Gray Matter and the US Current Account

After increasing steadily from the mid-1990s through the mid-2000s, the rate at which the US is borrowing from the rest of the world - our current account deficit - has come down considerably.

The current account deficit peaked at around 6% of GDP in 2006 and has hovered around 2.5-3% over the past several years.

During the period when it looked like the US current account deficit was growing inexorably, there was quite a bit of discussion of "global imbalances" and whether or not the US' borrowing was sustainable.

Despite years of borrowing, the US tends to earn a positive balance on income - i.e., the US receives more in payments on assets it owns abroad than it makes to foreign owners of US assets.  Ricardo Hausmann and Federico Sturzenegger argued that national accounts understate the true value of US foreign assets.  They called the gap between the accounting value and the true value "dark matter", which they largely attributed to the know-how exported (but not properly measured) with US FDI.  (I revisited this idea in a previous post).

Writing at Project Syndicate, Jeffrey Frankel offers another idea on why our balance of payments accounts may make the US deficit look worse than it really is:

Every year, US residents take some of what they earn in overseas investment income – interest on bonds, dividends on equities, and repatriated profits on direct investment – and reinvest it then and there. For example, corporations plow overseas profits back into their operations, often to avoid paying the high US corporate income tax implied by repatriating those earnings. Technically, this should be recorded as a bigger surplus on the investment-income account, matched by greater acquisition of assets overseas. Often it is counted correctly. But there is reason to think that this is not always the case...

...For example, US multinational corporations sometimes over-invoice import bills or under-report export earnings to reduce their tax obligations. Again, this would work to overstate the recorded current-account deficit.

While the efforts that US multinationals make to evade their tax obligations are probably technically legal in most cases, they go against the spirit of the US tax law, which taxes US corporations based on their global earnings (whether it should be this way is another matter).  Since it arises from a gray area in our tax code, perhaps the we should call the resulting gap between our measured and true foreign assets "gray matter."

Update: Empirical evidence from Gabriel Zucman (QJE, 2013) that some of the "dark matter" is in tax havens...

Germany's Turn

The US Treasury:

Within the euro area, countries with large and persistent surpluses need to take action to boost domestic demand growth and shrink their surpluses. Germany has maintained a large current account surplus throughout the euro area financial crisis, and in 2012, Germany’s nominal current account surplus was larger than that of China. Germany’s anemic pace of domestic demand growth and dependence on exports have hampered rebalancing at a time when many other euro-area countries have been under severe pressure to curb demand and compress imports in order to promote adjustment. The net result has been a deflationary bias for the euro area, as well as for the world economy. 

That is from the semi-annual "Report to Congress on International Economic and Exchange Rate Policies" (pdf).

Typically the headline from such reports is about China, as the US criticizes its policy of intervening to keep the RMB undervalued to support a trade and current account surplus, but stops short of officially declaring it a "currency manipulator" which could trigger a conflict (which some, like Paul Krugman, have said the US should be willing to start).

The shift in focus to Germany is a sign the policy discussion is catching up to reality.  Although it is still intervening in the foreign exchange market, China has allowed a significant appreciation of the RMB (and even more in real terms) over the past several years and its current account surplus has narrowed.  That said, its "rebalancing" is still far from complete - consumption remains very low as a share of GDP; the decrease in the share of net exports seems to have been made up for by an increase in investment rather than consumption (with the usual caveat that the data are less than perfect..).

The biggest threat to the world economy now is a crisis in Europe, and while the ECB has managed to calm (for now at least) fears of a dramatic collapse, the Euro-area economy is still in lousy shape, which is a tragedy for the millions unemployed there, and a drag on economic activity in the rest of the world.

The Treasury is correct that Germany's current account surplus plays a role - stronger demand growth in Germany would help the suffering "periphery" of Europe (Spain, Italy, etc..) by creating more demand for their exports.  But Germany continues to be in denial, as Bloomberg reports:

Germany today reiterated its rejection of the Treasury report, saying it doesn’t merit criticism. “There are no imbalances in Germany which require a correction of our growth-friendly economic and fiscal policy,” Finance Ministry spokesman Martin Kotthaus told reporters in Berlin. 

The difficulty, in part, comes from the moralistic connotations of some of the language used to discuss international flows.  That is, Germany is running a current account "surplus" which results from a high level of "savings", and saving and having a surplus sound like the results of virtuous behavior (while having deficits and low savings connote profligacy).  So the idea that German economic policy is part of the problem is a hard sell to politicians, commentators and voters (and even some economists who should know better).  But it takes two to have an imbalance.  Or as Karl Whelan put it on Twitter:

See German politicians know that running surpluses shows they are good morally upright people. All countries should run surpluses. With Mars
— Karl Whelan (@WhelanKarl) November 1, 2013

Germany wants all countries in EZ to run surpluses. But then we also need hard money and a strong euro which makes that almost impossible.
— Karl Whelan (@WhelanKarl) November 1, 2013

One thing that is lost is that the current account surplus implies a lower standard of living for German citizens because it means they get to consume less of what they make.  In the second quarter of 2013, private consumption accounted for only 57% of Germany's GDP (via OECD), which is pretty low (in the US, which tends to be on the high side, its around 70%).  While exporting always seems to sound great to everyone, every BMW that is exported to the US is one less BMW that a German gets to drive (and the surplus implies that Germany is getting pieces of paper - not Mustangs - in return).  In the case of China, policies that led to a high share of exports could be defended as a development strategy - while this meant that the level of consumption was lower at any point in time, it may have generated a higher growth rate.  Its harder to apply such a rationale to a relatively high-income country like Germany.

