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U.S. trade deficits, structural imbalances, and global monetary stability
Journal of Policy Modeling 29 (2007) 697–704
U.S. trade deficits, structural imbalances, and global monetary stability Dominick Salvatore a,b,∗ b
a Shanghai Finance University, China Department of Economics, Fordham University, NY 10458, USA
Available online 3 June 2007
Keywords: Trade deficit; Global monetary stability; Net lending; Growth rate
1. Introduction The U.S. has faced growing trade deficits for two decades, which now exceed 6% of GDP and are clearly unsustainable. Continued huge U.S. trade deficits could lead to a collapse (i.e., a sharp depreciation) of the dollar, which in turn could result in sharply higher interest rates and recession in the United States, and slower economic growth of the world economy. Inadequate U.S. savings and excessive savings in China, Japan, and some other (mostly Asian) emerging market economies, as well in S. Arabia and other OPEC countries are leading to huge capital inflows from these countries to the United States, an overvalued dollar, and excessive U.S. trade deficits; but a sudden sharp reduction in such capital inflows could inflict serious economic damage to the United States and the entire world economy. High unemployment in Europe and slow growth (until recently) in Japan due to their somewhat inflexible economies reduce the economic growth of these economies and push them toward trade protectionism in a vane effort to protect labor and unproductive sectors from world competition, especially from China and other dynamic emerging Asian economies. 2. U.S. trade deficits and trade surpluses of other leading areas Table 1 shows the huge and rapidly growing trade deficits of the United States, on the one hand, and the large trade surpluses of China, Japan, and S. Arabia since the mid 1990s, on the ∗ Correspondence address: Department of Economics, Fordham University, NY 10458, USA. Tel.: +1 718 817 4045; fax: +1 914 337 3355. E-mail address: [email protected].
0161-8938/$ – see front matter © 2007 Published by Elsevier Inc. on behalf of Society for Policy Modeling. doi:10.1016/j.jpolmod.2007.06.007
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D. Salvatore / Journal of Policy Modeling 29 (2007) 697–704
Table 1 Trade imbalances of leading areas, 1996–2005 (in billions of U.S. dollars) Country/area
1996
2000
2004
2005
United States U.S. with respect to Canada W. Europe Japan China Other Asia OPEC Euro Area Japan China S. Arabia
−191.0
−449.8
−662.0
−779.9
−24.3 −24.4 −48.7 −39.6 −38.0 −23.4 – 83.6 19.5 35.3
−54.8 −74.9 −83.0 −83.9 −104.4 −49.4 28.8 116.7 34.5 49.8
−69.1 −131.5 −77.5 −162.0 −114.8 −72.5 130.4 132.1 59.0 84.9
−81.1 −146.4 −84.7 −201.7 −83.2 −93.2 68.0 94.0 134.2 123.3
Source: Survey of current business, July 2006; IMF International Financial Statistics Yearbook (2006).
other. The table shows that the U.S. trade deficit rose sharply from $191 billion dollars or 2.4% of the U.S. GDP in 1996, to $450 billion or 4.6% of the U.S. GDP in 2000, and $780 billion or 6.3% of U.S. GDP in 2005. Trade deficits in excess or 2 or 3% of GDP are deemed by most economists and policy makers to be unsustainable in the long run and need to be corrected. Table 1 also shows that almost half of the U.S. trade deficit is with China and the other emerging markets of East Asia and Japan, and it is against the currencies of these nations that the dollar seems to be overvalued. The situation is different with respect to Europe and the euro. After being undervalued by as much as 30–35% during 2000 and 2001, the dollar subsequently depreciated with respect to the euro and, at the value of about $1.33 (April 2007) it can be regarded as undervalued by 10–15%. Thus, the U.S. trade deficit with the Euro Area can now be regarded as due primarily to inadequate savings in the United States and anemic growth in the Euro Area (see Table 2). An undervalued dollar vis-`a-vis the euro puts pressure on Euro Area’s exports to the United States and to the emerging markets of East Asia, whose currencies are also undervalued with respect to the euro (being, as they are, mostly pegged to the U.S. dollar). This is bad news for the Euro Area, whose growth has been anemic during the past decade and whose exports would come under renewed pressure if the dollar were to further depreciate. In today’s highly interdependent world, economic problems in one nation or area quickly spread to other nations and areas and can lead to a world-wide economic crisis. 3. Savings, investments, and net lending in the major economic areas The structural or fundamental cause of the large and unsustainable U.S. trade deficit is the grossly inadequate U.S. savings, on the one hand, and excessive savings in China, Japan, and some other (mostly Asian) emerging market economies, as well in S. Arabia and other OPEC countries, on the other. These lead to huge capital inflows to the United States, a large overvaluation of the dollar with respect to Asian countries, and to a huge U.S. trade deficits. Table 2 shows that the savings rate of the United States declined from an average of 16.3% of GDP from 1990 to 1999 to 13.3% of GDP in 2005, or by 2.9% points from 1991 to 2005, while U.S. investment rose from an average of 18.7% of GDP from 1990 to 1999 to 20.0% of GDP in 2005, or by 1.5% points from 1991 to 2005. As a result, U.S. net borrowing abroad
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Table 2 Savings, investments, and net lending in major economic areas, 1990–2005 (percent of GDP) Country/area
Average 1990–1999
Average 2000–2003
2004
2005
Cumulative change 1991–2005 (percentage points)
United States Savings Investment Net savings
16.3 18.7 −2.4
15.5 19.2 −3.7
13.4 19.6 −6.2
13.3 20.0 −6.7
−2.9 1.5 −4.4
Euro Area Savings Investment Net savings
21.2 19.8 1.4
20.9 20.7 0.2
21.2 20.5 0.7
20.9 20.9 0.0
−1.0 0.7 −1.7
Japan Savings Investment Net savings
31.4 29.0 2.4
26.7 24.0 2.7
26.4 22.7 3.7
26.8 23.2 3.6
−7.6 −9.7 2.1
China Savings Investment Net savings
38.7 37.0 1.7
37.1 35.0 1.9
46.8 43.3 3.5
51.3 44.1 7.2
13.5 9.4 5.5
Source: BIS, Annual Report (2006).
