Erkki Liikanen: Global rebalancing, asset prices and policy responses
Speech by Mr Erkki Liikanen, Governor of the Bank of Finland, at the Fifth High-Level
Seminar of the Eurosystem and Latin American Central Banks, Madrid, 10 December 2010.
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Due to the strike and weather conditions the speech was distributed in written form.
Some background
Global imbalances are certainly not a new policy concern. The most visible manifestation of
these imbalances is the large current account deficits and surpluses, but these are not the
whole story. Current account positions reflect a number of deeper, more fundamental
problems. Therefore, the inevitable future rebalancing has to involve deeper structural
changes in the countries involved.
The risks caused by the global imbalances have been well documented in research and
policy papers over the last ten years. Also, the imbalances have long been among the central
agenda items in several international meetings. Most recent serious efforts to address them
include the IMF-led Multilateral Consultations in 2006 and, today, the ongoing G20 Mutual
Assessment Process.
Such rounds of discussions have successfully established a broad agreement over the key
policy objectives to resolve the problem. At their simplest, these are remarkably
straightforward. National saving needs to increase in the major deficit countries (such as the
United States), and be reduced in the major surplus countries (such as emerging Asia and
the oil exporting countries). It has also been acknowledged that for both deficit and surplus
countries, meeting these objectives requires significant policy adjustments.
However, the multilateral initiatives to address global imbalances have so far suffered from
an obvious lack of traction to actual policy outcomes. Since the onset of the global financial
crisis, the imbalances have admittedly undergone a certain reduction. But recent projections
indicate that the imbalances tend to persist - or even grow - well into the future. It appears
that the imbalances have become an even more persistent characteristic of our economic
environment than was previously thought.
The nature of the imbalances
International surpluses and deficits are not, of course, harmful as such if they remain
reasonable. They are a natural reflection of financial integration. They provide flexibility to
savers and investors. By that, they are welfare enhancing. However, very large current
account deficits, when persistent and growing, fuel concerns of external sustainability.
Two main risks to the international community have been extensively debated for almost a
decade. First, sustainability concerns may lead to a sudden collapse of confidence in the
ability of the deficit countries to maintain their external positions. The resulting disruptive
adjustment would be harmful for the deficit and surplus countries alike and to the bystander
countries as well. So far, this risk has not materialized and for the moment, the US bond
markets do not seem to consider it particularly acute. The second risk is that the imbalances
may give rise to tensions in global trade as well as exchange rate relations; this risk is
materializing constantly, as witnessed in the run-up to the Seoul G20 Summit.
Beyond these two main risks, the financial crisis exposed a number of more subtle channels
of transmission through which global imbalances undermine global economic stability. In
particular, the enormous growth of financial intermediation and innovation, related to the
imbalances, combined with regulatory weakness, has made the international financial system
much too fragile relative to the accumulated risks. Also, the fragility of the international
financial markets has led to a volatility of capital flows which may harm even fundamentally
stable economies.
Easy and simplistic explanations of global imbalances have typically failed to stand the test
of time. They may explain the most conspicuous developments in any one time period, yet
fail to capture the multitude of relevant factors at play. It is therefore necessary to think of the
imbalances as products of several fundamental factors, which lie deeper than the superficial
level of macroeconomic policies. I will not go into these in great detail, but wish merely to
mention a couple of rather general trends.
The low pre-crisis national saving rates in deficit economies were supported by low
borrowing costs and the consequent asset price boom during the period of "great
moderation". The low borrowing costs themselves reflected a number of reasons - from the
"global savings glut" in emerging markets to failures in financial markets' risk assessments -
and their relative significance certainly varies from country to country. But now, the economic
structures of the deficit countries have adapted to the inflow of resources from abroad, and
their internationally competitive sectors are smaller than they should be.
The high saving rates in major surplus economies are largely driven broadly by two key
factors. Official sector savings derive largely from export-lead growth strategies based on
asset-accumulating competitive exchange rate pegs combined with capital controls. Private
sector savings for their part are motivated by structural forces, including demographic trends,
the lack of developed social safety nets and a still underdeveloped financial sector that
hampers domestic lending - and channels domestic savings abroad. Of course, in some
commodity exporting countries, surpluses and official sector savings have been boosted by
elevated commodity prices.
I would also like to emphasize the significance of the domestic policy contexts in the major
deficit and surplus countries. As I mentioned in the beginning, the solution to the issue of
external imbalances seems relatively simple if considered in isolation: just reverse the
existing divergent trends in saving and investment ratios between the countries involved. It is
important, however, to recognize that the global imbalances also reflect cross-country
differences in economic structures and real resources, which give rise to differing policy
interests.
The post-crisis outlook for the imbalances
So what does the crisis imply for the evolution of the imbalances going forward? Here I wish
to make a few brief observations.
On the one hand, the challenge of external rebalancing in the deficit countries has become
closely intertwined with the internal rebalancing between public and private demand.
Whereas the low saving rates in major deficit economies previously reflected large-scale
private sector borrowing, the rapid decline in private spending after the crisis replaced private
deficits with sizeable public sector deficits.
Too much of global demand and economic activity is now dependent on the fiscal deficits in
the developed world. Therefore, the deficit countries here face a dual task: to rebalance the
government budgets and, at the same time, to establish a growth-friendly economic
environment that provides a sustainable foundation for the growth of private spending.
