The economic cost of rebalancing the global economy

By: Eurointelligence Publication Review

 

Global Imbalances: Time for Action, by Alan Ahearne, William R. Cline, Kyung Tae Lee, Yung Chul Park, Jean Pisani-Ferry, and John Williams, Peterson Institute for International Economics, Policy Brief, March 2007

 

What are the economic implications of an adjustment in global imbalances? This is the kind of question ideally suited for the large global macroeconomic models, and was asked by a group of well known economists who wrote an insightful analysis about this issue.

 

The premise of the question is that global imbalances are unsustainable. Not everybody today shares this view, but it is still the mainstream view among international economists. Those who defend the thesis that the present situation may be more sustainable than it appears argue that the integration of global financial markets or the arrival of new financial products, such as credit derivatives, allow imbalances to be both larger and more persistent. Others have been pointing out that the return on US foreign assets is higher than the return on US foreign liabilities. But even if one takes account of these changes, macroeconomic projections still suggest that the imbalances are unsustainable. The authors cite an IMF study, which projects a rise in the US net foreign liabilities from 8% of world GDP to 15% in 2011.

 

The authors asked the question what scale of adjustment is needed in the world’s most important exchange rates to reduce the US current account deficit to a more sustainable level of 3% of GDP. To this effect, the authors looked at three different types of models: trade elasticities models, the well-known large macro models and reduced-form estimates of equilibrium exchange rates. The answers from those differing models were surprisingly similar. We therefore cite as an example the results from the NiGEM macroeconomic model, based on work by Ray Barrell, Dawn Holland, and Ian Hurst. According to their model, it would take a real devaluation in the US dollar of between 11% and 19%, a revaluation of the yen by 10%-14% and a revaluation of the renminbi by 3%-7% to achieve the desired adjustment. The perhaps surprising result is the effect on the euro, which is in a range of –3% to 6%. This suggests a global rebalancing would affect the euro in effective real terms probably less than other currencies.

 

The main differences in the results of the various models relate to the renminbi, with estimates ranging from +3% to +27%. But otherwise the pattern is relatively homogenous: the dollar needs to depreciate in real terms, while the renminbi and the yen need to appreciate, while the euro is approximately correctly valued. One has to remember that this is a statement about the real trade-weighted exchange rates, not nominal bilateral rates. The above mentioned adjustment scenario for the euro is still consistent with a bilateral euro-dollar revaluation of between 15% and 20%! What appears as an non-event from an economic point of view will still generate big newspaper headlines, and may not feel like a no-change scenario at all.

 

The authors suggest that policy action should bring about a co-ordinated adjustment, otherwise there would be scope for significant turmoil, especially in the euro/dollar rate, which could seriously overshoot if there is a disorderly adjustment. The authors present four policy conclusions – at least on our count:

 

1. Adjustment requires US domestic demand to grow by less than US output.  This could be achieved through a fiscal contraction.
2. Japan should let the yen appreciate, or even intervene to strengthen the yen.
3. China should revalue the renminbi by 10%, and gear macroeconomic policy to strengthen domestic demand.
4. The Europeans should allow the bilateral exchange rate to the dollar to appreciate, as long as the real effective exchange rate remains stable

 

This is where the paper ends. While the authors are undoubtedly right to highlight the policies that are necessary to solve the problem, there is not much chance that policymakers will heed the advice. At best, there will be an imperfect policy response. The renminbi will probably continue to rise over the next few years, but not nearly as much as suggested. There is no significant fiscal retraction in sight in the US for some time – on the contrary, one might expect both monetary and fiscal expansion if the US economy were to fall into recession. The Europeans would probably not be the main problem, though they will probably resist extreme shifts in nominal exchange rates, since this could have disturbing effects on financial and monetary stability, even if the real effective rate were to remain broadly unchanged.

 

The most likely scenario, from today’s point of view, is one of a small, but imperfect policy adjustment, with the bulk of the adjustment coming from financial markets – the latter probably in the form of a disorderly process. There will be ample scope for exchange rate overshoots, and a risk of a self-reinforcing global economic crisis if this process was accompanied by unilateral trade restrictions, especially in the trading relation between the US and China. We are somewhat less optimistic simply because this is not the way financial markets adjust – and it is the financial markets that will end up doing most of the adjustment.

 

 

Email:

 

munchau(at)eurointelligence.com

mundschenk(at)eurointelligence.com

 

 

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