Deficits, Debt and the Dollar Martin Wolf, Associate Editor & Chief Economics Commentator, Financial Times

Deficits, Debt and the DollarMartin Wolf, Associate Editor & Chief Economics Commentator, Financial Times Oxonia October 26th 2005Department of Economics, Oxford University

1. Deficits, debt and the dollar “Over the past decade a combination of diverse forces has created . . . a global saving glut.” Ben Bernanke, Governor of the Federal Reserve, March 10th 2005

1. Deficits, debt and the dollar “Long-term rates have moved lower virtually everywhere.” Alan Greenspan, chairman of the Federal Reserve, June 6th 2005

1. Deficits, debt and the dollar: outline • Greenspan’s “conundrum” • Global excess savings • Global “imbalances” • US as spender and borrower of last resort • The end-game

1. Conundrum • Why have monetary and fiscal policy been so loose? • Why are global real interest rates so low? • Why is the US running huge current account deficits?

1. Conundrum: real interest rates

1. Conundrum: long-term real rates

1. Conundrum: US current account

1. Conundrum: conclusion • Exceptionally aggressive monetary and fiscal policies, to escape the slow down • Low real rates, despite the strong global economic growth • Exploding US current account deficits • What is going on?

2. Savings surpluses and deficits • What lies behind all this is a move into surplus of savings over investment in a wide range of countries • In some case savings have risen more than investment • In some cases investment has fallen • In some cases savings have risen and investment has fallen • In important cases, the private sector’s excess savings has risen sharply, creating both fiscal deficits and current account surpluses

2. Savings surpluses

2. Savings surpluses: conclusion • The world is awash with excess savings • Almost every region is in surplus, except • The Anglosphere (and central and eastern Europe) • All this must be equilibrated through the global balance of payments • And, of course, it is

3. Global “imbalances”

3. Global “imbalances” • Two broad groups of countries • Mature high-income countries with slowly growing economies and chronic excess savings. Japan and “Old Europe” generated a combined current account surplus of $336bn in 2004, up from $189bn in 1996 • BUT the rest of the world – the emerging market economies - have moved from minus $99bn in 1996 to $323bn in 2004 • Thus the swing for the high-income countries was $147bn, but the swing for the rest was $421bn

3. Global “imbalances” • It is not just the current account surplus. Asian emerging countries are also recycling the capital inflow • This is particularly true for China, Taiwan, India and South Korea • This supports the dollar within the new Bretton Woods area

3. Global “imbalances” : conclusion • The rest of the world is generating large savings surpluses and parking them in the US • The big swings are the result of the financial crises of the 1990s and the recent oil price surge • These persuaded the Asian emerging market economies to stick with export-led growth • They are running current account surpluses and recycling capital inflows • This keeps the dollar up against their currencies

4. US as spender of last resort • US seeks internal balance • It accommodates the external imbalance imposed by the rest of the world • As issuer of the world’s key currency, it is in a unique position to be the world’s spender of last resort • In seeking internal balance in the US, the Federal reserve generates internal balance in the open economies of the rest of the world • It does this by offsetting their desired export surpluses

4. US as spender of last resort

4. US as spender of last resort • The macroeconomic variables: domestic income and expenditure and capital inflows from abroad are accommodating the growing structural deficit. • The current account tail is wagging the domestic economic dog • It will take a large adjustment in relative growth of exports and imports to halt the deteriorating trend

5. End-game • Is it plausible that the surpluses will begin to shrink? • In Japan and western Europe it is not very likely. These are natural surplus regions • In the oil exporters, it is quite likely, though they would be wise not to spend the windfall at once • The crucial players are the Asian emerging countries, since they could afford to run current account deficits

5. End-game • There are good reasons for the Asian countries to alter their policies: • It is hard to sterilise the monetary impact of huge reserve accumulations • Real returns on the assets they own are low and, ultimately, likely to be negative when currencies adjust • Subsidising exports through an undervalued exchange rate and unhedged lending in foreign currencies is expensive • Reserves are now adequate • And so insurance has become excessively expensive

5. End-game • But there are also advantages to sustaining the dollar • It gives economies a monetary anchor • It preserves export competitiveness • It creates a de facto Asian monetary system • It “pays for” US-provided security

5. End-game • The big decision-maker is China • It is prepared to buy an acquiescent US, but nobody knows on what scale (including, I think, the Chinese) • It does not know how far to let the currency appreciate • And it is not sure what the best exchange-rate regime would be • This is just not a high priority

5. End-game • What about the US? • As John Maynard Keynes said: If you owe your bank manager £100, you have a problem. If you owe him £1m, he has a problem • The US enjoys a huge transfer of resources – greater than the fiscal deficit or its entire military spending • This is guns and butter

5. End-game • So what are the drawbacks? • Industries producing tradeable goods and services are weakened • Protectionist pressure increases • If the fiscal deficit is to be reduced, the private sector’s financial deficit must be pushed upward again to very high levels • That would demand monetary loosening and debt expansion • If credit were to be cut off, the dollar would plunge, inflation would rise, interest rates would rise and the economy would, almost certainly, go into recession • The creditors are not necessarily friendly

5. End-game • The longer the delay the bigger the adjustment • The best approach would be a deal with Asia • Exchange rate adjustment • Fiscal tightening in the US • Expansionary policies in Asian emerging markets, together with structural reform • A co-operative solution or a mess looms ahead

Deficits, Debt and the Dollar Martin Wolf, Associate Editor & Chief Economics Commentator, Financial Times