However, though I don't agree with FT columnist Gideon Rachman's defense of Germany, he is correct that the Treasury's timing is poor (the report is required by law), coming on the heels of the reports that the US might have been spying on Angela Merkel, and that episodes like the debt ceiling wrangle seriously damage US economic policy credibility. 

The Economist's "Charlemagne" has a nice column this week on subject.

Update: See also Paul Krugman.

Dark Matter: A Quick Revisit

Back in the days before the 2007-8 financial crisis, one of the big sources of anxiety among (some of us) macroeconomists was the US current account deficit, a measure of how much the US was borrowing from the rest of the world each year.

After running deficits for most of the 1980s, an export boom helped bring the current account back into a small surplus in 1991 (aided, that year, by the financial assistance the US received from other countries to pay for the Gulf War).  The deficit began to grow again in 1992, and in the mid-2000's seemed to be on an ever-increasing path.

US Current Account (% of GDP), 1980-2006

The flow of borrowing naturally generated an increasing net stock of debt - the United States' foreign liabilities exceeded its assets in 1986, and the net international investment position (assets minus liabilities) became increasingly negative during the 2000's.

Note that the change in the net international investment position doesn't exactly track the current account deficit because of changes in the values of assets.

And yet, while this data seemed to indicate that the US was on an unsustainable borrowing path - and perhaps facing the risk that the willingness of the rest of the world to lend to it could quickly evaporate in a "sudden stop" crisis, like a number of emerging market countries had experienced - the US continued to receive more in income from its foreign assets than it made in payments to foreign holders of US assets.  That is, the income balance part of the current account remained positive.

US Net Income from Abroad, 1980-2006

How could the US consistently generate positive net income from its assets even as it became an increasingly large net debtor?  Ricardo Hausmann and Federico Sturzenegger turned this question on its head - they argued that if the US was earning net income, it should not be considered a net debtor.  In their account US foreign assets were under-estimated, with the official numbers leaving out what they dubbed "dark matter".  In a December, 2005 op-ed, they explained:

We propose a different way of describing the facts. We measure the assets according to how much they earn and the current account by how much these assets change over time. This is just like valuing a company by calculating its earnings and multiplying by a price-earnings ratio. Of course this opens up methodological questions, but the discrepancies with official numbers are so big that the details do not matter. To keep things simple in what follows we just take an arbitrary 5 per cent rate of return, which implies a price-earnings ratio of 20.

Let's get to work. We know that the US net income on its financial portfolio is $30bn. This is a 5 per cent return on an asset of $600bn. So the US is a $600bn net creditor, not a $4,100bn net debtor. Since the assets have remained stable then on average the US has not had a current account deficit at all over the past 25 years. That is why it is still a net creditor.

We call the $4,700bn difference between our measure of US net assets and the standard numbers "dark matter", because it corresponds to assets that generate revenue but cannot be seen. 

This hypothesis generated a considerable amount of discussion, nicely summarized in this Economist article from January 2006.  Many economists were skeptical of such a blithe interpretation of the situation.  One of the people quoted by the Economist was William Cline:

Mr Cline agrees with the dark materialists when they say there is “something misleading about calling a country that makes money on its financial position the world's largest debtor”. But sadly he does not think Americans can stop worrying. After making $36.2 billion in 2004, America made just $4 billion on its net foreign assets in the first three quarters of 2005. If it continues on its present trajectory, it will shell out about $190 billion in 2010, Mr Cline calculates. Using Messrs Hausmann and Sturzenegger's methodology, America's net foreign assets would then amount to minus $3.8 trillion. A dark matter indeed.

Seven years later, the US current account remains in deficit, though much less so:

US Current Account (% of GDP), 2001-2011 

That is, the US is still borrowing from the rest of the world, but at a reduced pace.  The value of the US' net foreign assets has been volatile as markets and currencies have gyrated over the past several years, but the official data says the US is even more in debt to the rest of the world now:

 And yet, the balance of income on foreign assets is more in favor of the US now than ever before:

US Net Income from Abroad, 2001-2011

Repeating Hausmann and Sturzenegger's calculation today says that (as of the end of 2011) the US was a net creditor by $4540 billion.  Relative to the official net international investment position of $4030 billion, that implies a stock of "dark matter" of $8570 billion!

Although the main source of "Dark Matter" in Hausmann and Sturzzenegger's original reckoning was the "know how" that helped US firms earn higher returns on Foreign Direct Investment (i.e., this was the main missing export), the most relevant for understanding what's happened since is probably the idea that the US exports "liquidity" and "insurance" services by selling assets that are considered safe and liquid by the rest of the world (e.g. US Treasury and "agency" - Fannie Mae and Freddie Mac bonds), while buying riskier assets.

The worry, circa 2005, was that buyers of US debt would run for the exit, leading to a spike in US interest rates and a collapse in the dollar.  The crisis we actually got had the opposite effect, as everyone rushed into US debt, which has helped drive yields down.  The US' net income is boosted by the fact that its paying very low returns on all those Treasuries being held abroad these days.  In Hausmann and Sturzenegger's framework, the financial crisis has been a huge boon to US exports of (unmeasured) liquidity and insurance services.

Rebalancing Watch, China Edition

We'll be discussing the US-China trade imbalance in Econ 270 next week.  This played a prominent role in worries about "global imbalances" that were prevalent several years ago.  The concerns linger, but both the US current account deficit and China's surplus have come down significantly over the past several years. 

