Full disclosure: I’m normally a fan of Mohamed El-Erian, former head of Harvard Management, now co-president of bond giant Pimco. But his current comment in the Financial Times, “How best to manage global imbalances,” struck me as more than a tad disingenuous.
Let’s go through the article:
Whatever happened to the debate on global payments imbalances?…At its roots, the policy solution called for simultaneous implementation of three sets of measures. First, a reduction in US domestic aggregate demand to contain imports and encourage a shift to exports. Second, an increase in consumption in Asia and the Middle East, including having China adopt a higher and flexible exchange rate. Third, structural reforms in western Europe to enhance the growth potential of the global economy.Most observers agreed on the elegance and theoretical potency of this policy combination, which reduces imbalances in the context of high global growth, contained inflation and relatively stable financial markets. Indeed, the question was never about design. It was about implementation.
I may be about to put foot in mouth and chew, but I follow the economic press pretty closely and saw no evidence of a discussion along the lines El-Erian indicates. Perhaps there was an article in Foreign Affairs that I missed, but the discussions I’ve read among top level economists seems still to be in the “is the culprit the savings glut in developing countries or is it overconsumptoin in America?” stage.
Now El-Erian does travel in elevated circles, so this idea may have been kicked around, but for it to have gotten anywhere, it would have had to either come out as an official recommendation of an august body or been otherwise pre-sold, via speeches and op-ed pieces. I have seen no trial balloons ANYWHERE in the US by anyone prominent arguing that a recession would be a good thing (um, that’s what “reduction in domestic aggregate demand” means). You’d need to do a pretty hard sales campaign, and I find no evidence of one.
And how could the Fed go along, given its mandate of full employment and price stability? That too would take a bit of artwork.
The only reference I have ever seen to something along El-Erian’s line of thinking was from El-Erian himself and Michael Spence in a Wall Street Journal op-ed more than a year ago, Except then they presented it as a scenario of how global imbalances could work themselves out on their own, not a policy recommendation. From the Journal:
Now to the future. Over time, emerging markets will inevitably divert more of their assets to more sophisticated investments abroad. That shift will have many effects, some of which depend on the decisions taken by emerging economies while others depend on the evolution of the global context….While the shift is inevitable, it would be unlikely that the emerging economies as a group would deliberately take actions that directly undermine global economic markets. There will also be domestic pressure on policy makers in emerging countries to gradually shift their emphasis away from the producer and towards the consumer…
Under this state of the world, domestic consumption in the rest of the world picks up over time, facilitating the needed adjustment in the U.S. The result is a gradual journey to a more normal relationship between assets and income returns, with savings moving to a more normal long-run pattern.
But this process is not automatic…. it is particularly sensitive to “policy mistakes.”
Among these policy mistakes, protectionism measures in the U.S. would derail the global adjustment So, too, would the inability of emerging economies to navigate their complex policy challenges.
Geopolitical shocks would also be a problem,….Finally, significant “market accidents” that, in the past, have been associated with excessive leverage and triggered sudden and large portfolio changes and credit rationing, would add to the policy complexity.
So where does all this leave us? The current configuration of global imbalances, while highly unusual is not a real puzzle. It is the result of a series of individual decisions in both advanced and emerging economies that were largely rational when considered at the micro level.
These decisions reflected individual self interest, and happened to coincide. The aggregation of these decisions at the national and international levels raises considerable challenges, as does the ability to maintain an orderly global reconciliation process over time. The fundamental question, therefore, is whether these global considerations will be sufficient to minimize the risk of “policy mistakes” in a world that is subject to geo-political risk and bouts of excessive leverage.
If this represented some sort of policy program agreed on in high circles, it was so coded that it went by me completely.
Back to the current offering from the FT:
The policy solution stalled because of a basic co-ordination problem, or what is known in game theory as the “prisoners’ dilemma”. While all parties had an interest in the outcome, any individual party that moved first risked being worse off if others did not follow. With multilateral co-ordination mechanisms such as the Group of Seven industrial countries and the International Monetary Fund lacking representation and legitimacy, there was no way to provide parties with sufficient assurances that their actions would be accompanied by others. As a result, no one took sufficiently meaningful action.
