An Imbalanced Recovery

Co-authored with Joseph E. Kasputys, Chairman and Founder IHS Global Insight

Before the economic and financial crisis hit with full force in 2008, we warned of the dangers of imbalances in the global economy. These global imbalances largely reflected underlying national imbalances in the United States, China, and other major economic powers. The problem for the United States at that time was easily demonstrated by the large current account deficit, which reached an unprecedented 6.0 percent of GDP in 2006. The current account deficit, in essence, is the amount we must borrow from other countries to maintain a combined level of domestic spending exceeding the incomes of consumers, businesses, and all levels of government. This level of borrowing was widely deemed not sustainable in the long run -- but economics is a behavioral science, and precisely when economic behavior would bring that borrowing to a halt was a matter of intense debate.

The counterpart to the U.S. deficit was the large trade surpluses of China, Germany, Japan, and the oil-exporting countries. Their surpluses reflected, among other things, high rates of saving in those countries and export-led economic growth policies.

As the global economy fell, affected nations undertook policies to pull themselves away from the brink of depression. At the moment of crisis, policies to stimulate the economy by sustaining demand made the most sense. Thus, those policies would tend to remedy the imbalances in other countries, but to exaggerate them in the United States.

In this country, the American Recovery and Reinvestment Act of 2009, monetary easing, and other steps provided a significant boost to aggregate demand. Other nations undertook similar efforts, although of different sizes and compositions. And to a large extent these efforts have paid off in renewed income growth, though at levels not sufficient to appreciably lower historically high unemployment rates.

Despite (or in the case of the United States, because of) these efforts, the global economy today looks similar in many respects to the economy of early 2008. Influenced by the domestic slowdown, the U.S. current account deficit had fallen to about 4.6 percent of GDP in 2008. With the recession well underway in 2009, the deficit fell to about 2.6 percent. But at present, the trade deficit is edging back up, to an annual rate of about 3.0 percent. While better than at the height of the pre-recession period, these numbers indicate that the United States continues to consume and invest more than it produces. A similar analysis for the major pre-recession surplus countries would indicate that although they, too, have moderated their consumption, investment, and saving patterns, the basic imbalances that existed before the crisis are still present.

That is not to say that everything remains the same. For example, the mix of spending in the United States has changed dramatically. Before, consumer and business spending were driving an economic expansion. Government spending contributed, but it was not historically high as a percentage of GDP. At present, consumers and businesses are putting their finances on a more stable footing, both out of necessity and prudence, and so personal consumption and private investment are sluggish. Meantime, the federal government deficit has moved up to about 10 percent of GDP, a level last experienced during World War II.

Looking ahead, it is easy to see that the recoveries taking place around the globe will not be stable or sustainable unless surplus countries, such as China and Germany, take steps to rebalance their economies away from export production and towards greater domestic consumption. It is also obvious that the United States cannot fall back into the pattern of over-consumption, leading to continuing high trade deficits and foreign borrowing. We must get spending under control, and some cutbacks in spending are taking place.

As mentioned, consumers are cutting back. The personal saving rate (based on disposable income), which was negative before the recession, is 3.7 percent so far in 2010. But the increase in the saving rate is modest by historical standards; and although monthly figures carry considerable statistical noise, the saving rate perceptibly peaked at 5.4 percent last year. And household saving has both a numerator and a denominator. With almost 10 percent of the workforce unemployed, and many more either discouraged from seeking work or "underemployed" (involuntarily in part-time or temporary, lower-wage work), the saving ratio may be helped by a low denominator of disposable income. What this figure will show, if and when employment and consumer incomes recover, is unclear. Newly employed workers could save more because of the trauma of their bouts of unemployment; or they could resume the U.S. consumption binge of the last three decades.

Businesses do appear to have restrained their spending, judging from cost-cutting, layoffs, and reports of record levels of corporate cash reserves. Of course, in a world of fluctuation-free and continuous economic growth, we would expect that every month would see a new record level of nominal corporate cash reserves. However, the level of business reserves does appear to be significantly above trend -- which is not a great surprise, given low levels of business capacity utilization and sluggish consumer demand.

Should the limited improvement in household saving over the last few months be a matter of alarm? Or concern? Or does it merely bear watching over the next few years? With the economic recovery appearing fragile, it would seem premature -- to say the least -- to intervene with public policy to restrain consumer spending. Altering consumer behavior has never been easy. Past efforts have often backfired. In fact, the beginning of a rapid decline in household saving came in the early 1980s, just as tax policy was changed in significant part to increase incentives for household saving. Recent legal changes with respect to automatic enrollment of new employees in pension programs probably have exhausted the limits of our sound ideas to increase saving.

The greatest need -- and the need most amenable to policy change -- is to reduce the deficit spending of the federal government. Many -- perhaps most -- macroeconomists would say that the economic recovery is too fragile to begin significant reduction of the federal budget deficit. However, it is none too soon to begin planning for deficit reduction, and actions by policymakers now that will bring the federal budget toward balance in the future would be reassuring for international financial markets. Certainly, the current budget deficit of 10 percent of GDP is a temporary phenomenon. Unfortunately, even with recovery, the deficit is forecast to remain at about 5 percent of GDP for the next 10 years (CBO). To rebalance our economy internally and externally with the rest of the world, the long-term federal budget deficit needs to come down.

After economic recovery and federal budget deficit reduction are secured, the nation should reassess its level of aggregate saving and its international imbalance, and if need be seek ways to encourage consumer thrift. And, we must continue all the while to press the surplus nations to move their international trade and capital flows toward a more stable footing.
Dr. Joseph E. Kasputys founded Global Insight, Inc. in March 2001 to join together the world's premier economic information and consulting firms, consisting of Data Resources (DRI) and WEFA (formerly Wharton Economic Forecasting Associates). He served as Chairman, President and CEO until the sale of Global Insight to IHS Inc. on October 10, 2008. During this period, he acquired and integrated eight additional companies providing economic and business information. Dr. Kasputys now serves as Chairman of IHS Global Insight and Chairman of the IHS Insight Advisory Board, which develops and recommends products and services that can best meet client needs utilizing all IHS insight capabilities.