Global imbalances: do they matter?

• Author: Xafa, Miranda

This article reviews the recent literature on global imbalances and discusses the policy implications of the various theories that have been advanced to explain their unprecedented increase. Most of these theories fit the stylized facts, namely, the steady increase in the U.S. current account deficit, the shift to a surplus position of the developing countries, and the low nominal and real interest rates globally. The "low U.S. savings" theory--reflecting the increase in the fiscal deficit and in housing wealth--views the current account deficit as the result of fiscal and monetary policy decisions in the United States that need to be urgently reversed to prevent a crash landing. Other theories however, focusing on developments outside the United States, portfolio balance effects, or previously neglected benign factors, do not yield such a doomsday scenario. It is relevant to note that there is no historical precedent of disorderly exchange rate adjustment in industrial countries that keep inflation under control (Croke, Kamin, and Leduc 2005). Concerns over a disorderly unwinding of global imbalances therefore appear exaggerated. This view, prevalent among market participants and several prominent academics, has not been widely embraced by policymakers.

Stylized Facts

The U.S. current account deficit has grown steadily to historically unprecedented levels over the past decade: $805 billion (6.5 percent of GDP) in 2005 and at an annual rate of $875 billion (6.7 percent of GDP) in the first three quarters of 2006 (Figure 1). The rising U.S. current account deficit has increased concerns among policymakers about a possible abrupt and disorderly unwinding, involving a major sell-off of dollar assets, a sharp increase in U.S. interest rates, and an associated sharp reduction in U.S. absorption. Such an abrupt unwinding of imbalances, triggered by a sudden loss of market confidence in the dollar, would obviously have negative spillover effects on financial markets and the global economy. Policymakers have therefore called for a rebalancing of demand across regions, with the United States reducing its fiscal deficit and the European Union implementing growth-enhancing structural reforms, and for adjustments in exchange rates, with Asian countries letting their currencies appreciate (G-7 Statement, April 21, 2006).

An interesting aspect of the imbalances is that the counterpart of the growing U.S. current account deficit is no longer just Japan and other industrial countries, as was the case a decade ago, but also the developing countries as a group, whose external position shifted from a deficit of $74 billion in 1996 to a surplus estimated at $587 billion in 2006 (or from a $63 billion deficit to $305 billion surplus if the oil-producing Middle East is excluded). The shift to a surplus position goes against the established wisdom that developing countries should be capital importers.

Finally, U.S. (and global) long-term interest rates, both nominal and real, are well below their historical norms at this stage of the business cycle, and they have hardly risen following the tightening of U.S. and global liquidity conditions since mid-2004. This fact, known as Greenspan's "conundrum," has helped limit the cost of servicing U.S. external debt.

There is no consensus explanation of the above stylized facts, but several hypotheses have been put forward.

Explaining the Imbalances

The question is whether the widening U.S. current account deficit is due to a temporary aberration or a structural change. A number of competing explanations of the stylized facts have been advanced, all of which conclude that structural changes have made the U.S. deficit and the dollar more sustainable than historical experience would indicate.

The "Low U.S. Savings" View

Obstfeld and Rogoff (2000, 2004), Roubini and Setser (2004), and others focus on the decline in the U.S. national saving rate since the beginning of this decade, reflecting both the swing from fiscal surplus to deficit and...