EC6201 International Economics

Economic Insight 3

Pek Yang Xuan

Article

Payment Imbalances and Global Economic Peril

AEI International Economic Outlook, Mar 2010
http://www.aei.org/docLib/01-IEO-g.pdf

Introduction

One of the main learning points of the recent depression is that payment imbalances, on a
large enough scale and stretching over a long period of time, are unsustainable and in
extreme scenarios may trigger events of catastrophic proportions such as the crisis.

The article, authored by the American Enterprise Institute for Policy Research, dissects the
roots of the crisis; it highlights each country’s unique situations and how their problems
individually contributed to the crisis and how they might take action to rectify the situation
accordingly. Its primary focus is international economics: international trade and finance,
and how countries are all participating in a global game of chess.

Its main points are (i) Although the economy is picking up in the wake of the recession, the
threat of maladjusted payments is ever-present and they have the potential to throw the
recovery off-track. (ii) Countries with Balance of Payment (BOP) deficits should set in place
policies that aim to reduce this deficit. (iii) Countries with BOP surpluses ought to spur
recovery by boosting domestic consumption.

Economic Concepts

1. Economic Integration

As the world economy becomes more globalized in nature, economic barriers between
countries break down and they do so in stages. There are 6 distinct stages 1 of economic
integration, beginning with the least significant stage of the establishment of Preferential
Trade Agreements and culminating in complete economic integration, as exemplified by the
harmonization of key economic (monetary and fiscal) policies across a common market. The
European Union is considered to be at the 5th stage: Economic and Monetary Union (EMU),
where a single currency is used in a single market.

2. Sovereign Debt

Sovereign debt is the sum of debts owed by a national government to other governments in
the form of bonds issued in the currency of the creditor. Issuance of bonds in another
currency has the advantage of a more stable currency, especially if the debtor country is
experiencing unstable inflation or exchange rate. It also facilitates the debtor’s activity in the
foreign country, because the debtor possesses the currency. If however the lender is unable
to eventually repay its debts by buying enough of the foreign currency when the bond has
matured, it must default. Bonds with high yields are those with high risk of default, so as to
protect the investors.
1
International Trade Theory and Policy, Steven M. Suranovic
 3. Current Accounts

Current accounts include the balancing of visible trade: sums such as imports and exports,
tax revenue and dividends paid to investors from other countries are catalogued so that
countries are able to keep tabs on their expenditure and income. When a country spends
more than it earns, it experiences a deficit, as in the case of the US and the PIIGS countries.
On the other hand, the Asian countries mentioned in the article, especially China, are
currently enjoying huge surpluses because of prudent saving practices. The public sector is
careful not to import too much from overseas, while at the same time boosting its own
export-fuelled economy.

Interesting Observations

1. Maastricht Criteria

Also known as the Euro Convergence Criteria, these are the economic requirements the EU
has set for its member countries. They include2 (i) Inflation rate equal to or less than 1.5
percentage points above the average of the three lowest rates within the EU the previous
year. (ii) A national budget deficit equal to or less than 3% of GDP. (iii) A national public
debt equal to or less than 60% of GDP. (Exceptions include countries with high debt levels
which are falling steadily) (iv) Long-term interest rates equal to or lower than 2 percentage
points above the rates in the 3 countries with the lowest inflation rates the previous year. (v)
The original national currency’s entrance into the ERM2 exchange two years prior to entry
into the EU.

These seem to me to be sound criteria that the Obama administration would do well to keep
in mind as they are constructing their budget: “the Obama administration seems to be
compounding the budget quagmire by cavalierly embarking on ambitious expenditure
programs, most notably health care reform, without raising taxes to fund those programs”.
As mentioned in the article, over a period of less than 20 years, the US has managed to
become the largest debtor in the world It is never sustainable for any country to persistently
rack up huge debts as the article mentioned, “any serious commitment toward medium-term
budget sustainability was conspicuously absent in the administration’s 2011 budget
proposal.” Consequences of these “spendthrift” habits are decreased credit ratings and
possibly depreciation of its currency. In direct contrast, we have prudent Asian countries
who are enjoying a “savings glut” which the author describes as a byproduct of its Asian
Crisis experience.

2. Sustainability of the Eurozone

How sustainable is the Eurozone? It is almost certainly the best example of economic
integration in the world, and yet the current crisis casts doubt on its model of operation. The
causes of its problems lie in the low interest rates the ECB offered Greece, and Greece’s
increased borrowing and subsequent inflation. Currently, 4 other countries, Portugal, Spain,
Ireland and Italy are also suffering from poorly managed public finances, their debt: GDP
ratios not meeting the Maastricht limits either.

