8th Annual ConferenceEurope and the US: Partners and Competitors - New paths for the future
Professor Otmar Issing, Member of the Executive Board of the European Central Bank,German British Forum,London, 28 October 2003.
It was just a few weeks after 11 September 2001, when the German British Forum met in London. On that occasion, I had already the privilege to participate in a panel on "a new framework for the US-European partnership." In my introduction, I stated that "... such traumatic events – hitting us as individuals, as nations and as a community of nations – have led us to rediscover a sense of purpose, reaffirm common values and act in solidarity. This brings people closer together in times of trial."
Unfortunately, this sense of closer-than-ever ties across the Atlantic has not lasted long. Two years and two wars later, the relationship has proved rockier than expected. These new challenges in the long-standing relationship between the US and Europe also reflect the fact that the world as a whole is changing rapidly, with Europe being no exception. After the successful introduction of the single European currency in a large number of countries, attention has now turned to drafting a Treaty establishing a Constitution for Europe. At the same time ten countries – mainly in eastern and central Europe – are preparing for accession to the European Union in 2004.
Developments like these – on both sides of the Atlantic but also in other parts of the world – will continue to influence our transatlantic ties, which – on the basis of deep roots and solid foundations – will have to adapt constantly in light of such changing circumstances. While these ties have many different dimensions and facets, all of which are interesting and important, I would like to concentrate in my remarks today on some economic issues, as these are closest to the core business of central banks. In particular, I would like to briefly elaborate on the issue of global imbalances, which have attracted so much attention. While the notion of global imbalances may have different meanings to different people, the interpretation which will underlie my talk this evening concerns the international flow of goods, services and capital. Such imbalances manifest themselves in large trade and current account deficits in some countries, with corresponding surpluses in others.
When one talks about global imbalances in this sense, one, of course, is immediately drawn to the persistent US current account deficit, which has existed more or less continually since the early 1980s and which currently runs at roughly 5% of GDP. As a consequence, the net liabilities of the US vis-à-vis the rest of the world increased to around 23% of GDP by end-2002 – compared with less than 5% in the early 1990s. Whereas the US current account deficit in the second half of the 1990s was largely a reflection of changes in the relationship between private-sector savings and investments, more recently the source of the deficit has shifted from the private sector to the public sector, thereby reviving the "twin deficit" debate of the 1980s.
In my remarks today, I would like to briefly discuss whether and under what conditions these imbalances should be a matter of concern, as, for example, expressed by the IMF in its most recent World Economic Outlook. Subsequently, I would like to share some thoughts on how to deal with the current imbalances and, maybe more importantly, how not to deal with them.
2. The case of current account deficits
The question that immediately arises when discussing current account deficits is whether we should be concerned about them and under what circumstances one might be justified in talking, in fact, about an imbalance manifesting itself in such a deficit. It is important to stress at the outset that, despite the negative connotation of the word "deficit", there is nothing inherently bad about a current account deficit per se. On the contrary, a temporary deficit may be beneficial to all countries involved. In fact, one of the main advantages of free capital movement is that in the short run – as in the case of a private household – current expenditures are not constrained by current income, and temporary income shortfalls can be smoothed over through borrowing, thereby avoiding undesirable fluctuations in consumption.
Likewise, when a country experiences a sudden increase in investment returns – for example, due to the introduction of new technology – it may not want to finance all of the newly profitable investment projects out of its own current income, as that would necessitate a temporary fall in consumption. Instead, the country would borrow capital from abroad, thereby again avoiding unnecessary fluctuations in its consumption. Such considerations are likely to have played a role in the rise of the US current account deficit in the second half of the 1990s, as the "new economy" phenomenon led to expectations of higher returns on investment spending.
Taking these kinds of considerations into account, it can be argued that it continues to be appropriate for the United States to run a current account deficit at the current juncture. In fact, the IMF estimates that a US current account deficit of around 2% of GDP would be consistent with the equilibrium saving-investment balance – a level significantly lower than the actual deficit.
3. Excessive current account deficits
There are three main reasons why a large current account deficit that goes beyond such medium-term equilibrium considerations may be a cause for concern and may, in that sense, qualify as an imbalance. First, persistent current account deficits – and, in particular, trade deficits – may give rise to protectionist pressures in the deficit country. If the country is a major trading nation, this may pose a serious threat to the global trading system. Second, there is the risk of a disorderly adjustment. And third, world savings may not be allocated efficiently. Let me briefly address these last two points.
