Imbalance in the world economy

Strong growth in the US economy contrasting with a lacklustre performance in Europe point to an increasing imbalance between the major industrial economies. Market forces will ultimately adjust the balance. But will this process be a benign one or a cause of spreading instability?

Apart from the oil price hike that I discussed in this column on 28 September, another serious threat to global financial stability is the imbalance in the economic conditions between the major industrial countries. The very strong economic performance of the US, in contrast to the relatively less impressive economic performance of the euro area, has led to large current account imbalances and currency misalignments that extend to the rest of the world.

Central to this imbalance is the strong growth in productivity in the US, made possible by the continued surge of investment in high tech equipment. This produced a rate of economic growth, forecast at over 5% this year, that is well above past trends and constrained inflation through offsetting the rise in labour costs. The US is therefore offering distinctly higher rates of return for direct investment and for portfolio investment in financial markets, when compared with other developed countries. This is sucking in large amounts of foreign capital and financing a historically huge, and still growing, current account deficit. At the same time, the US dollar has strengthened, further enhancing the rate of investment return in foreign currency terms. Many have questioned whether these trends in the US - rapid productivity growth, benign inflation, a large and increasing current account deficit and an appreciating currency - are sustainable.

Although, at around 3.5%, the euro area is recording a very respectable growth rate, the growth differential, and the rates of investment return compared with the US, are large enough to make a difference to investors. At the same time, notwithstanding the fact that gross domestic fixed capital formation as a percentage of GDP in the euro area is higher than that in the US, productivity growth is clearly much slower. Some have attributed this to institutional and market rigidities that are seen to have inhibited the degree to which the euro area could embrace the new economy and benefit from it. And so, before the euro could establish it rightful status in the global financial system as the currency of an economic area that is as large and influential as the US, it has been battered badly in the foreign exchange market. Some have even -- unjustifiably in my view -- begun to question its long-term viability, and the effect is that the euro exchange rate has clearly overshot. But current sentiment is that this may continue for a while before it is corrected, whether by intervention or other means.

Whatever the cause of this imbalance, market forces will work to reduce it eventually. The worry is, of course, whether the damage inflicted by this imbalance could, in the mean time, become systemic and contagious, undermining global growth and financial stability, before the eventual adjustment comes. Globalisation and the technology revolution are a potent combination that the ability of even the largest international financial institutions may find difficult to cope with, notwithstanding profits hitting records. And when the imbalance is corrected, the process may not be a smooth one at all, given the overshooting of the euro exchange rate that we have already seen. The optimistic outlook is that this correction would take the form of a catching up by the euro area in productivity growth. But if it is manifested instead in a disappointment in the US by any significant degree, the consequences for financial markets could be quite severe.

Joseph Yam
12 October 2000

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