(negative U.S. net savings) increased from an average of 2.4% of GDP from 1990 to 1999 to 6.7% of GDP in 2005, or by (−)4.4% points (−2.9 to +1.5) from 1991 to 2005. The counterpart of the huge U.S. net borrowing was the large foreign net lending to the United States, primarily by Asian countries, but also OPEC (mostly through secretive government investment funds channeled through intermediaries in London), with the Euro Area practically in savings–investment balance. Furthermore, while most foreign lending to the United States during the 1990s took primarily the form of foreign direct investments (FDI) attracted by high U.S. growth and profitability, during this decade, an increasing amount of foreign capital flows to the United States have taken the form of foreign official purchases of U.S. government securities and accumulation of dollar reserves, mostly by Japan and Asian emerging market economies, especially China, as well as OPEC nations, especially S. Arabia. By doing so, Asian countries avoided a large depreciation of the dollar vis-`a-vis their own currencies and hence a sharp reduction in their exports to the United States and to the rest of the world. Essentially, Asian countries thus followed an export-led growth financed by lending huge sums to the United States, a situation that leads some to call the present arrangement “Bretton Woods II” (see Doodley, Folkerts-Landau, & Garber, 2003). This resulted in a grossly overvalued dollar with respect to most Asian currencies and to large and unsustainable U.S. trade deficit (the counterpart of the large U.S. net borrowing abroad). There is now disagreement as to how long this process can continue. But a significant and rapid reduction in net foreign loans (capital inflows) to the United States could lead to a collapse of the dollar, sharply higher interest rates in the United States, and a U.S. and world economic crisis. The medium- and long-term solution to this problem is for the United States to adopt policies to stimulate domestic savings and curb its expenditures. This is not easy to do because American consumers and firms have become addicted to living with increasing levels of debt, and it is difficult to break the habit. A sufficient increase in the U.S. savings rate would reduce the need for capital inflows, reduce or eliminate the dollar misalignment, and reduce U.S. trade deficits
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Table 3 Growth of real GDP, labor productivity, and unemployment rate in United States, Euro Area, and Japan, 1996–2005 (percentages) Country/area
1996
2000
2004
2005
1996–2005 average
United States Real GDP Labor productivity Unemployment rate
3.7 1.8 5.4
3.7 1.9 4.0
3.9 3.1 5.5
3.2 1.8 5.1
3.3 2.1 5.0
Euro Area Real GDP Labor productivity Unemployment rate
1.4 0.8 10.7
3.9 1.4 8.2
1.7 0.8 8.9
1.5 0.5 8.6
2.0 0.7 9.1
Japan Real GDP Labor productivity Unemployment rate
2.6 2.1 3.4
2.9 3.2 4.7
2.3 2.1 4.7
2.7 2.3 4.4
1.2 1.4 4.5
Source: OECD, OECD Economic Outlook (December 2006).
to sustainable levels. The United States, however, is today hardly doing enough to overcome its savings–investment imbalance—a problem which could not, in any event, be easily or quickly solved. For their part, China and other emerging market economies should increase domestic expenditures to improve education, income distribution, infrastructures, and the environment, while Japan should restructure its economy to further stimulate its growth. The International Monetary Fund’s, through its new surveillance mandate, was expected to encourage the United States, China and Japan to take cooperative steps to reduce their saving–investment imbalance to sustainable levels, but to date it has done little along this direction, possibly because of political opposition by the nations involved. 4. Slow growth in Europe and Japan, and U.S. trade deficits A contributing cause of the large U.S. trade deficit is the slow growth (until recently) in Europe and Japan, which limited their imports from the United States. As shown in Table 2, even though savings and investment are in near balance, the Euro Area faces a serious structural imbalance, which has kept its growth rate below its potential and lower than growth in the United States over the past decade (see Table 3). The restructuring that has taken place in the Euro Area during the past decade has been inadequate and its economy, especially its labor market, remains too rigid. In addition, the Euro Area has not pursued the “new economy” aggressively and it has thus not been able to harvest as much benefits as the United States from it. From 1996 to 2005, the average annual growth rate was 2.0 for real GDP and 0.7% for labor productivity in the Euro Area, as compared with 3.3 and 2.1%, respectively, in the United States. This has kept the rate of unemployment much higher than in the United States and limited European imports (see Table 3). The appropriate long-term policy for the Euro Area to overcome its imbalance would be to accelerate or speed up the restructuring of its economy and liberalize its labor markets, as well as encourage more rapid adoption and spread of the new information and communications technology (ICT) so as to stimulate labor productivity and growth of its economy. Labor opposition, however,
