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

2 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 10 th 2005

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

4 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

5 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?

6 1. Conundrum: real interest rates

7 1. Conundrum: long-term real rates

8 1. Conundrum: US current account

9 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?

10 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

11 2. Savings surpluses

12 2. Savings surpluses

13 2. Savings surpluses

14 2. Savings surpluses

15 2. Savings surpluses

16 2. Savings surpluses

17 2. Savings surpluses

18 2. Savings surpluses

19 2. Savings surpluses

20 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

21 3. Global “imbalances”

22 3. Global “imbalances”

23 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

24 3. Global “imbalances”

25 3. Global “imbalances”

26 3. Global “imbalances”

27 3. Global “imbalances”

28 3. Global “imbalances”

29 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

30 3. Global “imbalances”

31 3. Global “imbalances”

32 3. Global “imbalances”

33 3. Global “imbalances”

34 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

35 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

36 4. US as spender of last resort

37 4. US as spender of last resort

38 4. US as spender of last resort

39 4. US as spender of last resort

40 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

41 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

42 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

43 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

44 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

45 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

46 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

47 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