Abstract
The purpose of this note is to discuss two complex issues. First, why might a country want to reduce its current account deficit or surplus? And second, why might the international community ask for more? We argue that, in many cases, current account balances reflect underlying domestic distortions. It is then in the interest of the country to remove those distortions and, in the process, reduce imbalances. We then discuss cases where spillover effects, either from deficits or surpluses, suggest a direct role for multilateral surveillance. This process can play two potentially useful roles: first, as a discussion of the differences in assessments; second, as a potentially useful commitment device for countries to implement some of the required but politically unpalatable fiscal or structural adjustments.
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Notes
In principle removing some distortions in a second-best world is not necessarily welfare-increasing. In practice, we could not find obvious examples of cases where removing distortions leading to excessive current account deficits or surpluses would be welfare-decreasing.
See, for example, Caballero and Lorenzoni (2007).
See, for example, Korinek (2010).
We touch on this issue in our previous work. For a more comprehensive discussion of proposals to reform the international financial system, see Mateos y Lago, Duttagupta, and Goyal (2009).
We discuss the potential multilateral consequences of such a strategy in the next section.
Clearly surpluses and deficits at the global level add up to zero. The point here is that individual surpluses can go on for a long time, while individual deficits face the risk of changes in investor sentiment.
We are grateful to a referee for suggesting this table.
In the recent crisis, for example, the evidence points to high precrisis short-term debt as having been particularly costly in terms of output for emerging markets (Blanchard, Das, and Faruqee, 2010). In a sample that includes both advanced countries and emerging markets, the evidence points to large precrisis current account deficits being associated with large output and demand declines (Lane and Milesi-Ferretti, 2011). Empirical research generally confirms that countries with large current account deficits are more at risk of an external crisis. At the same time, this research underscores the importance of a variety of other factors, including short-term debt, the level of reserves, the composition of external liabilities (debt vs. equity), real exchange rate appreciation, and so on. See, for example, Kaminsky and Reinhart (1999) and Catão and Milesi-Ferretti (2011).
The complexity of the issue is reflected in Article IV of the Fund's Articles which sets out obligations for members respecting their exchange rate policies. For the purposes of these obligations, the concept of an “exchange rate policy” is broad and includes domestic policies (for example, interest rate policies) that are pursued for balance of payments purposes. In some cases, these obligations focus on the intent of countries in implementing their exchange rate policies. For example, Article IV, Section 1 (iii) prohibits countries from manipulating exchange rates “in order to gain an unfair competitive advantage over other members.” In other cases, Article IV focuses on the results of these policies. Thus, the 2007 Surveillance Decision (which sets out guidance to members for the purposes of Article IV) provides that members should avoid exchange rate policies that result in “external instability”—for example, in the form of a significantly undervalued or overvalued exchange rate (“fundamentally misaligned”).
See, for example, Obstfeld and Rogoff (2010).
Eichengreen and Sachs (1985) point out that in a worldwide depression unsterilized monetary expansion (targeting an expansion of a trade surplus via currency depreciation) could actually be globally beneficial. Things are different, however, in a two-speed recovery where countries experiencing a boom prevent appreciation through sterilized foreign exchange intervention.
We have been struck not only by the importance of differences in objective functions, but also by the relevance of differences of opinion about macroeconomic mechanisms across G20 members in the G20 Mutual Assessment Process.
It is straightforward to include a risk premium in the model driving a wedge between the domestic and foreign interest rates.
References
Bernanke, Ben S., Carol Bertaut, Laurie Pounder deMarco, and Steven Kamin, 2011, “International Capital Flows and the Returns to Safe Assets in the United States, 2003–2007,” Federal Reserve Board International Finance Discussion Paper 1014, February.
Blanchard, Olivier, Mitali Das, and Hamid Faruqee, 2010, “The Initial Impact of the Crisis on Emerging Market Countries,” Brookings Papers on Economic Activity (Spring), pp. 263–307.
Blanchard, Olivier, and Gian Maria Milesi-Ferretti, 2010, “Global Imbalances: In Midstream?,” in Reconstructing the World Economy, ed. by Olivier Blanchard and Il SaKong (Washington: International Monetary Fund).