3.1. The risk of disorderly adjustment
Regarding the risk of a disorderly adjustment, it should be emphasised that any excessive current account deficit will need to adjust eventually. What cannot last, will not last. The crucial issue is whether the adjustment will be orderly or involve a large and disruptive change in key economic variables. Such a disorderly adjustment would affect not only the rest of the world but, in particular, the deficit country itself, turning this issue into a truly global one.
There are a number of factors, which may increase the risk of a disorderly adjustment. For example, the longer the flow imbalances exist and the larger they – and the associated stock imbalances – are, the larger the required adjustment back to more reasonable levels would be. The risk of a disorderly adjustment is likely to increase with the magnitude of the needed adjustment. A further factor that may play a role in determining the orderliness of the adjustment process is the composition of the capital flows which finance the current account deficit. In particular, "hot" portfolio flows may quickly reverse direction in a highly integrated global financial system characterised by close substitutability of different markets with respect to the diversification benefits they offer. In particular, if such capital flows are driven largely by uncertain return expectations, they may quickly decline or even reverse if these expectations turn out to have been overly optimistic.
This possibility was illustrated during the recent "new economy" euphoria, during which the United States attracted capital inflows at an unprecedented rate. As it became clear that the initial return expectations had been exaggerated, foreigners' net purchases of US stocks declined sharply – from USD 175 billion in 2000 to less than USD 50 billion in 2002. All other things being equal, this reduction in capital inflows would, in all likelihood, have resulted in a corresponding improvement in the current account balance accompanied by lower growth in the United States. However all things were not equal. Partly offsetting the decline in equity inflows, foreigners' investment in corporate and government bonds picked up, thereby limiting the impact on overall capital inflows.
3.2 Inefficient allocation of world savings
Regarding the third point – the possibility of an inefficient allocation of world savings – it can be argued that, as long as private individuals voluntarily engage in international transactions, which give rise to the current account deficit or the corresponding financial account surplus, there is in general no a priori reason to believe that the outcome would be inefficient. This is, after all, the basic tenet on which the case for market economies is based. However, as in the case of a private household's borrowing, under certain circumstances inefficiencies may nonetheless arise. In particular, overly optimistic expectations about one's earnings ability and imperfect information about the borrowing party on the part of the lender may result in inefficient over-borrowing. Both factors may have also played a role in the expansion of the US current account deficit in the second half of the 1990s.
As I mentioned earlier, expectations about the rates of return that could be achieved in connection with the "new economy" appear to have been overly optimistic. In fact, EU investors have incurred substantial losses on their investment in the US stock market during the second half of the 1990s. Considering only investment since 1997, estimates indicate that they lost between EUR 200 billion and EUR 540 billion from the stock market peak until mid-2002, with the concrete amount depending on the assumptions regarding the sectoral composition of European investment flows. These losses more than outweighed any initial gains. Thus, with hindsight it seems that too much private capital – in search of expected high returns – may have flowed to the United States, thereby providing the financing for the rising current account deficit in the second half of the 1990s.
Of course, history shows that periods of major technological innovations or inventions are often accompanied by such periods of excessive optimism and it is not clear whether there is room for an active role for policy-makers in such a situation, especially given the difficulties involved in identifying instances of such "irrational exuberance" at the time. At a minimum, however, it should be ensured that capital flows occur in an environment, in which timely and accurate information about investment projects is available, so that capital can flow to uses with the highest (risk-adjusted) rates of return. The importance of this condition is highlighted by the accounting irregularities at US companies, which resulted in an overstatement of actual profitability. With more accurate information at the time of the investment decision, less capital would in all likelihood have been invested in the affected companies and possibly less capital would have been invested in the United States as a whole, thereby limiting the surplus in the financial accounts – and, by accounting identity, the deficit in the current account.
Another reason why the efficiency of the allocation of global savings may be an issue is that, more recently, the external deficit of the United States reflects actions by public entities rather than private sector interactions. On the one hand, the US saving-investment gap is at present largely a public one, reflecting the increase in fiscal deficits. On the other hand, the financing of the current account deficit has shifted from private funds to public funds, as many central banks – in particular in Asia – are engaged in large purchases of US government securities. Given the historical track record of public entities with respect to the efficient use of funds, this shift towards the public sector – both on the financing and on the allocation side – may in itself provide some cause for concern.
4. The way forward: How to bring about an orderly adjustment?
The current level of the US current account deficit is in the longer run unsustainable and an adjustment will eventually occur, whether actively supported by macroeconomic policies or not. The question is only whether it will happen in an orderly fashion. By supporting an adjustment sooner rather than later policy-makers could, in principle, help to ensure such a gradual and orderly adjustment, while at the same time possibly contributing to a more efficient use of global savings and safeguarding the global trading system by limiting protectionist pressures. This would be in the interest of all countries involved, including the United States.
