Policy Implications of Global Imbalances - FEDERAL RESERVE BANK of NEW YORK
Speech
Policy Implications of Global Imbalances
January 23, 2006
Timothy F. Geithner
, President and Chief Executive Officer
Remarks at the Global Financial Imbalances Conference at Chatham House, London
Good morning.
Let me first thank the organizers of this conference for inviting me to speak
to you today. Over the next two days you will focus on the substantial financial
imbalances that characterize the world economy today. The size and duration
of these imbalances, perhaps the most visible of which is the U.S. current account
deficit, present challenges—and risks—for the world economy.
Understanding the forces behind the international capital flows and the associated
gaps between saving and investment within countries that led to these imbalances
is of crucial importance to economic policymakers as they struggle to consider
the implications of the imbalances on future economic growth. You have brought
together an excellent group of people to explore these issues.
You meet in the context of some remarkable developments in the world economy.
I thought I would begin by touching on some that bear most directly on the subject
of your conference.
Naturally, as a central banker, I’ll begin by observing that over the
past two decades, most of the world has experienced a substantial fall in inflation.
During this period, the rate of inflation in the United States fell to levels
broadly consistent with most definitions of price stability, and inflation expectations
at longer horizons imply confidence that these gains will also prove durable.
These gains were matched in many economies around the world, the result not
just of the now widespread practice of having a central bank with instrument
independence commit to an implicit or explicit goal of price stability, but
also of course of the effects of global economic integration on competition
and labor costs.
Productivity growth in the United States has continued at impressively strong
levels, adding to confidence that the acceleration of the last decade will prove
durable. It is not difficult to imagine a situation in which the driving forces
behind U.S. productivity growth eventually manifest themselves in other large
mature economies. So far, however, this positive productivity shock has not
been more generalized, and this has some implications for the central topic
of this conference.
Alongside the continuation of the U.S. expansion, global economic activity
has strengthened, and the pattern of global growth has become somewhat more
balanced. Private investment spending is growing at respectable rates in the
United States and strengthening in much of the world economy. Although there
will surely be variations over time, the process of economic reform and integration
in China and India is likely to entail a sustained period of relatively high
investment growth, as firms move to capture the higher returns available from
adding capital to labor.
In addition to these important changes in relative productivity outcomes and
more general gains in reducing inflation, we have seen a large increase in the
mobility of global capital and a wider dispersion in gaps between saving and
investment in national economies. The increase in the size of the U.S. current
account deficit and the emergence of substantial surpluses in emerging Asia,
the major oil exporters and Japan, reflect changes in saving and investment
behaviors, changes driven by very different forces in different countries. So
far, of course, these imbalances have been financed with relative ease, and
it is hard to find evidence in risk premia in financial markets of concern about
the sustainability of these trends.
One final point about the broader environment: These changes have taken place
in the context of unusually low forward interest rates, a subject that has been
the focus of considerable attention in U.S. markets in particular. Forward nominal
interest rates in the United States at the five- to ten-year horizon have stayed
at quite low levels over the past 18 months. Using the inflation expectations
derived from the TIPS (Treasury Inflation-Protected Securities), along with
measures of inflation risk premia, we can conclude with some confidence that
a key factor holding down forward nominal rates is a significant reduction in
expected future inflation and increased confidence in those expectations. Inflation
and inflation risk are not the whole story though, as forward real rates in
both the United States and many other countries have declined to unusually low
levels.
How much of the reduction in real forward rates is attributable to a drop in
expected real returns and how much is a reduction in the real risk premium is
still an open question. The low level of long-term real rates seems likely to
reflect in part a general rise in the supply of global saving relative to demand
for investment, and some have suggested this phenomenon may reflect concern
about prospects for future returns on investment. However, there is also evidence
from other financial market indicators that the required compensation for bearing
real risk has fallen, raising the possibility that the declines in real rates
are due not to pessimism (or at least not entirely), but instead to an increased
appetite for, or a decreased perception of, real risk.
