By Richard Alford, a former economist at the New York Fed. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.
Calls for global rebalancing are back in vogue, while the debate about the appropriate stance of domestic policy heats up again. While there is disagreement about the exact role the global imbalances played in the run up to the financial crisis and the crisis itself, there is general agreement that a rebalancing of the global economy is necessary if we are to enjoy a return to sustainable growth. There is less than full agreement on the net benefits of further monetary and fiscal stimulus.
China is in the hot seat and the Yuan exchange rate remains the focus, even as the US is placing greater weight on continued Chinese fiscal stimulus. In addition, US-based macroeconomists and policymakers are now focusing on and criticizing proposed fiscal austerity in Europe. Their concern is not solely with European economic performance per se. Among their concerns is the perceived impact that European austerity would have on US economic performance. They view demand and income growth in Europe as the means by which the US will reduce its current account deficit. There is little or no mention of any need for the Euro, the Dollar, or any currency other than the Yuan to adjust to promote or support the rebalancing.
These positions reflect interesting wrinkles in US economists’ and policymakers’ mind sets. They are a variant on the old US policy position first espoused by the then Secretary of the Treasury John Connolly: It’s our currency, but it’s your problem. The current version is: It’s our current account deficit, but it’s your problem. Alternative wording of the revised up dated Connolly doctrine: If the rest of the world will just pursue expansionary fiscal monetary policies, then the US can avoid having to choose between austerity and unemployment on the one hand or further increasing unsustainable deficits on the other.
However, the idea that given global counter-cyclical stimulus and “Bob’s your uncle”, the US will return to sustainable noninflationary trend growth does not stand up to analysis. It is unlikely that counter-cyclical expansionary policy abroad will correct the US current account deficit or help restore trend growth. In fact, the idea that the solution to the current US economic woes lies in traditional counter-cyclical policy is being questioned. Recently, in the FT, Jeffrey Sachs wrote:
• Now, against a backdrop of a widening sovereign debt crisis we need to abandon short-term thinking in favour of the long-term investments needed for sustained recovery
• .. Certain countercyclical spending is vital on social grounds. But stimulus measures …reflected a hope that a temporary fiscal bridge could carry us back to consumption and housing led growth — a dubious proposition since the old “normal” had been this financially unsustainable.
Sachs offered a number of guidelines for economic policy consistent, in his view, with restoring sustainable trend growth. They included:
• government should work with a medium-term budget framework of five years and within a decade-long strategy on economic transformation.
• governments should steer their economies towards needed long-term structural transformation. External deficit countries such as the US and UK will need to promote exports over the next five years …
• we need, in sum, to reset our macro timetables. There are no short-term miracles, only the threat of more bubbles if we pursue economic illusions…
Sachs cites the need for the US to promote export growth and not simply expand domestic demand. The language suggests that he believes that the US external position reflects a structural problem that has to be addressed if the US is to achieve sustainable trend growth. Furthermore, Sachs is not alone in his beliefs that inappropriate economic policy can contribute to the growth of the economic imbalances. For example, Edwin Truman writes:
“Instead, the imbalances and the crisis were jointly caused by flaws in the design and implementation of macroeconomic policies and the resulting global credit boom.”
If a return to external balance or at least a trade deficit of a sustainable size is required for the US to achieve sustainable growth and avoid future crises, is it reasonable to assume that demand stimulus abroad alone would bring about the required structural transformation in the US economy? There are numerous reasons to believe that is not the case. Returning to Truman:
Current account balances are endogenous to the economics of the overall economic and financial system. A country’s recorded, ex-post current account position must simultaneously satisfy three relationships: the difference between net domestic savings and net domestic investment, the difference between domestic production (output) and domestic demand (often referred to as absorption), and the difference between the net change in the demand for domestic assets by the rest of the world and the supply of those assets…
It follows that external adjustments also require parallel domestic adjustments in order to succeed. Calling on our trading partners to increase demand and their imports from the US will not narrow the trade deficit unless there is a narrowing of “the difference between net domestic savings and net domestic investment…”, but US domestic economic policy is not supportive of the required domestic adjustment. Continued deficit financing of stimulus packages widens the difference between net savings and investment. Monetary policy is also geared towards increasing consumption and reducing private savings. To the extent that a significant fraction of the consumer basket is comprised of imported goods and the US income elasticity of demand for imports is high, stimulating consumer demand increases domestic demand (often referred to as “absorption”) relative to domestic output. In short, US domestic economic policy is inconsistent with an effort to achieve external balance and hence a return to sustainable growth. Back to Truman for a moment:
It also follows that a large country has the capacity through the application its own policies to achieve, within a reasonable range, is preferred current account position….
Given that US macroeconomic policy remains inconsistent with reducing the external deficit (in fact, it is just the opposite), our trading partners might very well ask why they should deviate from their chosen policy stances to help the US reduce its external deficit when it is unwilling to adjust its own domestic policies to achieve that end.
The relative downplaying of the importance of exchange rate adjustment in addressing the US trade imbalance is also troubling. If the US is to correct its external imbalance, resources (capital and labor) are going to have to be reallocated to the production of tradable goods and services. In the absence of Dollar exchange rate adjustments, it is difficult to see reasons why the US economic agents would move into the tradable sector. In recent years, if anything, US resources have been moving in the opposite direction. It is unlikely that economic agents in the US will return to the tradable goods and services sector solely on the basis of promises by our own policymakers or other policymakers that demand for US exports will increase.
While exchange rate adjustments will not alone correct the imbalance, it is difficult to see a solution without some exchange rate adjustment. It is virtually impossible to see it given the absence of exchange rate adjustment coupled with fiscal and monetary policies which are inconsistent with a narrowing of the imbalance.
Returning to the principle point, the US faces structural and not just cyclical economic problems. The structural problems are reflected in mutually determined unsustainable current account and fiscal deficits, as well as depressed saving rates. It is easy to see evidence of structural problems in economic performance, All one has to do is look at recent economic performance (e.g. growth rates, growth in real wages, the number of workers who have joined the long-term unemployed etc.) relative to earlier periods and recognize that those less than satisfactory outcomes were only achieved with virtually constant economic policy stimulus (e.g. the cyclically adjusted Federal fiscal deficit) and asset-price-bubble-induced unsustainable increases in consumption relative to income. (See Brenner for evidence of the structural dimension of the current crisis.)
Once one recognizes that the US is contending with structural as well as cyclical problems, then it is clear that a move to sustainable trend growth requires something other than the standard countercyclical stimulus. In order to achieve balanced sustainable growth the US will have to increase savings (relative to income and consumption), increase investment relative to income, and increase the production of tradable goods versus nontradable goods. However current US policy has consisted of efforts to stimulate private consumption (decrease savings), increase public dis-saving, subsidize consumption of nontradable goods (housing) all coupled with perfunctory calls for exports to double.
Unfortunately, the US does not face a simple choice between lower fiscal deficits and idle resources on the one hand, and temporarily higher deficits and trend growth with full employment on the other. Or, as Sachs put it: “There are no short-term miracles…” The US also faces a choice between addressing the causes of structural imbalances now, perhaps at the expense of idle resources, or addressing the same problems in the future when the costs of adjustment will undoubtedly be higher. The costs of addressing the global imbalances now are higher than they would have been had they been addressed in 1996 or 2001.
Economic stimulus, which is not accompanied by steps to address the underlying structural problems, is a pernicious palliative. It will mask the costs of the structural problems; reduce any incentive politicians and policymakers have to pursue short-term costly, but longer-term higher payoff policies; and at the same time allow for the costs to resolve imbalances to fester.