Viv Davies interviews Bernard Hoekman for Vox

July 2010

Transcription of an VoxEU audio interview [http://www.voxeu.org/index.php?q=node/5363]

Viv Davies: Hello, and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davies from CEPR. It's the 28th of July, 2010, and I'm talking to Bernard Hoekman of the World Bank about the recent Vox ebook he edited with Stijn Claessens and Simon Evenett on rebalancing the global economy.

I began by asking Bernard to explain how global imbalances occur in the first place, why they are necessarily bad, and why they persist.

Bernard Hoekman: I guess the first thing to say is that it's not a new phenomenon. We've had global imbalances for many years in fact, decades and it's not necessarily a problem. In principle, there's nothing wrong with imbalances because imbalances really reflect the fact that there are differences in savings and investment opportunities across countries and insofar as the imbalances allow an efficient reallocation of savings across countries, that's actually a good thing.

The new thing, really, that has been happening over the last decade or so is the growth in the level of imbalances. So where we were before the crisis hit in 2008, the aggregate magnitude of global imbalances was reaching more than five percent of global GDP.

So if you add up all of the surpluses and all of the deficits and divide that by global production, you get around five percent. And that compares to an average of around one percent in the period before, let's say, 1990.

So we've seen very strong growth in global imbalances in the last two decades, 11 percent per year between 1990 and 2007, according to one of the papers in the ebook, by Caroline Freund, compared to a growth rate of around one percent per year before 1990. And that's relative to a trade growth rate of six percent.

So we've seen a really sharp increase in imbalances, and that's really a reflection of a number of things, but one of the major ones is the success of exports oriented development strategies that have been pursued in Asia, which generate large surpluses on their current accounts.

And that was really compounded by the desire of these countries, after the East Asian financial crisis, to self insure against these types of exogenous shocks. So there was a deliberate policy to maintain higher reserve ratios so that they wouldn't be as much affected by volatility in terms of capital flows.

And these surpluses have largely been invested in high income countries, in the United States, United States T Bills, and other OECD countries.

And in a sense, that helped lead to a very low interest rate environment, and a lot of people are arguing that that was one of the factors that actually led to the bubble in financial markets in the US and other countries. So, in effect, the imbalances in savings around the world have allowed countries like the United States to consume well above income levels.

So that persisted for quite a while. And a lot of people at the time were arguing that there wasn't anything necessarily wrong with that, but a lot of other academics were arguing at the time that this was something that was not sustainable.

So what we've seen in the crisis is that there's been a very significant reduction in the overall level of these imbalances, largely because economic activity declined so trade fell off a cliff. So as exports and imports fell, these imbalances have also shrunk. They fell by about 50 percent during the crisis.

But with the recovery, what we're seeing is that these imbalances are growing quite rapidly again.

And I think one of the key problems now and one of the key challenges is that, in a sense, the sustainability of these imbalances, it's a lot more fragile than it was before the crisis. Simply because a lot of countries are now looking at a situation where they have much higher debt levels, where they have much less in the way of fiscal space, budget deficits have increased quite significantly.

So one of the problems in terms of why they're bad in the current context is that it can generate quite significant instability, and it can lead to a crash, for example, of the dollar if markets lose confidence. So that's really one of the big threats that we're confronting now.

And a parallel threat in terms of why you need to worry about imbalances is that the policy responses by countries can be such that they can have very negative spillover effects on other countries.

So, for example, insofar as large deficit countries, like the United States, start engaging in protectionism in an effort to try and reduce the imbalances by reducing imports, that could have very negative implications also for other countries.

Viv: So this isn't the first time that we've experienced global imbalances, but history perhaps doesn't really tell us how best we should be dealing with them this time around.

Bernard: I think one of the things that history does tell us is that kind of nationalistic, in the sense of really focusing on a country's own situation, and not taking into account repercussions on other counties, or not pursuing a coordinated response to what is really a global problem, can lead us into serious problems and difficulties. If you look at past episodes of current account imbalances and how they were dealt with, and there's a number of these episodes which are discussed in the book by economic historians, both relatively recent, so imbalances that arose in the early 1970s, and again in the 1980s.

