By Brad Setser
He presents three answers to the question “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).
There are no shortage of advocates of do nothing. The don’t worry, be happy — unprecedented current account deficits in the US are a sign of strength, not weakness crowd seems to grow by the day. Yet all signs suggest that Greenspan’s prediction earlier this year that the current account deficit is about turn around won’t be born out. Oil is up. The dollar is up. Long-term rates are down, fueling an ongoing housing boom.
The current RMB peg has no shortage of defenders either. Some believe that a policy that has brought so many in China out of poverty should not be changed; some really believe in fixed exchange rates, no matter what, and adjustment to come through inflation in China/ deflation in the rest of the world; and some are just making a ton of money producing goods in China for sale around the world and don’t want a good thing to end.
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.
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.
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.
Which leaves only one viable policy course
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 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.
That strikes me as right.
The odds of it happening strike me as low.