The Shanghai stock market was up 4.5% in very nervous trading today but down 16.3% since its recent peak at 3478 on August 4, and still trading at more than 30 times earnings.  All this turmoil is triggering all sorts of worried comments about the sustainability of the fiscal stimulus package and whether it has already reached the end of its effectiveness (it hasn’t – the government still has credit and fiscal firepower, and will use it if growth slows down significantly in the next few quarters).  It also makes it harder, but probably more useful than ever, to focus on the bigger picture, and this entry is definitely big picture.  It also turned out to be a very long piece, as these big-picture pieces tend to. 

The topic is whether or not the global imbalances that have led to the current crisis were in any way “caused” by the Asian savings glut, and besides arguing why I think this may be the case, I want also to argue that getting this argument right is far more important than many seem to realize.  Mohamed Ariff, executive director of the Malaysian Institute of Economic Research, indirectly suggests why in a good OpEd article in today’s New Strait Times: 

China is seen as the beacon of hope in these days of gloom and doom. This has led some observers to think China will lead East Asian economic recovery and thereby spearhead a global economic turn-around. But this faith in China as saviour may be misplaced.China’s imports from the rest of East Asia consist mostly of raw materials, intermediate products and components and parts, the bulk of it turned into manufactures for exports. China’s imports of consumer products from the region account for no more than a small proportion.

China’s imports from its neighbours have plummeted in the wake of the slump in China’s own exports, although the Chinese economy is growing at seven to eight per cent, because China depends largely on domestic production for its own consumption, which does not spill over to the rest of the region through trade.

I started writing this because while googling around looking for something else, I stumbled early this week upon a blog by LSE’s Danny Quah with the intriguing title “Where in the world is Asian Thrift and the Global Savings Glut?”  I later found that like mine, his blog is carried by Nouriel Roubini’s RGE Monitor.  I also subsequently discovered by a weird coincidence that on Saturday I am sharing a panel with him in a conference at the Guanghua School at Peking University, where we will be discussing the “Reconstruction of Global Finance”.   

The whole “savings glut” debate is a controversial one because almost from the start it has degenerated into a fairly silly argument about who to blame for the global imbalances and the subsequent crisis – or more specifically and more excitingly, whether the predator was wholly the foolish American consumer or the beetling Chinese saver.  Three months ago Brad Setser discussed all this in one of his blog entries that (inevitably) drew more comments than most, and as usual he provides a concise and enlightening discussion on the subject which you might want to read.  He is a proponent of the hypothesis, but nonetheless pretty fair-minded. 

Professor Quah weighs in on the other side of the savings glut debate although, unlike most others in the debate, he seems not terribly concerned about assigning full blame to any of the major parties.  It is neither excess US consumption nor excess US savings that solely “caused” the imbalance, in other words, because necessarily both sides are required for it to exist. 

Except for the possibility of trade with outer space, the US deficit has to be matched dollar-for-dollar by trade surpluses in the rest of the world. Correspondingly, therefore, the rest of the world has been saving—consuming less than it has been producing—and accumulating dollar claims against the US as a result. 

In this description, however large the global imbalance, a savings glut—wherever or however it might arise on Earth—has no independent existence. It makes as much sense to say the world’s excess savings caused enthusiastic US consumers to flood into Walmart to buy $12 DVD players, as to say US consumer profligacy made hungry Chinese peasants abstain even more and instead plow their incomes into holdings of US Treasury bills.  

When two variables have always-identical magnitudes, obviously neither can usefully be said to cause the other.  

Who are the predators?

This is correct, but as an aside, the discussion about enthusiastic American consumers forcing the Chinese to save, or hungry Chinese savers forcing Americans to consume, typically uses colorful but totally inappropriate images to describe the dynamics of the this process.  For example, I often hear opponents of the Asian savings glut hypothesis say, voices dripping with disbelief, that the savings glut hypothesis insists that the poor American consumer rushed out to buy another DVD player because terrible China forced him to borrow the money and buy the DVD player.  How could that possibly happen? 

Well, that’s not how it would have happened.  In any large country, there are millions of households able and interested in increasing savings or in increasing borrowing.  Specific policies or financial conditions will determine at any given time changes in the behavior of some of these individual households, so that at the macro level, and only at the macro level, the country will have seen an increase in savings or an increase in consumption.   