Benefits of being in such a tightly integrated area are that the common currency would
encourage trade; when combined with the inevitable benefits such trade would provide
(growth and development opportunities) economic integration helps member countries
boost the welfare of their citizens, as well as keeps each of them competitive as goods outside
of the region get more expensive (as labor costs rise). However there are definitely problems,

2
Financial Glossary, Reuters
such as Greece’s banking system being very hard-hit by household defaults for months or
even years following this crisis, because they are not allowed to depreciate their currency.

Proposed solutions include “austere” fiscal policies that would almost certainly plunge the
country into a deeper recession, because growth would be hindered by the cuts in public
spending that are necessary to correct their current account deficits . GDP in turn would
suffer, according to the Keynesian multiplier relationship. Prices of services and goods
(including wages of workers) would fall. Many workers would be laid off as domestic demand
fell as a result of decreased public spending. All this is because the common currency
prevents them from devaluating their exchange rate in order to restore their
competitiveness.

3. Graphs

There are several interesting graphs in this article, and I shall be examining 4 of them: (1)
Figure 1: Unit wage costs in the Manufacturing Sector (2) Figure 4: Greece’s Fiscal Deficit
and Figure 5: Greece’s Current Account Deficit. (3) Figure 8: China’s Trade Surplus with the
US and EU.

(1) From here, we can see that Germany is the only country for which manufacturing
costs have decreased instead of increased. Spain’s costs have risen the most, about 20
index points compared with levels from 1998. Since all these countries are using the
Euro, it only makes sense that investors in labor-intensive industries would choose
Germany to set up factories. Germany has probably achieved the low rate of growth
of costs in manufacturing by developing energy-efficient technologies that are able to
substitute manpower, hence decreasing unit cost. This is probably how it has built up
such a healthy current account. It is also noteworthy that Italy, just like Spain needs
to take a leaf from German books and step up manufacturing technologies.
(2) From here we can see that Greece’s public finances are in a dismal state. Even before
the crisis struck, its public debt and current account deficits failed to meet the
Maastricht Criteria, and the crisis, when it did strike, further exacerbated the
problem, finally culminating in this European crisis that very nearly threatened the
foundations of the EU itself. Looking at the disparity between the first graph (average
of about deficit= 5% of GDP) of and the Maastricht criteria (deficit = 3% of GDP)
especially, I find it hard to believe that nobody noticed that Greece was turning a
blind eye to its ill-managed finances. This would teach the EU nations to never
neglect their fellow members’ financial health, and hopefully such crises would be
averted in the future before coming to fruition.
(3) China has been doing extremely well for itself, accumulating surpluses that have
undoubtedly been growing exponentially since the new millennium. As we have
learnt in economics lessons, this extra revenue is a good thing, allowing public
funding into services like healthcare and education for the people, and providing
capital for the government to invest overseas, generating more revenue. This leads
me to my next section, 1 Burning Question: Why would China give up all this surplus?

1 Burning Question

Besides preventing a global excess of goods in the export market, what are the incentives for
China to help the world by shifting resources away from export towards domestic demand?
Throughout the article, the author makes several mentions of how China ought to take
several economic policies, almost as if there exists some unspoken agreement between the
largest economies of the world to “take care” of the world economy and ensure everyone
benefits not just mutually, but equally (“Surplus countries should adopt budget policies and
structural reforms aimed at increasing their domestic demand by an amount sufficient to
offset the decline in domestic demand in deficit countries.”). This is incomprehensible to me
because I would assume that China would capitalize on its low labor costs to fuel its export-
oriented economy. Similarly, the article makes mentions of how Germany also owes it to the
world to export less and demand more imports. (“Germany’s move toward more restrained
budget policy will make it more difficult for Europe’s Mediterranean countries and for its
Eastern European periphery to redress their severe macroeconomic imbalances.”)

It may be past the US’ golden hour as the world’s economic hegemon. Since China are doing
so well, with large trade surpluses and even larger foreign reserves, why would they “use
exchange-rate policy to shift resources away from the export sector and toward domestic
demand” so as to “offset the decline in domestic demand in deficit countries”? How would
that be in their interest?

Conclusion

As the US struggles to pick itself up post-crisis, economic power is being redistributed across
the various countries. As it does not appear to be intending to keep its deficit or reduce it, the
US dollar may soon lose its position as the benchmark currency.

Secondly, the article shows how coordination of economic policies across different countries
is important. For all the US’ efforts in recovering, a surplus of goods in the market would still
occur should China not cut down on its export production.

Finally, it is important to recognize that Greece could possibly be one of many other nations
that neglect their public finances in favor of short-term growth. Monitoring and regulating
debt and current account deficits should be among the duties of organizations such as the
IMF and World Bank, ensuring that if another crisis does occur, it will not be because of
causes that could have been nipped in the bud.

References

http://glossary.reuters.com/index.php/Maastricht_Criteria

http://internationalecon.com/Trade/Tch110/T110-2.php

http://www.businessweek.com/news/2010-03-30/greece-leads-rise-in-sovereign-credit-
risk-as-bonds-struggle.html