Are the imbalances on the mend?

By Samuel Brittan

Problems are not so much solved as replaced by other problems. How many people remember that only a few months ago the main problem facing the world economy was supposed to be that of “imbalances”: the large current payments deficits of the US and a few other countries, offset by surpluses in China, Japan and the oil-exporting countries? Since then, while all eyes have been on the bank credit crisis the imbalance problem has begun to fade away.

To start with, the dollar has fallen by 36 per cent on the official trade-weighted index against major currencies since its high point in 2002 and by a sensational 41 per cent against the euro. Goldman Sachs has estimated that US real exports should rise by almost 8 per cent in 2007 against a rise of just under 3 per cent in imports. This will be for the first time in 12 years that net exports will have made a positive contribution to US growth.

This improvement is unlikely to reflect the slowdown in the US economy, which has been very recent to the extent that it has happened at all. Goldman attributes it to a combination of dollar depreciation and rapid economic growth in the developing world, most of all in Brazil, Russia, India and China – which it calls the Brics. My money is on the Brics.

The UK has not seen this turnround. Sterling has not had the sensational rise attributed to it by the popular press, which remains fixated on the bilateral dollar/sterling rate. But it has tended slightly upwards since 2002. The UK current deficit has remained stable so far this year; but as a proportion of gross domestic product it is half that of the US and is in any case a much smaller part of the world economy. The US improvement could still be a business cycle phenomenon, although I doubt if it is purely that. For what it is worth, the US budget deficit is, for now at least, on a sharply declining path.

These changes have reminded me of an event at a conference this summer to honour the centenary of the birth of the notable British economist, James Meade. Just as the conference seemed in danger of sinking into end of afternoon torpor, with papers discussing how many angels could dance on the head of a pin, it was brought to life by the Australian trade economist Max Corden, who startled everyone by saying that the US was simply selling financial claims and buying goods, which he calls “intertemporal trade”. He did not deny that this could give rise to a problem; and as a good pupil of Meade’s, he engaged in a thorough taxonomic analysis of the possibilities.

The morals I drew were, first, that the onus of proof was on those who regarded it as a problem, and second, that many of the advocated remedies could be worse than the disease. Indeed, foreign exchange and capital markets might be more successful in muddling through to a solution. Prof Corden’s latest analysis was given in the annual Wincott lecture, soon to be published by the Wincott Foundation.

Yet such is the perversity of humanity that governments could make the imbalances into a problem where none existed before. If the deficit countries are to reduce their deficits, they have to switch resources from home markets to exports or import saving activities. It would be lovely if this could be done painlessly without impinging on output and activity. But a substantial structural change of this kind does require some sort of domestic slowdown while resources are being switched.

The danger, in a nutshell, is that central banks and governments are so assiduous in promoting domestic growth that they will not tolerate a few quarters of lacklustre GDP performance. In that case, deficits will never be allowed to contract properly and will become a problem which they might not have been to start with. All I can suggest is that, in their regular interest rate decisions, they should err on the side of caution.

Looking further ahead, it would be helpful to have some long-term rules. We need here to go back to fundamentals. What we need is not a balance of payments policy, but some guidelines which would allow us to forget this whole issue.

It helps to remember that one object of monetary policy is to promote a reasonable, but not inflationary, growth of domestic demand. An approximation might be an objective for the growth of nominal GDP, which I have canvassed in the past but did not pursue, in view of a widespread lack of interest and the success, for a decade and a half, of the inflation target strategy. But now that so much is up in the air it is necessary to state the objective in terms of domestic expenditure rather than GDP so that central banks do not forestall any improvements in the external balance which the markets are trying to bring about.

There are several different ways of measuring domestic expenditure and I am not going to spoil my argument by amateur back-of-the-envelope calculations. For those who are worried that the public will be put off by words like “nominal” or “expenditure” I would suggest a popular translation as “national cash limits”, which should be familiar from discussions on public spending. Simply reiterating inflation objectives is unlikely to be adequate in the decades ahead.