It is Not Just up to Washington to Correct Global Imbalances, A Commentary By Rodrigo de Rato, Managing Director, IMF
December 31, 2005
A Commentary By Rodrigo de Rato
Managing Director of the International Monetary Fund
A Publication of The European Institute, Vol. 6 No. 4
December 31, 2005
There appears to be a widespread belief among European policy makers that global imbalances are only an American problem and not a European one. Many Europeans will say that Europe is an innocent bystander, and what is necessary is for the United States, with its huge external current account deficit, to reduce its fiscal deficit, and possibly for China to revalue its currency. Both views are way off the mark.
Many countries need to share the burden of reducing global imbalances and sustaining growth. Furthermore, since these imbalances will eventually be corrected, one way or another, it is worth bearing in mind that a disorderly adjustment of global imbalances would harm all countries. Europe would certainly be hurt by a disorderly adjustment, and has an interest in avoiding such an outcome.
But what are these key global imbalances, and what can policy makers do about them? Symptoms of the current global imbalances are high current account deficits and rapidly increasing debt in the U.S. and corresponding surpluses in Japan, many Asian emerging market economies, and increasingly oil-producing countries, including Russia as well as countries of the Middle East. These imbalances are unsustainable, and if they are corrected in a disorderly way, through an abrupt decline in the U.S. dollar and rise in interest rates, growth and prosperity all over the world will be threatened. The longer they are left unaddressed, the more threatening they become.
Some progress has been made recently in addressing the underlying issues. Fiscal revenues in the United States have rebounded. There has been progress with structural reform in the euro area and Japan, and the prospects for further progress in Japan are bright. And we have begun to see greater exchange rate flexibility in Asia. But these are just the first steps, and much more action is needed.
While much attention is focused on dealing with imbalances in Europe and the United States, other countries need to do their part. In emerging Asia, there is scope for greater exchange rate flexibility and increased domestic demand. The recent moves by China and Malaysia toward greater exchange rate flexibility are welcome, and other Asian countries have been allowing more flexibility as well. There is still scope for greater exchange rate flexibility. Such flexibility is in China's best interest, as it would provide more room for monetary independence and strengthen the economy's resilience to external shocks. Flexibility also would potentially raise domestic consumption in China by boosting households' real income. Indeed, faster domestic demand growth in Asia through structural reforms—including to encourage higher investment in some countries and better investment in others—should be part of an orderly adjustment process.
Oil producing countries, which now have some of the largest trade surpluses, can also help. Specifically, those oil producing countries whose macroeconomic positions are sufficiently strong can help reduce global imbalances by increasing productive spending, including in some cases social spending, in priority areas.
The U.S. economy has for some time been one of the main engines driving global growth. But as the projected net external liabilities of the U.S. continue to increase, so the vulnerabilities of the U.S. economy continue to grow. Therefore, it is particularly important, and increasingly urgent, that the U.S. tackle its current account deficit by increasing domestic saving to avoid the burden of adjustment falling on investment and growth. This requires bold action to reduce the fiscal deficit.
The U.S. administration recognizes the need for deficit reduction, but a major element in its plan is unprecedented cuts in spending. These would have been difficult to achieve even before the devastation wrought by Hurricane Katrina. Uncertainties about the costs of operations in Iraq and Afghanistan, the reconstruction of the Gulf Coast, and the outcome of Congressional debates on how to control entitlement spending, cast further doubt on whether the goals of the deficit reduction plan can be achieved.
In our view, actions on the revenue side, preferably through reforms to broaden and simplify the tax base, will also be needed. Measures to raise revenue are not very popular in Washington, but neither are higher interest rates, more expensive goods, or financial market turbulence, which are among the possible outcomes in the United States of a disorderly adjustment of global imbalances. And serious consideration of revenue measures could also be coupled with a long-overdue reform of the U.S. tax system.
U.S. policy makers should, therefore, give careful consideration to some of the measures suggested by the President's Advisory Panel on Federal Tax Reform, which issued its report in early November. Although the report proposes packages of measures that are revenue neutral, it points to a number of measures that could raise the tax yield and hence assist deficit reduction. Moreover, the report contains useful suggestions on how to streamline and simplify the current tax code, and suggests further shifting the tax burden from saving toward consumption, which could improve the efficiency of the tax system and help boost private savings.
If the U.S. is prepared to undertake ambitious fiscal adjustment, and also to tackle the long-term financial health of entitlement programs, its position would be much stronger. Tax reform should be debated in a manner that helps support these objectives. A balanced budget (excluding the surplus of the Social Security trust fund) over the medium term, coupled with reforms to place the Social Security and Medicare systems on a sound financial footing, would leave the U.S. fiscal system well placed to cope with the pressures of an aging population. And more immediately, it would raise national saving and help reduce global imbalances.
