In a succinct and well argued Financial Times comment, Richard Duncan weighs in on the savings glut versus overspending (aka money glut) theories of global imbalances, and concludes it’s the spending, stupid.
By way of background, let’s review the two competing notions of the causes of global imbalances, which is shorthand for “nice central banks in China, Japan, and the Middle East fund our chronic current account deficit.”
One is the savings glut story, in which parsimonious Chinese and Japanese force the US to consume to keep the world from falling into recession. This view is favored by the Fed, doubtless because this Keynesian version has the Fed as hapless victim. The other version, the money glut interpretation, holds that serial bubbles in the US have led to asset price distortion, excess liquidity, excessive borrowing by consumers, which in turn has led to excessive consumption, huge US trade deficits, which in turn produce huge trade surpluses in certain trading partners, who then inevitably have high domestic savings rates.
Note that these hypotheses are not mutually exclusive, but we lean towards the money glut as being the more significant contributor.
Why have this discussion at all? Isn’t the current account deficit/capital account surplus an accounting issue?
Not really. Which version of the story you believe determines which policy remedies you will favor, so getting the diagnosis right matters, particularly since this situation (at this scale, anyhow) is simply not sustainable. For example, Thomas Palley has framed the argument somewhat differently and that in turn affects his prescription:
Developing countries need to grow, but in today’s globalization it is easier to acquire capacity and grow through FDI than it is to develop domestic mass consumption markets. Consequently, rather than facing a saving glut problem, the global economy faces a problem of market demand failure in developing countries.
The challenge is getting corporations to invest in developing countries, but for purposes of producing for local consumers. That requires expanding markets in developing countries, which means tackling income inequities and getting income into the right hands. That is an enormous organizational challenge that is off the radar because economists focus exclusively on saving and supply-side issues.
Thus for him, the saving glut part of the equation is due to misguided development policies that give too much priority to encouraging third world countries to export at the expense of cultivating domestic markets.
But the reason for focusing on the overconsumption side of the issue is that the problem simply isn’t acknowledged in the US (indeed, note that this piece is running in the FT, not a US paper). Our policies are geared to preserving what George Bush described as the American way of life, no matter how much havoc it creates.
From the Financial Times:
It is clear from Alan Greenspan’s autobiography, The Age of Turbulence – chapter 18, “Current Accounts and Debt” – that the former Federal Reserve chairman misunderstood the causes and underestimated the consequences of the extraordinary growth in the US’s current account deficit. Today’s policymakers must see through his mistaken analysis and adopt policies to restore balance to the global economy.
According to Mr Greenspan, the deficit was caused by the high savings rate of countries with current account surpluses, combined with their inability to find sufficiently attractive domestic investment opportunities. High savings and unattractive investments at home, occurring at a time of declining “home bias” in investment, resulted in a massive increase in investments from those countries into US assets, we are told. In other words, high savings abroad resulted in increased consumption in the US.
Here is an alternative view. As globalisation made trade between high-wage and low-wage countries possible, consumers in the US began buying more products made in low-wage countries such as China because those products were cheaper. Meanwhile, people in low-wage countries continued to buy their own products for the same reason. Consequently, the US’s current account went from balance in 1991 to a deficit of $850bn in 2006.
At the same time, in order to prevent their own currencies from appreciating, the central banks of the surplus countries printed their currencies and bought (literally) thousands of billions of dollars to sustain their low-wage competitive advantage. Those central bank dollar reserves represented the bulk of the savings Mr Greenspan refers to in his chapter, although he makes no mention of the fact. Having “saved” so many dollars, central banks needed to invest them in US dollar assets to earn a return. This, rather than a decline in home bias, drove the surge of capital inflows required to finance the US’s soaring trade deficit.
In a nutshell, then, we have two competing theories of the causes of the US current account deficit and all the related imbalances created by it. Mr Greenspan’s explanation is that it is all the result of a savings glut and a decline in “home bias” in the surplus countries. The alternative explanation is that the US trade deficit has been caused by free trade with low-wage countries and financed by paper money creation by the central banks of the surplus countries. You decide which is more plausible.
Mr Greenspan contends that no real harm has been done by these imbalances. In fact, he believes that “in a market economy, rising debt goes hand in hand with progress”.
The truth is that the US current account deficit and the paper money creation that has financed much of it have fuelled an unsustainable economic bubble in the US and around the world that is precariously close to imploding.
Liquidity injections into the credit markets of well over $500bn by a range of central banks (in Europe, the US and the UK) have been required to stave off the complete systemic meltdown of the global financial sector. Meanwhile, the Fed has been panicked into an aggressive round of interest rate cuts, Fannie Mae and Freddie Mac, the US government-sponsored mortgage lenders, have expanded their balance sheets at an unprecedented pace and the US administration has been compelled to rush through a $150bn emergency fiscal stimulus package, all in the attempt to keep the US slump from dragging the world into a global recession.
