Jean-Philippe Cotis asks which kinds of reforms in Europe and Japan would help to reduce the US’s gaping external deficit.

The US current account deficit has entered uncharted waters, mirroring large surpluses in Japan, China and Germany. These imbalances will not vanish spontaneously. As they persist or widen, the probability of an abrupt adjustment will continue to grow. A dollar crash could entail large costs for the world economy, including Europe and Japan, where fiscal and monetary margins of manoeuvre to offset lower exports are modest.

Conventional wisdom holds that the orderly unwinding of these imbalances requires fiscal consolidation in the US, higher investment and greater exchange rate flexibility in emerging Asia, plus growth-enhancing structural reforms in continental Europe and Japan. So far, little progress has been made but how much current account adjustment can be expected via each of these channels?

US fiscal consolidation and Asian exchange rate flexibility would help. In the US, fiscal retrenchment-cum-dollar depreciation can restrain domestic demand while boosting exports. Removing the tax code’s anti-saving bias could help by ending the deductibility of interest payments on mortgages and consumer credit or taxing households less on income and more on consumption. And a stronger and more flexible renminbi would help to relieve pressure on other parities.

Structural reform

What about structural reform? The standard argument is that with meagre macroeconomic policy wherewithal, only structural reform can lift growth in Europe and Japan, and boost their imports of US goods and services. A more sophisticated view focuses on transition dynamics: stronger potential growth temporarily raises the return on capital, drawing in foreign money, as in the US during the second half of the 1990s. The impact on the current account was plain to see.

Alas, both the standard and sophisticated versions of ‘salvation through structural reforms’ are questionable. First, would higher potential growth outside the US reduce its deficit? Imports from Japan and Europe would increase but over time so would their capacity to export. In the long run, there is no correlation between growth and current accounts.

What about transitional effects? Why shouldn’t higher trend growth in Europe generate US-like outcomes for the benefit of the world economy? The realistic answer is that the configuration leading to falling US saving was exceptional. During the late 1990s, the pain of past US reforms was already fading when agents started to become aware of the magnitude of the growth dividend.

A repeat of such a scenario seems unlikely in Europe. Higher potential growth first requires difficult structural reforms that can generate anxiety and precautionary saving. Initially, demand may remain subdued even as supply expands, possibly translating into rising rather than falling external surpluses.

Market liberalisation

Labour market reforms, which have been increasing precautionary saving in Germany while making the economy more competitive externally, do not look like they will reduce current account imbalances. But other reforms may help. Financial market liberalisation may contribute to a stronger euro and yen through capital inflows, while allowing European and Japanese consumers to save less by using more flexible financial mechanisms. Similar stimuli may be expected from product market liberalisation and its likely consequences in terms of higher foreign penetration, falling prices and stronger real personal incomes. Liberalising Japan’s and Europe’s non-traded sectors would weaken their current account.

Product and financial market reforms would support aggregate demand and ease the pain of labour market reform while mitigating its potentially adverse short-run consequences for current account imbalances. Curing imbalances may still need traditional recipes, such as US fiscal retrenchment and more flexible exchange rate policies in Asia, which are desirable.

The rationale for structural policies would be to help Europe and Japan to cope better with currency realignment rather than to prevent it. Stronger growth to start with should make a slowdown less painful while increasing fiscal room to manoeuvre. And greater flexibility should increase resilience in the face of exchange rate shocks.

Jean-Philippe Cotis is chief economist at the Organization for Economic Co-operation and Development.

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