Despite a brief revival, the world economy is slowing again. A more sustained recovery will require international cooperation to reduce external imbalances in a way that reduces unemployment and maintains low inflation.
I have written before on the role of global imbalances in the crisis of 2008 and the relative economic stagnation that has followed. Michael Pettis (The Great Rebalancing) and Yanis Varoufakis (The Global Minotaur) have written very readable books on this theme and their ideas have often featured on this blog.
This post explores the role of the role of internal and external balance (or lack thereof) in helping us find a return to a more sustainable prosperity. These ideas form much of the theoretical content of The Leaderless Economy by Peter Temin and David Vines, which was published in 2013.
So do we need another policy scheme for restoring global prosperity? I would argue that we do. Global growth picked up in 2017 but, apart perhaps from the US, has begun to falter recently, not least in the UK, but also in continental Europe. Many economies have accumulated high levels of private and public debt, and have made little progress in reducing them.
Temin and Vines draw on a relatively mainstream Keynesian framework to interpret the problems that still afflict the global economy, and to provide a ‘way out of the woods’.
Internal and external balance
An economy is in internal balance when it has both full employment and stable prices or low inflation. External balance is achieved when an economy’s foreign assets or debts are growing no faster than its GDP. To put it anther way, the current account deficit or surplus as a share of GDP would be equal to or less than the growth rate of GDP.
The attainment of internal balance seems like a good thing. Full employment should mean that those who want it can find work, and low or moderate inflation should contribute to stability and efficiency.
Full employment and low inflation may not be sustainable over the long run, even if they can be achieved in the short to medium run. This combination of favourable economic outcomes will in part depend on the bargaining power of labour over wages, but this post is not the place to debate such ideas.
Nevertheless it is likely that faster growth in many countries with unacceptably high unemployment will help to reduce it significantly, without the costs of higher inflation.
The merits of external balance are not as obvious as those of internal balance. When a country runs a current account deficit, it is borrowing from abroad and accumulating debt. If this debt is used to finance productive investment, it can ultimately be paid off at some point in the future, with money to spare.
If it is used to finance unproductive or poorly allocated investment, then insufficient returns will be generated to fund the repayment. If it is used to finance increased consumption, then repayment of the debt will require reduced consumption in the future, all else being equal.
The first case will tend to lead to increased GDP in the long run, while the latter two cases will either reduce it or leave it unchanged, while increasing the debt burden.
One country running a current account surplus in, for example, a simple two-country world economy, is the necessary counterpart to the other running a deficit. The former will be lending to the deficit country and accumulating foreign assets. If these assets are productive, then they should generate a sufficient return on the investment. If not, then losses will be imposed on the surplus country in some form.
History shows that large external imbalances can be maintained for some time, but also that a ‘rebalancing’ will occur at some point.
Large current account deficits can lead to debt accumulating faster than GDP growth. As described above, if the debt is used to finance unproductive spending, then this will prove unsustainable and lead to a build-up of financial fragility and eventually either economic stagnation or recession as firms or households deleverage (pay down debt).
The illusion of The Great Moderation
Achieving both internal and external balance seems to be difficult. The ‘Great Moderation’, a phrase coined in the years prior to the 2008 crisis, was used to describe a period of apparent economic stability and prosperity: both unemployment and inflation were reasonably low in countries such as the US and UK, and growth was steady. However, this was accompanied by housing bubbles across the developed world, and rising private debt, reflected in significant external imbalances.
One way of thinking about the crisis and its aftermath is that it represents an end to the pattern of a hegemonic US running persistent current account deficits which stimulated the growth of demand in the rest of a world economy awash with excess savings and, overall, insufficient demand to absorb all that it produced.
An optimal response to this pattern of external imbalances requires the US to lead, or for the major economies to cooperate, in reducing the largest current account imbalances in a way which minimises unemployment and maintains low inflation.
Countries out of balance: some examples
Germany currently has low unemployment and inflation (internal balance), but a large current account surplus (external imbalance), so that it is relying on demand from abroad to sustain its internal balance.
The UK also has low unemployment and inflation (internal balance), but it is running a moderately large current account deficit (external imbalance). Its overall debt burden is continuing to rise.
China’s current account surplus was unsustainably large on the eve of the crisis (external imbalance), but has since fallen significantly, while its private debt burden has risen hugely, due to its funding of unproductive investment. It has low unemployment and inflation (internal balance).
Ways to rebalance
If the world’s major economies are to move towards external balance while also achieving or maintaining internal balance, then some combination of macroeconomic (fiscal and monetary), exchange rate and structural policies are needed. In this case, structural policies are those which change the structure of demand in the economy, such as the balance between consumption, investment and exports.
Those countries, such as Germany, which are running large current account surpluses, need stronger domestic demand to reduce the surplus towards balance. But Germany is already at full employment, so this would likely result in higher inflation, all else being equal.
The country therefore needs to shift away from its dependence on growth in exports and towards consumption. To achieve this, it either needs a stronger exchange rate vis-à-vis its trading partners or those countries running significant current account deficits need to reduce domestic demand, for example via tighter fiscal policy (some combination of higher taxes and lower public spending), even as Germany increases its own domestic demand.
As a member of the eurozone, Germany cannot revalue its exchange rate against other members. A stronger euro would also tend to worsen the current account balances of all members, albeit unevenly. But Germany is the largest economy in the region, and has the potential to drive stronger growth in demand in Europe if its domestic demand grows more strongly.
Like the US and UK, Germany has significant infrastructure needs, and a major programme of public investment financed by borrowing would benefit both itself and its neighbours. The expansion in domestic demand would spill over into increased imports and help reduce its current account surplus, which would boost other eurozone members’ net exports. But as already mentioned, there must be a simultaneous shift away from foreign demand in order to keep inflation reasonably low.
The US muddle and the China opportunity
Economic policy in the US is currently pretty muddled, with a combination of looser fiscal policy and tighter monetary policy raising interest rates and boosting the value of the dollar. This will harm exporters, widen the current account deficit and increase the country’s debt burden. At the same time, the government is trying to reduce the current account deficit through attempts at striking new trade deals, backed up with threats of increasing barriers to trade, particularly with China.
The US would benefit from a weaker currency and tighter fiscal policy. A major increase in public spending on infrastructure is sorely needed, just as in Germany. This could be funded through higher taxes so that fiscal policy is not loosened even further. But all this seems a long way off politically.
China is no longer running a large current account surplus and is therefore in external balance. However domestic demand is still being sustained by poorly allocated investment, which is adding to the country’s debt burden. The country badly needs to increase the share of consumption in GDP and reduce the share of savings and investment, while improving the allocation of the latter.
This could be achieved by raising the share of household income in GDP and by increasing public consumption on education, health and social welfare. This has already begun to happen, but there is some way to go. Growth is likely to slow as the government reigns in the growth in private debt. Ideally China should not have to rely on net exports to pick up the slack in demand, so stronger growth in domestic demand, particularly the consumption component, is vital.
The danger for China is that domestic demand weakens via reduced investment before consumption can pick up the slack, which could increase the current account surplus once again. This would put pressure on the rest of the world which would only be able to sustain growth through a further unsustainable increase in debt.
Movements towards external balance while also achieving or sustaining internal balance in the US, the eurozone (led by Germany) and China are the key to a more sustainable global recovery. But without some constructive leadership which encourages cooperation between the major economies, this all seems highly unlikely. Even having the right economic theories and policies is not enough. The politics need to be right too.