(i) Briefly, what is the issue? What impact does it have on different regions’ GDP, prices, exchange rates and Interest rates?
The issue is an unprecedented level of world surplus savings (especially in the Asian economies) that faced with weak investment opportunities serve to fund a growing US current account deficit which creates dangerous world imbalances.
The Euro-zone and Japan have slow GDP growth and their savings increase due to a lack of confidence in both financial and social security systems as well as the inability of the private sector to find investments. Also we see increasing fiscal deficits, very low real interest rates and low inflation. The Euro appreciated vs. USD, creating loss of export competitiveness that added up to a weak demand. The yen has been down in real terms (to avoid deflation).
Therefore, most of the countries (specially Asia and specifically China) are using this surplus to lend money to the US, thus making the US both borrower and spender of last resort (to finance mainly US consumption, its current account deficit and to some extent its fiscal deficit). Furthermore, any FDIs from Europe and the US into developing Asian economies are recycled (although the Asian countries keep the technology) into Asian Central Banks’ purchase of US Treasuries. The banks also use this as a mechanism to maintain export competitiveness by fixing their currency against the USD, which increases their foreign reserve accumulations.
Tight monetary and fiscal policies as well as direct interventions in credit markets have helped to sustain this high domestic savings. China’s economic growth rate is 9%, due to: increasing exports & spending in capital goods and construction; very low interest rates; increasing (but still low) inflation and real exchange rate depreciation.
(ii) Why does it put the world economy at high risk? What is the worst possible outcome?
The US current account deficit has increased to 6.5% of GDP, because of low and falling savings as well as private spending rising faster than disposable income. The US net external liabilities have also increased to levels that had never been seen before. Thus, in order to achieve a growth of output in line with full employment, US domestic demand needs to grow more than GDP (since imports grow also 6% more than exports). Therefore the US has increased its current account deficit to adjust the current account surplus of the rest of the world. The alternative would have been not to dispose of all those savings causing a global slump.
But how long will both the US current account deficit and Asian countries exchange rate + saving & lending policies, be sustainable? Not long, because:
o In the US: “What can’t go on, won’t”
o It is impossible to bridge the current account deficit through the growth of exports over imports, because at current real exchange rate, imports grow twice as fast as exports...