I discussed the US current account in a recent post.  China recently reported a trade deficit (!).  That was a bit of a fluke, according to The Economist:

China’s trade balance often dips around Chinese New Year, as export factories close for the festival. The holiday also arrived earlier this year than last, distorting the data. But even if the figures for January and February are added together, China ran a deficit of over $4 billion. Exports and imports typically rebound in sync as China gets back to work. This year, imports rebounded alone.

But the broader trend is for a significantly sinking surplus. Jeff Frankel attributes this to real appreciation:

[T]he yuan was finally allowed to appreciate against the dollar during 2005-08 and 2010-11, by 25% cumulatively [=17% + 8%]. Second, and more importantly, labor shortages began to appear and Chinese workers at last began to win rapid wage increases. Major cities raised their minimum wages sharply over each of the last three years [FT, Jan. 5]: 22% on average in 2010 and 2011 (somewhat less this year, in response to slowing demand: 8.6 % in Beijing, 13% in Shenzhen and Shanghai). Meanwhile another cost of business, land prices, rose even more rapidly.

As a result, whereas all signs still pointed to a substantially undervalued yuan as recently as four or five years ago, this is no longer the case. One important measure of undervaluation — a comparison of China’s prices with what is normal given the country’s level of income (the so-called Balassa-Samuelson relationship) — showed the renminbi as undervalued against the dollar by as much as 36% on 2000 data (Frankel, 2005) . Even after an improvement in the international price data, Balassa-Samuelson regressions estimated the undervaluation at roughly 30% in 2005 and 25% as recently as 2009. (Others had other ways of estimating undervaluation; see Goldstein, 2004, and those surveyed by Cline and Williamson, 2008.)

The renminbi’s real appreciation against the dollar over the last three years has amounted to 12%, reducing the degree of undervaluation by roughly half, depending on whether one measures it against the dollar or against all countries. More is to be expected, as Chinese relative wages continue to rise. In any case, China’s real exchange rate is already closer to this measure of equilibrium than are most countries’ exchange rates (Cheung, Chinn and Fuji, 2010).

However, Michael Pettis argues that China is trading external imbalances for internal ones (and trouble down the road...):

So is China rebalancing?  Of course not.  Rebalancing would require that the domestic consumption share of GDP rise.  Is the consumption share of GDP rising?  Clearly not.  If consumption had increased its share of GDP since the onset of the crisis, the savings share of GDP would be declining.

And yet savings continue to rise.  This is the opposite of rebalancing, and it should not come as a surprise.  Beijing is trying to increase the consumption share of GDP by subsidizing certain types of household consumption (white goods, cars), but since the subsidies are paid for indirectly by the household sector, the net effect is to take away with one hand what it offers with the other.  This is no way to increase consumption.

Meanwhile investment continues to grow and, with it, debt continues to grow, and since the only way to manage all this debt is to continue repressing interest rates at the expense of household depositors, households have to increase their savings rates to make up the difference.  So national savings continue to rise.

That sounds like trouble, though this Economist article noted that there are some reasons to believe that estimates of Chinese consumption might be understated:

China’s official statistics show private consumption growing less quickly than the economy as a whole from 2001 to 2010. But they also show retail sales growing faster than GDP from 2008 to 2010. The discrepancy is partly because China’s retail-sales figures include some things they should not (such as government purchases and sales of chemicals and other wholesale goods), and miss out other things (like health care and other services), that are a big part of consumer spending. But several economists also believe the official figures understate private consumption.

To derive an alternative measure, Yiping Huang and his colleagues at Barclays Capital, an investment bank, have tried to pick out those retail sales that are likely to reflect consumer purchases. He has combined those purchases with sales figures for service firms. By this alternative measure, consumption fell as a share of GDP until 2008, but started growing strongly thereafter. “Rebalancing of the Chinese economy has already started,” the Barclays economists conclude.

US Borrows PI from the Rest of the World

A little PI day gift from the BEA, which released a preliminary estimate showing that US Current Account deficit as a share of GDP fell slightly last year, to 3.14%.  That's down a bit from 3.24% in 2010 (the actual deficit grew, but GDP grew more), and well off its peak of 5.98% in 2006.

The current account deficit is smaller than the trade deficit, which was 3.82% of GDP, reflecting the fact that the US receives more payments from foreign assets than it sends out.  This is true even though the value of US foreign assets is less than foreign-held assets in the US, because the US gets higher returns on its foreign investment than foreigners get on their investments here.  That doesn't mean the US is a lousy place to invest - it reflects the mix of assets held.  A large part of foreign-owned assets are low-yielding US treasury bonds, while US investment abroad tends to be more weighted towards higher-return (but riskier) equity investment.

The current account deficit represents how much the US is borrowing from the rest of the rest of the world. Roughly speaking, the part of our imports that aren't covered by exports or net income from foreign assets are paid for by selling I.O.U.'s (financial assets like stocks and bonds).

In 2005-06 there was a great deal of hand-wringing about the ballooning deficit and worry about how much longer the rest of the world would be willing to lend to the US.  While it hasn't gotten much attention, amidst all the hysteria about debt, it is noteworthy that the US is now considerably less dependent on borrowing from the rest of the world than it was 6 years ago. 

