Imbalance Preliminaries

1. G20 Guidelinesfor Persistently Large ImbalancesJeffrey FrankelHarpel Professor of Capital Formation & Growth Experts PanelG20 Working Groupon the Framework for Strong, Sustainable and Balanced GrowthParis, 13 January, 2011

2. Imbalance Preliminaries • First, we must reject the mercantilist view that trade deficits are always necessarily bad • Sometimes deficits make sense, • e.g., for a country that has just discovered oil.

3. An example of intertemporal optimization in practice: • When Norway discovered North Sea oil in 1970s, it temporarily ran a large CA deficit, • to finance investment (while the oil fields were being developed) • & consumption (as was rational, since Norwegians knew they would be richer in the future). Subsequently, Norway ran big CA surpluses.

4. Preliminaries,continued • Second, we must equally reject the view that current account deficits always necessarily represent intertemporal optimization • A developing country that runs a persistent large deficit risks an eventual crisis, • due to financial market imperfections • default risk, moral hazard, distorted incentives, • procyclical fiscal policy, procyclical capital flows…

5. In my judgment, it would indeed be useful if a current account deficit or surplus of 4% of GDP triggered a G-20 process to consider if the “imbalance” was a problem and, if so, what combination of policy responses is appropriate.

6. Example: the combination of a big US CA deficit and big Chinese CA surplus could result in a G-20 agreement that the US national saving rate and Chinese exchange rate are both part of the problem, and both require gradual but genuine adjustment. • It would be better than some alternatives: • hardlanding for the $ and new crisis; • US Congress passes WTO-illegal trade sanctions • as punishment for Chinese “currency manipulation”; • or China accuses US of QE2 “currency war.”

7. Can the academic literature shed light on indicator variables? • 10 years ago, economic research focused on two entirely distinct international financial problems: • (I) Crises in emerging markets • (II) G-7 current account imbalances. • Historic convergence: • a decade later, the two worlds overlap.

8. Today, major emerging markets: • are in the G-20, • float, • run current account surpluses, and • have lower debt than advanced economies. • Debt/GDP of the top 20 rich countries (≈ 80%) is twice that of the top 20 emerging markets, and growing. • Some EMs • have better credit ratings than some advanced economies, • have learned how to follow countercyclical fiscal policy • while the US, UK, and much of Europe have forgotten how to, and • were better able to weather the 2008-09 global recession.

9. What did we learn from the empirical literatureon emerging market crises? • Frankel & Saravelos (2010) survey 83 contributions in the pre-2009 EarlyWarningIndicators literature. • The indicators found useful most often, by far: • Foreign exchange reserves (e.g., relative to debt) • Real exchange rate (e.g., relative to historic PPP). • These were also the two indicators most often statistically significant in predicting, across 5 measures, how hard countries were hit by the 2008-09 global crisis. • Also useful: current account and national saving / GDP.

10. EWIs: The variables that show up as the strongest predictors of country crises in 83 studies are: (i) reserves and (ii) currency overvaluation Source: Frankel & Saravelos (2010)

11. Best and Worst Performing Countries -- F&S (2010), Appendix 4

12. F & Saravelos (2010):Multivariate

13. (II) What did we learn from the literature on G-7 current account imbalances?

14. Economists were split between Ken Rogoff * Maury Obstfeld Larry Summers Martin Feldstein Nouriel Roubini Menzie Chinn Me Lots more Ricardo Caballero * Richard Cooper Ben Bernanke Michael Dooley Pierre-O. Gourinchas Alan Greenspan Ricardo Hausmann Lots more those who saw the USdeficit as unsustainable, requiring a $ fall, & those who saw the US as providing a service. 14 * Some claim that the financial crisis of 2007-09 fit their theories.

15. Were current account imbalances the cause of the financial crisis, as many say? • Those of us who predicted an unsustainable US current account deficit and a $ hard landing were proven wrong by the 2008 movement into $. • Meanwhile, those who said the US CA deficit was sustainable because of the superior quality of US assets were also proven wrong. • corporate governance, • accounting system, • securities markets, rating agencies… MSN Money & Forbes

16. Were current account imbalances the cause of the financial crisis? continued • Not in my view. The financial excesses of 2001-2007 would have been pretty much the same even if each country’s inflows & outflows had netted out. • The US ran current account deficits (financed by foreign official $ purchases) as a side effect of excess liquidity and overspending, not primarily as a cause. • In net terms, private foreigners financed less of the US CA deficit than foreign central banks after 2003. • The story is in the gross volume of financial transactions, • not in net cross-border flows.

