Batten Down the Hatches in Case the Economic Storm Hits

Op-ed in the Financial Times

December 28, 2005

People complain about the weather all the time, but no one does anything about it. So it goes with the potential economic storm that will be generated by the inevitable adjustment of global imbalances.

We are told repeatedly that the US current account deficit is unsustainable, that the US housing bubble and government deficits bring the day of reckoning closer, and that underlying protectionist pressures imperil the Doha round of trade negotiations, if not the entire trading system. The recommended policy responses are limited to those that would simply bring on the adjustment-contraction of US domestic demand, direct political conflict with agricultural interests, a sharp dollar decline, rising interest rates-a little bit earlier and perhaps only a little less severely.

Yet, we can at least prepare for bad weather before it hits. Imagine if knowing that New Orleans was likely someday to be hit by a powerful hurricane had actually induced reasonable preparations. Levees could have been built more strongly, evacuation plans drawn up, early warning systems made credible to suspicious citizens. No one could have prevented Katrina, but the damage from it could have been significantly reduced.

Similarly, there are policy steps that should be taken to batten down the global economy ahead of a potentially severe shock from renewed trade protectionism or dollar adjustment. Little has been done to prepare, however, because policymakers have little incentive to plan ahead. Trade negotiators and the special interests trying to constrain them benefit from pursuing a strategy of brinkmanship and so will do nothing to reduce the chances or costs of a Doha crack-up. The US and Chinese finance officials have not yet gone to the brink over revaluing the renminbi, but they are sufficiently tempted to draw lines in the sand that they, too, have little interest in lowering the stakes of economic conflict.

If the governments of the big economies wanted to learn from Katrina, though, they would take action to limit the damage that resolving the current global imbalances could bring.

First, they should strengthen economic linkages. Foreign direct investment and capital flows link economies even when trade barriers constrain commerce. The United States, the European Union, and Japan could reverse the effect of their recent decisions to block cross-border mergers by simplifying the process in three ways: agreeing on a narrow definition of what constitutes a "national security" exception; bringing accounting standards negotiations to a close, which would remove uncertainty for prospective investors; and publicly repudiating the often-invoked image of foreign investors as "vultures" who prey on employees. All this would help protect the ties between economies, encouraging continued cross-border integration of production as well as flows of capital, whatever happens with the trade round.

Second, they should enhance financial stability. Financial fragility is the primary means by which limited shocks get escalated into macroeconomic crises. Right now, with interest rate spreads at historic lows, any international adjustment that pushed up interest rates and reversed current account surpluses outside the United States could lead to sharp declines in asset values and therefore in financial sector capital. Bank supervisors in the big economies should be tightening their scrutiny and encouraging increased provisioning by banks. Financial regulators should be warning householders of the risks presented by investments that have appeared stable in recent years. Where crisis response infrastructure is lacking-as arguably the decentralized system in the European Union is-now would be a good time to rationalize.

Third, they must commit to macroeconomic stabilization. Central banks and budgetary officials could reassure the public that they will respond strongly to swings in growth (thereby avoiding the mistakes of Japanese officials in the 1990s and EU officials in recent years). In fact, if they credibly commit to stabilization policy, private-sector expectations may limit overshooting of exchange rates and investment levels. For the US Federal Reserve, the Bank of Japan, and the European Central Bank, this is a matter of adopting inflation targets that would oblige monetary policy to offset excessive movements in prices up or down; for the budgetary authorities, this means giving automatic stabilizers full room to work (for example, by the European Union reworking the stability and growth pact) or authorizing sufficient unemployment benefits in the United States and Japan. There are constructive measures that governments can and should take to prepare for the adjustment process, independent of their present politically determined approaches to trade negotiations or exchange rate policy. They probably have time to do so before the storm arrives.

The US practice of selling off assets to fund a consumption boom today may be a lousy idea for anyone who cares about future American income, but that does not make it immediately unsustainable. As 2005, 2004, and 2003 have shown, there is plenty of foreign appetite for US assets and thus room for the current account deficit to continue to expand. Given growth differentials and liquidity of investment assets, both still favoring the United States over other markets, 2006 will probably show more of the same. Instead of wondering why the hurricane has not yet hit, let us take advantage of that fact to prepare for when it comes.