Global Imbalances: its the capital account

Let’s spend a minute talking about global financial imbalances. I mean current account balances and deficits globally. By construction all global current account deficits and surpluses sum to zero — one country’s surplus is another’s deficit etc. (Actually if you look at the data this isn’t true, but the differences are small and it’s meant to sum to zero)

A current account deficit means that the country is consuming (or investing) more than it produces. It does this by borrowing from the surplus countries. A country that runs a current account surplus is doing the opposite — it’s consuming less than it produces and it saves or lends the difference to the deficit countries.

Now these surpluses and deficits are very controversial. Germany, China, Japan, the oil producing countries, Singapore, Hong Kong, Taiwan, South Korea all run biggish surpluses as a percentage of their GDP.

The main deficit countries are the USA (the largest part of the global deficit but still under 3% of GDP) and the U.K. (very small in absolute terms but almost 6% of UK GDP). The biggest neutral country is India which buys oil and pays for it in IT exports.

Now some people argue that because the surplus countries produce more goods and services than they consume, they have expanded their factories and jobs by more than they are ‘entitled’ to and they’ve done this by in effect cannibalising the demand from the deficit countries.

This is Trump’s point about America but quite honestly you can read this view almost every day, even in the Economist and the FT with respect to Germany. What should happen, these people argue, is that domestic borrowing in the surplus countries should increase — and this would reduce their exports and allow more of their output to be consumed at home.

Can you see the theory that underlies these views? It’s the the idea that the natural state of affairs is for countries to run neither deficits or surpluses. The mere fact that there are deficits and surpluses seems to give some people knee tremors.

But how should *we* think about this? Is it natural for countries to have no surpluses or deficits?

I don’t think so.

A useful starting point is to remember that a current account deficit means that the deficit country is borrowing from the international market. So the question we must ask is this: in what circumstances does it make sense for a country to borrow from the international market?

And countries with surpluses are those which are saving or lending to the international market and accumulating financial assets. Again we can ask: in what circumstances does it make sense for a country to save or lend to the international market?

These are the critical questions.

If you’ve been paying attention, you will remember my post on the UK current account deficit, in which I pointed out that some countries might want to run structural deficits if their populations are young or growing in size or if their productivity is low and capital investment could raise it or if they are old societies running down historically accumulated international reserves. And there is one more category which is of course that if you issue the global reserve currency, you probably have to run deficits (borrow) to provide liquidity to the global markets.

It seems to me, given the dramatic ageing of the population, the high level of productivity (and so declining marginal returns on capital) and the shrinking population, that you might expect Germany and Japan — even China — to run large current account surpluses- THAT would be the equilibrium situation for these countries. They need to save to pay for the retirement and old age of their population because they don’t have the young people whom they can tax in the future. So I don’t think these surpluses are problematic.

But that doesn’t mean that the US and UK should run deficits- because in the relative scale of these things, the UK and US are also ageing and on a global scale they have high productivity so the marginal returns on capital are low. These places should clearly run surpluses.

No, the countries that should borrow for consumption and investment according to my theory, are places like India, sub-Saharan Africa and places like Indonesia where increasing capital investment would increase output, productivity and GDP and ensure a flow of income to repay the international borrowing.

But it doesn’t happen. At least not on a big enough scale to eliminate the US and UK deficits. But if it did occur, global employment would rise sharply, wages would rise sharply and employment everywhere would rise sharply. It’s in everyone’s interests that it should happen.

But why doesn’t this happen?

Quite simply because the country that runs the biggest current account deficit is by definition the issuer of the international reserve currency. Think about it- what is money? It’s nothing but a short dated borrowing certificate issued by a state or one of its banks. A current account deficit implies that the state or banks in the deficit state are ‘issuing’ deposits or international reserve currency.

If the rupee for example were to become the global reserve currency — and that could only happen If India ran large current account deficits — a lot of our problems would be solved. India would receive immense flows of capital to raise its productivity, ageing savers in the developed world would get a high and decent income on their investments in India (because of rising productivity), rich countries would export capital equipment and tools and technology to India and so create jobs at home.

But the Indian state does not have anywhere near the institutional credibility of the United States to be able to become an issuer of a key global reserve currency, let alone the issuer of the only global reserve currency. And until it does, the markets will be reluctant to hold significant quantities of rupee denominated assets. So lending to India from the international market will be continue to be limited, despite its productivity potential and global savings will continue to be diverted to richer countries that don’t need it and can’t use it. That’s what being a third world country means. It’s a real bummer.

And that in a nut shell is the real root of global imbalances.

Until the Germans, Japanese and Chinese feel able to invest their surplus capital in India or Africa (I.e lend to these places in quantity), the market will continue to fear holding EM assets and will close out the EM asset holdings in favour of buying EM goods. That raises the US deficit as I have argued before. So Trump’s critics have a point. But so does Trump.

We need a new international financial architecture to achieve this.

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