by Simon Tilford
The developed world’s slide into recession threatens an outbreak of protectionism. Unlike in 2008, governments now have few tools with which to combat a renewed economic downturn, which raises the likelihood of it developing into a slump. If so, protectionist pressure is certain to build. The country that moves first to erect trade barriers will no doubt take the blame for the resulting damage to the trading system. But the real villains will be the countries that skew their exchange policies, tax systems and industrial structures to gain export advantage. The irony is that the countries that are most dependent on free trade – those that produce more than they consume – are the biggest obstacle to a sustained recovery in the global economy. They need to change course before it is too late: all will suffer if countries move to erect new trade barriers, but the surplus economies will suffer most.
Surplus country governments regularly exhort deficit countries to pay-down debt, save more and ‘live within their means’. But the real problem facing the global economy is an acute lack of aggregate demand. The world is awash with savings, but there is a dearth of profitable investment opportunities, which in turn reflects the weakness of consumption. The answer is not therefore for everybody to save more. This will be disastrous: it will further depress consumption and hence investment, and aggravate fiscal problems. If countries with big trade deficits (and correspondingly high levels of indebtedness) are to save more, surplus countries (those that live within their means) will have to save less and spend more.
The weakness of domestic demand in the US, UK and across much of the eurozone is hitting global demand hard, but there is nothing to offset it. The big surplus countries – Germany, China and Japan – are not taking any steps to offset the contraction in demand elsewhere. Such a state of affairs is fraught with risk. If the world is to continue enjoying the benefits of global trade and finance, the global imbalances have to be unwound.
What are trade imbalances? A country’s trade balance is a reflection of what it spends minus what it produces. In surplus countries income exceeds their spending, so they lend the difference to countries where spending exceeds income, accumulating international assets in the process. Deficit countries are the flipside of this. They spend more than their income, borrowing from surplus countries to cover the difference, in the process accumulating international liabilities or debts. Export-led growth in surplus countries feeds (and is dependent on) debt-led growth in deficit countries. It is impossible for all countries to run surpluses, just as it is impossible for all to run deficits.
Are trade imbalances sustainable? Trade imbalances and the accompanying capital flows between countries are not necessarily a problem. Fast-ageing wealthy societies tend to have excess savings and it makes sense to invest these in countries where domestic savings are insufficient to meet investment needs. Historically, this typically meant investing money in rapidly developing emerging markets. So long as current-account deficits remain modest and economies invest the corresponding capital inflows in ways that boost productivity growth, such imbalances are sustainable. But the imbalances we see today are of a different character. First, they are much bigger. The most egregious is that between China and the US, where still poor China is running a huge trade surplus with the US. Many of the other imbalances are between countries of broadly similar levels of economic development, such as those between members of the eurozone, or that between Japan and the US.
Imbalances of this scale and nature are far from benign. First, they lead to destabilising capital flows between economies. For example, the global financial crises of 2007 and the subsequent eurozone crisis were basically the result of capital flows between countries. Over-leveraged banks amplified the problem, but the underlying cause was outflows of capital from economies with excess savings in search of higher returns. Much as in the surplus economies themselves, the US, UK and the members of the eurozone that attracted large-scale capital inflows struggled to find productive uses for them: rather than boosting productivity, the inflows pumped up asset prices and encouraged excessive household borrowing.
The imbalances survived both crises, and are now growing again from an already high level. This is clearly unsustainable. Unlike in the run-up to the financial crisis, the current situation has nothing do with excess demand in the deficit countries, but is taking place against a backdrop of stagnation and falling living standards in these economies. Households and firms in the deficit countries are saving more, but there has been no offsetting decline in private sector savings in the surplus countries. Against this kind of economic backdrop, trade deficits constitute a major drag on economic activity as they drain demand and employment, forcing governments to step-in and fill the gap by running big fiscal deficits. The external demand upon which the surplus countries depend relies implicitly on unsustainable fiscal policies in the deficit countries.
How can imbalances be reduced? The deficit countries need a combination of higher net exports (export minus imports) and higher net savings (domestic savings minus domestic investment), while the surplus countries require the reverse. Put another way, the deficit countries need to get over their dependence on debt, surplus countries their addiction to exports. Deficit countries need more domestic savings and surplus countries more consumption.
