Deconstructing the policy prescription

On April 21, 2006 in the run-up to the IMF meeting, finance ministers and central bank governors of the G-7 countries issued a statement that bears scrutiny. It underscored their commitment ?to strengthen economic policies in our countries; work together to remove distortions to the global adjustment process; resist protectionism….? It acknowledged that while ?strong global economic expansion continues into its fourth year and the outlook is (generally) favourable,? some ?risks remain from oil market developments, global imbalances, and growing protectionism.?

With surpassing deftness, the statement avoided any reference to the elephant in the room?the US current account deficit of $800 billion in 2005 (6.5% of GDP). The financial surpluses of oil exporting countries (and what they ought to do with it), China?s inflexible exchange rate regime and her current account surpluses got attention, though reference to Japan?s external surpluses or her interventions in the exchange market did not find mention, no doubt part of the convention of mutual politeness that members of the G7 practise.

There are plenty of things truly odd about the size and persistence of the US current account deficit. The willingness of countries like Japan, China and oil exporters such as Russia and some Opec members to finance the huge US deficit enables it to persist and expand. But that does not absolve the US authorities from the obligation to rectify the imbalance.

From a reading of the G-7 statement, one might get the sense that it seeks to transfer much of the responsibility to the financiers of the deficit, even though its first action point is that the US should take steps to cut its fiscal deficit and raise private savings. This relatively mild formulation is, however, undercut by specifying ?entitlement spending? (welfare benefits) to be the sole area of fiscal consolidation in the US. Then again, this action point is followed by the tired placebo on structural reforms in the euro-zone and Japan. One senses an absence of will to do much about the great global imbalance?the US current account deficit? while acknowledging, albeit indirectly, that it is a problem.

Considerably more direct is the testimony made some days later to the US Congress by chairman Ben Bernanke of the US Fed. It does not shy away from mentioning and quantifying the great imbalance. Nor does he propose managing ?entitlement? expenditure as the sole means of fiscal consolidation. He presents legislators with the common sense option of either phasing out tax cuts or slashing welfare spending or a combination of both. Chairman Bernanke does not quite spell out his views on what needs to be done about the current account deficit, but throws broad hints worth dwelling on.

While referring to the 15 continuous rate increases, Bernanke states that ?(t)his sequence of rate increases was necessary to remove the unusual monetary accommodation put in place in response to the soft economic conditions earlier in this decade.? The choice of words might suggest that the state of ?unusual monetary accommodation? has been ?removed??all in the past tense. A subsequent statement that ?at some point in the future (we) may decide to take no action at one or more meetings,? might be read as negating the earlier one or qualifying it to say the process was nearly over?an implied suggestion widely taken up by the financial media and other commentators. It is entirely possible this is an accurate reading, but an alternative reading is possible, too.

First, Mr Bernanke characterised the US economy in 2006 as one with ?continuing expansion? and that ?appears to have grown briskly,? while job gains ?averaged about 200,000 per month between January and March.? As regards the future, ?broadly, the prospects for maintaining economic growth at a solid pace in the period ahead appear good.? Second, as the ?slack? in the system has been absorbed, resulting in above-trend growth of 4% and as ?the utilisation rates of labour and capital approach their maximum sustainable levels,? growth should be consistent with ?the productive capacity of the economy.?

While it is not certain what that is in numerical terms, ?policymakers must do their best to help to ensure the aggregate demand for goods and services does not persistently exceed the economy?s productive capacity.? Monetary policy will need to respond to the ?assessment of the medium-term risks to [the dual] objectives of price stability and maximum sustainable employment. Focusing on the medium-term horizon is necessary because of the lags with which monetary policy affects the economy.?

Referring to the US current account deficit, the Fed chairman opined that in order to ?reduce its dependence on foreign capital, the United States should take action to increase its national saving rate. The most direct way to accomplish this would be by putting federal government finances (on track). Our trading partners can help mitigate the imbalance by relying less on exports as a source of growth.?

Left unstated is the inevitable second leg of domestic policy. Which is to raise interest rates, designed to reduce leveraged consumption and raise the incentive to save. US personal savings have been negative or near zero for some time and textbook economics tell us that in the allocation of personal income between consumption and saving, interest rates have a non-insignificant part to play.

This alternative reading?a combination of favouring a pace of growth that is in consonance with the productive capacity of the economy (including domestic financial resources), the importance of the medium term horizon for policy purposes and, finally, the compelling need to squeeze the current account deficit?all point in the direction of a sustained and medium-term bias to higher interest rates.

?The writer is economic advisor to Icra