Flexible markets, freer trade, more responsible fiscal and foreign exchange policies, and a better International Monetary Fund are the keys to reducing increasingly troubling global imbalances says David Dodge, Governor of the Bank of Canada.

Speaking to la Conférence de Montréal today, Dodge attacked the question of large, global economic imbalances that, as he notes, “have become the subject of increasing concern among market participants and policy-makers around the world. I am referring, of course, to the persistent and growing current account deficit in the United States that is mirrored by large current account surpluses elsewhere, especially in Asia.”

“Up to now, world capital markets have been managing these imbalances in a reasonably smooth way,” he says. “In the short term, it is reasonable to expect that they will continue to do so. But over the medium term, imbalances of this magnitude are not sustainable. At some point, they will have to be resolved.”

“These imbalances will ultimately be resolved, either in an orderly, or in an abrupt, disorderly way,” he suggests. “The question is, are current economic policies and today’s international monetary order likely to facilitate an orderly resolution of the imbalances? If not, what changes are needed to reduce the risk of an abrupt, disorderly adjustment?”

Dodge notes that key impediments to the resolution of imbalances include both national policies and the international monetary order. On the national front, he says, “First, microeconomic policies should allow markets for both goods and labour to function as well as possible and with a maximum degree of flexibility. Almost every country, including Canada, talks a good line about this, but action has been rather slow everywhere. Second, strong policies must encourage the creation and maintenance of a sound financial system that can efficiently allocate domestic and foreign savings. Progress here, although slow, is taking place … Third, all countries must pursue fiscal policies aimed at producing a sustainable public debt-to-GDP ratio. Where structural fiscal balance is absent, it should be achieved; where it is present, it should be maintained. There are some real problems on this front in the United States, in Europe, in Japan, and in some developing countries.”

He suggests that better national policies should help ease the imbalances, but noted that currency adjustments are necessary, too. The obvious target here is China, which remains under pressure to allow some appreciation of the yuan against the U.S. dollar.

“When the nominal exchange rate is fixed, the only way to bring about adjustments in the real exchange rate is through large movements in relative wages and prices. Theoretically, this is feasible — but only if wages and prices are highly flexible both upwards and downwards. But this high degree of flexibility is practically non-existent,” he says.

“And so, when exchange rates are fixed, global economic adjustment can still take place, but it comes at a high cost — through shrinking output and rising unemployment in countries with current account deficits and through very high inflation in countries with current account surpluses.”

“So there are impediments in Europe, the United States, and Asia that are all getting in the way of a timely and orderly resolution. Because of this, global imbalances are growing, and this is increasing the risk of a disorderly correction at some point down the road,” he cautioned. “In addition, the longer the adjustment is delayed, the greater the risk that industrialized nations will take protectionist measures against emerging-market economies that are perceived as not playing by the rules.”

As for the international front, Dodge stresses that further enhancement of the rules of free trade through the Doha round and a strengthening of the World Trade Organization to ensure proper compliance with the rules is necessary.

“Of course, free trade needs the support of well-functioning capital markets, as well as exchange rate regimes that allow market-equilibrating forces to play a greater role in the adjustment process. Just as the WTO provides critical support for trade, there is also a need for an effective organization to support the international monetary system,” he notes. And that task falls to the International Monetary Fund.

He called for reform at the IMF, which was created at a time of largely fixed exchange rates. Dodge suggested that change is needed in four areas: the IMF should focus its surveillance on systemic issues that can affect global financial stability; it should limit its lending as economies must rely on market-based mechanisms to resolve financial crises; there must be clear rules governing access to Fund resources; and, the IMF must be more effective in its role as a forum where global economic issues are discussed and solutions are found.