Caballero, Ricardo, and Guido Lorenzoni, 2007, “Persistent Appreciations and Overshooting: A Normative Analysis,” NBER Working Paper 13077 (Cambridge, MA: National Bureau of Economic Research).
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Korinek, Anton, 2010, “Regulating Capital Flows to Emerging Markets: An Externality View,” unpublished (University of Maryland, May).
Lane, Philip R., and Gian Maria Milesi-Ferretti, 2011, “The Cross-Country Incidence of the Global Crisis,” IMF Economic Review, Vol. 59, No. 1 (April), pp. 77–110.
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Additional information
*Olivier Blanchard is Economic Counsellor and Director of the Research Department of the IMF. He obtained his Ph.D. at MIT in 1977, taught at Harvard, and returned to MIT in 1982. Gian Maria Milesi-Ferretti is Assistant Director in the Western Hemisphere Department of the IMF. He received his undergraduate degree in economics from Università di Roma in 1985 and his Ph.D. from Harvard University in 1991. The authors are grateful to George Akerlof, Caroline Atkinson, Tam Bayoumi, Ricardo Caballero, Stijn Claessens, Jörg Decressin, Nicolas Eyzaguirre, Josh Felman, Jean Pierre Landau, Reza Moghadam, Antonio Spilimbergo, Ted Truman, Kenichi Ueda, David Vines, as well as Pierre-Olivier Gourinchas and two anonymous referees for useful comments.
Appendix
Appendix
Current Account Surpluses, the Liquidity Trap, and World Demand: A Simple Model
Consider the following simple two-country macroeconomic model. Demand for domestic output Y in the home country is a function of the real exchange rate e (the price of domestic goods in terms of foreign goods), with an appreciation reducing demand by crowding out net exports, and of the interest rate r, with a lower interest rate associated with higher demand. An analogous condition holds in the foreign country, where instead an appreciation in the home country is associated with higher output. We ignore expected inflation, and thus make no distinction between nominal and real interest rates (the model could be extended to allow for changes in expected inflation, but this would take us too far here).
Iso-output loci for the home and foreign country are represented in Figure A1. For the home country, for a given level of output, a decrease in the interest rate (which increases domestic demand) requires an appreciation (which reduces the current account): the domestic iso-output loci are downward sloping. Symmetrically, the foreign iso-output loci are upward sloping.
Equilibrium Exchange Rate and Interest Rate
Assume that policy is used to maintain output at potential in both countries. And assume perfect capital mobility, so domestic and foreign interest rates must be equal:Footnote 13
The two corresponding iso-loci are drawn in Figure A2, and equilibrium is given by point A. Now consider an increase in desired saving in the foreign country. For a given r *, maintaining output at potential requires a depreciation from the point of view of the foreign country, so, given our definition of the exchange rate, an increase in e. The right shift in the foreign iso-output curve implies that the equilibrium is now at B. The exchange rate is higher and the equilibrium interest rate is lower. The increase in saving in the foreign country drives down the world interest rate. In the foreign country, the adverse shift in demand is offset by a lower interest rate and a depreciation. Output remains at potential, and the current account improves. In the home country, the effect of the appreciation is offset by the lower interest rate and output remains at potential. The appreciation leads to a deterioration of the current account.
Impact of an Increase in Desired Foreign Saving
Now consider the case in which the desired increase in foreign saving occurs when the domestic short-term interest rate is at or close to zero. In Figure A3, the initial iso-loci are drawn so the initial equilibrium interest rate is equal to zero.
Increase in Foreign Saving, Zero Bound on Interest Rates
In response to an increase in desired saving in the foreign country, the foreign iso-locus shifts to the right. But now that the interest rate can no longer decrease, the new equilibrium is at point C. The home country cannot offset the depreciation through a decrease in the interest rate and thus output is lower. (The iso-locus going through point C corresponds to a lower level of output.) Thus, in this case, higher desired saving in the foreign country leads to a decrease in output in the home country.
This is of course a very stylized model, and one can think of alternative policy instruments—most obviously fiscal policy—that may help sustain domestic demand in the home country. However, this policy strategy may not be viable if there is a need for fiscal policy adjustment to ensure debt sustainability.