Global Imbalances - The Basic Story

One of the root causes of the financial crisis has been the unnatural sight of capital flowing uphill, that is from poor to rich countries. In a famous calculation, Robert Lucas (1990, AER) showed that if a rich and poor country have equivalent production technologies and differ only in income per head, then because the amount of capital employed in the poorer country will be less than in the richer country, the marginal efficiency of capital must be higher in the poorer country and so attract capital. For example, latest EIU data suggests that Chinese PPP per capita income is around $5,000 and the US is $45,000 which implies (calculation available on request) that the rate of return on capital in the US should be around 3-4% of that in China and should mean that China runs a current account deficit financed by a US surplus. The reality has, of course, been the obverse with US recycling China’s capital flows.

Let us examine the basic problem. Global savings equal investment at a single world interest rate (absenting risk). Figure 1 draws the equilibrium for the two country world of China and the USA, given their savings and investment schedules. In a closed economy, US interest rates would clear the domestic market for saving above R* and output would be determined accordingly. But when we open up to capital flows at the world interest rate, R*, the US expands its investment demand relative to savings, running a deficit, and at those interest rates China generates a current account surplus. The surplus (deficit) in each year adds (reduces) to net foreign assets in each year in the creditor (debtor) country.

The counterpart of savings excess in China is excessive investment in the US - recall that this comprises both public and private investment. Is a small reduction in US demand (investment) the answer? Not necessarily. Even if demand falls sufficiently to eliminate the US current account deficit at stable world rates, R*, then China would still have excess savings. This excess would drive rates down from R* and lead to the re-mergence of a current account deficit, albeit with lower world rates and a lower level of global imbalances. Obviously with large enough falls in US demand you could get zero current account balances in both countries at very low R and low US demand. Perhaps this is the solution, as we stare at a global recession, that we are heading towards?


We can also consider a number of alternative solutions. For example, a shift up in Chinese demand to clear the surplus at R*, at the original equilibrium, will mean excess demand in the US continues and thus world rates R* will go higher and there will still be a Chinese surplus and a US deficit. Obviously again if Chinese demand shifts up even further we can have no capital flows but at significantly higher world interest rates and high world demand. This may not be the solution we are heading towards!

The problem with this diagram as far as I can see is that any R can lead to an initial equilibrium providing China is willing to lend (or borrow) and US is willing to borrow (or lend). And what we learn is that if we want to adjust to some different level or direction of capital flows is that if only one country adjusts the overall change in rates and output will be greater than if they both adjust somewhat.

So what is the constraint or target? It must be something to do with the equilibrium level of net foreign assets to GDP and flows from one country to another to meet that target. The US is a debtor nation, (at around 6-7% of global GDP) implying that its current demand will be met by saving from higher future income. In this scheme (and I do not know the actual numbers but according to the IMF’s WEO Emerging Asia is in credit by around 5% of global GDP) then China will be the creditor. But for the reasons given earlier China should probably be the net debtor and borrow from its higher future income. And so if we are to get to a situation when eventually China becomes a debtor so capital flows downhill (from rich to poor), this will imply the need for a surplus in the US and a deficit in China, which implies lower US demand, greater US savings, higher Chinese demand and lower Chinese savings. But we probably knew that!

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