Although the annual numbers suggest the US current account deficit may be stabilizing at a lower level, there are some worrying signs in the quarterly data.  In the fourth quarter, exports fell slightly and the balance on income decreased.  The widening trade deficit continued in more recent monthly data. This is where we may see the impact of rising oil prices (petroleum products account for over 40% of the US trade deficit) and the slump in Europe - not only is European demand not growing, the crisis is probably depressing the value of the Euro, which makes European exports cheaper relative to US goods.  In the actual fourth quarter data, exports to Europe increased slightly, but it is something to watch going forward.

On a related note, NPR recently ran a story on "reshoring" of manufacturing to the US.

A Silver Lining to the Debt Ceiling Fiasco?

In a recent Project Syndicate column, Stephen Roach shared some observations from recent conversations with Chinese policymakers, who were not pleased with the debt ceiling mess:

Senior Chinese officials are appalled at how the United States allows politics to trump financial stability. One high-ranking policymaker noted in mid-July, “This is truly shocking… We understand politics, but your government’s continued recklessness is astonishing.”

Roach suggests that China may be losing its appetite for US Treasuries, and this, he believes, spells trouble for the US:

So China, the largest foreign buyer of US government paper, will soon say, “enough.” Yet another vacuous budget deal, in conjunction with weaker-than-expected growth for the US economy for years to come, spells a protracted period of outsize government deficits. That raises the biggest question of all: lacking in Chinese demand for Treasuries, how will a savings-strapped US economy fund itself without suffering a sharp decline in the dollar and/or a major increase in real long-term interest rates?

The US should hope he's right.  An abrupt reversal would be very disruptive, though it would probably do more harm to China than the US (provided the Fed steps in to limit the increase in US interest rates).  But China's massive purchases of US assets aren't a benefit to the US overall - they are part of a policy that has distorted the US economy away from tradable goods production and towards excess homebuilding (and asset bubbles).

The reason China has accumulated gigantic holdings of US Treasuries is that it has been intervening in foreign exchange markets - selling renminbi for dollars - to keep the value of its own currency down and the dollar up.  It then invests the dollars in Treasuries (i.e., the Treasury bond holdings are a consequence of the foreign exchange policy).  The result is US-produced goods are more expensive relative to Chinese goods. This contributes to the trade imbalance and reduces the size of US exporting and import-competing sectors.  Furthermore, many other countries feel the need to undertake similar interventions to maintain competitiveness vis a vis China, so it is not just the bilateral trade balance that is affected.

According to Roach, China has recognized the need to "rebalance" its own economy to rely less on exports and more on domestic consumption:

China has adopted a very transparent response. Its new 12th Five-Year Plan says it all – a pro-consumption shift in China’s economic structure that addresses head-on China’s unsustainable imbalances. By focusing on job creation in services, massive urbanization, and the broadening of its social safety net, there will be a big boost to labor income and consumer purchasing power. As a result, the consumption share of the Chinese economy could increase by at least five percentage points of GDP by 2015.

If the debt ceiling mess has given China's leadership a greater sense of urgency to get on with that, that's a good thing for them, and for us.

Roach's column came out before the S&P downgrade, but that may have reinforced China's views.

The Savings Glut, Revisited

In a speech on "Global Imbalances" today in Paris, Ben Bernanke revisited the "savings glut" hypothesis he offered in 2005.  The current account balance (CA) is the difference between investment (I) and net national saving (NS):

 CA = NS-I

A current account deficit occurs when investment is greater than domestic saving - the gap is filled by selling assets to the rest of the world.

Although it is commonplace to criticize deficit countries for low savings - and the savings rate in the US did indeed become very low - Bernanke argued in 2005 that the US current account deficit was driven by foreign savings.  The financial inflows stemming from the foreign "savings glut" drove up the prices of US assets (including bonds, thereby driving down interest rates), and the decline in US savings followed from the resultant increase in wealth.

As a share of GDP, the US current account deficit peaked at just over 6% of GDP in early 2006.

I today's speech, Bernanke cites evidence that there was strong international demand for "safe" US assets, which supports his 2005 hypothesis.

He is careful not to blame the financial inflows for the crisis.  The failure was how the US dealt with them.  This has a parallel to the 1997 Asian financial crisis:

The preferences of foreign investors for highly rated U.S. assets, together with similar preferences by many domestic investors, had a number of implications, including for the relative yields on such assets. Importantly, though, the preference by so many investors for perceived safety created strong incentives for U.S. financial engineers to develop investment products that "transformed" risky loans into highly rated securities. Remarkably, even though a large share of new U.S. mortgages during the housing boom were of weak credit quality, financial engineering resulted in the overwhelming share of private-label mortgage-related securities being rated AAA. The underlying contradiction was, of course, ultimately exposed, at great cost to financial stability and the global economy.

To be clear, these findings are not to be read as assigning responsibility for the breakdown in U.S. financial intermediation to factors outside the United States. Instead, in analogy to the Asian crisis, the primary cause of the breakdown was the poor performance of the financial system and financial regulation in the country receiving the capital inflows, not the inflows themselves. In the case of the United States, sources of poor performance included misaligned incentives in mortgage origination, underwriting, and securitization; risk-management deficiencies among financial institutions; conflicts of interest at credit rating agencies; weaknesses in the capitalization and incentive structures of the government-sponsored enterprises; gaps and weaknesses in the financial regulatory structure; and supervisory failures.

Ouch.  That's harsh, though he could take the Asia analogy one step further - as Simon Johnson does - and acknowledge that the "breakdown" in the US was partly because we have our own form of "crony capitalism" where the financial industry has, to a degree, captured the regulatory and political system.

