In the Background, Rebalancing

The crisis we've had (I hope I'm not jinxing anything by using the past tense) was not the crisis that I was worried about. With the US running a large current account deficit - $803.5 bn (6.1% of GDP) in 2006 - international macro worrywarts could find plenty of reason to be concerned that US dependence on foreign purchases of our assets would end unpleasantly with a dollar rout and skyrocketing interest rates if foreign creditors rushed for the exit, as they often have done for emerging markets. As Brad DeLong put it:

The prevailing view was that the truly dangerous financial crisis would be one produced by the unwinding of "global imbalances"--a collapse in the dollar and a panicked flight not toward but away from dollar-denominated cash--that could not be handled by the Federal Reserve because in such a crisis the assets that it would create would be assets that nobody wanted to hold.

That was not the crisis we got, and, at times, the dollar has actually risen due to it's "safe haven" role in world financial markets (an irony noted in this earlier post). But, along the way, some of the global imbalances we were worried about have gotten considerably smaller. For the first quarter of 2009, the preliminary estimate of the seasonally adjusted US current account deficit was 2.9% of GDP. Brad Setser writes:

[T]here has been a major adjustment. The question is whether it will be sustained when the US recovers and US demand picks up.

That depends on the course of the dollar, to be sure. And of the course of the dollar depends on whether private demand for US assets picks up, as well as whether countries like China maintain dollar pegs. But it also depends on the nature of the global recovery – and the strength of stimulus policies other countries adopt. And their at least there is a bit of hope, at least so long as China sustains its current highly stimulative policies. China’s June surplus was lower than expected, in part because China’s imports picked up before China’s exports. That’s goods news for global adjustment.

There sometimes is a tendency to speak about the world’s macroeconomic imbalances as if nothing has changed. That increasingly strikes me as a mistake. The world’s imbalances haven’t gone away, but they have shrunk dramatically.

Japan is now running an external deficit. China’s surplus shrank, at least in q2. The US deficit is much smaller now than in the past. Europe’s internal imbalances also have shrunk.

The adjustment came the painful way – with sharp falls in exports and imports. But it was still adjustment. The trade deficit fell sharply. The rise in the public borrowing buffered an enormous fall in private borrowing, and private demand. It cushioned rather than stopped the adjustment. The challenge now is try to make sure the recovery doesn’t undo the adjustments that happened during the crisis.