Against this backdrop of a favorable but so far uneven productivity shock,
lower inflation expectations and risk premia, greater economic and financial
integration, and divergent saving and investment patterns, what are the implications
of the imbalances that are the subject of this conference?
It is important to note that the greater dispersion in external imbalances
is the inevitable result of a fundamentally healthy change in the world economy.
As the world progresses toward increasingly integrated financial and goods markets,
other things being equal, we would expect to see an increase in the number of
countries with surpluses or deficits, and larger surpluses and deficits, as
flows of both assets and goods work to equalize desired saving and investment
around the world.
If we were confident that the imbalances we observe simply reflected a more
efficient allocation of the world’s stock of saving to its most productive
uses, if relative prices adjusted freely in response to changing fundamentals,
and if economies were flexible and agile in adapting to those changes, then
we might also reasonably expect these imbalances to rise and fall through smooth
and gradual adjustments in relative prices and flows of goods and services.
Of course, this is not quite the world we live in today.
The fact that we’re discussing the issue of the sustainability at all
reflects concern that the pattern of global capital flows we see today in unlikely
to be consistent with the likely evolution of economic fundamentals over time.
This suggests that it is worth focusing attention on the sustainability of the
forces behind these capital flows rather than simply concluding from the favorable
assessment of underlying risk and return in today’s financial prices that
these imbalances can persist for a protracted period of time.
The size and durability of the imbalances that characterize the world economy
today reflect a myriad of different forces: from differences in actual and potential
growth rates, the degree of openness of financial and product markets, the type
of exchange rate regime in place, the borrowing requirements of the sovereign,
the degree of financial market development, the extent of the official safety
nets, to differences in attitudes toward risk and expectations about the future.
The interactions of these forces are complex and vary over time. And this limits
our capacity to judge the sustainable level of imbalances.
On its face, the increase in the size of the U.S. current account deficit suggests
that the United States has been the principal beneficiary of the increased availability
of global savings and the greater apparent willingness of the world’s
savers to invest outside their home countries. At the same time, however, it
is not difficult to see that if the deficit continues to run at a level close
to 7 percent of GDP—and most forecasts assume it will for some time—the net international investment position of the United States will
deteriorate sharply, U.S. net obligations to the rest of the world will rise
to a very substantial share of GDP, and a growing share of U.S. income will
have to go to service those obligations. This fact alone suggests that something
will have to give eventually, and this raises the interesting question of how
these imbalances have persisted on a path that seems unsustainable with so little
evidence of rising risk premia.
Part of the answer seems to lie in the fact that these capital inflows into
the United States, however, are not solely the result of the decisions of private
actors, but reflect official intervention by countries with exchange rate regimes
tied to the dollar, including those in Asia and the major oil exporters.
Research at the Federal Reserve and outside suggests the scale of foreign official
accumulation of U.S. assets has put downward pressure on U.S. interest rates,
with estimates of the effect ranging from small to quite significant. If this
is right, the apparent reduction in real rates is less likely to signal concern
over expectations of future growth and future returns on investment, and is
more likely to signal the special consequences of these exchange rate arrangements
and their effects on private behavior, as well as the increase in international
capital mobility.
What then can we say about the implications of the pattern of imbalances we
see today?
The trajectory of the U.S. current account deficit has led most observers
to conclude the U.S. external imbalance is unsustainably large and will have
to come down over time. Beyond this general judgment about unsustainability,
there is little consensus on how this adjustment process will unfold or on its
implications for economic activity and financial markets. The plausible outcomes
range from the gradual and benign to the more precipitous and damaging. The
size of the imbalance and the inevitability of eventual adjustment, however,
mean that the world will be living for a considerable period of time with some
risk of large movements in relative prices, greater volatility in asset prices,
and periods of slower growth in the United States and in the rest of the world.
That said, a number of observers have suggested that living with these imbalances
for an extended period of time presents very little risk to the U.S. and world
economy. These arguments are worth some attention.