Bernanke also has an uncomfortable analogy for the surplus countries that are not allowing their currencies to appreciate:

These issues are hardly new. In the late 1920s and early 1930s, the U.S. dollar and French franc were undervalued, with the result that both countries experienced current account surpluses and strong capital inflows. Under the unwritten but long-standing rules of the gold standard, those two countries would have been expected to allow the inflows to feed through to domestic money supplies and prices, leading to real appreciations of their currencies and, with time, to a narrowing of their external surpluses. Instead, the two nations sterilized the effects of these capital inflows on their money supplies, so that their currencies remained persistently undervalued. Under the constraints imposed by the gold standard, these policies in turn increased deflationary pressures and banking-sector strains in deficit countries such as Germany, which were losing gold and foreign deposits. Ultimately, the unwillingness of the United States and France to conduct their domestic policies by the rules of the game, together with structural vulnerabilities in financial systems and in the gold standard itself, helped destabilize the global economic and financial system and bring on the Great Depression. 

In his central banker-ly caution, he refuses to name names, but he's obviously alluding to China's policy of keeping renminbi undervalued. 

Although he has a knack for giving very comprehensive speeches sometimes, there are some important closely-related issues that Bernanke did not touch on this time.  In particular, the demand for US assets was partly due to the fact that the dollar is the most widely-used "reserve currency" (i.e., held in official portfolios).  This periodically generates complaints from the rest of the world (and for the US, its a mixed blessing), but Bernanke did not point to any alternative.  Nor did he suggest that it gives the US any special responsibility (and, personally, I don't believe that it does).  Also, one significant motive for reserve accumulation is self-insurance - countries burned by reliance on inflows of foreign savings decided to build up their own.  An better international insurance mechanism would reduce that need.  In theory, that is part of what the IMF is supposed to provide.

Update: A nice response to the gold standard analogy from Free Exchange.

Rebalancing Watch

International trade fell sharply during the worst days of 2008-09, and this was reflected in a sharp decline in the US trade deficit.  One of the big questions in the recovery is whether the trade deficit (or, more broadly, the current account deficit) will return to its pre-crisis level.  That is, was the reduction in the deficit temporary, or have we achieved some "rebalancing"?

Friday's advance estimate of GDP provides some encouragement in this regard.  The US economy still has a long way to go, but it is now at least back to its pre-recession level of output.  The trade deficit remains smaller than it was before the recession - it was 3.3% of GDP in the 4th quarter of 2010, versus 4.9% in the last quarter of 2007.

The widening trend that began in mid-2009 appears to have leveled off or reversed.  Menzie Chinn James Hamilton suspects that the decline in the trade deficit in the quarter was tied to the decline in inventory accumulation:

But the fact that a huge negative contribution of inventories coincided with a huge positive contribution of imports does not seem to be a coincidence. There's a clear pattern in the recent data that when one of these makes a positive contribution to GDP growth, the other makes an offsetting negative contribution. Although we often think of inventories as a substitute for production (you could either produce a good or sell it out of inventories), in the current environment inventories seem to act more as a substitute for imports (you could either import the good, or sell it out of inventories).

Nonetheless, it looks like the trade deficit may not headed back to where it was. What happens going forward depends in large part on what happens with the US' trading partners.  Faster growth in the rest of the world should reduce the trade deficit.  We're seeing this in much of the developing world, which is recovering more quickly (indeed many emerging markets now face a danger of inflationary overheating).

At Project Syndicate, Martin Feldstein argues that one of the major surpluses, China's, will come to an end because its astronomical saving rate is headed down:

China’s national saving rate – including household saving and business saving – is now about 45% of its GDP, which is the highest rate in the world. But, looking ahead, the five-year plan will cause the saving rate to decline, as China seeks to increase consumer spending and therefore the standard of living of the average Chinese.

The plan calls for a shift to higher real wages so that household income will rise as a share of GDP. Moreover, state-owned enterprises will be required to pay out a larger portion of their earnings as dividends. And the government will increase its spending on consumption services like health care, education, and housing.

These policies are motivated by domestic considerations, as the Chinese government seeks to raise living standards more rapidly than the moderating growth rate of GDP. Their net effect will be to raise consumption as a share of GDP and to reduce the national saving rate. And with that lower saving rate will come a smaller current-account surplus.

Of course, declining savings only reduces the current account if investment doesn't also fall with it.

Real exchange rates play a role, too, and in this regard, inflation in China is causing its exports to become more expensive, its intervention to hold down the nominal exchange rate notwithstanding.  The Times' Keith Bradsher reports:

Inflation is starting to slow China’s mighty export machine, as buyers from Western multinational companies balk at higher prices and have cut back their planned spring shipments across the Pacific...

Already, the slowdown in American orders has forced some container shipping lines to cancel up to a quarter of their trips to the United States this spring from Hong Kong and other Chinese ports. 

See also this recent post.  Whether it comes by inflation or a movement in nominal exchange rates, a Chinese real appreciation would take some pressure off other developing countries which are shadowing China in holding down their currencies.

The Ultimate Response to "the Chinese Professor"

One unfortunate aspect of tough economic times is that the fear and anxiety that people feel can be exploited with appeals to tribalism.  For example, a group called "citizens against government waste" has been pushing a right-wing political agenda with this ad:



There are any number of substantive flaws in the ad's argument I could point out, but I could not hope to respond better than this hilarous parody, from Taiwan's Next Media Animation:



That comes to my attention via James Fallows (see also his post on the original ad).

What Happens to a Global Rebalancing Deferred?

