Global imbalances are back

Multiple shocks have rocked the global economy. While the bulk of economic research is focused on understanding the impact of these shocks, one school of research is warning us about global imbalances making a comeback.

Before discussing global imbalances, we need to understand current accounts. The current account records exports and imports of all goods and services of a country with the rest of the world. In case of a current account surplus, an economy’s exports are higher than imports, whereas a deficit indicates that exports are lower than imports. Deficits are financed via capital inflows, which come from countries with surpluses. They invest these surpluses as capital outflows. It is natural that some countries will have surpluses and others will have deficits, and it is also a zero-sum game. The problem starts when these deficits/surpluses become large and persistent, transforming into so-called global imbalances.

Global imbalances have occurred in multiple waves since the 1870s, which is when the journey of globalisation began. In the first wave, capital flowed from the UK to Australia, in line with growth theories that suggest return on investments are higher in poor, capital-scarce countries. The wave ended as a result of World War I. In the 1920s, the US became a surplus country that channelised funds to Latin America and Europe. That ended in crisis due to the abrupt tightening of monetary policy by the Federal Reserve. Global imbalances were limited for the next 50 years due to the Great Depression, World War II, and the Bretton Woods system that limited capital flows.

The breakdown of Bretton Woods in 1971 led to the return of global imbalances with one major change. Unlike previous waves where the surplus countries were rich and deficit countries were poor, the major deficit country in this case — the US — was the richest. It financed its deficits from other surplus countries. Till the 1980s, US deficits were financed by oil-exporting countries and Japan who were then joined by emerging countries such as China. This reverse flow of capital from emerging to developed countries was first highlighted by economist Robert Lucas and became known as the Lucas paradox. Economists explained the paradox by highlighting that the poor countries, apart from facing political risks, also lacked human and physical capital as well as financial systems. Thus, the returns were not as high there, as suggested by the growth theory.

Economists also tried to explain what was leading to high deficits and surpluses in the US. In 2002, then Fed Chair Ben Bernanke, in a famous speech, said that the US generated high deficits as its investments were higher than savings, and the rest was financed by borrowing from abroad. The savings were low as high government deficits were eating into the savings pool. China was doing the opposite by deploying their higher savings into global markets, particularly US government bonds, financing the latter’s high current account deficits and budget deficits. In Bernanke’s words, there was a savings glut in emerging countries, particularly China, that led to the reverse flow of capital. The speech sparked wide debates among economists on whether a savings glut or investment deficit led to the imbalances.

The debates on global imbalances paused following the 2008 crisis. In fact, a few economists opined that global imbalances led to the crisis. Excess savings depressed interest rates around the world, leading to a search for higher yields, which found their way in housing markets and complex financial products. The bubbles in housing and finance markets eventually led to the 2008 crisis. The US current account deficit declined from 6% of GDP before the crisis to 2% of GDP after it.

Nearly 20 years later, why are global imbalances making a comeback? Prima facie, global imbalances had only narrowed, but never really disappeared. The multiple shocks of Covid-19 and the ongoing wars have widened the US budget and current account deficits to 5% and 4% of GDP respectively. On the surplus side, China has used an aggressive mix of industrial policies to keep its exports competitive. Such policies are used by governments to promote certain economic sectors and combine subsidies, tax breaks, tariffs, and infrastructure support to pick “economic winners”. Governments worldwide have used some variants of industrial policy, leading to heated debates about whether such policies have worked. Just like global imbalances are making a comeback, so are these policies.

Global imbalances are not just back, they are also threatening to push the global economy into a major crisis. History suggests that if imbalances widen they could lead to or deepen crises. The global economy is in a precarious position with heightened geopolitical frictions and the geoeconomic fragmentation of supply chains. The two key protagonists of today’s global imbalances— the US and China — are also the key actors in the game of geopolitics. How this combination of imbalances and uncertainty will play out is anyone’s guess.

The author teaches at the National Institute of Securities Markets

Disclaimer: The views expressed are the author’s own and do not reflect the official policy or position of Financial Express.