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has so far prevented most European governments from introducing the deep structural reforms necessary. This may be understandable. Europe is rightly proud of its high wages and generous social protection benefits, and it seems unwilling to compromise them. It is also difficult to introduce reforms and restructure labor markets when the economy is growing slowly. Furthermore, the benefits of restructuring generally come only over time, while most of the costs are paid upfront. The longer the restructuring is delayed, however, the more the Euro Area falls behind the U.S. in real per capita income. After rapidly reducing the gap in real per capita income from less than 50% in 1950 to nearly 90% in the 1980s, the Euro Area average real per capita income slipped back to about 76% of U.S. income in 2005. Faster growth returned in Europe and slowed somewhat in the United States in 2006, but it is uncertain whether this situation will continue past the current year. The Japanese imbalance is also structural and mostly internal in nature, thus requiring, for the most part, domestic policies to correct. Specifically, Japan has been in a serious financial and economic crisis since the beginning of the 1990s and still faces major structural imbalances. Domestic deflation rather than international disturbances is the primary cause of the large undervaluation of the yen with respect to the dollar and thus of the large Japanese trade surplus vis-`a-vis the United States. As shown in Table 2, Japan simply saves too much and consumes and invests domestically too little. Japan followed three policies to correct its domestic deflation and structural imbalance. It pursued a very powerful expansionary monetary policy, which has kept nominal interest rates at a practically zero level (with real rates negative because of domestic deflation). It adopted an equally powerful expansionary fiscal policy (evidenced by an average annual budget deficit of 6.4% of GDP from 1996 to 2005 and 6.8% from 2001 to 2005—and a public debt equal to 172.1% of GDP in 2005). Finally, Japan intervened in foreign exchange markets in a massive way to prevent a further yen appreciation and a reduction of its exports. In fact, Japan foreign exchange dollar reserves increased from about $120 billion in 1996 to $830 billion at the end of 2005. Yet, until 2004, Japanese growth remained very subdued. Despite the fact that growth resumed in 2004, remaining structural imbalances still keeps Japan performing below its potential. Only by stimulating domestic investments and consumption can Japan eliminate its structural imbalance. Japan should open up its economy more widely to imports and allow the yen to appreciate further with respect to the dollar, thus eliminating its undervaluation (now estimated to be in the range of 15–20%) with respect to the U.S. dollar. Although it is not easy to get Japanese consumers to spend more and save less, Japanese firms to increase the rate of domestic investments, and the Japanese governments further liberalize the economy, these are the policies generally believed to be required for Japan to overcome its structural imbalances and increase its rate of growth. Increasing domestic investments would also address the problem created by the expected higher future costs of providing for Japan’s rapidly aging population. 5. From unsustainable to sustainable U.S. trade deficits There now seems to be a general agreement among experts that the current U.S. trade deficit in excess of 6% of GDP is clearly unsustainable in the long-run and must be brought down. The longer the adjustment is delayed, however, the greater is the danger that the markets will bring about a adjustment in the form of a reversal of financial capital inflows to the United States, a sharp depreciation of the dollar, and possibly much higher interest rates and recession the United States,
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and reduced world economic growth. Avoiding this risk requires a coordinated policy action in the form of an increase in the U.S. savings rate, an increase in expenditures on domestic and foreign goods and services by China, Japan and OPEC countries, as well as higher growth in Europe and Japan (i.e., expenditure-changing policies in the deficit country and surplus countries). Inevitably, this will trigger an effective dollar depreciation that would stimulate U.S. exports and discourage U.S. imports (i.e., expenditure switching). Thus, the controversy that is raging today among experts as to whether to correct the unsustainable U.S. trade deficit by expenditure-changing or expenditure-switching policies is useless and unnecessary. The appropriate expenditure-changing policies will inevitably lead to expenditure switching. This was how the controversy over the absorption versus the elasticity approach was resolved more than a half a century ago. The resolution then and now is that both policies are usually required to reduce a trade deficit to sustainable levels, except that now we need not force an effective depreciation of the dollar because that will automatically occur once the appropriate expenditure-changing policies are adopted in the deficit country (the United States) and the surplus countries (China, Japan, OPEC and other surplus countries in Asia, Europe, and elsewhere). The question is not whether adjustment needs to occur but whether it will be brought about by the appropriate policies and take place gradually rather be forced by the market and be sudden and potentially highly disruptive. Adjustment does not mean, however, correcting the U.S. trade imbalance completely. Although there is no precise figure, there is a general consensus that an adequate adjustment would mean bringing the U.S. trade deficit from the current 6% or more of GDP down to 2 or 3% of GDP. An OECD Interlink Model simulation exercise indicated that in order to reduce the U.S. current account deficit by 2% points of GDP required an increase in the U.S. savings balance (public and private) of 6% points over a 6-year horizon or a 20–25% nominal effective dollar depreciation (and proportionately more to cut the current U.S. trade deficit to a sustainable level). Other simulations (for example, Milesi-Ferretti & Gian Maria, 2006) seem indicate that to the U.S. trade balance is somewhat more responsive to a dollar depreciation, so that in order to cut the U.S. trade deficit to the sustainable level of, say, 3% of GDP in the medium term requires an effective dollar depreciation of between 10 and 20%. All that I would add to this is that the word “or” in the OECD Interlink Model simulation results seems misplaced because an improvement in the U.S. fiscal position, by resulting in lower capital