Tim Duy notes that the shifts in relative global demand that would lead to a 'rebalancing' of current account deficits and surpluses seem to be on hold. With the crisis in Europe leading to a decline in the euro, which, in turn appears to have given China cold feet about letting the yuan rise, it looks like we may be back to the status quo ante where the US is the world's "consumer of last resort". He concludes:

Where does this all leave us? The rest of the world is intent on pursuing a begger thy neighbor strategy, with the US being the neighbor. I suspect US policymakers will eventually relent; it will be the only choice left. All we can do now is sit back and wait for the inevitable explosion in the US trade deficit, waiting idly by for the next crisis and the "chance" to bring some sanity to the global financial architecture.

Michael Pettis believes that the European crisis makes the yuan revaluation more urgent, but he is not optimistic that the powers-that-be see it that way. He worries the end result will be trade tension and protectionism:

Most policymakers around the world – while publicly excoriating the US for its spendthrift habits – are intentionally or unintentionally putting into place polices that require even greater US trade deficits.

This cannot be expected to happen without a great deal of anger and resistance in the US. The idea that suffering countries should regain growth by exporting more to the world, and that rapidly growing surplus countries should not absorb much of this burden, will only force the US into even greater deficits as US unemployment rises to reduce unemployment pressure in Europe, China, Japan and elsewhere.

I would be surprised if the US accepted this with equanimity. On the contrary, I expect it will only exacerbate trade tensions and ensure that next year the dispute will become nastier than ever.

Of course, real exchange rates can adjust due to price changes as well as exchange rate movements. Some of the recent wage gains by Chinese workers give some reason for optimism. In a story about rising prices of Chinese exports, the Times' David Barboza writes:

Last week the Japanese automaker Honda said it had agreed to give about 1,900 workers at one of its plants in southern China raises of 24 to 32 percent, in hopes of ending a two-week strike, according to people briefed on the agreement. The new monthly average would be about $300, not counting overtime.

And last Thursday, Beijing announced that it would raise the city’s minimum monthly wage by 20 percent, to 960 renminbi, or about $140. Many other cities are expected to follow suit.

Analysts say the changes result from the growing clout of workers in China’s economy, and are also a response to the soaring food and housing prices that have eroded the spending power of workers from rural provinces. These workers, without factoring in the recent wage increases by some employers, typically earn $200 a month, working six or seven days a week.

But there are other reasons. Analysts say Beijing is supporting wage increases as a way to stimulate domestic consumption and make the country less dependent on low-priced exports. The government hopes the move will force some export-oriented companies to invest in more innovative or higher-value goods.

Also, other emerging market countries are providing another engine of demand. At project syndicate, Mohammed El-Arian and Michael Spence write:

Over the past two years, industrial countries have experienced bouts of severe financial instability. Currently, they are wrestling with widening sovereign-debt problems and high unemployment. Yet emerging economies, once considered much more vulnerable, have been remarkably resilient. With growth returning to pre-2008 breakout levels, the performance of China, India, and Brazil is an important engine of expansion for today’s global economy.

High growth and financial stability in emerging economies are helping to facilitate the massive adjustment facing industrial countries. But that growth has significant longer-term implications. If the current pattern is sustained, the global economy will be permanently transformed. Specifically, not much more than a decade is needed for the share of global GDP generated by developing economies to pass the 50% mark when measured in market prices.

(see also Mark Thoma's comments).

The Daily Show on Global Rebalancing

The reduction in the trade deficit means a shift in tradable goods production to the US. Or, as the Daily Show's Aasif Mandvi puts it: "you're telling me that we Americans have to make our own cheap plastic crap?"

The Daily Show With Jon Stewart	Mon - Thurs 11p / 10c
Wham-O Moves to America
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Even before China's recent decision to allow the Yuan to resume appreciating, increasing costs due to higher inflation meant it was becoming less undervalued in real terms.

Looking at the factory in the background suggests that Wham-O's manufacturing in the US is very capital-intensive, as standard trade theory would predict since the US is, relative to China, a capital abundant country (however, this may be an example of a violation of the "no factor intensity reversals" assumption...).

See also this report on the Daily Show's visit from Wham-O's local paper.

Stiglitz Says Chill Out on China

At Project Syndicate, Joseph Stiglitz argues that it would be counterproductive for the US to confront China over the exchange rate. He concludes:

Since China’s multilateral surplus is the economic issue and many countries are concerned about it, the US should seek a multilateral, rules-based solution. Imposing unilateral duties after unilaterally labeling China a “currency manipulator” would undermine the multilateral system, with little payoff. China might respond by imposing duties on those American products effectively directly or indirectly subsidized by America’s massive bailouts of its banks and car companies.

No one wins from a trade war. So America should be wary of igniting one in the midst of an uncertain global recovery – as popular as it might be with politicians whose constituents are justly concerned about high unemployment, and as easy as it is to look for blame elsewhere. Unfortunately, this global crisis was made in America, and America must look inward, not only to revive its economy, but also to prevent a recurrence.

Though he doesn't name names, he clearly seems to be answering Paul Krugman's recent column on the subject (discussed in this earlier post).

Update: Krugman responds.

Update #2: See also Martin Wolf, who agrees with Krugman.

The Liberty of Insignificance

China no longer enjoys it, Martin Wolf writes:

A country’s exchange rate cannot be a concern for it alone, since it must also affect its trading partners. But this is particularly true for big economies. So, whether China likes it or not, its heavily managed exchange rate regime is a legitimate concern of its trading partners. Its exports are now larger than those of any other country. The liberty of insignificance has vanished.

