This article originally appeared in the Financial Times on June 16, 2008

Whatever happened to the debate on global payments imbalances? Talk of an elegant policy solution, involving co-ordination and "shared responsibility", has given way to the realities of an ad hoc process involving considerable risk of economic and financial instability.

At its roots, the policy solution called for simultaneous implementation of three sets of measures. First, a reduction in US domestic aggregate demand to contain imports and encourage a shift to exports. Second, an increase in consumption in Asia and the Middle East, including having China adopt a higher and flexible exchange rate. Third, structural reforms in western Europe to enhance the growth potential of the global economy.

Most observers agreed on the elegance and theoretical potency of this policy combination, which reduces imbalances in the context of high global growth, contained inflation and relatively stable financial markets. Indeed, the question was never about design. It was about implementation.

The policy solution stalled because of a basic co-ordination problem, or what is known in game theory as the "prisoners' dilemma". While all parties had an interest in the outcome, any individual party that moved first risked being worse off if others did not follow. With multilateral co-ordination mechanisms such as the Group of Seven industrial countries and the International Monetary Fund lacking representation and legitimacy, there was no way to provide parties with sufficient assurances that their actions would be accompanied by others. As a result, no one took sufficiently meaningful action.

With the policy solution stuck, the process is now being driven by the reality that components of the imbalances have reached their natural point of exhaustion. The risk is that while the imbalances will be corrected over time, it will be at a high cost for the global economy. Relative prices are now leading the adjustment process through the impact of a substantial terms-of-trade shock led by the surge in oil and food prices. Second-round effects, via the prices of other goods and wages in some emerging economies, will also be in play.

The price shock will serve to undermine real incomes in the US and lower imports. On the policy front, it will accentuate the tug of war that the Federal Reserve faces on account of its now conflicting inflation and employment objectives. Emerging economies face greater inflation in the context of their buoyant liquidity conditions. Several will see their real effective exchange rates appreciate, by means including measures to allow the nominal exchange rate to appreciate markedly against the dollar. In Europe, growing demands for wage increases may force companies to step up structural reforms and will cause the European Central Bank to increase its hawkish rhetoric.

Under this scenario, the question for markets is no longer whether the global imbalances adjust. They will. Instead, the focus should be on the collateral damage of the adjustment process – damage that is region-specific given differences in policy flexibility and initial economic and financial conditions. In the US, look for renewed pressure for further fiscal stimulus and a monetary policy that, while appropriate for the US, is too inflationary for the rest of the world. In Asia and the Middle East, the spike in inflationary pressures may inadvertently slow the move towards more efficient tools of indirect economic management. In Europe, expect attempts to bypass fiscal responsibility guidelines in order to mute political protest.

As this bumpy and disorderly process plays out, it is important not to lose sight of important lessons. Indeed, the fact that the system has ended up eschewing the superior policy solution speaks to the urgency of learning from them. An increasingly interconnected world cannot maintain high growth and low inflation without a bold modernisation of the mechanisms for international policy co-ordination, starting with the G7. Governments must continue to refine their policy instruments and pay greater attention to the secondary and tertiary consequences of their actions. The private sector must assume greater responsibility for forward-looking risk management. In the absence of these changes, the inevitable adjustment of the global imbalances will continue to entail a serious cost in global welfare.

The writer, co-chief executive and co-chief investment officer of PIMCO, is author of When Worlds Collide: Investment Strategies for the Age of Global Economic Change (McGraw Hill)