inflows to the United States, would automatically lead to a dollar depreciation. That, is, the dollar exchange rate would more or less automatically find its own operational equilibrium level. Working the other way (i.e., starting by encouraging an effective dollar depreciation vis-`a-vis the Chinese yuan as a step to also get Japan and other Asian surplus countries to revalue their currencies) is likely to lead to a serious deflationary crisis in China, reminiscent of what occurred in Japan after it allowed the yen to sharply appreciate vis-`a-vis the dollar, starting in the early 1970s. The appropriate policy to bring the U.S. trade deficit down to a sustainable level must start by the U.S. reducing its expenditures and increasing its savings to an adequate level. But, as indicated above, the United States seems unwilling or unable to do so at a sufficient scale and rapidly enough—hence lies the danger to the stability of the entire international monetary system. On the other hand, it should not be difficult for China to increase its expenditures (and thus smooth the international adjustment process) out of its newly found riches in the form of the world’s largest international currency reserves (now exceeding one trillion dollar or more than 25% of its GDP) on improved education, infrastructures, environment, and promoting more regional equality. In fact, this is exactly what China seems to be doing and intends to do in the future. The resulting smaller
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and gradual appreciation of the yuan (than the United States has been demanding) will encourage Japan and other Asian surplus countries to also allow their currencies to appreciate—something that they have been resisting so as not loose international competitiveness vis-`a-vis China. 6. Conclusions Inadequate U.S. savings and excessive savings in China, Japan, and some other (mostly Asian) emerging market economies, as well in S. Arabia and other OPEC countries, are leading to huge capital inflows from these countries to the United States, an overvalued dollar, and an unsustainable trade deficit. Left uncorrected, this could lead to a collapse (i.e., a sharp depreciation) of the dollar, which in turn could result in sharply higher interest rates and recession in the United States, and slower economic growth of the world economy. To eliminate or reduce this danger, the United States needs to reduce its expenditures and sharply increase its savings while surplus nations need to increase their expenditures. Europe and Japan also need to restructure their economies in order to stimulate their growth and increase their imports. All these measures would automatically lead to an effective depreciation of the dollar and reduce U.S. trade deficits to a sustainable level. If the United States does reduce its expenditures and increase its savings rapidly and sufficiently enough to bring about a timely adjustment to its external imbalance, the markets may force a more sudden, drastic, and painful adjustment. High unemployment in Europe and slow growth (until recently) in Japan due to their somewhat inflexible economies sharply reduces the economic growth of these economies and push them toward trade protectionism in a vane effort to protect labor and unproductive sectors from world competition, especially from China and other dynamic emerging Asian economies. References BIS. (2006). Annual report. BIS: Basel. Doodley, M., Folkerts-Landau, D., & Garber, P. (2003). An essay on the Revived Bretton Woods System. NBER Working Paper No. 9971, Month. IMF. (2006). Annual report. Washington, DC: IMF. IMF. (2006). World economic outlook. Washington, DC: IMF. Milesi-Ferretti, & Gian Maria. (2006). Methodologies for CGER exchange rate assessments. IMF, November. OECD. (2006). Economic outlook. Paris: OECD.
Further reading Edwards, S. (2005). Is the U.S. current account deficit sustainable? And if so how likely is adjustment likely to be? Brookings Papers on Economic Activity, No. 1, pp. 211–271. Eichengreen, B. (2006). Global imbalances and lessons of Bretton Woods, NBER Working Paper No. 10497, May. Eichengreen, B. (2006). Global imbalances: The blind man and the elephant. Issues in Economic Policy. The Brookings Institution, No. 1, January. Geitner, T. (2006). Policy implications of global imbalances. General financial imbalances conference at Chatham House, London, January 23. http://www.ny.frb.org/newsevents/speeches/2006/gei060123.html. IMF. (2004). The global implications of the U.S. fiscal deficit and of China’s growth. In World economic outlook. Washington, DC: IMF., pp. 63–102 IMF. (2005). Global imbalances: A saving and investment perspective. In World economic outlook. Washington, DC: IMF., pp. 91–124. Krugman, P. (2007). Will there be a dollar crisis? CERP. Matthew, H., Thomas, K., & Robert, L. (2006). Recycling petrodollars. In Current issues in economics and finance. Federal Reserve Bank of New York.
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Obstfeld, M., & Rogoff, K. (2005). Global current account imbalance and exchange rate adjustment. Bookings Papers on Economic Activity, No. 1, pp. 67–146. OECD. (2004). The challenge of narrowing the U.S. current account deficit. In Economic Outlook. Paris: OECD., pp. 149–168. Rogoff, K. (2006). How strong the case for coordinated response to global imbalances. Journal of Policy Modeling, 695–699. Salvatore, D. (1998). Europe’s structural and competitiveness problems and the Euro. The World Economy, 189–205. Salvatore, D. (2005). Currency misalignments and trade asymmetries among major economic areas. The Journal of Economic Asymmetries, 2(1), 1–24. Salvatore, D. (2006). Twin deficits in the G-7 countries and global structural imbalances. Journal of Policy Modeling, 701–712. Shi, J. (2006). Are currency appreciations contractionary in China? NBER Working Paper No. 12551, September. World Bank. (2006). Annual report. Washington, DC: World Bank. World Bank. (2006). World development indicators. Washington, DC: World Bank.
