The dominant short-term economic problem today is the contrast between the prosperity of most emerging markets/developing countries and the excess capacity in most of the advanced economies (the principal exceptions being Australia and Sweden). No one begrudges the success of the poorer countries in starting to catch up, but they gain nothing (and lose a little, e.g. in aid foregone) by the difficult situation of the developed countries.
One of the reasons for the excess capacity in most advanced economies is the large payments imbalances that are reemerging in the world economy. These imbalances drain demand from where it is in short supply to economies that tend as of now to suffer from excess demand. The particular problem is China’s large surplus, which is making life difficult not just for the United States and other rich countries but for developing countries like Brazil and India that wish to maintain an element of export-led growth.
One of the greatest inadequacies of the international monetary nonsystem that emerged from the 1970s is the absence of pressures on surplus countries to participate in the adjustment process. In this it is all too similar to the Bretton Woods system as it eventually emerged. It is well known that Keynes’s original blueprint for a postwar monetary order contained elaborate proposals to pressure surplus countries into contributing to adjustment. These were rejected by the United States, which at that time regarded itself as a permanent surplus country.
Ironically, during the Committee of Twenty negotiations to replace the collapsed Bretton Woods system in the early 1970s, the United States proposed rather similar arrangements, which it termed a “reserve indicator” system. Although it still had a current account surplus at that time, attention was in those days focused on the official settlements balance, and the US current surplus did not match its capital outflow, so this was in deficit. It was of course the great surplus country of those days, Germany (aided by its European allies), who successfully interred the US proposal.
The trouble with both of these proposals today is that it has become all too easy to avoid an undesired reserve buildup by shunting a part of the accumulation into a sovereign wealth fund. Yet one does not want to prohibit countries investing a part of their current earnings for the future, or one is liable to end up incentivating the Norways of this world to cut down on oil production. At the same time, the problem of surplus countries stealing demand by failing to adjust is so serious as to demand a solution.
Fortunately several people, especially my colleagues at the Peterson Institute, have been inventing solutions more appropriate for the present day. For example, it has been proposed that the International Monetary Fund (IMF) should be obliged to send a mission to any country with a surplus greater than 4 percent of GDP, charged with examining whether its exchange rate was undervalued. Or it has been proposed that the World Trade Organization be given the power to penalize a country for maintaining an undervalued exchange rate by using its dispute settlement system to authorize trade restrictions against an offending country (with the evidence to convict being supplied by the IMF). Or (as Fred Bergsten argued in these columns on October 3, 2010), it has been proposed that a reserve currency country should have the right of counter-intervention against an undervalued currency, subject to a right of appeal to the IMF.
So far the only proposal to have figured in recent official discussions envisaged countries (other than the oil exporters) agreeing to aim at avoiding imbalances greater than 4 percent of GDP. This idea appears to have originated in China, been enthusiastically taken up by the Korean hosts of the recent G-20 meetings, and introduced into official discussions by the US treasury secretary, before being shot down by surplus countries, especially Germany, in the G-20 context.
There are other proposals too, which do not require the endorsement of the surplus countries because they envisage unilateral action rather than an IMF agreement. In particular, Daniel Gros has proposed that the right to hold official assets in a reserve currency should be granted only to countries that grant foreigners a reciprocal right to hold their currencies, which would make them vulnerable to the Bergsten proposal. (At least, it would do if there were no private assets to hold.) And Gary Hufbauer envisages taxing the income yielded by Chinese assets in the United States.
In addition to agreement to press surplus countries to adjust, one would also need some understanding on what sorts of measures they would take to effect adjustment. There need be no compulsion on countries to act in this way: If they can see a preferable alternative, they would be free to pursue it, though they would have to bear the consequences if it proved ineffective. For most countries, allowing or engineering an appropriate exchange rate change is the obvious weapon, since if the exchange rate is right then the national incentive to secure full employment guarantees that saving/investment balances will follow. For countries that are locked into a monetary union, and therefore cannot use the exchange rate as an instrument of national policy, the necessary instrument would be acceptance of an endogenous national rate of inflation that might exceed that targeted by the monetary union.
Agreement is now more urgent than ever in view of this being so key to global growth. One realizes that China and Germany (today’s major surplus countries) are hardly likely to agree to such a profound change in the international rules of the game without some pretty strong inducements, but it is surely worth thinking about what could persuade them to agree rather than wait for a crisis.
This posting is based on the author’s study Getting Surplus Countries to Adjust (Peterson Institute Policy Brief 11-1, Washington).