Mr Greenspan has obviously confused cause and effect in claiming that a savings glut in the surplus countries caused the current account deficit. It is equally obvious that he has drastically underestimated the destabilising consequences of that deficit. In his words: “I would place the US current account far down the list” of imbalances to worry about. It is now clear just how great his misjudgment was.
The current account deficit must quickly be brought to the top of the list of things for our current policymakers to worry about – and to resolve. If this imbalance is permitted to grow, or even to persist at current levels, the outcome can only be new and greater credit-induced economic convulsions that will require ever larger government bailouts and ever-increasing government encroachment into the economic sphere.
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This is one of the most common sensible explanations yet rejecting the savings glut. Stephen Roach has also rejected it on the basis that a global interpretation must be based on global variables. The savings glut thesis relies on the existence of large current account surpluses that by definition aren’t global. On the other hand, while Brad Setser does great work tracking the flows, he is inextricably wedded to the savings glut thesis and is unshakably convinced that current account surpluses are the cause of current account deficits. It’s good to see an examination of both sides of the argument from time to time.
There’s another argument against the savings glut interpretation, which I’ve never seen. While the debate seems to revolve around an equation that is an accounting identity, there are banking system identities involved that aren’t so symmetric.
In the case of the US bilateral deficit with China, for example, the dollars that are used to buy Chinese products at Wal-Mart originate from a US bank. The dollars may be pre-existing or produced from new credit. These dollars are exported to China’s ownership in exchange for product. This type of transaction produces a current account deficit “at the margin”.
These dollars when in China’s possession remain captive to the US banking system. This is because China can’t get value without clearing those dollars through the domestic US banking system (via US dollar nostro accounts of other banks if necessary).
In this sense, the US current account deficit is self-funding.
It is only the price of financial assets, including both the dollar itself and all dollar financial assets, that determines the nature of the financial asset composition of the self-funding deficit.
China’s choice as to how to use its imported dollars is a portfolio decision – ranging from expenditure on imports through investment in US treasuries. The elementary, default or do nothing transaction is to leave those dollars ‘unemployed’ in a bank account. But they must still flow through from there to a US domestic bank, via a nostro account, in order for credit to be given to the ultimate Chinese owner of those dollars.
In a larger financial asset sense, the default decision for China is to ‘save’ those dollars. This may occur through the elementary default transaction described above, or through additional financial asset transactions such as purchasing US treasury bonds. But the larger default choice of saving is essentially, as is the case in all economics, a decision not to spend.
Thus, ‘saving’, whether it is at a micro or macro level as defined in economics, is fundamentally an effect rather than a cause, because it is the result of a decision not to spend. This is consistent with the way in which saving is calculated according to the logic of national accounts construction. Saving is defined as the residual of not spending.
So China’s savings glut is an effect, not a cause, not only in terms of banking system mechanics, but as well in terms of the logic of the economic definition of savings.
And in the same way, the marginal expenditure that contributes to the US current account deficit is a cause, not an effect, in terms of banking system mechanics, and economic logic.
The banking explanation of the current account deficit is therefore asymmetric, as opposed to the accounting identity, which is symmetric, and the savings glut thesis, which is asymmetric in the other direction.
But isn’t “At the same time, in order to prevent their own currencies from appreciating, the central banks of the surplus countries printed their currencies and bought (literally) thousands of billions of dollars to sustain their low-wage competitive advantage.” the sentence to which the savings glut hypothesis finallay refers to?
I don’t see at all, why the forced saving of emerging markets via regulation should be out of game. Therefore this is not really an alternative view.
How can the Financial Times continue to miss the fact that the so-called “liquidity injections” have been nothing more than the continued rollover of TOMO’s that already existed?
Liquidity hasn’t been added to the system.. even with the TAF. Although it makes for good press, that rollover of 500B in tomo the other month by the ECB was a net of zero liquidity added.
The TAF was funded by the redemption of T’s that weren’t re-issued.
Moving forward, I hope all analyses of Greenspan’s actions or public comments start with “We know he was wrong. What should he have done instead?” It’ll save time.
Because the re-entry of China to the world trading system was so “deflationary” (in the pricing sense, though not in the money supply sense), as the supply of manufactured goods surged, the only way to keep the general price level from plunging was to expand the money supply in proportion. If the prices of tradeable manufactured goods drop, then keeping the general price level reasonably constant implies raising the prices of non-tradeables.
Nobody forced USA companies to ditch their workers and factories and replace them by chinese workers and factories.
USA companies managers are the cause here.