But also if you look at the situation in the inter war period, in terms of tensions between large surplus and deficit countries, one of the, I think, clear messages that comes out of those chapters and those analyses is that coordination is quite critical, because nationalistic, unilateral types of responses can very quickly lead towards negative implications for the world as a whole.

So if you take the case of the 1970s, when imbalances at that time were such that the United States wanted to put a lot of pressure on surplus countries at the time, like Germany, that actually led to the end of the fixed exchange rate regime, the Bretton Woods system. It led to the use of protectionist actions by the United States.

So the United States put an across the board import surcharge on imports in an effort to try and improve the current account. And again, that had negative implications for the rest of the world.

Similarly, in the 1980s, there were a number of efforts to actually try and engage in more coordinated actions. There again, the way that was done, the countries that were in surplus take the case of Japan, for example.

There are a number of papers, again, in the ebook that look at the Japanese case and, again, argue that the kind of policy responses and the policies that the Japanese government was encouraged to adopt, like monetary expansion, revaluing the exchange rates or exchange rate appreciation, resulted in large deficits.

It resulted in bubbles in the Japanese economy and a decade of slow growth.

Again, what comes out of that story is that it takes two to tango. You need to focus both on actions in the surplus countries and in the deficit countries.

Viv: Recently, the G20 has stressed the importance of achieving more balanced global growth, and in fact made a pledge at Pittsburgh, and later at Toronto, towards implementing policies that will achieve that. So does that mean that now we are moving towards a consensus on what needs to be done in terms of the required policy responses, both at national and the systemic, global levels?

Bernard: Well, consensus, I think, is a strong word. But in broad terms, I think there is agreement in terms of what needs to be done. Surplus countries need to invest more. They need to import more. They need to consume more, not just of tradeables but in particular, also, of non tradeables. Deficit countries need to increase net exports to generate the financing they need to service their debt. But also, to reduce their deficits, they need to save more.

So in broad terms, I think everybody agrees in terms of where we need to go, in terms of the direction of change. The problem is, how do you get countries to actually do what is required in a way that minimizes the cost of adjustment on the various sides?

And in particular, here the challenge is, how do you get the surplus countries to actually take actions, to invest more domestically, to save less, in a sense? So markets will be imposing disciplines on countries that are in deficits, but you're not going to have it on the other side of the equation.

I think there's also here a problem in terms of moving in the direction that I think everybody agrees a country should be moving in, is ensuring that, actually, there is coordination and cooperation.

And I think there is a bit of a fallacy of a composition issue going on, in the sense that if all deficit states start to cut back now on government expenditures, start closing fiscal deficits, et cetera, that could have negative effects on growth, overall.

And clearly what you need, from the perspective of deficit countries, in terms of getting out of the debt hole that they're in, is you need economic growth. So there's a really fine balancing act there. And I think, there again, it's important that both sides play a role in the rebalancing so as not to put all the burden of adjustment on the deficit countries.

Viv: So it seems like the real problem of rebalancing may not be primarily a technical or a purely economic one, but more of a political one. It's bringing to light sharing the burden of adjustment and how the costs of adjustment should be distributed. And as you say, that requires a much more coordinated response and collective responsibility. Do you see signs of that collective responsibility taking shape now?

Bernard: There are some interesting chapters in the book that get into this particular issue, in particular one by Mohamed El Erian and Mike Spence, where they argue that you actually saw quite a bit of cooperation early on in the crisis, certainly relative to what we've seen in the past or what we might have expected. But what we've seen more recently is a reversion towards more unilateral, more nationalistic, in the sense of looking at what's in my interest, that type of responses.

And Anne Krueger also has a chapter on this, where she argues that the coordination mechanisms we have today, in a sense, they're focusing us on the right issues. But the trouble is there's really a lack of incentive, there's a lack of an enforcement mechanism, to actually get countries to do what, in principle, they should be doing. We have a coordination and a cooperation challenge here.

So again, the key issue is to get surplus countries to adjust. And in part, they would have to do this to enhance flexibility of the exchange rates. In part, they'd need to create more incentives to invest at home. And that really gets us into a structural reform agenda, which will take time and which, often, is going to be politically difficult.

The question really is, how do you incentivize surplus countries to cooperate? I think here there are a number. And again, this is not a new issue.