17. 7 challenges to “twin deficits” view US investment climate Global savings glut “It’s a big world” Valuation effects will pay for it US as the World’s Banker “Dark Matter” Bretton Woods II

18. Conclusion regardingsustainability of the imbalances: The 7 arguments are clever, but I am not convinced. Some of these arguments rely on $ retaining its unique role in world monetary system forever. But the US may not be able to rely on exorbitant privilege forever.

19. Conclusions for the G-20/IMF Mutual Assessment Process • Regardless whether one thinks that big current account imbalances caused the global financial crisis, 2007-09, they could cause the next crisis. • G20 is the forum to consider the controversies. • with the IMF supplying the numbers • As in G20 Mutual Assessment Process, IMF, Nov. 2010 at://www.imf.org/external/np/g20/pdf/111210.pdf . • A good G-20 result would be shared recognition that China’s currency and America’s budget deficit should both gradually adjust.

20. Useful indicators for the G20 MAPShort list: • Budget deficit & national saving /GDP. • Current account /GDP. • Not bilateral trade balances, • which are not economically relevant, • even though the US Treasury biannual reports use them: as shown statistically in Frankel & Wei (2007)"Assessing China's Exchange Rate Regime,"Economic Policy.  • Real exchange rate. • relative to the country’s long-run history • and also relative to the long-run equilibrium rate predicted by the Balassa-Samuelson relationship.

21. When the concern is global aggregate demand, rather than imbalances • The locomotive theory: • In times of global recession, the concern is that each country holds back expansion of demand (esp. fiscal) unless it is done cooperatively. • Examples: 1978 Bonn Summit & 2009 London Summit • There may also be times when the concern is that each country will expand too much, unless they can agree on cooperative discipline. • Then indicators of demand are needed.

22. For the longer term, the G20 may want to focus on a broader list of economic variables • Precedent: The Tokyo Summit of May 1986 decided that G-7 Finance Ministers of the G-5 countries, would focus on a set of 10 “objective indicators.” • No pretense was made that the members would rigidly commit to specific numbers, in the sense that sanctions would be imposed on a country if it deviated far from the values agreed upon. • But the plan did include the understanding that "appropriate remedial measures" would be taken whenever there developed significant deviations from the “intended course.” • Like Truman’s recent “Strengthening IMF Surveillance” proposal • Policy Brief 10-29, PIIE, Dec. 2010. Athttp://www.iie.com/publications/interstitial.cfm?ResearchID=1730

23. The list of 10 “objective indicators” chosen by the G-5 in 1990: • 4 “locomotive” oriented indicators: • growth rate, inflation, unemployment, money; • 3 “imbalance” oriented indicators: • fiscal deficit/GNP, • current account & trade balances; • 3 “currency war” oriented indicators: • reserve holdings, exchange rate, and interest rate.

24. Proposal: • Cut down the list of objective indicators • by focusing on nominal GDP • or, better yet, nominal demand. • Nominal GDP is a “sufficient statistic” for each country’s contribution to aggregate demand • allowing deletion of: real growth, inflation, unemployment, money. • Reference: • Frankel, "International Nominal Targeting (INT): A Proposal for Monetary Policy Coordination in the 1990s," The World Economy, 13, no. 2 (June 1990), 263-273. • At http://www.hks.harvard.edu/fs/jfrankel/MONTDUMM.R51.PDF

25. Appendix:Seven Clever Reasons We Have Been Told Why We Are Not Supposed to Worry About the US Twin Deficits[i] [i] But I don’t believe them: Frankel, “Nine Reasons We Are Given Not to Worry About the US Deficits,”   Commission on Growth & Development. At http://ksghome.harvard.edu/~jfrankel/GrowthCommssnReasonsWorryDeficits.pdf

26. 1. Capital flows to US due to favorable investment climate & high return to capital . But Even before the slowdown, US business Investment < in 90s IT boom (or 60s, 70s, & 80s). FDI has flowed out of the US not in. The money coming into US is largely purchases of short-term portfolio assets, esp. acquisition of $ forex reserves.

