False warnings from the Fund

On the weekend of April 18, the managing director of the IMF, Rodrigo Rato, issued a warning, which was reported by the financial press as "ominous".

He warned that the global financial system was now out of kilter because of the huge US current account deficit and the inflexible currency regimes in Asia.

These comments were obviously addressed at the American and Chinese governments. Mr Rato is reported to have said: "If policies do not adapt and change to react against these imbalances we run the risk of an abrupt corrections of the markets when confidence for different reasons could evaporate or could be reduced."

These comments are vague but the substance behind them is that the US should reduce its trade deficit and the Chinese eliminate its surpluses by revaluing their exchange rate.

The present state of affairs where the Chinese use their exchange surplus to buy US treasury bonds is not a desirable option, nor in the long run sustainable.

No one would wish to disagree with such carefully considered global opinions but the mechanics and economics of proposed changes are somewhat less obvious.

Suppose, for example, that the Chinese decided to diversify their foreign surplus portfolio by investing in bonds and debts of other countries, would that work any better?

It is self-evident that the Chinese would seek to put their surpluses in those countries that have ample reserves, like, let us say, as a remote but illustrative possibility, India.

But what then would India do with this surplus?  Either her managers would invest their surplus directly back in US treasury bonds or, if they chose to diversify their portfolio, their bankers would put it in US bonds.

It is in the nature of banks that they do not run out of deposits unless it is thought that they cannot meet their nominal obligations. In one way or the other, directly or indirectly, the Chinese surplus will end up in US paper so long as the US remains the final sovereign bank.

The net position may not change much for America although it would owe its debt to China partly directly and partly through India. The details of such changes are clearly irrelevant because for the world as a whole the net surpluses in trade are always as a matter of accounting matched by the net deficits of other countries.

If the US deficit is to be reduced, it has to be counter-balanced by an increase in deficits or a reduction in surplus of other countries in order to achieve the targets that the IMF wants.

In place of these generalities about rectifying imbalances, a very much more useful exercise by the managing director would have been to suggest the names of countries that might be persuaded to increase their trade deficits or reduce their trade surplus.

They did not altogether neglect that for they recommended that Western Europe and Japan should conduct some expansionary policies; but the Fund could not propose increasing public expenditure because most of these countries already suffer a fiscal deficit.

Moreover, in Japan's case fiscal deficit or expansion does not seem to translate itself into trade that is a demand for goods but seems to add only to corporations using ingestible surpluses to reducing an overhang of past debts.

It seems that Japan suffers from what has been described as a "Balance Sheet Recession", which is reluctance to borrow for expansion even at zero interest rates.

Companies are concentrating only on reducing debts to bring their liabilities below fallen asset prices. The further asset prices fall, the less paradoxically can companies afford to expand and the more they must use their profits and surpluses to meet their liabilities.

As for asking the Europeans to expand this tends to provide no solution as they mange to do so only with exports, which further increase trade surpluses that tend to be invested in America.

In this confusing picture, the Fund directors are able to pinpoint only one important economic lacuna. That is, the Asian surpluses influenced by the low valuation of the Chinese currency.

Thus, it is suggested that if the Chinese valued up their currency all other Asian countries could do so and thereby help to reduce the American deficits hopefully by buying American goods and services rather than treasury bonds.

The IMF managing director, therefore, considers removing price and exchange imbalances as fundamental to the smooth working of international economy.

Moreover, the present Chinese demand has not only raised demand for oil, raw materials, and commodities but also inflated their prices to an unsustainable level. It is desirable to remove these imbalances by a smoother working of the price mechanism.

The gravest danger with concentrating on removing imbalances is that it can tip economies into a deep depression. Two examples are worth quoting.

The first is from the thirties; just before the General Depression, the share price bubble burst in 1929, President Hoover and his treasury secretary Andrew Mellon saw it as an ideal opportunity to clean up the system of incompetent management that had been responsible for bank and corporate failures.

Mellon advocated "liquidate labour, liquidate stocks, liquidate real estate... it will purge the rottenness of the system ... Values will be adjusted and enterprising people will pick up the wrecks."

Unfortunately although values adjusted no one was there to pick up the wrecks and the economic world experienced the greatest catastrophe it had ever known.

Nor is this an isolated example; in attempting to pull the Japanese out of the slump the present Koizumi government decided that there was to be "no economic recovery without structural reform".

Since the structural reform had to be carried out by banks and companies, no recovery was allowed to proceed until the issue of non-paying loans -- the rotten part of the Japanese economy -- is resolved.

Since this problem cannot be resolved, no reform has been carried out and Japan staggers from one recession to another.

The purpose of this paper is to warn reformers like Rato that in spite of their vast experience, the workings of markets are not as easily identifiable and that all great depressions come not from the exaggerations of markets, whether they result from purchasing too many bonds or in paying too much for imports, but in the unwise intervention of those in authority who can convert a downturn to a depression.

In trying to persuade the Americans to reduce their trade deficits or to persuade the Asian countries to alter their exchange rates Mr Rato is playing the most dangerous game of all in economics. He is pretending that he has an answer, as did Mellon and Hoover, or as Koizumi now does.

The danger lies not in the disequilibria in the markets but in attempts to design a financial architecture that seems appropriate for a particular moment in time.