Quite interestingly enough, people like John Maynard Keynes, this was one of the key things he was concerned about in the interwar period, and he proposed a mechanism to address these types of issues, which really revolve around trying to impose some disciplines on surplus countries, that large surpluses don't get sustained over time.

So there are some proposals that are embedded in some of the chapters in the ebook, along the lines of, maybe one thing we should be considering is to tax capital flows.

So the surplus countries, obviously they're investing those resources in other parts of the world, so one option would be tax those flows and allocate some of the revenues that are raised that way to actually help promote the adjustment process in deficit countries. So that could be allocated through a transfer of funds to the IMF, to other international organizations.

So there are a number of ideas out there, but all of them revolve around trying to get the surplus countries to be part of the solution to the problem.

Viv: I guess a lot of the debate so far on global imbalances is focused on the demand side in particular. But the book also suggests that there is a case to be made for the importance of supply side factors, too. Could you expand a little on that, perhaps?

Bernard: I think that's one of the themes that emerges from quite a few of the chapters in the book. So if you think about how do you define the current account deficits or surplus, it's really, on the one hand, we have the difference between aggregate savings and investments. And if you split that up between private and public, you've got savings minus investments plus the government sector, so what the government is raising in terms of taxes minus what the government is spending. And then we have the current account, more traditionally defined as the difference between overall exports and imports.

Now, a lot of the focus of attention in terms of reducing imbalances is focusing on, if you're a deficit country, increase your net exports. So increase gross exports, reduce imports. But also, get savings up, because that's the other side of the coin. Similarly, surplus countries, their prescription is, well, you're in surplus because you're saving a lot more than you're investing. So one of the solutions would be consume more, including not just tradeables but also non tradeables. And invest more domestically; create more investment opportunities in your own country so that you have less of a need to export capital to the rest of the world.

Now, a lot of the policy prescriptions in terms of how to do that, you can put that under the heading of the demand side, and it really revolves around expenditure switching and changing domestic absorption.

So the deficit countries would have to consume less, and one way of doing that, and one way of getting them to increase their net exports, is to adjust the exchange rate so that people have more of an incentive to export more and import less.

Now, that's very much what a lot of the debate is about. So there's been a huge amount of discussion in terms of bilateral exchange rates and how we should be moving towards a more flexible exchange rate regime. Which is all well and good, and I think that's an important part of the story.

But I think the supply side, really, and structural changes are going to be very important in terms of making all this work. Because, if you think about the phrase "increase savings, " or "increase investments, " the question is, what instruments do I have to invest in? Where do I allocate my savings? How do you actually increase exports?

One of the objectives of the United States, for example, is to double exports over a period of five years and, in that way, actually help reduce the current account deficit and help attain the rebalancing objectives.

But if you think about what all that implies, it really gets you very quickly into consideration of discussions of, where do you invest in? So what areas should there be government, public investment in? What is actually constraining investment opportunities in surplus countries?

Let's look at the reasons why most of these savings are being invested in the rest of the world. So that gets you pointed at things like the local investment climate, barriers to entry, product market regulation. But also you need to look at trade barriers. So again, if you think about exports and imports, one of the reasons surplus countries might be having a surplus on the trade balance, is, well, they might have barriers to imports.

There's an interesting paper in the ebook by some people from the OECD, who argue that if you look at the composition of trade barriers today, barriers to trade in services are significantly higher than barriers to trade in goods on average across all countries.

But if you also look at who has a comparative advantage in exporting services, that tends to be countries like the United States.

So part of the rebalancing equation has to go beyond goods. It should cover services, but there's a big policy dimension towards actually encouraging that trade, in terms of reducing barriers, reducing regulatory constraints, towards not just trade but also investment. Services account for 60 70+% of GDP of most countries today.

So if you think about the prescription that surplus countries should be exporting less, should be investing more at home, almost by definition, you're going to be looking at a lot of services markets, which do tend to be more regulated. They do tend to have higher barriers to entry and operating costs than other markets.

So that really points to a structural reform agenda, which is really a supply side type story.

Viv: What are the implications of global imbalances and the process of rebalancing for the least developed and the developing countries? Do they have a responsibility to act, too, or are their options going forward more dependent upon the actions of the industrialized countries?

