The G20 Takes a Step Back

An agreement reached by G20 finance ministers at their meeting in South Korea October 22-23 looks like an important step back from the brink of global currency war (and the even scarier prospect of a trade war).

According to the official communiqué issued at the end of the meeting, the ministers agreed that all countries would undertake structural reforms of their economies to boost global demand, foster job growth, and raise potential growth. All countries would make efforts to move toward a more market-determined exchange rate that reflects underlying economic fundamentals and would refrain from competitive devaluations of their currencies.

The advanced countries in particular pledged to pursue credible, ambitious, and growth-friendly medium-term fiscal consolidations. The advanced countries would also guard against excess volatility and disorderly movements in their exchange rates and work to promote a stable and well-functioning international financial system.

As a means of measuring progress, the communiqué indicated that reductions in external imbalances would be considered. And that is the potential rub in the agreement. Changes in external imbalances (more specifically, current account imbalances) can be a very poor indicator of whether or not countries are following appropriate economic and structural policies.

The problem is that a country’s external current account balance is the end result of a long string of different transactions in goods, services, income, and capital flows. These transactions are influenced by myriad factors, of which a country’s economic policies and structure at any given time may play only a small role. Therefore, a country’s authorities may have only a limited ability to influence the current account balance. Moreover, it is not clear at all times that an increase (or decrease) in an external imbalance is necessarily a bad (or good) thing.

The behavior of the U.S. current account deficit during the past thirty years illustrates the latter point. In the 1980s and 2000s, lax fiscal policy contributed to consumption booms that led to gaping current account deficits in the United States. In sharp contrast, the 1990s were marked by more appropriate macroeconomic policies. In particular, there was a substantial consolidation of the U.S. fiscal position (the budget swung from a sizable deficit to sizable surpluses). Nevertheless, large current account deficits were sustained. The difference with the 1980s and 2000s was that during the 1990s the fiscal consolidation contributed to a boom in investment in the United States that led to substantial capital inflows and an appreciation of the dollar, which pushed up the current account deficit. This was a sustainable situation, while deficits in the 1980s and 2000s were not sustainable.

The current pattern in China’s current account surplus also illustrates how using movements in external imbalances may give a misreading of whether appropriate adjustments in economic and structural policies are taking place. Since its peak at around 10 percent of GDP in 2007, China’s current account surplus has shrunk to less than 5 percent at present, an impressive drop. But this decline has not reflected the kind of significant policy adjustments that are needed to rebalance China’s economy away from it heavy dependence on investment and exports for growth towards greater reliance on consumption. Instead, it has predominantly reflected the impact of the cyclical downturn in the world economy on China’s exports and a sharp rise in imports during 2010 associated with the stockpiling of raw materials.

Neither of these factors will have a lasting effect on China’s current account surplus. In fact, the IMF’s latest World Economic Outlook forecast projects that China’s current account surplus will rise steadily over the next five years to 8 percent of GDP as growth in the world economy picks up.

The G20 ministers explicitly recognized these types of problems in interpreting movements in current account imbalances, and they rightly stressed that the appropriate standard is to judge the consistency of a country’s external position with its fiscal, monetary, financial sector, structural, and exchange rate policies. Reductions in external imbalances are intended only to indicate that polices are changing in an appropriate way.

However, there is a significant risk that the fact that, at best, reductions in external imbalance are only a very crude indicator will be forgotten by policymakers.

Instead, current account imbalances could well become targets on their own, which would neglect the real roots of the problem with global imbalances. The early analysis of the G20 meeting points to the potential severity of this risk, with suggestions that reductions in current account imbalances have become the key objective.

Thus the G20 process could easily degenerate into a simple current account balance numbers game, with countries engaging in short-term policy expediencies to provide temporary reductions in external imbalances. Lost would be the need and impetus for meaningful policy adjustments to deal with the continuing serious imbalances in savings and investment among the major countries. This would be a very unfortunate outcome, and the G20 finance ministers meeting in South Korea would end up representing a big step backward for the world economy.