One view is that the rise in the surplus saving of the rest of the world, the
relative ease with which capital now moves across borders, and the increase
in the relative attractiveness of claims on the United States together may suggest
that the world can sustain larger imbalances, more easily, for a longer period
of time than would have been possible in the absence of these conditions. This
is true. But even if we could be confident that the world would be comfortable
financing the United States on these terms for some time, that fact alone does
not mean that it is prudent for the United States to continue borrowing on this
scale, particularly given that doing so means that the net obligations of the
United States to the rest of the world are likely to rise sharply relative to
GDP.
Another argument for being relatively sanguine about the risks evokes the so-called
Lawson Doctrine, noting that when imbalances are principally the reflection
of the decisions of private savers and investors, those imbalances should not
be a concern to policymakers. This may be true, but it does not apply to the
present circumstances. The fact that we are using a substantial part of the
resources we are borrowing from the rest of the world to finance an unsustainable
level of public dissaving leaves us more vulnerable than if those resources
were being used for productive private investment. Large structural fiscal deficits
limit the size of the sustainable external imbalance for any country, even the
United States, and they necessarily increase concern about the terms on which
we are likely to finance the present imbalance.
There is also a view that the exchange rate arrangements that exist in the
present context—the substantial share of the world economy that shadows
the dollar—should increase our confidence that this pattern of imbalances
could be financed without stress for some time. But a prolonged continuation
of the exchange rate arrangements that have given rise to the large increase
in foreign official investments in U.S. financial assets is unlikely to be consistent
with the domestic requirements of those economies, and for this reason many
are already in the process of change. The impact of a reduction in the scale
of official accumulation of dollar assets could potentially be fully offset
by increases in purchases by private investors. But even in the context of a
continued high degree of confidence in the relative return on claims on the
United States, it is hard to know with confidence how the preferences of private
savers will respond to the gradual evolution in their nation’s exchange
rate regimes that is now underway.
Some have drawn comfort from the adjustment process experienced by other economies
with large external deficits. Industrial countries that have gone through a
process of current account rebalancing have not generally experienced particularly
damaging moves in interest rates or exchange rates. But the present circumstances
seem sufficiently different from historical precedent that history may not be
a particularly useful guide. And even in these past cases, the adjustment process
did entail a slowdown in GDP growth, increasing unemployment, and a sharp fall
in investment.
Finally, there is the belief that the nature of U.S. external assets and liabilities
mitigate the potential problems ahead. U.S. residents do in fact earn more on
their assets than they pay on their liabilities, and U.S. firms operating abroad
earn a higher rate of return than do foreign firms operating in the United States.
Also, the fact that U.S. gross assets are denominated in foreign currencies
but U.S. liabilities are mainly denominated in dollars implies that even a modest
rise in the value of other currencies relative to the dollar can significantly
reduce our net liability position by increasing the value of U.S. gross foreign
assets relative to foreign liabilities.
Nevertheless, going forward, the scope for positive net factor payments from
abroad and sizable valuation effects is limited. The U.S. trade deficit is now
roughly the size of the current account deficit, and U.S. net interest earnings
have fallen to quite low levels. The continuing buildup in liabilities should
soon push U.S. net investment income balances into deficit, with progressively
larger net transfers of income to the rest of the world. In that event, net
income flows will begin to boost the nation's current account deficit instead
of reducing it, reinforcing the deterioration in net liability position of the
United States.
The arguments I have just described highlight factors that may improve the
odds of a more protracted, gradual and benign scenario, but they do not really
alter the general conclusion that these imbalances are unsustainable and that
they will need to unwind at some point.
Time does not necessarily help. The longer these gaps continue to build, the
greater the ultimate adjustment required, and the greater the risks that accompany
that process.
What does this mean for economic policy in the United States and the rest
of the world? The conventional policy prescription includes the encouragement
of higher public savings in the United States, the implementation of structural
reforms designed to increase flexibility and raise potential growth rates in
economies outside the United States, and movement toward increased exchange
rate flexibility. The principal rationale for each of these policies is independent
of the external imperative. But the fact that these policies would contribute
to a benign external adjustment process strengthens the case for action on these
fronts.