Don't Like International Capital Mobility?

Blame French socialists, says Dani Rodrik (in the context of a Project Syndicate column in favor of Brazil's tax on short term capital flows):

It may seem curious that [IMF Managing Director] Strauss-Kahn’s instincts are so off the mark on the matter of capital controls. One might have thought that a socialist, and a French Socialist at that, would be more inclined toward finance skepticism.

But the paradox is more apparent than real. Financial markets in fact owe French Socialists a great debt. Received wisdom holds the United States Treasury and Wall Street responsible for the push to free up global finance. But far more influential may have been the change of heart that took place among French Socialists following the collapse of their experiment in Keynesian reflation in the early 1980’s. When capital flight forced François Mitterrand to abort his program in 1983, France’s Socialists performed an abrupt volte-face and embraced financial liberalization on a global scale.

According to Harvard Business School’s Rawi Abdelal, this was the key event that set in motion the developments that would ultimately enshrine freedom of capital movement as a global norm. The first stop was the European Union in the late 1980’s, where two French Socialists – Jacques Delors and Pascal Lamy (the president of the European Commission and his assistant, respectively) – led the way. Then it was the turn of the Organization of Economic Cooperation and Development (OECD). Eventually, the IMF joined the bandwagon under Michel Camdessus, another Frenchmen who had served as Governor of the Bank of France under Mitterrand.

A New Cop on the Imbalances Beat?

The President's trip to China next week induces a bit of nostalgia for those famous "summit" meetings of the Cold War, when the "leader of the free world" would go "toe-to-toe with the Russkies."

Of course its far better, though perhaps less dramatic, that the meetings will deal with the "balance of financial terror" instead of nuclear terror. One element of reducing that terror will be convincing China to relax its de facto Dollar peg (but not too abruptly, please). Simon Johnson suggests an approach to deal with this issue:

Talking in public about big sticks never goes down well in Asia, and the administration should deny any inclination in this direction. But the mainstream consensus is starting to shift toward the idea that the World Trade Organization (W.T.O.), not the I.M.F., should have jurisdiction over exchange rates. The W.T.O. has much more legitimacy, primarily because smaller and poorer countries can bring and win cases against the United States and Western Europe in that forum. It also has agreed upon and proven tools for dealing with violations of acceptable trade practices; tailored trade sanctions are permitted.

No one wants to take precipitate action in this direction, but extending the W.T.O.’s mandate in the direction of exchange rates would take time — and presumably warrant discussion at the G-20 level. The United States has great influence over the G-20 agenda, and Mr. Obama’s staff members should hint, ever so gently, that this is where they see the process going.

Hmmm... living in Middletown Connecticut and Oxford Ohio, I'd missed the shift in the "mainstream consensus." Very interesting...

China's Cares for our (Fiscal) Health

The New Republic's Noam Scheiber reports that our largest creditor is, understandably, taking an interest in issues that affect the US government's future fiscal position:

To his surprise, when [Budget Director Peter] Orszag arrived at the site of the annual U.S.-China Strategic and Economic Dialogue (S&ED), the Chinese didn't dwell on the Wall Street meltdown or the global recession. The bureaucrats at his table mostly wanted to know about health care reform, which Orszag has helped shepherd. "They were intrigued by the most recent legislative developments," Orszag says. "It was like, 'You're fresh from the field, what can you tell us?' "

As it happens, health care is much on the minds of the Chinese these days. Over the last few years, as China has become the world's largest purchaser of Treasury bonds, the government has grown increasingly sophisticated in its understanding of U.S. budget deficits. The issue has become all the more pressing in recent months, as the financial crisis and recession pushed the deficit to record levels. With nearly half of their $2 trillion in foreign currency reserves invested in U.S. bonds alone, the Chinese are understandably concerned about our creditworthiness. And this concern has brought them ineluctably to the issue of health care.

The United States' dependence on foreign purchases of Treasury bonds means that no issue that affects the deficit is solely "domestic." The US has an interest in China's health care system, too, as it contributes to the high savings rate that fuels China's side of the current account imbalance. Scheiber writes:

The Chinese save such freakish amounts because consumer credit is scarce, insurance is rudimentary, and their social infrastructure is threadbare. They must often pay for houses in cash, and for medical procedures out of pocket.

Update (8/20): Ilian Mihov suggests (with evidence) that healthcare and education costs played a key role in the rise of US consumption.

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.

The MPC is Very Low

The BEA reports disposable income increased by $178 billion in May, while consumption increased $25 billion. In the textbook Keynesian framework, that implies an extremely small marginal propensity to consume of 0.14 (25/178). That, in turn, means a modest multiplier effect. While expansionary fiscal policy is still the right thing to do, a smaller multiplier means a larger stimulus is necessary to achieve a given increase in output.

Of course, the fluctuation in the MPC serves to highlight the limitations of the "consumption function" approach...

Another implication of incomes growing faster than consumption is an increasing savings rate. In May, the savings rate was 6.9%, which means we've quickly and painfully re-attained historically "normal" levels, according to this chart at Economix, after hovering near zero over the past several years. More domestic saving also means less borrowing from the rest of the world, which is reflected in a narrowing current account deficit.

Who is Beggar-ing Whose Neighbors?

The FT's Martin Wolf has an interesting column about global imbalances and the economic slump. He calls on the surplus countries to take responsibility for increasing global demand:

In normal times, current account surpluses of countries that are either structurally mercantilist – that is, have a chronic excess of output over spending, like Germany and Japan – or follow mercantilist policies – that is, keep exchange rates down through huge foreign currency intervention, like China – are even useful. In a crisis of deficient demand, however, they are dangerously contractionary.