27. 2. “The problem is a global savings glut, not a US saving shortfall.”[1] True, foreign net lending to US is determinedby conditions among foreign lenders as much as in US. But “savings glut” misleading: Global saving is not up. [2] Rather, global investment is down (even before 2008 slowdown). This pattern is inconsistent with the hypothesis that the exogenous change is an increase in saving abroad: that would have shown up as a rise in investment. The pattern is consistent, rather, with the hypothesis that the US shortfall is sucking in capital from rest of world. ____________________________ [1] Bernanke (2005). [2] Japan’s household saving rate = 7% of disposable income, vs. 23% in 1975.

28. 3. “It’s a big world.” Alan Greenspan, Richard Cooper, & others: world financial markets are big, relative even to $3 trillion of US net foreign debt, and increasingly integrated. => Foreign investors can bail the US out for decades. Foreign investors moving, even slowly, toward fully diversified international portfolios (away from “home country bias”), can absorb US current account deficits for a long time. True. But , for assessing default or country risk, global wealth may not be the relevant denominator.

29. If the US were any other country… The proper denominator of US debt would be not the size of the world portfolio, but US ability to pay Measured by US GDP, or by US exports or tradable goods production which is unfortunate, in light of low US X/GDP ratio -- Obstfeld & Rogoff (2001, 2005). US Debt/export path may be probably explosive.

30. 4. US CA deficit need not imply rising debt & debt-service, due to valuation effects Lane & Milesi-Feretti (2005…) compute valuation effects. Gains in $ value of assets held abroad, particularly via $ depreciation, have largely offset increased quantity of liabilities => US net debt has risen “only” to $2 ½ trillion, despite much larger increase in liabilities to foreigners. But how many times can the US fool foreign investors?

31. 5. US as World’s Banker Despite years of deficits, net investment income remained in surplus. Why? US earns higher rate of return on its assets abroad (especially FDI) than it pays on its obligations (especially T bills), because US has assets of uniquely superior quality . Kindleberger (1960s): US is World Banker, taking short-term deposits & investing long-term. Gourinchas & Rey (2005): US is global “venture capitalist.” Caballero, Farhi & Gourinchas (2007): “Intermediation rents…pay for the trade deficits.” Forbes (2008): Money flows to US from places less-developed financially Also theories by Mendoza, Quadrini & Rios-Rull(2006),Wei & Wu, and others

32. 6. Dark Matter “That US Net Investment Income is still in surplus implies missing assets.” Hausmann & Sturzenegger (2006) called hidden US assets (know-how) that are not properly reflected in service export numbers “dark matter.” The argument probably overemphasizes the reliability of investment income data(relative to service export data) Kozlow(2006): Dark Matter based on faulty interpretation of the data Curcuru, Dvorak, & Warnock(2007) : US capital gains on foreign securities are overstated, and so US international investment income is too. Daniel Gros(2006): foreign companies understate profits of US subsidiaries, to avoid taxes; again net US income overstated. 32

33. 7. Bretton Woods II: “China’s development strategy entails accumulating unlimited dollars.” Deutschebank view (Dooley, Folkerts-Landau, & Garber,2005…): Today’s system is a new Bretton Woods, with Asia playing role that Europe played in 1960s. That much is right. DFL ideas were original: China piles up $ not because of myopic mercantilism, but as part of an export-led development strategy that is rational given China’s need to import workable systems of finance & corporate governance.

34. But it is not sustainable. • It may be a Bretton Woods system, but we are closer to 1971 (date of collapse) • than to 1944 (date of BW agreement) • or 1958 (when convertibility was first restored). (1) Capital mobility is much higher now than in 1960s. (2) The US can no longer necessarily rely on support of foreign central banks, either economically or politically. (3) The theory that China imports a world-class system of finance & corporate governance from the U.S. no longer looks so good.

35. “Dollar holders won’t sell because they would be only hurting themselves” • This factor was the same in 1973. In fact the governments holding $ then had an agreement not to sell (which is not true today). • When the time comes, each central bank will be afraid that if it is the only one that doesn’t move out of $, everyone else will anyway, driving the dollar down, and leaving it “holding the bag.” • Just as in any speculative attack.