Maurice Obstfeld | Macro Paper Warehouse

Chapter 34 The intertemporal approach to the current account

The intertemporal approach treats the current-account balance as the outcome of forward-looking saving and investment decisions rather than as a residual determined by relative prices, and this chapter surveys the theory and the evidence for it as developed since the early 1980s. The authors trace its origins to two pressures: Lucas’s critique, which suggested that open-economy models “might yield more reliable policy conclusions if demand and supply functions were derived from the optimization problems of households and firms rather than specified to match reduced-form estimates,” and the large, divergent current-account adjustments that followed the oil shocks of 1973-74 and 1979-80, on which “[n]either the classical monetary models nor the Keynesian models in vogue at the time offered reliable guidance.” Before any theory they flag a measurement problem that “plague[s] all of the empirical literature”: reported current accounts omit net capital gains on foreign assets and are not corrected for inflationary erosion of their real value, so that for the United States in 1991 the economically meaningful deficit is “probably much closer to” minus 108.7 billion dollars than to the national-accounts figure. The theory is then built up in stages. From time-separable isoelastic preferences and the economy’s intertemporal budget constraint comes a characterisation in which the current account responds to deviations of interest income, output, government consumption and investment from their permanent levels, plus a consumption-tilting term reflecting any gap between world real interest rates and domestic impatience – each prediction stated with an explicit ceteris paribus clause. The model’s quantitative failure is displayed rather than hidden: with a world real interest rate of 8 percent, growth of 4 percent and an intertemporal elasticity of 0.4, the implied steady-state net foreign asset position is minus twenty times annual output and “the economy’s trade balance surplus each period must be 80 percent of GDP” – levels “never observed in practice.” Successive sections add comparative advantage, investment with adjustment costs, nontradables, consumer durables, terms-of-trade and transfer effects, demographic structure and fiscal policy, then uncertainty under complete markets, bonds only, partially complete markets and endogenous incompleteness. On the evidence, the authors first take on Feldstein and Horioka, reproducing the original 16-country OECD regression for 1960-74 (a saving coefficient of 0.887 with a standard error of 0.074, R-squared 0.91) and reporting a weakened but still highly significant coefficient of 0.622 for 1982-91; they also note that the average OECD time-series correlation between saving and investment rates over 1974-90 is 0.495 after linear detrending and 0.512 in first differences. Their conclusion is that these correlations “provide[] no basis at all for dismissing the basic premises of the intertemporal approach,” offering four reconciling mechanisms – current-account targeting by governments, OECD countries sitting near stochastic steady states for external debt, retained earnings raising investment through the Gertler-Rogoff channel, and demographic structure – while conceding that “no single one fully explains the behavior of all countries.” Formal structural tests are treated much more sceptically. Constructing permanent values is “perhaps the most problematic issue of all”: with a real rate of 3 percent, moving the persistence parameter from 1 to 0.97, “an amount generally too small to detect empirically,” halves permanent output, and the discount rates that would remove this sensitivity “appear implausible.” The Campbell-Shiller present-value tests reject the model’s exact restriction for most countries – Sheffrin and Woo reject for Canada, Denmark and the UK but not Belgium; Ghosh does not reject for the US but rejects for Canada, Germany, Japan and the UK; and even the weaker Granger-causality implication is passed only by the US in Ghosh’s full sample – while the actual current account is generally more volatile than the predicted one, six times more so for Canada on Otto’s estimate, which Ghosh reads as evidence of “’too much’ capital mobility, in contrast to the Feldstein-Horioka claim of too little.” Extending Britain’s sample back to 1870 improves the visual fit “dramatically” yet still fails the formal restriction. Distinguishing global from country-specific shocks helps substantially: global shocks are about half of G-7 productivity shocks, and once separated “the coefficients on the global shocks are invariably much smaller than those on the country-specific shocks, and are usually insignificant.” The chapter’s closing claim is comparative rather than triumphal: the models “provide only a starting point,” but the complete-markets alternative makes the current account “little more than an accounting convention” in a world the authors judge far from complete, while Mundell-Fleming “offers no valid benchmark for evaluating external balance” and “has no clear, much less testable, predictions about current-account dynamics.”