Bernard: Well, they have a key role to play in this. So developing countries have to be part of the rebalancing story in general, in part because independent of any policy actions at all, the growth is really in emerging markets and developing countries. So I think we're looking at a reasonably long period of relatively low, slow growth in industrialized countries, so growth is going to be much higher in developing countries. So that in itself is going to lead to a gradual rebalancing of the world economy in terms of which countries account for what share of GDP overall.

So I think that's part of the solution and that will, of course, take some time. But I think they also have an important role to play in terms of policy and support, putting in place policies to support rebalancing. Because, in a sense, capital really should not be flowing to the OECD countries from developing countries. Capital really should be invested in developing countries. And again, this points very much towards a structural agenda.

So why would you invest your reserves in U.S. T bills? That really suggests that there's a lack of opportunities in the developing countries, on average overall. So a lot of what I was just saying about services and the structural reform agenda really applies very much here, so improving the investment climate, dealing with barriers, to trade barriers to entry, and so forth.

And I think that will not just help in terms of rebalancing, but I think undertaking those types of reforms would also help improve productivity, especially in the non tradeable sector.

So if you think about investing more, consuming more of non tradeables, encouraging investment from the rest of the world, and from OECD countries in particular, in services, will help improve productivity of downstream firms, who have access to lower cost, higher quality types of services.

So I think, again, developing countries have a big role to play in this agenda, in terms of encouraging a shift away from large surpluses that are invested in low interest bearing bonds and so forth. And to shift those resources towards what should be a higher rate of return, real activities, real investment in these countries.

And there are a number of chapters in the ebook that go into this in some length, in terms of what areas... In particular, there's one by Jong-Wha Lee from the Asian Development Bank, pointing to the need for both financial sector reform, but also investments in health, education, and, of course, social protection, social insurance in countries like China. One of the reasons savings rates are so high is because we don't have those systems in place. So putting those systems in place, investing in those types of systems will help reduce the need for the type of savings and surpluses we see today.

Viv: Bernard, before we wrap up, I'd just like to see what your thoughts are on what we're witnessing quite recently in that there's been a very clear divide of opinion amongst economists on the issue of fiscal austerity versus stimulus, or as the FT has put it, to tighten or not to tighten, that is the question. But given this strong difference of opinion amongst some of the world's leading economics experts, do you think it's realistic to expect that policy makers can have confidence in the advice that they're being given regarding solutions to the question of economic rebalancing?

Bernard: Well, there's clearly a lot of debate and there are lots of differences in views that have been expressed. But in terms of the question you're posing, the advice on solutions to rebalancing, I don't think there are big fundamental differences in terms of where to go. I think the differences are really more on timing, when to do certain things and on ensuring coordination.

I think that's really a critical issue. That's where the challenge is. So clearly deficit countries have to bring their house in order. They have to cut back on expenditures. They need to pursue the structural reforms that we just spoke about, and I think there's general agreement on the policy agenda that these countries need to pursue.

And again, people will differ in terms of where to put the emphasis, but I think overall there is quite a bit of agreement on that. And I think the same thing applies to surplus countries, who also have a clear self interest in actually ensuring that there isn't a disorderly unwinding or a crash of the dollar, largely because they have these surpluses. Those are resources which they own, and they should be looking to see their citizens see an increase in real incomes.

I think really the challenge, and I think what you were referring to is the debate between austerity versus stimulus, and I think that's really more short run, and it's a coordination issue again. And I think here the G20 has a big role to play. But again, I've noted in a number of the contributions to the ebook, I think there's general agreement on the normative shoulds, but it's a lot harder to actually make that a reality and to implement what needs to be done.

And clearly what you don't want right now, and again I think here there probably is a bit more disagreement between different observers, but I would argue you definitely don't want to see both the deficit and surplus countries, at the same time, start reducing budget deficits quite significantly. Because that is going to have major implications for growth, and that will make it a lot harder to actually pursue this rebalancing agenda in a way which is actually feasible.

So again I think it's a timing and coordination question as opposed to there really being significant differences in terms of the diagnostic.

Viv: Bernard, thanks very much for talking to us today.

Bernard: Your welcome, my pleasure.