Tuesday, July 10, 2012

Current Account Imbalances

The U.S. economy has been running very large trade deficits for the last . China and Germany, among others, have been running very large trade surpluses. Should this be a matter for concern? If so, why?
As a starting point, here are figures showing the current account balances in the U.S., China, and Germany, from the ever-useful FRED website at the Federal Reserve Bank of St. Louis.

Of course, no economist would want to endorse the claim that nations should always have balanced trade. There are valid reasons for a nation to run trade deficits for a time (which means importing capital from abroad) or to run trade surpluses for  a time (which means investing capital abroad). Long ago, the standard textbook example was that high income countries, where capital was relatively plentiful, should run trade surpluses and invest the funds in low-income countries, where capital was relatively scarce. With the U.S. economy running huge trade deficits and China's economy running huge surpluses, that scenario is now standing on its head.

In the June 2012 issue of Finance and Development, Mohamed A. El-Erian offers a nice essay expressing the conventional wisdom about large and persistent trade imbalances.

"There will eventually come a point when deficit nations will find it difficult to continue to spend massively more than they take in. Meanwhile, surplus countries will find that their persistent surpluses undermine future growth. For both sides, the imbalances will become unsustainable, with potentially serious disruption to the global economy. ... The global imbalances are best characterized as being in a “stable disequilibrium.” They can persist for a while. But if they do, the global economy will continue to travel farther afield from the equilibrium associated with high global growth, sustainable job creation, and financial soundness ...

Indeed, where most academics do not differ is in their concern that persistent imbalances expose the global economy to sudden stops in investment flows, as happened in the fourth quarter of 2008. At that time funds ceased flowing to emerging markets and sought safe havens like U.S. government securities, which is what happened more recently in Europe. The extreme worries relate to currency fragmentation in Europe and worsening funding conditions for the United States. Both of these low-probability “tail events” entail catastrophic disruptions, with virtually no country in the world immune to negative spillover effects. Economists also point to mounting risks of currency wars
and protectionism ..." 
But as one digs down into the conventional wisdom on trade imbalances, the exact reason to worry about them is not as clear as one might like. Are the patterns of very large surpluses and deficits bad for their countries in and of themselves? Or is the danger that the trade imbalances may make global financial crises more likely? Or is the problem just that globalization has created larger and tighter linkages across countries, and the trade imbalances are not a central part of the story? Maurice Obstfeld takes on these kinds of questions in his Richard Ely lecture that was recently published in the May 2012 issue of the American Economic Review. (The AER is not freely available on-line, although many readers will have access through library subscriptions.)

Obstfeld makes clear that current account imbalances are not always a cause for concern. He writes:
"Before proceeding, I have to emphasize that just as the “consenting adults” framework claims, some current-account imbalances, even very large ones, can be justified in terms of economic fundamentals and do not pose threats to either the national or international economy. Such imbalances need not be a symptom of economic distortions elsewhere in the economy, but instead reflect reasonably forward-looking decisions of households and firms, based on realistic expectations of the future. Not all fall into this category, however, and the facts of the case are typically amenable to different interpretations--witness the debate over the global imbalances of the mid-2000s, notably the US deficit ..." (The Summer 2008 issue of my own Journal of Economic Perspectives had a pro and con on the U.S. trade imbalance, with Richard Cooper arguing that the U.S. trade deficits were a reasonable outcome of underlying economic forces, and Martin Feldstein arguing that they were an unsustainable situation and cause for concern.)

That said, Obstfeld offers three reasons for concern over current account deficits. First, current account imbalances may in some cases be a sign of an underlying economic problem; in particular, it may represent a surge of borrowing and credit that is fueling an unsustainable asset-market bubble. However, current account imbalances don't always signal an unsustainable credit boom, and credit booms can happen without a current account deficit. Obstfeld write:

"Numerous crises have been preceded by large current-account deficits—Chile in 1981, Finland in 1991, Mexico in 1994, Thailand in 1997, the United States in 2007, Iceland in 2008, and Greece in 2010, to name just a few. But temporal priority does not establish causality, and the empirical literature of the last two decades has not established a robust predictive ability of the current account for subsequent financial crises (especially where the richer economies are concerned). There are cases in which even large current-account deficits have not led to crises, as noted above, and furthermore, several notable financial crises were not preceded by big deficits, including some of the banking crises in industrial countries during 2007–2009 (for example, Germany and Switzerland)."

 Obstfeld's second concern is that large trade deficits, when an economy is receiving an inflow of foreign capital, make an economy vulnerable to a "sudden stop" of that capital. I've make this point before in a post about ways of illustrating the financial crisis of 2008. The graph shows the inflow of foreign capital to the U.S. economy. Notice first how this inflow of foreign capital rises dramatically through the 2000s, as the U.S. trade deficit plummets. But then focus on what happened during the financial crisis in late 2008 and early 2009: those inflows of financial capital not only went away, but actually turned into an outflow for a time. The inflows of foreign financial capital have since returned--but the vulnerability of the U.S. economy to a "sudden stop" of capital inflows is clear.

Obstfeld's third point is that current account imbalances may be a signal of larger financial imbalances.  He writes: 

 "Global imbalances are financed by complex multilateral patterns of gross financial flows, flows that are typically much larger than the current-account gaps themselves. These financing patterns raise the question of whether the generally much smaller net current-account balance matters much any more, and, if so, when and how. ... In the mid-1970s, gross financial flows were much smaller than trade flows, but the former have grown over time and on average now are of comparable magnitude to trade flows. ...

I will also argue that while policymakers must continue to monitor global current accounts, such attention is far from sufficient to ensure global financial stability. ... [L]arge gross financial flows
entail potential stability risks that may be only distantly related, if related at all, to the global
configuration of saving-investment discrepancies. Adequate surveillance requires not only
enhanced information on the nature, size, and direction of gross global financial trades, but better understanding of how those flows fit together with economic developments (including
current-account balances) in the world’s economies, both rich and poor."

In the conclusion, Obstfeld writes: "To my mind, a lesson of recent crises is that globalized financial markets present potential stability risks that we ignore at our peril. Contrary to a complete markets or “consenting adults” view of the world, current-account imbalances, while very possibly warranted by fundamentals and welcome, can also signal elevated macroeconomic and financial stresses, as was
arguably the case in the mid-2000s. Historically large and persistent global imbalances deserve
careful attention from policymakers, with no presumption of innocence."