Globalization and Capital Markets

Written as the financial-globalization backlash of the late 1990s was at its height, this chapter asks whether the integration of world capital markets at the turn of the twenty-first century was unprecedented, and what governed its rise and fall. The received narrative is a U – high mobility under the classical gold standard, destruction between 1914 and 1945, slow reconstruction under Bretton Woods, and a renewed rise after the early 1970s – and the authors are explicit that this is a hypothesis to be tested rather than a result, labelling their own stylised figure of it “Conjecture?” with the source listed as “Introspection.” The explanation they propose is the open-economy policy trilemma: since a government can have at most two of free capital movement, a fixed exchange rate, and a monetary policy oriented to domestic goals, capital mobility survived wherever politics supported one of the corner solutions and was suppressed wherever governments tried to occupy the middle ground. Because no single measure of market integration is decisive – price convergence and flow volumes both fail as criteria, and “all such tests may be able to evaluate market integration, but only as a joint hypothesis test where some auxiliary assumptions are needed” – the paper runs a battery. On quantities, foreign assets were about 7 percent of world GDP in 1870, just under 20 percent at the 1900-14 zenith of the gold standard, 8 percent in 1930, 11 percent in 1938, 5 percent in 1945, 6 percent in 1960, 25 percent in 1980 and 62 percent in 1995 – so “the 1900-14 ratio of foreign investment to output in the world economy was not equaled again until 1980, but has now been approximately doubled,” with liabilities tracing the same path (21 percent in 1914, 11 percent in 1938, 2 percent in 1960, 30 percent in 1980, 79 percent in 1995). Measured against the GDP only of countries with data, however, the seven great creditors exceeded 50 percent from 1870 to 1914, a level “we only surpassed … as recently as 1990, and only narrowly even then.” On prices, long-term real interest differentials against the United States for Britain, France and Germany are stationary over the whole 1890-2000 span and in most subperiods, with the unit-root null rejected at 1 percent almost everywhere except the recent float; covered and quasi-covered nominal differentials since 1870 widen in exactly the periods the U predicts, and threshold estimates of the no-arbitrage band – roughly 19 basis points for New York-London and 35 for London-Berlin before 1914, against 60 and 91 in the interwar years and about 6 in the mid-1980s – put pre-1914 integration “truly impressive compared to conditions over the following half-century or more.” Cross-country dispersion of dollar equity returns follows the same U for the G7. The authors then argue that only policy can account for the mid-century collapse, since “technology is a poor candidate” – financial techniques were not forgotten in the 1930s, and some, such as foreign exchange futures, matured then. The political-economy section supplies supporting evidence from bond spreads: on a consistent 1870-1940 London panel, being on gold lowered spreads by about 57 basis points before 1914 and only peripheral countries were punished for public debt (7.2 basis points per 10 percentage points of debt to GDP), whereas for 1925-30 the gold dummy is insignificant or wrongly signed, core and periphery are no longer distinguished, debt sensitivity is roughly five times larger, and estimated reputational persistence falls from 0.68 to 0.30. Finally the paper insists on one large difference between the two globalizations. Pre-1914 flows were long-term and nearly one-way, so gross and net positions nearly coincided; today the same rich countries top both the asset and liability rankings, net positions have stayed very low since 1980, and the developing-country share of global liabilities has fallen from 33 percent in 1900 to 11 percent in the 1990s. Today’s integration is therefore “mostly a rich-rich affair, a process of ‘diversification finance’ rather than ‘development finance’,” and the Lucas paradox of capital failing to reach capital-poor countries is, if anything, sharper now than a century ago.

The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?

International macroeconomics, the authors observe, “is a field replete with truly perplexing puzzles, and we generally have five to ten (or more) alternative answers to each of them. These answers are typically very clever but far from thoroughly convincing, and so the puzzles remain.” This paper proposes a single culprit for six of them: significant but plausible costs of trading goods across borders, modelled as Samuelsonian iceberg costs, interacting with the high elasticity of substitution between home and foreign goods. The strategy is deliberately restrictive. Rather than selecting, puzzle by puzzle, from the menu of possible capital market imperfections, the authors ask “how far one can go in elucidating major empirical riddles without appealing to intrinsically international capital-market imperfections” – and find that “once one allows for trade costs in goods markets, many of the main empirical objections to the canonical models of international macroeconomics disappear.” The mechanism is always the same interaction. With an elasticity of substitution of 6 and trade costs of 25 percent applied to all of output, home expenditure on home goods exceeds home expenditure on imports by a factor of 4.2, a ratio “consistent with those we observe for many OECD countries.” The same two parameters, in a two-period small-country endowment model, generate a five-segment step function linking the current account to the domestic real interest rate: for small imbalances trade costs have no effect at all, but once a deficit is large enough to reverse the direction of trade in the home good, its price rises today relative to tomorrow and the effective real borrowing rate jumps. With a world rate of 5 percent, trade costs of 10 percent and an elasticity of 6, the country’s real interest rate can range from 20 percent to −8 percent. The observed range is far narrower, which is exactly the point – “incipient real interest differentials put a sharp check on a country’s incentives to run large current-account deficits or surpluses” – and is consistent with the Feldstein-Horioka slope having fallen from 0.89 in the original 1960s-70s data to 0.60 for OECD countries over 1990-1997 while remaining far above zero. The prediction that deficit countries face higher real rates is tested on annual OECD data for 1975-1998 and confirmed: with country fixed effects and time dummies, a one-percent-of-GDP rise in the current account surplus is associated with roughly a 20 to 30 basis point fall in the real interest rate. In a stochastic version with complete Arrow-Debreu markets, the same parameter pair – an elasticity of 6 and trade costs of 25 percent – delivers a home equity share of 81 percent, against the 80-90 percent observed and the roughly 50-plus percent the traded/nontraded dichotomy can explain; with an elasticity of 10, trade costs of just 10 percent yield 72 percent. The consumption correlations puzzle then follows largely as a corollary, and the authors add a reframing: the right benchmark for consumption correlations is output net of investment and government spending, whose average G7 correlation is 0.17, well below the 0.40 average consumption correlation. For the last two puzzles – the three-to-four-year half-life of real exchange rate deviations, and the broad disconnect between exchange rates and macroeconomic aggregates – the authors are explicit that trade costs alone are not enough: “to explain adequately the various pricing puzzles, we would need to develop a much richer framework featuring imperfect competition plus sticky prices and/or wages,” and they do not build one here. What they argue instead is that trade costs “must constitute an essential element, implicitly if not explicitly,” because with pervasive retail-level segmentation and prices preset in local currency, exchange rate movements have minimal short-run real effects “and therefore must be huge to clear financial markets.” The closing section confronts the obvious objection – transport technology has improved and tariffs have fallen – and reports that the quantity puzzles have indeed become less acute while net transport costs may not have fallen much, since shipping costs rose for manufactures even as they fell for bulk commodities.