Are Global Imbalances Curable? (Part II)

Why does specialization lead to an imbalance of payments — with some countries having net surpluses and others having net deficits?

Economic theory predicts that normally a surplus country would enjoy an increase of wealth, so it would import more and its current account would end up being roughly balanced again.

Economic theory also predicts that normally a deficit country would face high interest rates and would cut borrowings and rebalance its current account. But in reality, we have observed persistent imbalance on both sides. Why?

It has a lot to do with the pattern of specialization we have observed above. It is not a coincidence that none of the surplus countries has a highly developed financial market. They specialize either in manufacturing or in oil exporting.

In contrast, the production of financial services is concentrated in New York and London. Like other activities, finance also concentrates in places where it is done in the most efficient way.

As a result, hard-earned money flows from the surplus countries to the deficit countries. That is, the financial markets in the surplus countries are incapable of channelling savings to domestic investment or consumption.

This observation has an ironic implication for the current debate, which often lays blames on the U.S. financial market for causing the financial crisis. While the American financial market may be too fluid, the financial markets in the surplus countries are too static.

This also leads us to understand how the imbalance comes into place. However, if the financial markets in the deficit countries, particularly United States and Great Britain, could properly digest the "excessive" supply of saving from the surplus countries, then the imbalance would not have mattered. Yet, the world is full of friction, so we end up with the imbalance.

However, the imbalances did not necessarily lead to the financial crisis. If the U.S. financial market had not been overly concentrated in the housing and commodity markets, there would have been no asset bubbles — and there would have been no global financial crisis.

There seem to be numerous opportunities for high-return investments in other parts of the world. For example, investing in infrastructure in Africa and India should be profitable in view of the low quality of infrastructure over there.

Unfortunately, the financial sector is the most sensitive industry in terms of demands for legal protection and information so, surprisingly, it is the most home-biased industry despite its fluidity. Bankers prefer doing businesses in their home countries where they feel easy with the legal system.

For that very reason, it is not an accident that the deficit countries have the best legal framework for financial market development. As a result, money flows there and mostly stays there.

Unfortunately — yes, unfortunately — there are not that many new technologies or other productive activities to invest in those countries.

In the end, their financial sectors flourish on creating its own "productive" assets, which are basically assets on paper accumulated on derivatives and other sorts of financial innovations. Thus, the bubbles.

The crisis seems to have reached its bottom and there seem to be lights at the end of the tunnel signaling for a recovery. However, there will be no corrections for the imbalance even if the world economy recovers. We will quickly go back to business as usual. The proposals currently put on the table are not going to offer the cure.

If the adjustments in the surplus countries are unlikely to happen or at least take time to happen, we cannot expect that the adjustments in the deficit countries happen quickly either. Money is still going to be cheap and borrowing is still optimal to finance consumption.

In the end, economics wins the game. Unless we reject free trade and the free flow of capital as well as the division of labor associated with them, we will have to live with global imbalances for quite a long time.

Therefore, the problem facing us is not to correct the imbalance, but how to neutralize its negative consequences. To do that, we have to realize that neither side of the imbalance is capable of finishing the business on its own. We have to find a global solution.

The solution is to create non-country-specific financial assets and make them sufficiently profitable for the surplus countries to invest in. The major purpose of such assets is to overcome the problem of home biases of the financial sectors in both the surplus and deficit countries.

The IMF's special drawing rights (SDR) can be an archetype of such assets. The recent move of the East Asian countries to establish a regional fund is another example.

Most of the world is still very poor and desperately needs investment. If the arrangement is executed in the right manner, this investment can be profitable and the surplus countries will be willing to contribute.

In this respect, the IMF and the World Bank should enlarge and strengthen their current operations to accommodate more contributions from the surplus countries. A way to do this is for either or both institutions to issue bonds to their member countries and use the raised money to invest in countries where investment is desperately needed.

This, of course, will require these countries to take on debt — that is, to become new deficit countries. In the short run, this is equivalent to a reconfiguration of the geography of the present imbalances. The surplus will still be provided by the current surplus countries, but the deficit will be spread out to more countries.

The benefit is that we can avoid the asset bubbles we have seen in this round of financial crisis. In the long run, we may have more benefits. The shift of deficits will have a deflating effect on cross-border demand. Debt-financed consumption in the current deficit countries will decline, reducing imports from the surplus countries.

This decline will not be picked up by more imports from the new deficit countries because the investment diverted to these countries will be partly transformed into domestic demand. That is, we may expect that the global imbalance be cured in the long run.

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