to form, whose bursting in 1990 ushered in 14 years of depressed growth.
The lesson from this is that adjustment is a delicate process of aligning the planets. Correction of one imbalance may create new ones, and the exchange rate is the most likely element to go astray. Exchange rates probably have to shift quite a bit (for example, 15 to 25 per cent for the yuan), and once exchange rates are unanchored from their accustomed settings, they can move well outside their longer-term equilibria. The yen provides an example, moving from about 80 to the dollar (in 1995) to almost 150 (1998). If the yen, with a deep market and an experienced financial sector, can move through such a range with little regard for the fundamentals, then the Chinese are entitled to be reluctant to leave the yuan to find its own level. Policy co-ordination could establish some understandings about what is a "normal" broad range for currencies, with some assurances that other countries would co-operate if the currency moved outside this range. Policy co-ordination might make it harder for the US to point the finger of blame mainly at others, and would put it under notice to undertake the necessary adjustment to its own savings/investment balance.
And policy co-ordination provides the opportunity for a general dialogue between the combined policy makers and financial markets, which may help to broaden the understanding of the process.
The group that did this job in the 1980s was the G5, the predecessor to the G7. But this does not include the country that is now the focus of most attention - China. There are some moves to include it, but rather than continue with this ad hockery, it might be better to shift to an existing group that would be appropriate for the role in the longer term - the G20 .
There seems a better chance of having a useful debate in the G20 than in the G7 or at the International Monetary Fund. The former is unrepresentative (reflecting the global pecking order of an earlier era), the latter overly influenced by the powerful and often doctrinal secretariat. The Fund was a loud voice in the advocacy of exchange rate regimes that were either immutably fixed (currency boards) or clinically-clean free floats, which seems an inadequate policy menu for the delicate adjustment process ahead. It, too, is overweight with Europeans - not desirable in meetings where consensual discussion is important. "The EU voices are heard much too often," a seasoned US official says.
The G20 format provides the opportunity for discussion rather than set-piece speeches, backed up by working groups that address the issues rather than rehearse the doctrine. None of this would make the necessary adjustment painless, but it might help.
Stephen Grenville is a visiting fellow at the Lowy Institute for International Policy and former deputy governor of the Reserve Bank of Australia.
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