Improving the U.S. fiscal position is the most effective means we have available
to reduce our vulnerability during this prolonged period of adjustment. The
United States needs to produce a substantial reduction in its structural deficit
over the medium term and begin to reduce the more dramatic longer term gap between
resources and commitments. And the United States needs to restore a reasonable cushion
in its structural budget balance to help deal with future shocks.
If we are unable to begin to generate more confidence in the capacity of the
U.S. political system to produce these improvements, we would face a greater
risk of future increases in risk premia. And even though substantial fiscal
consolidation would not by itself bring the external imbalance down to a more
sustainable level, it would improve the prospect for a smoother adjustment to
that outcome.
The general risk inherent in these imbalances—the risk of more adverse
growth outcomes and asset price volatility—reinforces the importance
of sustaining the strength and resilience of the U.S. financial system. Our
financial system today is in substantially stronger shape than it was even in
the recent past, and the major institutions now appear to be managed so that
they are less vulnerable to the type and magnitude of shocks they’ve experienced
in the past couple decades.
What is important of course is that they are as well positioned to deal with
the full range of potential future risks. This requires continued investments
in risk management and controls to match the increasing complexity of these
challenges, and it requires a cushion of capital and liquidity large enough
to capture the potential risk of losses in a less favorable macroeconomic environment.
The increase in the flexibility and resilience of the U.S. economy over the
past two decades has a lot to do with the increased openness of the U.S. economy.
And sustaining this flexibility, which is so important to our capacity to adjust
to shocks, requires that we continue to support the process of openness and
economic integration. We jeopardize future income gains if we are unable to
sustain support in the United States for what has been a relatively open trade
policy. How effective we are in meeting this political challenge is likely to
depend significantly on how effective we are in improving educational opportunity
and achievement in the United States, and perhaps also in improving the design
of the temporary assistance we provide those individuals who bear the brunt
of the adjustment costs that come with greater global economic integration.
These policies by the United States would help improve the prospects of a more
benign adjustment process. But they would not be sufficient to produce a more
favorable adjustment path. A more favorable adjustment scenario would require
policy changes in each of the major economic areas.
For global growth to be sustained at a reasonably strong pace during this period
of adjustment, the desirable increase in U.S. savings, and the necessary slowing
in U.S. domestic demand growth relative to growth of U.S. output, would have
to be complemented by stronger domestic demand growth outside the United States,
absorbing a larger share of national savings. Exchange rate regimes, where they
are currently closely tied to the dollar, will have to become more flexible,
allowing exchange rates to adjust in response to changing fundamentals. Reforms
to financial systems and to social safety nets over time would help reduce the
need for exceptionally high levels of domestic saving we see in many countries.
The global nature of these requirements does not imply that the United States
can put the principal burden for adjustment on others. If we focus adequate
political capital on the factors within our control, we will have more credibility
internationally in encouraging policy changes outside the United States that
might reduce our collective risks in the adjustment process ahead.
What does this mean for monetary policy?
Monetary policy itself cannot sensibly be directed at reducing imbalances, but
the past and future evolution of global capital flows will of course matter
for monetary policy by virtue of their impact on the outlook for output and
inflation. For example, the forces that seem to be supporting an unusual level
of capital flows into the United States may be materially dampening the level
of forward nominal and real interest rates, and other things being equal, this
would tend to produce higher levels of demand growth than would prevail in the
absence of those factors. Thus, the factors that have contributed to this pattern
of external imbalances complicate the task of judging the appropriate stance
of monetary policy in the United States today.
Perhaps it makes sense to conclude with the more general observation that changes
in the size of global capital flows and the accompanying imbalances increase
the importance of sustaining the credibility of monetary policy, because they
increase the costs of a loss of credibility or a negative shock to credibility.
We live with considerable uncertainty about the sustainability of the pattern of
global capital flows and the relatively low risk premia that prevail today.
That uncertainty necessarily adds to the normally substantial degree of uncertainty
we face in making monetary policy judgments. And it reinforces the case for
preserving confidence in our commitment to keep underlying inflation low over
time, and for retaining the capacity to respond with flexibility to the challenges
we face in this uncertain world.
Thank you.
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