Countries with large external surpluses import demand from the rest of the world. In a deep recession, this is a “beggar-my-neighbour” policy. It makes impossible the necessary combination of global rebalancing with sustained aggregate demand. John Maynard Keynes argued just this when negotiating the post-second world war order.

In short, if the world economy is to get through this crisis in reasonable shape, creditworthy surplus countries must expand domestic demand relative to potential output. How they achieve this outcome is up to them. But only in this way can the deficit countries realistically hope to avoid spending themselves into bankruptcy.

Some argue that an attempt by countries with external deficits to promote export-led growth, via exchange-rate depreciation, is a beggar-my-neighbour policy. This is the reverse of the truth. It is a policy aimed at returning to balance. The beggar-my-neighbour policy is for countries with huge external surpluses to allow a collapse in domestic demand. They are then exporting unemployment. If the countries with massive surpluses allow this to occur they cannot be surprised if deficit countries even resort to protectionist measures.

(For a similar argument by Michael Pettis, see this earlier post).

Dani Rodrik has a related worry, that America's propensity to import reduces the effectiveness of any stimulus because a significant portion of the spending will be on imported goods. That is, the marginal propensity to import reduces the simple spending multiplier (which he guestimates at 1.8):

Now suppose that we had a way to raise the multiplier by more than half, from 1.8 to 2.8. The same fiscal stimulus would now produce an increase in GDP of $2.8 trillion--quite a difference. Nice deal if you can get it.

In fact you can. It is pretty easy to increase the multiplier; just raise import tariffs by enough so that the marginal propensity to import out of income is reduced substantially (to zero if you want the multiplier to go all the way to 2.8). Yes, yes, import protection is inefficient and not a very neighborly thing to do--but should we really care if the alternative is significantly lower growth and higher unemployment? More to the point, will Obama and his advisers care?

Being the open economy that it is, I fear that the U.S. will have to confront this dilemma sooner or later. In an environment where the dollar has already appreciated against the Euro and even more significantly against emerging market currencies, fiscal stimulus here will produce an even larger current account deficit. If American consumers decide to spend 40 cents of a dollar of additional income on cheap imports from China and other foreign countries, the multiplier will be a mere 1.3. How long will it take before politicians of all stripes cry foul over the leakage through the trade account and the "gift to foreigners" that this represents? And they will have Keynesian logic on their side.

One would hope that a decline in the Dollar - though not too abruptly, please - could be an adjustment mechanism (even if panic-induced demand for US Treasuries has moved the Dollar in the other direction lately) but Chinn and Wei's finding that flexible exchange rates do not facilitate current account adjustment suggests otherwise. That's counter-intuitive, but I guess I shouldn't be too surprised; some of my own work has studied another aspect of the "exchange rate disconnect" puzzle.

Global Rebalancing and the Depression

On his China Financial Markets Blog, Michael Pettis draws a parallel between the global imbalances of the depression and those today, with the US of the 1920's in surplus the country role played by China today:

In the 1920s excess and rising capacity in the US could be exported, mostly to Europe, while massive foreign bond issues floated by foreign countries in New York permitted countries to run large deficits, but as the US continued investing in and increasing capacity without increasing domestic demand quickly enough, it was inevitable that something eventually had to adjust. The financial crisis of 1929-31 was part of that adjustment process, and it was not just the stock market that fell – bond markets collapsed and bonds issued by foreign borrowers were among those that fell the most. This, of course, made it impossible for all but the most credit-worthy foreigners to continue raising money, and by effectively cutting off funding for the current account deficit countries, it eliminated their ability to absorb excess US capacity.

The drop in foreign demand forced the US either massively to increase domestic demand or massively to cut back domestic production. The fact that another consequence of the financial crisis was a collapse of parts of the domestic banking system, leading to banking panics and cash hoarding, meant, as it often does in a global crisis, that the US had to adjust to a drop in demand both domestically and from abroad. But instead of expanding aggressively, as Keynes demanded, FDR expanded cautiously, and in 1937 even decided to put the fiscal house back in order by cutting fiscal spending, thereby stopping the recovery dead in its tracks.

In this situation, Pettis believes that the surplus countries - most especially China - need to generate additional demand. The recently announced Chinese stimulus package seems like a good step in this direction, but he sees some counter-productive moves as well:

...I worry that the global problem has never been a lack of US demand – it has been lack of Asian demand. The US has already provided a greater share of global demand than is healthy for either the US or, as we have clearly seen, for the world.

A massive fiscal expansion by the US would certainly boost global demand, but it would do so at the expense of increasing US indebtedness by far more than it increases demand for US goods (much of the expansion in demand would simply be exported to countries that continue to suffer from overcapacity) and of course it would not solve the global overcapacity problem. It might even exacerbate it. The best that one could hope for, if the US took the lead in fiscal expansion, is that Asian countries make heroic efforts to shift their economies as quickly as possible from export dependence to domestic demand dependence, but I have already argued that with the best will in the world this will be a long and difficult process, and I am not sure anyway that most countries have the political will to force the shift. China, for example, is raising export rebates and talking about depreciating the currency – hardly the actions of a country working hard to reduce global overcapacity.

Hm... under the circumstances, I think we might want to try the "massive fiscal expansion" and worry about imbalances later. There is no sign that the US Treasury will have any trouble borrowing as much as it wants.