How will the story of the “global imbalances” end? How should the policy changes needed to avert the worst outcomes be organised? These are the obvious questions raised by my two recent explorations of the global macroeconomic picture (Analysis, ”The paradox of thrift”, June 12 and Capital flows must change course” June 26).

The latest annual report from the Bank for International Settlements provides, as always, an excellent framework for considering the dangers. It explicitly recalls the late 1960s, which started with healthy growth and finished with the inflationary disorder of the 1970s.

What then are the symptoms shared by these two epochs? The BIS lists low real interest rates, rapid credit expansion, a weakening dollar, monetary expansion in countries resisting exchange rate appreciation, lax fiscal policies and rising commodity prices (especially oil).

The echoes are indeed ominous. Imagine that oil prices jumped above $100 a barrel. Imagine, too, that external official support for the US dollar were to be withdrawn, perhaps because of rising fears over domestic inflation in creditor countries.

If long-term US interest rates then rose sharply, it would be almost impossible for the Federal Reserve to cut short-term interest rates. Highly indebted US households would cut spending (see chart). The consequent recession would spread rapidly worldwide.

The exchange rate policies of east Asia are at the heart of this story. These countries have adopted exchange rate policies that tend, in turn, to generate large current account surpluses, sizeable inflows of capital and huge reserve accumulations, the monetary impact of which is then sterilised instead of allowed to work through the economy. Excess savings are the result.

Meanwhile, US monetary and fiscal authorities have to generate sufficient demand to sustain domestic output in line with potential. Today, demand must be about 6 per cent bigger than potential supply to offset the external deficit. The policies needed to sustain demand include large fiscal deficits and monetary policies that keep the private sector spending at historically unprecedented levels in relation to income. The asset price bubbles are no accident. They are a necessary component of the mechanism that generates the needed US demand. Thus the policies that thwart market-led adjustment are creating monetary disorder.

So what is to be done? One answer is: nothing. Let each country choose the policies that make sense to it. Some argue, in support, that correction should be as manageable as it was in the late 1980s. But the US current account deficit was then much smaller in relation to gross domestic product; the movement of the real exchange rate was also far bigger than it has been this time; and relative growth rates of trading partners were also much more helpful (see charts).

The dangers will grow if correction does not begin soon. One such danger is protectionist pressure not only in the US but also elsewhere. As Maurice Obstfeld of the University of California at Berkeley and Kenneth Rogoff of Harvard note, a big reduction in the US current account deficit that does not include sizeable exchange rate and macroeconomic adjustments in Asia would impose a devastating shock on the already troubled eurozone.* Maintenance of liberal trade in Europe would prove impossible.

Without big change in policies, the situation seems certain to deteriorate: US net liabilities will continue to rise in relation to GDP; and so, quite possibly, will the current account deficit. The longer this goes on, the larger the ultimate adjustment will be.

A second answer then is: rely on the US’s big stick. Under this alternative, the US would bully China into making a big adjustment of its exchange rate and macroeconomic policies. But there are three huge objections: first, China is far from the only country that needs to change its policies; second, the Chinese would find making such concessions to public pressure from the US an intolerable repetition of the humiliations they endured in the 19th and 20th centuries; and, third, they would almost certainly do the bare minimum, which would exacerbate ill will without rectifying the situation.

This leaves a third answer: serious multilateral discussion in which the US leads but does not attempt to dictate. The right way to approach the Asians, and particularly the Chinese, is by discussing their responsibility for the health of an open world economy on which all depend. As a rising power, China should be invited to share in these discussions, by both exercising its voice and implementing its share of policy changes.

Those changes must be large. They should include reform of the International Monetary Fund, to make it relevant to today’s world, and a radical restructuring of the increasingly absurd Group of Eight. A forum must be found, together with a permanent secretariat, that makes possible serious discussion of how to proceed among the players that matter.

The reason this is so important is that the policy adjustments required of China and other Asian countries are large and complex. It is only by understanding their concerns that there will be a reasonable chance of reaching a workable and sustainable solution.

The US cannot dictate the policy changes or the pattern of global payments it desires to its partners. It must rely on institutions of co-operation, instead. The exchange rate and macroeconomic policies of east Asia are indeed destabilising. But a necessary condition for a successful response is a shared recognition of the dangers. The second necessary condition is determination to reach an agreed solution.

US leadership is missing in action but remains indispensable. Leadership means seeking a way to reconcile the vital interests of all the important players. For this the present G8 is irrelevant. The only way forward is better institutions and a deeper dialogue with the right partners.

* Global Current Account Imbalances and Exchange Rate Adjustments, May 2005, http://post.economics.harvard.edu/ faculty/rogoff/rogoff.html

martin.wolf@ft.com

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