International linkages and policy coordination Cambridge Endowment for Research in Finance (CERF)Alphametrics Ltd. The Cambridge Alphametrics Model LINK meeting November 2006

CERF and Alphametrics 2 What we can agree so far  A short-term quarterly model such as LINK provides useful information about the current state of the world economy  Views on the merits of short-term policy-making depend on the intuition of the policy-maker and the perspective of the beholder  The time-scale for resolution of major imbalances is longer than the time-horizon of the model  We need longer-term models

CERF and Alphametrics 3 What are the major imbalances in the global economy ? 1. Income inequality 2. The US deficit 3. Pressure on the environment

CERF and Alphametrics 4 The Cambridge Alphametrics Model: central elements  The objective is to provide a quantitative framework for scenarios of growth and income distribution that takes account of resource constraints  The target is to identify and measure processes that change the structure of the world economy and economic possibilities in each country and region

CERF and Alphametrics 5 The Cambridge Alphametrics Model: understanding of the mid-term  We need to understand historical processes that have created major imbalances and get ideas about the potential pay-off from different patterns of development  Without some degree of consensus it is difficult to imagine that global imbalances can be resolved

CERF and Alphametrics 6 Specifically … [hidden]  Are there plausible scenarios for a substantial reduction in the US deficit over the next 5-10 years ?  What degree of convergence of per capita income in the world as a whole is conceivable and over what timescale ?  Can resource constraints and maintenance of the natural environment be reconciled with upward convergence of income levels ?

CERF and Alphametrics 7 Global inequality - income  Countries in the top 20% measured by per capita income receive 60% of world income  Those in the bottom 50% receive less than 20% of world income Distribution of world population and income by country, 2005

CERF and Alphametrics 8 …and exports  Countries in the top 20% of the income distribution produce 75% of world exports  Those in the bottom 50% produce 7% of world exports Distribution of world population, income and exports by country, 2005

CERF and Alphametrics 9 Shares of the total value of world trade in goods and services, Model #1 Trade and income  Export-led industrial growth has made it possible for many countries to take advantage of modern technology and exploit economies of scale and specialization  Other countries that rely on primary products and energy had a more uneven experience

CERF and Alphametrics 10 Trade balances by commodity group  Market prices are very important for exporters of primary products  Real demand is more important for exports of manufactures and services Percent of world population in countries with surpluses or deficits in the specified range

CERF and Alphametrics 11 9 market shares showing the largest absolute changes, Changes in shares of manufactured export markets Together with historical and cultural factors, policies on trade, investment, taxation, education and infrastructure are more important than exchange rates

CERF and Alphametrics 12 Model #2 The balance of payments structural flows financial flows change in reserves balance of payments flows as % of GDP selected countries  structural flows include the current account and direct investment  the interesting question is the impact on the exchange rate

CERF and Alphametrics 13 real and nominal exchange rate changes selected countries Exchange rate volatility nominal exchange rate real exchange rate  real exchange rates have been highly volatile in nearly all countries  there is zero correlation between financial flows and exchange rates

CERF and Alphametrics 14 Model #3 Financial markets  Movements in financial markets have important effects on investment and consumer spending  Monetisation and financial liberalisation mean that personal wealth is held in funds, equity, bonds, bank deposits and real estate  The market valuation of assets is relatively uncertain yet investors measure the benefits in financial terms and such influence spending

CERF and Alphametrics 15 Expansion of aggregate demand [hidden]  Expansion of demand is a necessary condition for sustained growth of the world economy  If a correction of the US deficit does take place it is problematic whether other regions of the world will have the confidence to take up the challenge and boost domestic demand

CERF and Alphametrics 16 An optimistic scenario  The best foundation for sustained growth and improved income distribution would be a consensus on a combination of policies  Structural policies would include energy saving and accelerated relocation of production of tradeable goods and services to low income regions. The USA may also need to take action to save energy and build up export industries  Financial policies would include support for demand expansion in developing regions and a less conservative stance in Europe

CERF and Alphametrics 17 Sustainable reflation  W Europe and Asian countries can bring about a reduction of the US trade deficit by relying more on domestic spending and cutting their combined trade surplus Rest of Asia Rest of world China Japan Trade surplus ($billion)

CERF and Alphametrics 18 Energy efficiency would be a must and is possible  Energy saving will reduce damage to the environment and facilitate a more balanced pattern of trade Rest of Asia China Japan Energy consumption (tons of oil per million $ income)

CERF and Alphametrics 19 Growth generalized Africa6.1% Middle East 5.1% Former USSR 7.1% Eastern Europe 5.5% Western Europe 2.7% USA2.2% Other Dev 3.0% China7.6% Other Asia 7.3% Latin America 6.0% Per capita income,