Again, El-Erian says pretty directly that this idea got at least to the talking stages. But who in the US has the authority to push the economy into a recession? The last guy who did that, Volcker, had Carter’s blessing and even broader support (at least initially) because there was a general recognition that inflation had gotten to a level that was painful. We aren’t even close to that sort of consensus on our trade deficit or lack of savings as a problem.
The Europeans agreeing to “structural solutions” I assume is code for more more flexible labor markets. But Europe is not a major actor in the global imbalances story, so it isn’t clear why they should go along and impose unpopular measures to solve a problem not of their making. And the Chinese building a consumer economy is a much longer time horizon process than cutting domestic demand might be in the US. How do you sync the two programs?
Back to El-Erian:
With the policy solution stuck, the process is now being driven by the reality that components of the imbalances have reached their natural point of exhaustion. The risk is that while the imbalances will be corrected over time, it will be at a high cost for the global economy. Relative prices are now leading the adjustment process through the impact of a substantial terms-of-trade shock led by the surge in oil and food prices. Second-round effects, via the prices of other goods and wages in some emerging economies, will also be in play.The price shock will serve to undermine real incomes in the US and lower imports. On the policy front, it will accentuate the tug of war that the Federal Reserve faces on account of its now conflicting inflation and employment objectives. Emerging economies face greater inflation in the context of their buoyant liquidity conditions. Several will see their real effective exchange rates appreciate, by means including measures to allow the nominal exchange rate to appreciate markedly against the dollar. In Europe, growing demands for wage increases may force companies to step up structural reforms and will cause the European Central Bank to increase its hawkish rhetoric.
Under this scenario, the question for markets is no longer whether the global imbalances adjust. They will. Instead, the focus should be on the collateral damage of the adjustment process – damage that is region-specific given differences in policy flexibility and initial economic and financial conditions. In the US, look for renewed pressure for further fiscal stimulus and a monetary policy that, while appropriate for the US, is too inflationary for the rest of the world. In Asia and the Middle East, the spike in inflationary pressures may inadvertently slow the move towards more efficient tools of indirect economic management. In Europe, expect attempts to bypass fiscal responsibility guidelines in order to mute political protest.
As this bumpy and disorderly process plays out, it is important not to lose sight of important lessons. Indeed, the fact that the system has ended up eschewing the superior policy solution speaks to the urgency of learning from them. An increasingly interconnected world cannot maintain high growth and low inflation without a bold modernisation of the mechanisms for international policy co-ordination, starting with the G7. Governments must continue to refine their policy instruments and pay greater attention to the secondary and tertiary consequences of their actions. The private sector must assume greater responsibility for forward-looking risk management. In the absence of these changes, the inevitable adjustment of the global imbalances will continue to entail a serious cost in global welfare.
To be honest, I do not believe there is any pretty way out of the situation we are in.
However, I question El-Erian’s assumption at the beginning of the final paragraph, that we can have a highly interconnected world with high growth, low inflation, and some measure of stability. El-Erian believes that more powerful international institutions will do the trick, but there are limits to how much sovereignity nations are willing to sacrifice. I can’t see the US, China, or Russia ceding too much control.
And as we have noted before. some evidence suggests that free capital flows in and of themselves produce instability and crises. A recent paper by Kenneth Rogoff and Carmen Reinhart found that
Periods of high international capital mobility have repeatedly produced international banking crises, not only famously as they did in the 1990s, but historically.
Thus part of the solution may not lie in stronger international organizations, but more robust, and somewhat more self-contained domestic markets. The notion of China and India being less export and more domestic consumption oriented fits that pattern. And that in turn means a somewhat lower level of international trade and capital flows.
Danny 
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It’s an interesting comparison – between Volcker’s decision on inflation and a similar policy question re global imbalances.
International capital flows are largely a function of international trade imbalances. The horse is trade, the cart is capital flows, and the natural result is some monetary instability. China’s concentration of its reserve position mostly in US treasuries and agencies has been a bottleneck and catalyst for such instability. This is a great distortion of global risk allocation, essentially forcing the global private sector to be overweight risky assets.
As Brad Setser often reminds us, such analyses should pay a lot more attention to the usually high proportion of international capital flows that result from foreign central bank FX intervention and reserve positions, as well as their concentration in low risk assets. El-Erian doesn’t mention any of this.
The most visible thrust of US policy response so far seems not to be trade protectionism or monetary policy, but reciprocal asset protectionism via SWF investment restrictions.