Are Global Imbalances Curable? (Part I)

The current financial crisis has its roots in global imbalances, but the real causes of global imbalances and their linkage with the crisis are still unclear.

The consensus seems to suggest that the imbalance was caused by the deficit countries’ excessive consumption and the surplus countries’ excessive savings. As an accounting fact, this certainly is true.

And, because it sounds like a plausible explanation, both academics and policymakers are embracing that view and quickly proposing the “right” cure — that is, to increase consumption in the surplus countries and to increase savings in the deficit countries.

Indeed, some encouraging signs have emerged from the deficit countries. For instance, domestic savings in the United States has increased since the crisis broke out.

Taking this as evidence that the United States, the largest deficit country, is shifting away from excessive consumption, many people have begun to doubt whether there is a chance for sustaining the export-led growth model of the surplus countries.

After all, if Americans do not want to consume too much, where should the surplus countries, especially China and Japan, sell their products?

Unfortunately, rising U.S. savings rates may be temporary, and the surplus countries will continue on the export-led growth model, whether they like it or not. Of course, rapid export-led growth is perfectly compatible with a trade balance or a deficit in the exporting country, as for example, was the case in Korea before the mid-1980s. But export-led growth cannot proceed without robust external markets.

The real cause of global imbalances rests in the basic economics that have shaped the new international division of labor that started immediately after World War II ended — but has accelerated after the fall of the Berlin Wall.

The United States and Great Britain were the only two economic giants in the free world when World War II ended. But Germany and Japan joined quickly by specializing in what they were good at — such as manufacturing.

On the other side of the Iron Curtain, the Soviet Bloc formed another circle of an international division of labor. Then, the fall of the Berlin Wall started a new wave of globalization with every country being brought into a unitary world system of division of labor.

A pattern to this new wave of division of labor becomes immediately apparent. On the deficit side, we have the United States, Great Britain and Australia, all of which have adopted the Anglo-Saxon model of capitalism.

The surplus side is more diverse, but we can still see a pattern. There are three groups of countries: the old manufacturing giants (namely, Germany and Japan), the newly emerged “world factories,” especially China — and the oil exporters.

The Anglo-Saxon model of capitalism strongly favors the service sectors, especially finance. Harvard economist Andrei Shleifer and his coauthors have found strong evidence that the common law countries — the Anglo-Saxon countries — have better-developed capital markets than countries with other legal origins.

Whether legal origins provide the right explanation is still debatable, but it is clear that the United States and Great Britain are more dependent on the capital market to raise capital, and their finance sectors are much more dynamic than those of countries like Germany, Japan and France.

In economic jargon, the Anglo-Saxon countries have developed a comparative advantage in finance, therefore, they specialize in finance. For that reason, we see a “hollowing out” of manufacturing in those countries.

An indicator of this phenomenon is that finance and real estate contribute 20% of the U.S. GDP, but manufacturing only contributes 14%. (World Bank data series are much more complete for industry than for manufacturing.) While Japan and Germany continue to derive more of their GDPs from industry than the United States and the United Kingdom, all four countries have seen the share of GDP derived from industry decline by more than 40% since 1970. The statistics are as follows:

• Japan from 46% of GDP in 1971 to 30% in 2006
• Germany from 47% to 29%
• The UK from 43% to 24%
• The United States from 35% to 22%

The old manufacturing giants, Germany and Japan, continue to have comparative advantages in manufacturing, because they have accumulated strong manufacturing capacities in both physical and human capital. This has a lot to do with the history they have inherited from the first wave of division of labor.

At that time, their roles were already cemented in manufacturing goods for ultimate consumption in United States. Their current strengths lie in sophisticated consumer products and intermediate inputs.

Newly emerged manufacturers like China export mainly low-end consumer products. Their comparative advantages lie in their relatively cheap, but educated labor forces. Joining the world system helps those countries tap into the potential of their abundant labor forces.

In the case of China, accession to the WTO in 2001 has made a big difference. Between 2001 and 2007, China’s exports grew by 24% per annum, compared with 17% in the 1990s, according to the World Bank. Since China’s imports grew by only 21% in the latter period (compared with 18% in the former), China’s burgeoning foreign exchange reserves have also built up considerably since 2001.

Looking at India from the lens of China, we find that India is following China’s trajectory closely and opening up to international trade.

The oil exporters have traditionally provided oil dollars to the United States. These countries have small manufacturing sectors, but their oil income is more than enough for them to import consumer goods. What is surprising is that in the last decade, Russia has joined the rank of these countries.

Being a traditionally strong manufacturer has not immunized Russia from being captured by the Dutch disease. Its exports are dominated by raw materials, and its inflation rate has seldom fallen to single digits.

In summary, this round of globalization has a strong tendency to have countries specialize in specific economic activities, in which these countries enjoy comparative advantages.

Editor’s note: This the first of a two-part series. Read the second part.