U.S. trade deficits, structural imbalances, and global monetary stability Dominick Salvatore a,b,∗ b
a Shanghai Finance University, China Department of Economics, Fordham University, NY 10458, USA
Available online 3 June 2007
Keywords: Trade deficit; Global monetary stability; Net lending; Growth rate
1. Introduction The U.S. has faced growing trade deficits for two decades, which now exceed 6% of GDP and are clearly unsustainable. Continued huge U.S. trade deficits could lead to a collapse (i.e., a sharp depreciation) of the dollar, which in turn could result in sharply higher interest rates and recession in the United States, and slower economic growth of the world economy. Inadequate U.S. savings and excessive savings in China, Japan, and some other (mostly Asian) emerging market economies, as well in S. Arabia and other OPEC countries are leading to huge capital inflows from these countries to the United States, an overvalued dollar, and excessive U.S. trade deficits; but a sudden sharp reduction in such capital inflows could inflict serious economic damage to the United States and the entire world economy. High unemployment in Europe and slow growth (until recently) in Japan due to their somewhat inflexible economies reduce the economic growth of these economies and push them toward trade protectionism in a vane effort to protect labor and unproductive sectors from world competition, especially from China and other dynamic emerging Asian economies. 2. U.S. trade deficits and trade surpluses of other leading areas Table 1 shows the huge and rapidly growing trade deficits of the United States, on the one hand, and the large trade surpluses of China, Japan, and S. Arabia since the mid 1990s, on the ∗ Correspondence address: Department of Economics, Fordham University, NY 10458, USA. Tel.: +1 718 817 4045; fax: +1 914 337 3355. E-mail address: [email protected].
0161-8938/$ – see front matter © 2007 Published by Elsevier Inc. on behalf of Society for Policy Modeling. doi:10.1016/j.jpolmod.2007.06.007
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D. Salvatore / Journal of Policy Modeling 29 (2007) 697–704
Table 1 Trade imbalances of leading areas, 1996–2005 (in billions of U.S. dollars) Country/area
1996
2000
2004
2005
United States U.S. with respect to Canada W. Europe Japan China Other Asia OPEC Euro Area Japan China S. Arabia
−191.0
−449.8
−662.0
−779.9
−24.3 −24.4 −48.7 −39.6 −38.0 −23.4 – 83.6 19.5 35.3
−54.8 −74.9 −83.0 −83.9 −104.4 −49.4 28.8 116.7 34.5 49.8
−69.1 −131.5 −77.5 −162.0 −114.8 −72.5 130.4 132.1 59.0 84.9
−81.1 −146.4 −84.7 −201.7 −83.2 −93.2 68.0 94.0 134.2 123.3
Source: Survey of current business, July 2006; IMF International Financial Statistics Yearbook (2006).
other. The table shows that the U.S. trade deficit rose sharply from $191 billion dollars or 2.4% of the U.S. GDP in 1996, to $450 billion or 4.6% of the U.S. GDP in 2000, and $780 billion or 6.3% of U.S. GDP in 2005. Trade deficits in excess or 2 or 3% of GDP are deemed by most economists and policy makers to be unsustainable in the long run and need to be corrected. Table 1 also shows that almost half of the U.S. trade deficit is with China and the other emerging markets of East Asia and Japan, and it is against the currencies of these nations that the dollar seems to be overvalued. The situation is different with respect to Europe and the euro. After being undervalued by as much as 30–35% during 2000 and 2001, the dollar subsequently depreciated with respect to the euro and, at the value of about $1.33 (April 2007) it can be regarded as undervalued by 10–15%. Thus, the U.S. trade deficit with the Euro Area can now be regarded as due primarily to inadequate savings in the United States and anemic growth in the Euro Area (see Table 2). An undervalued dollar vis-`a-vis the euro puts pressure on Euro Area’s exports to the United States and to the emerging markets of East Asia, whose currencies are also undervalued with respect to the euro (being, as they are, mostly pegged to the U.S. dollar). This is bad news for the Euro Area, whose growth has been anemic during the past decade and whose exports would come under renewed pressure if the dollar were to further depreciate. In today’s highly interdependent world, economic problems in one nation or area quickly spread to other nations and areas and can lead to a world-wide economic crisis. 3. Savings, investments, and net lending in the major economic areas The structural or fundamental cause of the large and unsustainable U.S. trade deficit is the grossly inadequate U.S. savings, on the one hand, and excessive savings in China, Japan, and some other (mostly Asian) emerging market economies, as well in S. Arabia and other OPEC countries, on the other. These lead to huge capital inflows to the United States, a large overvaluation of the dollar with respect to Asian countries, and to a huge U.S. trade deficits. Table 2 shows that the savings rate of the United States declined from an average of 16.3% of GDP from 1990 to 1999 to 13.3% of GDP in 2005, or by 2.9% points from 1991 to 2005, while U.S. investment rose from an average of 18.7% of GDP from 1990 to 1999 to 20.0% of GDP in 2005, or by 1.5% points from 1991 to 2005. As a result, U.S. net borrowing abroad
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Table 2 Savings, investments, and net lending in major economic areas, 1990–2005 (percent of GDP) Country/area
Average 1990–1999
Average 2000–2003
2004
2005
Cumulative change 1991–2005 (percentage points)
United States Savings Investment Net savings
16.3 18.7 −2.4
15.5 19.2 −3.7
13.4 19.6 −6.2
13.3 20.0 −6.7
−2.9 1.5 −4.4
Euro Area Savings Investment Net savings
21.2 19.8 1.4
20.9 20.7 0.2
21.2 20.5 0.7
20.9 20.9 0.0
−1.0 0.7 −1.7
Japan Savings Investment Net savings
31.4 29.0 2.4
26.7 24.0 2.7
26.4 22.7 3.7
26.8 23.2 3.6
−7.6 −9.7 2.1
China Savings Investment Net savings
38.7 37.0 1.7
37.1 35.0 1.9
46.8 43.3 3.5
51.3 44.1 7.2
13.5 9.4 5.5
Source: BIS, Annual Report (2006).