It is not every household that rushes out to consume when consumption rises, and this never happen because predatory savers force an otherwise unwilling consumer to buy.  So if it had indeed been rising Asian savings that drove the US consumption binge, policies aimed at constraining Asian consumption and boosting Asian production (which cause savings to rise) will have initially led to a rising Asian trade surplus and US trade deficit, as the tradable goods sector in Asia expands and the tradable goods sector in the US contracts. 

This surplus would be recycled into the US via purchases of highly liquid securities.  If the Fed failed to respond to this increase in liquidity by raising interest rates and contracting money (and contracting the tradable good sector), the financial system would have to accommodate the rising liquidity as it has always done throughout history – by growing financial balance sheets and taking on more risk.  In that case the conditions for consumer borrowing will have been made increasingly easy, and those households who needed or were predisposed to borrow under easier lending conditions, and pressure on the parts of banks to extend credit, will do so.   

As long as there are some households willing, however appropriately or foolishly, to increase consumption, the easier availability of consumer credit will cause them to increase consumption – this has happened many times and in many countries, and has nothing to do with a predisposition to excess consumption.  Furthermore as recycled liquidity boosts household wealth by boosting the value of homes and investment portfolios, the rising wealth of each individual household will have an impact similar to rising income – and with it consumption will rise.   

So the point is the not very controversial suggestion that a surge in domestic liquidity in the US can easily cause US consumption to rise.  If that liquidity surge was “caused” by the recycling of a large and growing trade deficit, then it is easy to see how at the macro level US consumption would rise in response to a surge in Asian savings. 

Similarly, the proponents of the Asian savings glut hypothesis wonder in disbelief how an American consumer deciding to buy a DVD player could have possibly “forced” poor Chinese peasants to cut their already minimal consumption and increase their savings.  But there was no force.  A sudden explosion in binge consumption in the US would divert production from China, and as China increased the share of its output dedicated to exports, total production would not immediately be matched by total domestic consumption (Americans bought some of it) and the Chinese savings rate would necessarily increase – whether at the household level or at the corporate or government level. 

The interest rate argument 

The point is that sarcastic comments about predatory American consumers forcing dim-witted Chinese households to save more and consume less, or predatory Chinese savers forcing helpless American households to borrow and consume, may be good debating tactics but they are misleading and explain nothing.  At the macro level either event – higher Asian savings leading to higher American consumption, or higher American consumption leading to higher Asian savings, or even a combination of the two – is perfectly possible. 

So why should we accept the Asian savings glut hypothesis?  One argument that I first saw proposed by Brad Setser was that if the imbalances had been driven by US consumption, and therefore US borrowing needs, the consequence should have been an increase in US interest rates.  Had they been driven by excess savings, US borrowing rates would have probably declined.  

In fact during most of the relevant period US interest rates did decline, even leading to the US Fed several times complaining about its inability to control domestic long-term rates.  So that pretty much settles it, right?  But Professor Quah dismisses this argument: 

Many other factors could, of course, have driven down short rates: US monetary policy responded to national economic downturns in 1991 and 2001. Through the 1990s inflation rates worldwide converged and fell, together with short-term interest rates set by central banks everywhere. The burst of the dot-com bubble in March 2000 saw the NASDAQ index decline 77% in the following 18 months, prompting action by the US Federal Reserve. Japan’s monetary policy during its decade-long recession drove nominal interest rates there to zero. 

Although he is right, this is not a completely satisfying dismissal.  The same savings glut that pushed down US interest rates could easily have pushed down global interest rates, especially in a world that was seeing rapidly rising capital flows that in many cases were aimed at “arbitraging” (absolutely the wrong word, of course, but one widely used in the markets at the time) interest rate differentials.  After all it is often the case that, especially during periods of large international movements of capital, increases or reductions in US interest rates (or in British rates during the globalization period at the end of the 19th Century) are matched by changes in foreign interest rates. 

Still, the fact is that his response does show that the interest rate argument is not final.  There might be other perfectly good reasons that explain the decline in US interest rates. 