While Europe so far has not been at the center of the problem of widening external imbalances, it should be part of the solution—for its own sake, as well as for the health of the global economy. The fact that the euro area's current account balance has been small and stable while imbalances have grown elsewhere is no assurance that it can escape the fallout from a disorderly adjustment—especially given the major international role of the euro. Moreover, whether adjustment of the U.S. current account deficit is orderly, occurring through a gradual increase in its public or private savings, or disorderly, occurring through an abrupt exchange rate depreciation and a rise in interest rates that would force a drop in investment and growth, one outcome is likely to be lower growth of exports from other countries to the U.S. This would hurt growth in Europe, which is the last thing Europe needs.
Europe's key economic challenge is to raise its growth and employment performance, with an aging population. Social cohesion is already under pressure. Symptoms include growing hostility toward further European integration and globalization. Absent reform, social cohesion is likely to diminish further. A falling working-age population and rising spending related to aging will cause major problems. At present there are somewhat less than four people in the age range 15-65 for every one person over 65. By 2050 that ratio could be closer to two to one.
Part of the solution must be to achieve higher employment. Several countries in Europe have already shown ways to tackle structural problems in employment, without undermining social solidarity. Indeed, employment growth in the EU has been about the same as that in the U.S. over the past decade. This achievement is mostly due to more job-friendly wage policies, the liberalization of part-time and temporary employment, and the phasing-out of early-retirement schemes. It shows that reform is possible in Europe, and that it can both improve economic prospects and support social solidarity. But more needs to be done if Europe is to enjoy sustained strong growth.
A high priority is to reform welfare and improve labor utilization. Different countries need to take different steps, and European countries can learn from each other. Europeans sometimes resist reforms by stating a reluctance to copy the American model. But there is enough good performance in Europe for the continent's countries to benefit not by emulating any transatlantic blueprint, but by copying the most effective European models. Several policy options could be considered—each more relevant for some countries than others:
- Reform pensions in a sensible way: raise statutory retirement ages by linking them to life expectancy and introducing actuarial fairness. This would promote intergenerational equity and help the sustainability of pension plans.
- Supporting the jobless, but strengthen incentives: be generous with unemployment benefits but limit their duration. Long-term unemployment benefits can also be linked to active job searching and the performance of socially useful work.
- Make it easier for people to work, but limit distortions: governments, for example, could help people maintain adequate living standards through income tax credits rather than employer subsidies to create jobs at high minimum wages.
- Continue to overhaul employment protection legislation: more flexible labor contracts, for example, would promote job creation and prevent the existence of dual labor markets. This would be a more equitable approach to job protection than that embedded in the current employment protection legislation in many countries. In a globalized world, a focus on income generation rather than job creation per se will produces the greatest gain.
- Promote more active social spending: better education and job retraining would improve employment and income prospects and lessen the need for income support through welfare mechanisms.
Another promising avenue toward higher growth and efficiency is through further integration of Europe's financial markets. Greater financial integration should enhance competition, improve efficiency, lower the cost of capital, and improve monetary transmission. Some progress has been made, and much has been done at the EU level to advance the integration of national financial markets. But effective implementation is still needed, and work has barely begun on differences in taxation and legal systems that have impeded financial integration. Also, financial innovation is still very much proceeding at the national rather than European level. Further progress will require overcoming vested interests at the national level, and establishing a level playing field for financial institutions to compete and innovate, to the benefit of consumers and investors.
Finally, it will be crucial to advance the deregulation of product and services markets. While some progress has been made in deregulation of product markets, wide divergences exist across EU countries. And the largest sector of the economy—services—remains insular. A good start would be the adoption of the EU Services Directive without delay and dilution.
This is an ambitious agenda for both European countries and the United States, but there is high payoff from structural and fiscal reform. From an international perspective, restoring confidence and revitalizing growth in Europe through structural reforms that address supply-side constraints and raise domestic demand would help raise global growth and offset the potential contractionary effect of fiscal adjustment in the United States. And structural reform that helps the global economy is also in the best interests of the people of Europe. Similarly, fiscal reform in the United States is not primarily a service to the world, but a service to the American people. Both are simply the right things to do.
Another major contribution to redressing global imbalances would be to end the extreme poverty that persists in large parts of our world while unprecedented abundance reigns in others. A critical test of these commitments will be the ability of governments to rise above narrow interests in completing the WTO's Doha Round of trade liberalization talks and cooperate for the greater good of all.
To date, progress has been disappointing. Trade negotiators seem to be still postponing the tough decisions, pushing them ever closer to the deadline for the Round. There are costs to this delay. The absence of an early outcome implies lost growth opportunities for rich and poor countries alike, prolonging global imbalances and delaying efforts to accelerate the pace toward the Millennium Development Goals. Failure would cast a shadow over the multilateral trading system and further embolden protectionists, at a time when the world needs cooperation rather than conflict.