(negative U.S. net savings) increased from an average of 2.4% of GDP from 1990 to 1999 to 6.7% of GDP in 2005, or by (−)4.4% points (−2.9 to +1.5) from 1991 to 2005. The counterpart of the huge U.S. net borrowing was the large foreign net lending to the United States, primarily by Asian countries, but also OPEC (mostly through secretive government investment funds channeled through intermediaries in London), with the Euro Area practically in savings–investment balance. Furthermore, while most foreign lending to the United States during the 1990s took primarily the form of foreign direct investments (FDI) attracted by high U.S. growth and profitability, during this decade, an increasing amount of foreign capital flows to the United States have taken the form of foreign official purchases of U.S. government securities and accumulation of dollar reserves, mostly by Japan and Asian emerging market economies, especially China, as well as OPEC nations, especially S. Arabia. By doing so, Asian countries avoided a large depreciation of the dollar vis-`a-vis their own currencies and hence a sharp reduction in their exports to the United States and to the rest of the world. Essentially, Asian countries thus followed an export-led growth financed by lending huge sums to the United States, a situation that leads some to call the present arrangement “Bretton Woods II” (see Doodley, Folkerts-Landau, & Garber, 2003). This resulted in a grossly overvalued dollar with respect to most Asian currencies and to large and unsustainable U.S. trade deficit (the counterpart of the large U.S. net borrowing abroad). There is now disagreement as to how long this process can continue. But a significant and rapid reduction in net foreign loans (capital inflows) to the United States could lead to a collapse of the dollar, sharply higher interest rates in the United States, and a U.S. and world economic crisis. The medium- and long-term solution to this problem is for the United States to adopt policies to stimulate domestic savings and curb its expenditures. This is not easy to do because American consumers and firms have become addicted to living with increasing levels of debt, and it is difficult to break the habit. A sufficient increase in the U.S. savings rate would reduce the need for capital inflows, reduce or eliminate the dollar misalignment, and reduce U.S. trade deficits
700
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Table 3 Growth of real GDP, labor productivity, and unemployment rate in United States, Euro Area, and Japan, 1996–2005 (percentages) Country/area
1996
2000
2004
2005
1996–2005 average
United States Real GDP Labor productivity Unemployment rate
3.7 1.8 5.4
3.7 1.9 4.0
3.9 3.1 5.5
3.2 1.8 5.1
3.3 2.1 5.0
Euro Area Real GDP Labor productivity Unemployment rate
1.4 0.8 10.7
3.9 1.4 8.2
1.7 0.8 8.9
1.5 0.5 8.6
2.0 0.7 9.1
Japan Real GDP Labor productivity Unemployment rate
2.6 2.1 3.4
2.9 3.2 4.7
2.3 2.1 4.7
2.7 2.3 4.4
1.2 1.4 4.5
Source: OECD, OECD Economic Outlook (December 2006).
to sustainable levels. The United States, however, is today hardly doing enough to overcome its savings–investment imbalance—a problem which could not, in any event, be easily or quickly solved. For their part, China and other emerging market economies should increase domestic expenditures to improve education, income distribution, infrastructures, and the environment, while Japan should restructure its economy to further stimulate its growth. The International Monetary Fund’s, through its new surveillance mandate, was expected to encourage the United States, China and Japan to take cooperative steps to reduce their saving–investment imbalance to sustainable levels, but to date it has done little along this direction, possibly because of political opposition by the nations involved. 4. Slow growth in Europe and Japan, and U.S. trade deficits A contributing cause of the large U.S. trade deficit is the slow growth (until recently) in Europe and Japan, which limited their imports from the United States. As shown in Table 2, even though savings and investment are in near balance, the Euro Area faces a serious structural imbalance, which has kept its growth rate below its potential and lower than growth in the United States over the past decade (see Table 3). The restructuring that has taken place in the Euro Area during the past decade has been inadequate and its economy, especially its labor market, remains too rigid. In addition, the Euro Area has not pursued the “new economy” aggressively and it has thus not been able to harvest as much benefits as the United States from it. From 1996 to 2005, the average annual growth rate was 2.0 for real GDP and 0.7% for labor productivity in the Euro Area, as compared with 3.3 and 2.1%, respectively, in the United States. This has kept the rate of unemployment much higher than in the United States and limited European imports (see Table 3). The appropriate long-term policy for the Euro Area to overcome its imbalance would be to accelerate or speed up the restructuring of its economy and liberalize its labor markets, as well as encourage more rapid adoption and spread of the new information and communications technology (ICT) so as to stimulate labor productivity and growth of its economy. Labor opposition, however,