The bilateral trade argument 

Quah’s main argument against the savings glut hypothesis, at least as far as his blog entry, seems to be that it could not have been a rise in Asian savings that drove the global imbalances because had it done so, much of the imbalance would have rested between Asia (or China, more specifically) and the US.  The strongest piece of evidence he presents is a chart that shows the US bilateral trade balances between the US on one side and China, developing Asia, the EU, and oil exporters on the other.  I have reproduced the graph below, but if you can’t see it well, just click on Quah’s blog (blocked in China, so China-based readers will need to use a proxy), and click on the graph itself for an enlargement (I wish I was clever enough to do things like that).

As the chart shows, the US trade deficit rose nearly as quickly, or even more so, with those other regions as it did with China and/or developing Asia.  It wasn’t just a US-China phenomenon or a US-Asia phenomenon, it was a US-everybody phenomenon. 

Quah’s argument seemed to be a powerful one at first, and I had to think about it for a while or else I would have to find myself deserting from the “savings glut” camp.  In the end, however, I think his argument it turns out not to be very satisfying and I still think it runs against a timing story that better explains the imbalances.  I’ll say more on that later, but it seems to me that in a “globalized” world, if the Asian savings glut hypothesis is true, not only would rising bilateral trade deficit between the US and other countries outside of developing Asia be possible, but they would even be almost necessary. 

Why?  Because we have to be careful about misreading bilateral trade numbers.  It is the aggregates that usually matter.  I don’t have the data in front of me, but I believe that Europe did not run significant and rapidly growing aggregate trade surpluses during this period.  If that’s the case, then a growing bilateral surplus with the US is perfectly consistent with the savings glut hypothesis as long as you assume that trade is international and that any specific product can be produced and assembled in many countries – which is of course a pretty unremarkable assumption. 

So, for example, if rising Asian net savings “caused” rising American net consumption (in the way described above – no sarcasm, please), it would mean that money recycled from Asia into the US caused the US trade deficit to rise as it was intermediated by the financial system into consumer financing, even as it caused Asian trade surpluses to rise. 

It’s the aggregate balance that matters 

But, and this is the important point, the trade did not need to occur only at the bilateral level.  If rising Chinese savings was intermediated into rising US consumption and this bilateral relationship was resolved, to take a concrete example, by Chinese exporters producing shoes and American consumers buying shoes, the trade would not have had to occur directly between the two.  When Americans shop for shoes, they don’t care which country saw net savings rise, and when Chinese sell shoes they don’t care whose economy saw an increase in net consumption.  China could have produced shoes, sold them to a designer in Italy, where they would be packaged and branded, and then sold to American consumers. 

In this simple case, Chinese excess savings would have “caused” Americans to borrow money and buy the shoes, and so China would run a trade surplus, the US would run a trade deficit, and Italy would be balanced.  But Italy would nonetheless show a bilateral surplus with the US and a bilateral deficit with China.   

Excess US consumption, in other words, would still have been “caused” by excess Chinese savings in this case, but global trading and processing networks would have the bilateral trade imbalances, and their countervailing obverses, spread out though the world.  Many countries would run surpluses with the US and deficits with Asia, but at the aggregate level they would balance out at close to zero, and the US would be left with the sum of its bilateral deficits and Asia with the sum of its bilateral surpluses. 

The point is that there is nothing in the Asian savings glut hypothesis that requires that all trade imbalances occur at a bilateral level and only between the participating countries – that the deficit/surplus imbalances occur between the US and Asia.  It only requires that the US, as the equilibrator to rising Asian savings, have a large and growing trade deficit and Asia have a large and growing trade surplus.  If other regions also have large and growing aggregate trade surpluses that fed into the US deficit at the same time, that would perhaps be the problem Quah says it is, and either would need to be explained or would create problems for the hypothesis.  But they didn’t. 

With one big exception, of course.  Oil exporters did see not only rising bilateral trade surpluses with the US, but they also saw rising aggregate surpluses.  Does this somehow weaken the savings glut hypothesis?  Again no, because those surpluses reflect one thing only, rising oil prices, and in an environment of rapid US and Asian growth, we would expect oil (and other commodity) prices to rise.  In fact the savings glut hypothesis would predict that as long as the recycling was occurring efficiently, both countries would grow quickly and high commodity prices would be not only possible, but in fact highly likely. 