In terms of policy, one priority here lies in measures to maintain the availability of credit to the
private sector, for example through repair and reform of the financial sector.
However, credit is not enough by itself. The growth of private demand must lie on a
sustainable basis. In the deficit countries, future growth inevitably needs to rely increasingly
more on net exports. This is a competitiveness question, but also a structural question. And
this, of course, goes part and parcel with the objective of reducing the external imbalances.
On the other hand, recent events clearly demonstrate how the current crisis has increased
the international pressure on emerging market countries with surpluses. This was clearly
apparent at the last round of G20 discussions, where foreign exchange issues were at the
centre of the agenda. Undoubtedly, the problem has not gone away and will be one of the
hardest issues also in the upcoming meetings.
However the exchange rate, the real exchange rate to be exact, is only a part of the
adjustment mechanisms which can lead to a more balanced redistribution of economic
activity and spending. In the end, the more the surplus countries can achieve through
opening their markets, increasing competition, and diversifying their economies towards
services, the less pressure will prevail on their exchange rates, and the smaller are the
inflationary pressures they encounter.
So, orderly balancing is about structural changes in all affected societies, in deficit countries
as well as surplus countries, around the globe. The political difficulty of making these
adjustments happen is considerable.
The roles of the euro area and Latin America
No matter how the eventual and necessary global adjustment will take place, it will have spill
over effects that concern us all.
What unites the Latin America and euro area is the fact that global imbalances are not a
problem of our own making. Both regions, taken as aggregates, have had broadly balanced
current accounts and maintained flexible exchange rate regimes. But still, neither region
would be immune to the spill over effects from a possible disorderly adjustment. And they
would not be immune to the changes in relative prices which go together with an orderly
adjustment, either.
It is this common role as exposed bystanders where the Latin American and European
viewpoints meet, regarding the global imbalances. Policy makers in both regions worry about
the danger of exchange rate volatility, and should think hard how to position their economies
for the future, post-adjustment circumstances.
For the euro area, the challenges are threefold. There is the fiscal challenge you are well
aware of; there is the challenge of increasing the productivity of the Euro area economies,
especially in the countries with big external deficits, and there is the challenge of
strengthening our financial system, which was so severely shaken by the crisis. Of these, I
think the productivity challenge is the most fundamental in the long run, and much of the
fiscal sustainability issue hinges on that as well. And without credible public finances, there
cannot be a lasting solution to the stability of the financial sector.
Latin America for its part has already fallen victim to some of the fallout from global
imbalances. Since the bust of the US asset price boom, the suppressed domestic demand
coupled with near-zero interest policy has turned private capital to search for higher yield in
the still-growing emerging markets. Latin America has painful experiences with excessive
external indebtedness, and hence the prospect of large capital inflows causes
understandable concern.
Under such circumstances of potentially disruptive capital inflows, capital controls have
understandably become an increasingly attractive option for emerging markets trying to
temporarily smooth the inflow of foreign capital, alleviate excessive pressure on the
exchange rate and mitigate a build-up of risk in their domestic economies.
The debate over the desirability and effectiveness of capital controls is still ongoing and I do
not wish to give definite advice on their proper role and scope. However, I do believe that
financial development and innovation tends to make the maintenance of capital controls
progressively more difficult and ineffective. And even as views on the controls have become
more pragmatic within the international community, the historical experience thus far is
mixed. It is safest to consider them as a temporary expedient, which cannot be relied upon to
provide a lasting solution.
I would also note that a proliferation of capital controls can introduce potentially adverse
distortions in the international financial system, which should not be ignored. Where
necessary, the international community should therefore seek to establish common principles
for their appropriate design. This is an area where the IMF policy advice and monitoring
could have a greater role.
Conclusion: addressing the problem
Finally, let me say a few words about how the problem of global imbalances could be
constructively addressed. I will leave a more detailed discussion on this for the subsequent
sessions of this seminar, but wish to highlight one observation that is relevant to what I have
just said.
If deficit and surplus countries would choose to pursue policies based on their narrowest
selfinterests, seeking to postpone inevitable structural changes, the problems of global
imbalances - and their adverse effects - would be likely to persist.
The only way to address the problem is international policy coordination. It is not enough to
simply demonstrate that the imbalances can be addressed through an orderly, policy-driven
adjustment. What is also required is a credible commitment from all key stakeholders to
follow a cooperative approach.
As I see it, success in the latter requires two things. Partly, the commitment to a cooperative
approach is a commitment to compromise. This can be achieved only through an open and
direct interaction involving all key players. Despite its limitations, the G20 Mutual Assessment
Process is the best tool we have for the task. Its mere existence has facilitated an exchange
of views that was long lacking from international policy coordination.
But, and fortunately so, the necessary global rebalancing is not only about making
compromises. The world economy is not a zero sum game, and better cooperation delivers
real benefits to be shared. One needs to present a convincing enough a case - in both the
major deficit and surplus economies - that the spillovers from globally inconsistent policies,
are not in the interest of any country. This is certainly not an easy feat and will be a major
challenge in the discussions going forward. The challenge is even larger because the
solution involves so deep adjustments, not only in macroeconomic policies, but in the very
economic structures of the countries involved.