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has so far prevented most European governments from introducing the deep structural reforms necessary. This may be understandable. Europe is rightly proud of its high wages and generous social protection benefits, and it seems unwilling to compromise them. It is also difficult to introduce reforms and restructure labor markets when the economy is growing slowly. Furthermore, the benefits of restructuring generally come only over time, while most of the costs are paid upfront. The longer the restructuring is delayed, however, the more the Euro Area falls behind the U.S. in real per capita income. After rapidly reducing the gap in real per capita income from less than 50% in 1950 to nearly 90% in the 1980s, the Euro Area average real per capita income slipped back to about 76% of U.S. income in 2005. Faster growth returned in Europe and slowed somewhat in the United States in 2006, but it is uncertain whether this situation will continue past the current year. The Japanese imbalance is also structural and mostly internal in nature, thus requiring, for the most part, domestic policies to correct. Specifically, Japan has been in a serious financial and economic crisis since the beginning of the 1990s and still faces major structural imbalances. Domestic deflation rather than international disturbances is the primary cause of the large undervaluation of the yen with respect to the dollar and thus of the large Japanese trade surplus vis-`a-vis the United States. As shown in Table 2, Japan simply saves too much and consumes and invests domestically too little. Japan followed three policies to correct its domestic deflation and structural imbalance. It pursued a very powerful expansionary monetary policy, which has kept nominal interest rates at a practically zero level (with real rates negative because of domestic deflation). It adopted an equally powerful expansionary fiscal policy (evidenced by an average annual budget deficit of 6.4% of GDP from 1996 to 2005 and 6.8% from 2001 to 2005—and a public debt equal to 172.1% of GDP in 2005). Finally, Japan intervened in foreign exchange markets in a massive way to prevent a further yen appreciation and a reduction of its exports. In fact, Japan foreign exchange dollar reserves increased from about $120 billion in 1996 to $830 billion at the end of 2005. Yet, until 2004, Japanese growth remained very subdued. Despite the fact that growth resumed in 2004, remaining structural imbalances still keeps Japan performing below its potential. Only by stimulating domestic investments and consumption can Japan eliminate its structural imbalance. Japan should open up its economy more widely to imports and allow the yen to appreciate further with respect to the dollar, thus eliminating its undervaluation (now estimated to be in the range of 15–20%) with respect to the U.S. dollar. Although it is not easy to get Japanese consumers to spend more and save less, Japanese firms to increase the rate of domestic investments, and the Japanese governments further liberalize the economy, these are the policies generally believed to be required for Japan to overcome its structural imbalances and increase its rate of growth. Increasing domestic investments would also address the problem created by the expected higher future costs of providing for Japan’s rapidly aging population. 5. From unsustainable to sustainable U.S. trade deficits There now seems to be a general agreement among experts that the current U.S. trade deficit in excess of 6% of GDP is clearly unsustainable in the long-run and must be brought down. The longer the adjustment is delayed, however, the greater is the danger that the markets will bring about a adjustment in the form of a reversal of financial capital inflows to the United States, a sharp depreciation of the dollar, and possibly much higher interest rates and recession the United States,
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and reduced world economic growth. Avoiding this risk requires a coordinated policy action in the form of an increase in the U.S. savings rate, an increase in expenditures on domestic and foreign goods and services by China, Japan and OPEC countries, as well as higher growth in Europe and Japan (i.e., expenditure-changing policies in the deficit country and surplus countries). Inevitably, this will trigger an effective dollar depreciation that would stimulate U.S. exports and discourage U.S. imports (i.e., expenditure switching). Thus, the controversy that is raging today among experts as to whether to correct the unsustainable U.S. trade deficit by expenditure-changing or expenditure-switching policies is useless and unnecessary. The appropriate expenditure-changing policies will inevitably lead to expenditure switching. This was how the controversy over the absorption versus the elasticity approach was resolved more than a half a century ago. The resolution then and now is that both policies are usually required to reduce a trade deficit to sustainable levels, except that now we need not force an effective depreciation of the dollar because that will automatically occur once the appropriate expenditure-changing policies are adopted in the deficit country (the United States) and the surplus countries (China, Japan, OPEC and other surplus countries in Asia, Europe, and elsewhere). The question is not whether adjustment needs to occur but whether it will be brought about by the appropriate policies and take place gradually rather be forced by the market and be sudden and potentially highly disruptive. Adjustment does not mean, however, correcting the U.S. trade imbalance completely. Although there is no precise figure, there is a general consensus that an adequate adjustment would mean bringing the U.S. trade deficit from the current 6% or more of GDP down to 2 or 3% of GDP. An OECD Interlink Model simulation exercise indicated that in order to reduce the U.S. current account deficit by 2% points of GDP required an increase in the U.S. savings balance (public and private) of 6% points over a 6-year horizon or a 20–25% nominal effective dollar depreciation (and proportionately more to cut the current U.S. trade deficit to a sustainable level). Other simulations (for example, Milesi-Ferretti & Gian Maria, 2006) seem indicate that to the U.S. trade balance is somewhat more responsive to a dollar depreciation, so that in order to cut the U.S. trade deficit to the sustainable level of, say, 3% of GDP in the medium term requires an effective dollar depreciation of between 10 and 20%. All that I would add to this is that the word “or” in the OECD Interlink Model simulation results seems misplaced because an improvement in the U.S. fiscal position, by resulting in lower capital