Structural changes in both the surplus and deficit countries can clearly contribute to the necessary adjustments. Countries where expenditure lags output, such as Germany and Japan, could take steps to reverse the decline in wages and salaries as a proportion of national income. This would boost consumption, encourage more investment, and hence lower their corporate sectors’ excess savings. For its part, China could discourage excess savings by reducing subsidies to its corporate sector, which is sitting on very large sums of cash. The Chinese authorities could also improve the country’s social safety net and hence lower households’ precautionary savings. However, such adjustments will take time, and time is in short supply. The only way to facilitate rapid adjustment is through shifts in relative prices.
There are three ways of bringing about these movements in prices, or shifts in countries’ so-called ‘real exchange rates’. The fate of the international trading system could depend on which is chosen. First, domestic prices can fall in the deficit countries. This comes about through declining costs and prices, as wages are cut and governments pursue fiscal austerity. Higher unemployment encourages households to save more, and the price of imported goods rise relative to domestically-produced ones.
This is basically what is being attempted in the eurozone. Trade imbalances are to be addressed by deflation in the deficit countries. Policy across the eurozone as a whole has a strongly deflationary bias, as much in the surplus economies as the deficit ones. This implies very weak economic growth, falls in prices (relative to the outside world) and higher unemployment. It also implies higher savings as governments tighten fiscal policy, companies sit on cash rather than investing it and fearful households boost their savings and rein in consumption. The risk is that the deficit countries’ debt burdens will increase further (as the value of their debts grow, while their incomes fall), exacerbating their fiscal problems and undermining their ability to pay their creditors. Far from taking up some of strain from the Americans, the eurozone is trying to run a big surplus with the rest of the world, adding to trade tensions.
Given how indebted the deficit countries are (in terms of public and private debt) rebalancing needs to take place through a combination of movements in nominal exchange rates (where possible) and somewhat higher inflation in the surplus countries. Very low interest rates and quantitative easing in the US is pushing up inflation in countries with currencies linked to the dollar – first and foremost China. The US has little option but to continue pumping dollars into its financial system, in order to compensate for the drag on its economy from the trade balance, and some of this money will continue to leak out to China. However, concerned at the rise in inflation, the Chinese authorities are taking robust steps to slow their economy by clamping down on the amount state-owned banks can lend. Easily the least damaging adjustment in the eurozone would be through higher inflation in Germany. But there is little sign of this. And if there were, the European Central Bank would raise interest rates.
Finally, changes in relative prices can be brought about by movements in nominal exchange rates. For example, the Chinese could allow the renminbi to rise against the dollar or Germany could withdraw from the eurozone and reintroduce the D-mark, which would then appreciate sharply in value. Movements in nominal exchange rates offer by far the least damaging route to the needed rebalancing. It would avoid deflation in the deficit countries or inflation in the surplus ones.
The Chinese government is somewhat schizophrenic about the potential impact of renminbi revaluation. On the one hand it maintains that it would not make any difference, because the deficits in countries like America reflect the latter’s lack of savings, which would not be affected by an appreciation of the Chinese currency. On the other hand, it argues that a stronger renminbi would hit the Chinese economy hard and be disastrous for global economic growth. In short, the Chinese government is dependent on the others running up debt, but at the same time condemns them for doing so. Movements in nominal exchange rates may yet be the mechanism by which the German trade surplus is cut. The current eurozone strategy of deflation in the deficit economies rather than reflation in Germany threatens to force economies out of the currency union. This would open the way for a rebalancing of the German economy, but at enormous political and economic cost to Europe.
Surplus country governments, notably the Chinese and German ones, often warn of the risks of protectionism. They fail to make the connection between the structures of their economies and the trade deficits (and rising indebtedness) of others. As a result, they are the real threat to the international trading order. If the US cannot rebalance its economy and get it growing sustainably, there is a real risk it will opt for protectionism. Other countries with big trade deficits could quickly follow suit. The resulting rebalancing would be brutal for the surplus countries, and many of the benefits of global trade and finance would be lost. To prevent this, the G20 needs to agree a global strategy to rebalance demand. This would require the surplus economies to acknowledge that they are part of the problem and to develop strategies to reduce their export dependence.
Simon Tilford is chief economist at the Centre for European Reform.