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Rodney N. Sullivan, CFA


Global Trade Imbalances Matter

Daily calls for resolving the ongoing sovereign debt crises plaguing the global economy make clear that theyre not over yet, but a continuation of the sovereign debt crises of countries with large and rising trade decits is not necessarily a fait accompli. Mitigation of the impact of these trade imbalances requires more than aggressive monetary policy alone.1 A credible commitment by both governments and citizens to rein them in is also needed. Attempting to muddle through absent such a rm scal plan will only undermine the economic recovery.

accommodated the ongoing borrowing needs of decit countries, largely without disruptionthe borrower country (e.g., Spain) buys goods and nancing from the lender country (e.g., Switzerland). This relationship offers strong win-win potential between the borrower and lender nations. However, as we have seen in recent years, such an approach is vulnerable to a sudden stop in nancial markets whereby short-term debt nancing for the decit country is not rolled over promptly enough to maintain uidity in markets and economies. The result is a nancial liquidity crisis.

Informed Consenting Adults Consenting Adults

The current global economic slowdown is clearly a structural one, and structural transitions are rarely smooth and painless. Consider, as shown in Figure 1, the glaring global dysfunction of the United States, the United Kingdom, Australia, and Spain (among others, including Portugal and Greece) running current account decits since the mid-1980s, each with cumulative trade decits now exceeding 30% of GDP. Because a countrys excess spending over income must, by denition, be sustained by sales of foreign assets or loans from other countries, these decits translate into surplus countriespredominantly Switzerland, Japan, China, and Germanyholding more than $8 trillion in cumulative claims against decit countries.2 A country with a current account decit is a net consumer that is becoming increasingly indebted. Its spending and investment are more than its production. This outcome can occur only if other countries are lending their savings to it or if the country is running down its capital account assets.3 But a country that is running a current account surplus is accumulating wealth and staking claims on foreign assets. Until recently, global trading partners used what might be called a naive consenting adults approach to managing the enormous ow of funds between countries, whereby surplus countries It doesnt have to be so painful. The win-win relationship can be restored. Surplus countries can continue to lend freely to decit countries but only if the latter take the necessary steps to become internationally competitive, including reducing current account decits. Lender countries will lend only if they believe they are not throwing money down a bottomless pit. Even though this approach may well involve a challenging leap to a new paradigmfrom naivet to informed adulthood a credible deleveraging plan is a necessary condition for a sustainable recovery. A strategy of naive hope combined with monetary policy alone is simply not enough in an environment of rapidly rising credit needs, especially for a global economy that is so dependent on trade. Economic sustainability means nations working to ensure their international competitiveness. Like a bank, a country with a rising short-term debt position vis--vis foreign lenders is vulnerable to a catastrophic run if liquid securities are insufcient to pay off lenders. Consider Greece in 2010, Iceland in 2008, Mexico in 1994, and Chile in 1981. Concerns about such runs, of course, have featured prominently in the ongoing European economic instability because investors fear that the deterioration of one countrys trade balance will spill over into the global nancial superstructure.

The Editors Corner is a regular feature of the Financial Analysts Journal. This piece reects the views of the author and does not represent the ofcial views of the FAJ or CFA Institute.

2012 CFA Institute

Editors Corner

Figure 1.

Cumulative Current Accounts as a Percentage of GDP, 19702010

Cumulative Current Account (percentage of GDP) 150




100 70 80 United Kingdom Germany Switzerland 90 United States China Japan Australia 00 Spain 10

These examples, however, do not necessarily establish a causal link between trade imbalances and currency crises. There are cases in which even large current account decits have not led to crises. The most compelling means to an orderly reversal is for both the government and the citizens of every large net debtor nation to take steps to put into place a credible and resilient plan for repaying debt. So, decit countries can shrink their spending patterns in line with their declining wealth and surplus countries can continue to lend. Consider Ireland, a nation that has made rm commitments to repay lenders and recapitalize its banking system. Unfortunately, by declaring the euro irreversible, European policymakers have effectively undermined efforts to require those reform measures so badly needed in some countries. This result has had the effect of further hampering global economic growth and dragging down other nations. As we all know, we didnt arrive at these massive global trade imbalances overnight, and the resolution will likewise take time. But continuing to merely muddle through will serve only to hamper recovery further. Note how attempts at monetary

policy (Tempelman 2012) have proven a rather blunt tool for resolving nancial instability and unsustainable global scal imbalances. Even worse, some countries have denied the magnitude of the situation by following a status quo scal policy. Current account balances do matter. They must be accounted for because they hold macroeconomic implications both at home and abroad (Obstfeld 2012). But imbalances need not be threatening to either the international or the national economy. Containing the damage of the inexorable rebalancing of current large trade decits requires global cooperation in devising a credible scal plan to reduce decits in an orderly fashion. Alternative solutions alone (e.g., stepping harder on the monetary accelerator) will continue to prove insufcient. Informed, adult resolve is needed to avoid another wave of severely troubled countries. I thank Jerry Tempelman and Xi Li for constructive dialogue and comments. Abby Farson Pratt provided analytical support for this article.

November/December 2012

Financial Analysts Journal

1. There is an abundant literature on the impotence of a standalone monetary policy absent a coordinated scal policy. See, for instance, Sargent and Wallace (1981), Friedman (1968), and Sims (2012). 2. A countrys trade balance of payments represents the sum of all nancial transactions between that country and the rest of the world. The balance of payments comprises a current account and a capital account. The current account reects the difference between its national exports and imports, whereas the capital, or nancial, account reects the change in national ownership of assets. The current account, usually much larger than the capital account, is my focus here. 3. More specically, the current account balance equals the sum of the following gross ows: (Exports Imports) + (Income received on foreign assets Income paid on liabilities to foreigners) + Net transfers. Stated in terms of nancial account ows, the current account balance for a country equals (Increase in foreign assets) (Increase in foreign liabilities).

Friedman, Milton. 1968. The Role of Monetary Policy. American Economic Review, vol. 58, no. 1 (March):117. Obstfeld, Maurice. 2012. Does the Current Account Still Matter? American Economic Review, vol. 102, no. 3 (May):123. Sargent, Thomas J., and Neil Wallace. 1981. Some Unpleasant Monetarist Arithmetic. Federal Reserve Bank of Minneapolis Quarterly Review, vol. 5, no. 3 (Fall):117. Sims, Christopher A. 2012. Statistical Modeling of Monetary Policy and Its Effects. American Economic Review, vol. 102, no. 4 (June):11871205. Tempelman, Jerry. 2012. Against Quantitative Easing by the European Central Bank. Financial Analysts Journal, vol. 68, no. 4 (July/August):46.


2012 CFA Institute