inflows to the United States, would automatically lead to a dollar depreciation. That, is, the dollar exchange rate would more or less automatically find its own operational equilibrium level. Working the other way (i.e., starting by encouraging an effective dollar depreciation vis-`a-vis the Chinese yuan as a step to also get Japan and other Asian surplus countries to revalue their currencies) is likely to lead to a serious deflationary crisis in China, reminiscent of what occurred in Japan after it allowed the yen to sharply appreciate vis-`a-vis the dollar, starting in the early 1970s. The appropriate policy to bring the U.S. trade deficit down to a sustainable level must start by the U.S. reducing its expenditures and increasing its savings to an adequate level. But, as indicated above, the United States seems unwilling or unable to do so at a sufficient scale and rapidly enough—hence lies the danger to the stability of the entire international monetary system. On the other hand, it should not be difficult for China to increase its expenditures (and thus smooth the international adjustment process) out of its newly found riches in the form of the world’s largest international currency reserves (now exceeding one trillion dollar or more than 25% of its GDP) on improved education, infrastructures, environment, and promoting more regional equality. In fact, this is exactly what China seems to be doing and intends to do in the future. The resulting smaller
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and gradual appreciation of the yuan (than the United States has been demanding) will encourage Japan and other Asian surplus countries to also allow their currencies to appreciate—something that they have been resisting so as not loose international competitiveness vis-`a-vis China. 6. Conclusions Inadequate U.S. savings and excessive savings in China, Japan, and some other (mostly Asian) emerging market economies, as well in S. Arabia and other OPEC countries, are leading to huge capital inflows from these countries to the United States, an overvalued dollar, and an unsustainable trade deficit. Left uncorrected, this could lead to a collapse (i.e., a sharp depreciation) of the dollar, which in turn could result in sharply higher interest rates and recession in the United States, and slower economic growth of the world economy. To eliminate or reduce this danger, the United States needs to reduce its expenditures and sharply increase its savings while surplus nations need to increase their expenditures. Europe and Japan also need to restructure their economies in order to stimulate their growth and increase their imports. All these measures would automatically lead to an effective depreciation of the dollar and reduce U.S. trade deficits to a sustainable level. If the United States does reduce its expenditures and increase its savings rapidly and sufficiently enough to bring about a timely adjustment to its external imbalance, the markets may force a more sudden, drastic, and painful adjustment. High unemployment in Europe and slow growth (until recently) in Japan due to their somewhat inflexible economies sharply reduces the economic growth of these economies and push them toward trade protectionism in a vane effort to protect labor and unproductive sectors from world competition, especially from China and other dynamic emerging Asian economies. References BIS. (2006). Annual report. BIS: Basel. Doodley, M., Folkerts-Landau, D., & Garber, P. (2003). An essay on the Revived Bretton Woods System. NBER Working Paper No. 9971, Month. IMF. (2006). Annual report. Washington, DC: IMF. IMF. (2006). World economic outlook. Washington, DC: IMF. Milesi-Ferretti, & Gian Maria. (2006). Methodologies for CGER exchange rate assessments. IMF, November. OECD. (2006). Economic outlook. Paris: OECD.
Further reading Edwards, S. (2005). Is the U.S. current account deficit sustainable? And if so how likely is adjustment likely to be? Brookings Papers on Economic Activity, No. 1, pp. 211–271. Eichengreen, B. (2006). Global imbalances and lessons of Bretton Woods, NBER Working Paper No. 10497, May. Eichengreen, B. (2006). Global imbalances: The blind man and the elephant. Issues in Economic Policy. The Brookings Institution, No. 1, January. Geitner, T. (2006). Policy implications of global imbalances. General financial imbalances conference at Chatham House, London, January 23. http://www.ny.frb.org/newsevents/speeches/2006/gei060123.html. IMF. (2004). The global implications of the U.S. fiscal deficit and of China’s growth. In World economic outlook. Washington, DC: IMF., pp. 63–102 IMF. (2005). Global imbalances: A saving and investment perspective. In World economic outlook. Washington, DC: IMF., pp. 91–124. Krugman, P. (2007). Will there be a dollar crisis? CERP. Matthew, H., Thomas, K., & Robert, L. (2006). Recycling petrodollars. In Current issues in economics and finance. Federal Reserve Bank of New York.
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Obstfeld, M., & Rogoff, K. (2005). Global current account imbalance and exchange rate adjustment. Bookings Papers on Economic Activity, No. 1, pp. 67–146. OECD. (2004). The challenge of narrowing the U.S. current account deficit. In Economic Outlook. Paris: OECD., pp. 149–168. Rogoff, K. (2006). How strong the case for coordinated response to global imbalances. Journal of Policy Modeling, 695–699. Salvatore, D. (1998). Europe’s structural and competitiveness problems and the Euro. The World Economy, 189–205. Salvatore, D. (2005). Currency misalignments and trade asymmetries among major economic areas. The Journal of Economic Asymmetries, 2(1), 1–24. Salvatore, D. (2006). Twin deficits in the G-7 countries and global structural imbalances. Journal of Policy Modeling, 701–712. Shi, J. (2006). Are currency appreciations contractionary in China? NBER Working Paper No. 12551, September. World Bank. (2006). Annual report. Washington, DC: World Bank. World Bank. (2006). World development indicators. Washington, DC: World Bank.