Resident Fellow  Desmond Lachman

All is not well in today’s global economy. Indeed, all too many disturbing parallels with the disastrous 1920s and 1930s now seem to be emerging in the international payment system. In particular, global payment imbalances are the most pronounced in the past sixty years, currency manipulation for competitive advantage is becoming the norm, and serious protectionist pressures are coming to the fore.

To make matters worse, the IMF, the supposed guardian of the international financial system, seems to be fast asleep at the wheel. For rather than seeing its role as that of guardian of the system, the IMF now seems to see its role as that of the world economy’s cheerleader. And in assuming that role, the IMF assures us that, historical experience to the contrary, this time it is really different. In the IMF’s view, far from being a source for concern for continued global prosperity, today’s massive global payment imbalances are really a sign of sustainable global economic strength.

The most obvious sign that something is seriously amiss in today’s international payment system is the unprecedented balance of payments deficit of a savings-short United States, the world’s largest economy. At its present 7 percent of GDP, the United States external current account deficit is by far at its widest level in the post war period and it is as yet to show any real signs of leveling off. As a result, the United States, which not so long ago was the world’s biggest creditor nation, has now become the world’s largest debtor nation. Even more disturbing is the fact that on present trends, the United States’ external debt is set rise to over 100 percent of GDP by 2020.

Further signs that something is seriously wrong in the global economy are recent exchange market developments in China and Japan, the two countries with the world’s largest payment surpluses. Despite its repeated assurances to the contrary, China continues to effectively peg its currency to the depreciating US dollar. It does so by intervening massively in its foreign exchange market at the staggering rate of US$250 billion year. In so doing, it keeps its currency artificially weak and it seriously thwarts the depreciation of the US dollar needed to bring the US balance of payments back to a more sustainable level.

At the other end of the spectrum, Japan now refrains from exchange market intervention. It does so at a time that the Japanese yen continues to plumb new lows in reflection of Japan’s still very low interest rates and its poor public finances. This hands-off exchange rate policy effectively provides Japan with a large competitive edge in global markets and it is now raising howls in official European circles as the Japanese yen sinks to record lows against the Euro.

Within Europe itself, marked divergences in economic performance have emerged between individual members of Europe’s single currency market. In time, those divergences could undermine the very viability of the Euro arrangement in its present form especially should markets lose patience with profligate countries like Greece, Italy, and Portugal. Despite their large budget deficits, these countries can all still borrow in the market at terms not very different than Germany. 

While Germany has managed to reform its labor market over the past five years, the same cannot be said of Europe’s Mediterranean countries. As a result, those countries have now lost anywhere between 33 and 45 percent in competitiveness to Germany. Regaining this competitiveness could very well condemn these Mediterranean economies to politically unacceptable slow growth rates over the next few years.

As tensions between the world’s major countries mount over exchange rate management, the IMF is surprisingly passive in seeking to defuse the real risks of protectionism and of disorderly financial markets. Rather than pushing ahead with its admittedly half-hearted multilateral surveillance initiative announced last April aimed at facilitating a co-operative solution to the global payments problem, the IMF has chosen to embark on a cheerleading campaign. It has done so to convince financial markets that today’s unprecedented payment imbalances are not a matter for serious concern but rather a sign of global economic vigor.

In effectively withdrawing itself from the role of finding a co-operative solution to the global payment problem, the IMF is straying very far from its original mandate. After all, the IMF was created in 1944 with the explicit purpose of promoting international monetary cooperation and of preventing a repeat of the highly destructive financial market disorder of the inter-war years. If the IMF chooses not to play that role now at a time of unprecedented large payment imbalances, one has to ask whether the IMF ever will. This has to raise the further and more existential question as to what precisely might be the IMF’s role in today’s world economy.

Desmond Lachman is a resident fellow at AEI.