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July-August 2007
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< previous | 1 | 2 | 3 | 4 The “rational reason” for reserve accumulation by countries like China, says Kenneth Rogoff, Cabot professor of public policy and professor of economics at the KSG, “is that they are terrified of having a financial crisis and, by stocking up on Treasury bills, the government puts itself in a position to bail out banks and bail out companies in an emergency.” Free trade may be good, but financial-market liberalization can be destabilizing, because it exposes small economies to massive flows of capital, measured in billions of dollars daily, that crisscross the globe at the speed of light. These flows are the sum of the actions of investors worldwide, and can subject countries to the capricious swings of free markets. If investors lose confidence in Thai investments, for example, and all pull their money from the country at once, their sudden withdrawals can precipitate a collapse of the currency, followed by dire effects on citizens’ standard of living. This is what happened during the Asian financial crisis of 1997 to 1998. After a series of emerging-market meltdowns, says Abdelal, accumulation of reserves has become the way developing countries can “self-insure against a crisis—a kind of national insurance within the international system,” without the loss of face and autonomy associated with a bailout by the IMF. But the argument that countries such as China want to avoid a crisis probably explains only “the first couple hundred billion” of reserve accumulation, says Rogoff. “What they are doing now goes far beyond that—and has a corrupting aspect, because if banks and state-owned firms know they are going to get bailed out, they keep doing the same things they were doing to get in trouble in the first place.” Summers believes that the reserve accumulation going on now “is, in significant part, because they want to maintain an export-led growth strategy.” In 1999, he observed that the global economy depended on the U.S. economy (which accounts for almost 30 percent of global economic output, and an even higher proportion of final demand), and that the U.S. economy depended on American consumers (whose consumption is equivalent to 70 percent of GDP). Consumption had become what Summers has called the “single American engine” propelling the world economy. In such an environment, keeping exports inexpensive has been a rewarding strategy among our trading partners for maintaining their economic growth. China’s purchases of dollars keep that country’s currency weak relative to ours, making Chinese goods inexpensive for American consumers. “The reserves are not objectives in and of themselves,” Summers says. “They are a means to maintaining an exchange rate at which their exports will be extremely competitive, and so are a kind of subsidy to domestic industry.” “What the Chinese have been doing works, they feel,” says Rogoff—and it does work “for the one-third of people who live on the coast…[even though it] has worked a lot less well for everybody else in China. If you go into rural China, there are 150 million people who are effectively unemployed. Large sections of the rural population live in something most of us would call poverty.” 
Photograph by Stu Rosner Laura Alfaro The reserve policies of China and other developing East Asian nations “are very costly,” notes HBS’s Laura Alfaro. “When we talk about this in class, our students say, ‘This is an economy growing at 10 percent a year. It is impossible not to come up with projects [for domestic investment] that will generate greater returns—even just 1 percent higher—than the U.S. Treasury interest rate.” But even though in principle there are a lot of good, productive investments there, Rogoff says, much social and institutional change needs to take place to make rural China look like the coast. Instead of increasing domestic investment to better balance the world economy, the Asian economies should concentrate on fostering domestic consumption, Rogoff believes. “Consider the fact that in China they invest more than 40 percent of GDP. That means they are not consuming it, so their standard of living could be much higher. This is very much a political-economy problem, because the elites enjoy a perfectly fine standard of living,” he says. In broad terms, “The Asian currencies need to appreciate, and the Asian economies need to become less dependent on export-driven growth by cultivating domestic demand, which means raising living standards in these countries.” Developing countries are not the only ones accumulating reserves. Oil exporters are buying Treasuries for a different reason: they are “raking money in hand over fist with the sky-high oil prices, and are having trouble spending it as fast as they are earning it,” Rogoff says. “Mind you, these are countries which are very poor, and in many of them there are a very small number of very rich people who don’t know what to do with the money. Saudi Arabia is one example, where even with today’s oil prices, average per-capita income is only $7,000 to $8,000—and even that is misleading because the royal family controls about half of the total income. So people are hardly rich there, and if it was a democracy, I don’t think they would have any trouble figuring out how to spend the money.” Rogoff suggests that they “need to strengthen their education systems, social-safety nets, and invest in the core of lower-income [people], where there is a huge scope for greater expenditures. Whether the elites will approve of that, I can’t say, but that would certainly help reduce risk from current global account imbalances.” The causes of the U.S. current account deficit, in other words, extend well beyond the sphere of our own national control. Because they are rooted in a system that is international in scope, solving the problem without sacrificing global growth will require international cooperation. The ContrarianBut what if our current account deficit is a side effect of globalization that is not going to go away? Richard Cooper, Boas professor of international economics, takes a much more relaxed view about this possibility than his colleagues do. In theory, he says, the deficit could persist forever, as long as it eventually stops increasing as a percent of the U.S. GDP. Cooper, who was undersecretary of state for economic affairs from 1977 to 1981, and chair of the Federal Reserve Bank of Boston from 1990 to 1992, sees global imbalances as a natural consequence of a decline in investment “home bias.” “What do we mean by globalization?” he asks. “What we mean is that everyone around the world thinks beyond [his or her own] national boundaries when it comes to allocating their savings.” Americans used to invest almost 100 percent in the United States, but now allocate a portion of their portfolios abroad. “That is a process that is going on worldwide: foreigners are investing more abroad, too, but foreigners save more than Americans do.” Because the United States is 30 percent of the world economy, a world with no home bias would see foreigners investing 30 percent of their savings in the United States and Americans investing 70 percent of their savings outside the country. “If you apply those two numbers to actual savings levels,” Cooper says, “you get a $1.1 trillion current account deficit in the year 2005, with foreigners investing $2.3 trillion in the U.S. on savings of over $8 trillion, and Americans investing $1.2 trillion abroad. The difference between those two is $1.2 trillion.” International diversification of investments, in other words, causes the current account gap. 1 | 2 | 3 | 4 | continued >  
 
 
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