In a speech today, David Dodge, governor of the Bank of Canada, warned about the threat that global economic imbalances could pose, both in the short-term and long-term, to the health of the global economy.

Speaking to the Spruce Meadows Roundtable in Calgary today, Dodge discussed two types of global economic imbalances – existing uneven savings and investment patterns between countries, and the threat of a long-run, demographics-led investment shortage.

The existing imbalances are largely characterized by the large and growing U.S. current account deficit, and large surpluses elsewhere, particularly Asia. He noted that these imbalances are not necessarily a bad thing, “However, when imbalances grow at an unsustainable pace, as appears to be the case at present, some form of correction must take place,” he warned.

“If markets are allowed to operate without interference, imbalances can resolve themselves in a reasonably smooth manner. But in the absence of appropriately functioning market mechanisms, there is a greater risk that the correction will be abrupt and disorderly,” he said. “Beyond disruption to financial markets, a disorderly correction might also lead governments to adopt wrong-headed protectionist measures, which would then exacerbate the damage to the global economy.”

Regardless of how these imbalances are resolved, Dodge said it is clear that the resolution will require greater net national savings in the United States. Higher interest rates can be expected to lead to increased savings. “Authorities could also encourage greater national savings with a tighter fiscal policy. And they could implement structural reforms to encourage national savings through taxation, social security premiums, and other measures,” he noted.

But, at the same time, other countries should be working to stimulate their domestic demands, he added. This may involve monetary policy, structural reforms or more stimulative fiscal policy.

The other type of imbalance the world faces will be posed by evolving economic and demographic realities. “As I see it, if countries do not have the appropriate structural policies in place, there is a risk of a prolonged deficiency in global demand in the future,” he said.

He suggested there’s “a possibility that, over the next couple of decades, the global economy might face a protracted period in which desired savings exceed planned investment, partly because of demographic trends. If economic policymakers do not take appropriate measures quickly enough, there is even a risk, albeit a small one, that the world economy could end up with the classic dilemma — first spelled out by John Maynard Keynes — of widespread demand deficiency and a persistent deflationary gap.”

“If there is no increase in global demand to offset the expected increase in desired savings, it may be difficult for monetary policy to effectively fulfill its role as the main short-run economic stabilizer in the years ahead,” he warned.

The one thing that all governments can do to stimulate demand, Dodge stressed, it is to have appropriate structural policies. “Structural policies that promote economic flexibility are important in all circumstances. We all need to take steps to improve the flexibility of our labour markets and, in particular, to make sure that older workers who want to remain in the workforce are not discouraged from doing so. We also need to recognize that well-functioning credit markets are extremely important, so that households can borrow against future income, and businesses are able to make investments for the future,” he said.

“The improvement of labour and financial market policies is particularly important in Europe. In emerging Asia, improving income-security policies is essential in order to reduce the need for households to build up large amounts of precautionary savings. As well, stronger, more efficient domestic financial systems could go a long way towards raising confidence and promoting increased spending,” he added.

“I’m not saying that a disorderly correction to global imbalances is certain to happen. Nor am I saying that the global economy is inevitably headed for a deflationary shortfall in demand. What I am saying is that, as prudent policymakers, we must not rely on good fortune to help us muddle through,” Dodge said. “We need to get going on these policy issues now, before it is too late to take remedial action.”

“In particular, we need to make sure that our structural policies encourage maximum economic flexibility and that they do not impede investment and growth. We need to make sure that we will have the fiscal flexibility to handle the demographic challenges of the future. And we must continue to conduct monetary policy with the aim of keeping inflation low, stable, and predictable, to maximize the chances that our economies will operate at full capacity,” he concluded. “We must act now to meet the challenges of today, and of the future, for the benefit of all our citizens.”