Read Martin Wolf on Global Imbalances ...

... and then ask yourself the question

What part of the puzzle is missing?

Before we get to that however, I should note that Mr. Wolf, as ever, makes [1] some very interesting points in his recent column. Basically, he latches on to the lingering asymmetries of the global economy which persist even as we progress into the worst financial crisis since the Great Depression (shocking that this feels so effortless to write!). The first immediate question which arises is whether Bretton Woods II is actually dead or not? Wolf's seems to argue that it is not and I tend to agree. At least, there is deep rooted structural component in the system which seems relentless in its push towards keeping status quo. It is almost as if a hidden gravitional force is pulling the system back into its grid each time someone or something may suggest that it has changed. Consider consequently the point that what we are effectively observing at the moment is an attempt across the board to substitute slumping aggregate demand from private agents by government ditto. Consider also that those countries who are set to spent the most are those who exactly need to balance their growth path on towards one driven more by savings. Or to put it more directly. Savings come in many shapes and sizes and one of them is through external surpluses (and fiscal) to drain what has hitherto been excessive growth. At some point, economies such as the UK, the US etc will have to face the need to cut back spending be it fiscal or private. However herein also lies the rub.

Enter Wolf's first paragraph.

The world has run out of willing and creditworthy private borrowers. The spectacular collapse of the western financial system is a symptom of this big fact. In the short run, governments will replace private sectors as borrowers. But that cannot last for ever. In the long run, the global economy will have to rebalance. If the surplus countries do not expand domestic demand relative to potential output, the open world economy may even break down. As in the 1930s, this is now a real danger.

Now, this is worth chewing on for more than a couple of seconds. What Wolf is consequently arguing here is that whatever global economy will emerge on the back of this mess it will have to be one in which the capital flows should exhibit radically different tendencies. In fact, I think that this hits the proverbial nail on the head and it is a point which is important to remember before one sets out to claim the doom of the Anglo-Saxon/Western financial capitalist system. Consequently, it was always held that the US should reduce its external deficit as an integral part of the global economy's path to re-balancing. Add to this economies such as Spain, the UK, Eastern European countries, New Zealand, Australia, and you have a good overview, I think, over economies which have to reduce their propensity to grow beyond their means through external deficits. Yet, what about the flip side to these deficits in the form of the surplus countries, how do they play their part. Well, they don't and this is the point. Thus, we have Wolf's perhaps most important point.

Surplus countries often enjoy contrasting their prudent selves with the profligacy of others. But it is impossible for some countries to spend less than their incomes if others do not spend more. Lenders need borrowers. Without the latter, the former will go out of business.

At this point, I wish that I had the equivalent of an internet megaphone so that I could get this point out to as many as possible. Unfortunately, I will have to make due with you, my dear reader, but I do feel strongly about hammering home this point. On several occasions have we heard rants about the profligacy of the deficit nations and how, in more polemic circles, the surplus countries were holding the deficit countries by the, erm, b'lls. Of course, once you stop to think about it is not certain who is holding whose private parts here. As such, in a crisis such as this when it is the deficit economies who are predominantly faltering, the surplus economies can only really do two things. Find new customers or cut back and live of off whatever internal momentum they have. In the current context, the former seems to be out and so far, external surplus economies seem very eager to finance the continuation of the current edifice by their willingness to fund the e.g. the US at current yields. For Wolf, this is also where the principal problem is; 

This then is the endgame for the global imbalances. On the one hand are the surplus countries. On the other are these huge fiscal deficits. So deficits aimed at sustaining demand will be piled on top of the fiscal costs of rescuing banking systems bankrupted in the rush to finance excess spending by uncreditworthy households via securitized lending against overpriced houses.

This is not a durable solution to the challenge of sustaining global demand. Sooner or later -- sooner in the case of the UK, later in the case of the U.S. -- willingness to absorb government paper and the liabilities of central banks will reach a limit. At that point crisis will come. To avoid that dire outcome the private sector of these economies must be able and willing to borrow; or the economy must be rebalanced, with stronger external balances as the counterpart of smaller domestic deficits.

End game indeed, but there is still the small problem of just how this will end. I mean, this is the fascinating thing about this situation. Everyone with even a faint economic intuition can see that the current asymmetric build up of deficits in the face of the lingering stock of debt cannot continue. I would hold this true for the entire global economy. However, this also means that the ability to grow without the help of others becomes an extremely scarce characteristic. We should remember here that many of those external surplus countries simply do not have the fiscal muscles to do much (e.g Germany and Japan). And this is where I think Wolf's argument meets its limits. Consider consequently the following; 

In short, if the world economy is to get through this crisis in reasonable shape, creditworthy surplus countries must expand domestic demand relative to potential output. How they achieve this outcome is up to them. But only in this way can the deficit countries realistically hope to avoid spending themselves into bankruptcy.

(...)

We are all in the world economy together. Surplus countries must willingly accommodate necessary adjustments by deficit countries. If they decide to sit on the sidelines, while insisting that deficit countries deserve what is happening to them, they must prepare for dire results.

Ermm, excuse me a minute Mr. Wolf, but could you run that by me again? "How they achieve this outcome, is up to them". That does not seem like a very good answer and in my opinion this cuts laterally through to the core of the issue here. As such, we need to consider why some economies are unwilling, or more specifically, unable to, to revert (back) to a growth path in which domestic demand plays the big part. As I have argued on an endless amount of occasions, demographics play a crucial role here and even more so in the aftermath of the current crisis since some hitherto deficit economies now face a long hard walk towards whatever kind of export induced growth that will be left once Japan, Germany, China have had their way.

The Missing Piece?

In a theoretical context I have explained before how I believe that a some form of the intertemporal current account can explain this. Specifically, in the context of my upcoming thesis I intend to investigate how the heck one would go about modelling this. This is to say, there are models out there to conceptualize this argument but none of them, as far as I know, explicitly incorporate what we know (and what we don't) about the demographic transition. My main argument arises in the context of the idea that an ageing economy will tend to have a specific consumption/investment behavior (or intertemporal preference if you will). The important question to ask then is what happens as the world collectively ages? For example, what will be the potential negative externalities arising from a process by which the economies of the world all move in the same direction with respect to intertemporal preference of investment and consumption. In lay man terms; who is going to do the importing in the future?

Perhaps this and future work in that direction will allow us to move beyond this idea of it being up to them? I certainly hope so.

[2] In this context, I shall neatly leave out the question of whether Ricardian Equivalence holds or not and in whatever form it will materialize. 

[1] get non-walled version here.