I sometimes have the impression that Europe and the United States are separated by two different schools of thought in that respect. In Europe the view seems to prevail that a problem with the US current account deficit indeed exists, while on the other side of the Atlantic many people do not consider this to be a problem, at least not for the US, but rather for Europe. Consequently, Europe should find a solution to it. Paraphrasing a statement, which former US Treasury Secretary Connolly made with respect to the US currency, one could summarise this view as "It may be our deficit, but it is your problem." It is, however, important to acknowledge that this is an issue of global relevance, as the smooth adjustment of a situation that is unsustainable is in the interest of countries on both sides of the Atlantic and also the rest of the world. Indeed, it appears that, despite the occasional rhetoric to the contrary, policy-makers in the US are well aware of the potential negative consequences of a disorderly adjustment on the US economy.
But how can an adjustment be achieved? A slowdown in the deficit country's growth rates relative to the rest of the world typically plays an important role in any such adjustment. This could, for example, mean an actual growth slowdown in the United States, thereby reducing the demand for imported goods and services, or a growth acceleration in the rest of the world, which increases the demand for US exports. If we had to decide on one or the other, the choice would not be difficult – it is higher growth everywhere else. This preference is also reflected in frequently heard demands from the other side of the Atlantic that Europe should generate faster growth to aid the adjustment process. In this respect it is extremely important to specify how this higher growth is to be achieved. Artificially stimulating the economy by large budget deficits and/or inflationary monetary policy is no viable option. In fact, history tells us that such policies can only provide temporary straw fires, with potentially damaging long-term consequences. To illustrate this point let me briefly take you back in time to the mid-1980s. At that time, the US-dollar had been appreciating rapidly over a number of years and the US current account stood at around 3% of GDP – at that point a post-war historical peak. Concerned about the potential side effects and risks involved in such an unsustainable situation, policy-makers from the main industrialised countries decided to tackle this problem in a coordinated fashion. In addition to agreeing to bring down the external value of the US dollar, they also decided that Europe and Japan should pursue policies aimed at stimulating domestic demand. They would thus become the "locomotives", which would bring about the adjustment, while at the same time raising global growth. In the so-called Louvre Accord in 1987 the governments and central banks of the major industrialised countries, for example, agreed that Japan would "follow monetary and fiscal policies which will help to expand domestic demand and thereby contribute to reducing the external surplus." We all know what happened subsequently. The expansionary policies in Japan and, in particular, the monetary easing that was involved contributed to an asset market bubble, which burst and led to a decade of very sluggish growth and created structural imbalances which are still constraining growth in Japan to some extent today. Seen from this perspective, some of the problems of today's world economy date back to misguided policies triggered by efforts to solve global imbalances.
Instead of short-term activism, which is likely to create imbalances in other areas and does not solve the underlying problem, sustainable policies are needed, with a view towards the medium and long-term. Currently, there are no major imbalances in the euro area constraining growth. The real structural problem in Europe is that the long-term potential or sustainable rate of growth is too low. Thus, the primary task for Europe is to pursue policies that lead to an increase in potential growth. This is, of course, an objective in and of itself and not primarily a reflection of the need to adjust external imbalances. In this context, one has to realise that macroeconomic policies can not be used to mitigate the structural causes of the relatively modest growth rates and the high levels of unemployment which weigh heavily on most European countries. Other policies, mainly aimed at the micro level, have to be employed for that purpose. One important first step in that respect was taken during the Lisbon European Council meeting in March 2000, where EU Heads of State and Government set out an ambitious agenda, which includes the further deregulation of utilities markets, the reduction of regulatory barriers to trade in services and improvements in the efficiency and transparency of financial markets.
Macroeconomic policy must contribute to this process by providing a stable environment, in which such micro policies can develop their fullest potential. For monetary policy this means a policy of price stability which is not only sustainable in the long term but has also been shown to provide the best contribution that monetary policy can make to long-run growth. The ECB's forward-looking policy with the objective of ensuring medium-term price stability together with necessary structural reforms is thus an indispensable condition for raising the potential growth rate of the euro area economies. In that context, one of the main reasons why such a policy is effective in providing a growth-enhancing environment is that it anchors and stabilises people's expectations about future price developments. Therefore it is crucial to carefully guide those expectations, rather than try to manipulate them to obtain short-term benefits, while endangering the longer-run credibility of the overall monetary policy strategy.
In that context, let me briefly address an argument that is sometimes made to justify the demand for a more aggressive expansionary policy in Europe. According to this argument, the United States have contributed to strong global growth in the second half of the 1990s, thereby "saving" the rest of the world, and in particular Europe, from stagnation and recession. This implies, according to the proponents of this argument, that it would now be Europe's turn to do likewise and to provide the needed growth impetus. This argument is not new and was used already extensively in the mid-1980s when the world economy, as I said earlier, found itself in a similar situation as today. But the argument is as wrong and dangerous today as it was then. The United States has not conducted macroeconomic policies with a view towards the world, thereby sacrificing domestic policy objectives in favour of global considerations. Both then and now, for good reasons the focus has been on the United States and the resulting policies happened to provide the rest of the world with some benefits – at least in the short run. This stance was succinctly summarised by Federal Reserve Chairman Greenspan in a 1999 Senate hearing: "We would never put ourselves in a position where we envisaged actions we would take to be of assistance to the rest of the world but to the detriment of the United States." As a consequence, the argument – which is sometimes elevated to the standard of a "moral obligation" – that European policy-makers should forego important domestic policy goals is untenable. This is especially true if such goals were to be sacrificed in favour of short-term stimulus measures, which would not solve any of the underlying real problems, which give rise to the existing imbalances.
Having said that, I would like to add that any initiative to raise sustainable growth in Europe would, of course, be very welcome in itself and would, as a positive by-product, help to eliminate currently existing imbalances. As the large US current account deficit corresponds to capital imports on the same scale, one important lesson is that we have to make Europe a better place for investment, a place which will attract capital from all over the world – European savers included. This will result in higher growth in Europe and, as a side effect, contribute to the global adjustment process. This is the lesson that should be drawn – not the use of misguided macroeconomic policies, which add to rather than reduce imbalances domestically and on a global level.
Although faster growth in the rest of world may support the adjustment process, part of this adjustment will eventually have to come from an adjustment of the saving-investment gap in the United States. Although the private sector has undergone a substantial correction phase in the aftermath of the bursting of the "new economy" bubble, some further adjustment may be necessary in order to achieve a long-term sustainable balance sheet situation. A considerably larger correction will be necessary for the public saving-investment balance, with the current fiscal stance certainly not being sustainable in the long run. Such a correction will in all likelihood imply lower growth for some time. The choice is, however, not between correction or no correction, but between a correction sooner rather than later. The current situation is not sustainable and an adjustment is inevitable. A timely one may in the end be less costly than a postponed but eventually more disruptive one.
In conclusion, let me emphasise, in order to avoid misunderstandings, that we at the European Central Bank are very much aware of our responsibilities in a world characterised by close trade and financial linkages between countries and regions. With the euro being the world's second most important currency, these responsibilities must not be ignored. The important issue is how these responsibilities are translated into concrete policy actions. For example, the ECB has shown that it is prepared and stands ready to act swiftly and with determination in the case of extraordinary circumstances such as those arising from the tragic events of 11 September 2001. Regarding the current global imbalances, the euro area will play its part in trying to ensure that the adjustment will be as orderly as possible. However, it would be dangerous to believe that excessive expansionary measures would be a valuable contribution. They would be in the interest neither of the US nor of the euro area, as they would give rise to imbalances elsewhere which would have to be corrected at some point in the future as well. Even now, there is certainly no lack of liquidity in the world.
Stability – also on the global level – begins at home and a narrow focus on the external side is certainly too short-sighted. In particular, the notion that higher growth – regardless of how it is achieved – is beneficial for the global economy, is fundamentally flawed. Rather than shifting imbalances between countries and regions, a more sensible approach would be for macro policy-makers to provide the framework within which sustainable growth can be achieved. For monetary policymakers, this means trying to achieve medium-term price stability.
Europe and the US have strong historical ties and their relationship is in a state of constant flux. Of course, the relative importance of the two facets of this relationship – partnership and competition – also varies over time. Competiting for world savings by offering high returns and competing in search for good economic policies is healthy and should be encouraged. While being thus rightly competitors in those areas, a shared set of common values will ensure that the United States and Europe must always remain partners on a number of policy issues concerning matters of mutual interest, such as ensuring a free and open world trading system or the smooth further integration of new dynamic economic regions into the world economy. The orderly adjustment of existing global imbalances should always be considered as an issue of shared interest. We can only succeed in this respect, if we act as partners, rather than as antagonistic competitors. In the longer run, domestic and global stability, national and international interests, do not conflict, but go hand in hand.