So as I see it, this is how the arguments and counterarguments stand: 

1.        The argument that declining US interest rates proves the correctness of the savings glut hypothesis is wrong.  Declining US interest rates are suggestive but not final.  Other things could have explained declining US interest rates during this period, and of course there is easily a possibility of feedback loops in which any initial decline in US interest rates could, by increasing household wealth (via rising asset values) increase consumption and the US trade deficit, leading to Asian recycling, and so on to more lower interest rates. 

2.        The argument that rising US bilateral deficits with many regions around the world disprove that the savings glut hypothesis is also wrong, and much less suggestive.  On the contrary, if the hypothesis is correct and if trading is truly globalized, we would expect US bilateral deficits to be high with nearly everybody.  At the aggregate level, however, we would not expect anyone except the high-saving Asian saving countries to run large trade surpluses. 

3.        There was also an argument that I associate with Morgan Stanley’s Stephen Roach – a very smart man who by the way disagrees strongly with the hypothesis – since he was the one who first made this argument to me, over a lunch at Peking University two years ago.  According to Roach there has been no significant increase in global savings during the savings-glut-hypothesis period, which pretty much demolishes the idea of a saving glut.   

I disagree because the hypothesis doesn’t imply in any way that global savings have increased.  In a closed economic system, unless investment has increased commensurately, an increase in savings in one part of the system must necessarily come with a reduction in savings elsewhere, and this was exactly the point of ascribing the current trade imbalances to a forced rise in Asian savings.  Rising Asian savings “forced” declining US savings by causing the US financial system to accommodate growing domestic liquidity by taking on risk (again, no sarcasm please – you might disagree but in itself this is not implausible). 

Timing the flows 

So where does that leave us?  Before answering, I think there is another thing to think about here, as I wrote earlier in this entry, and that is the timing issue. 

In a June 4, 2008 entry, much of which is reproduced here, I mentioned a very interesting paper by German economist Jorg Bibow of the Levy Economics Institute of Bard College (The International Monetary (Non-)Order and the “Global Capital Flows Paradox”).  In it the author considers the “paradox” of high and rising capital flows from developing to developed countries during the past decade.  This is a paradox because most economic theory (and history) suggests that developing countries are net recipients of investment, not net providers. 

Bibow rejects the Asian savings glut hypothesis, but my understanding of his paper is that he agrees with much of what I understand the theory to be but rejects it on much narrower technical grounds – he claims that the saving glut hypothesis is based on the “fatally flawed” (his words) loanable funds theory.  However his narrative (to be horribly post-modern for a moment) of events seems very close to my own. 

What interests me most is the data he provides in his paper (and you can see the accompanying graphs by following the link to his paper).  First off, Bibow discusses the evolution of the US current account deficit over the past fifty years.  

Basically, according to the data quoted in Bibow’s paper, the US current account has been within a range of a surplus of 1% of GDP and a deficit of 1% of GDP for most of last fifty years with two exceptions.  The first exception occurred in the mid-1980s when the US current account deficit rose to nearly 3.5% of GDP in 1986-87 before declining sharply and running into a small surplus in 1990.  The second exception began technically in 1994, around the time of the Mexican crisis, when the US current account deficit climbed to around 1.6% of GDP, before it began to decline again, but it really took off in 1997-98, when it raced forward to peak at around 7% of GDP in 2007.  

As an aside I should add that there was an acceleration of the growth rate of the deficit around 2004, if I remember, and I have a pretty strong suspicion that this had something to do with the financing of the Iraq war.  As I have pointed out before, US asset markets and consumption often boom during unpopular wars, like the Vietnam War, which tend to be financed not with taxes but with money creation and debt, and often these two things lead to great markets – for a while. 

If the US trade deficit was driven simply by an out-of-control US consumption binge, it is a little hard to see why it would have followed a pattern of general stability marked by two surges – a small one from 1984-88 and a very large one after 1997.  If it was driven by Asian savings, this pattern becomes a little easier to understand – or at least, what amounts to the same thing, we can posit a more plausible story to explain it.   

The narrative  

I will ignore the 1980s surge because this post is already too long, but again one can tell a very plausible story based on Japanese trade policies and domestic savings.  The post-1997 surge is much larger and more interesting.  1997 was, of course, the year in which several Asian countries, after years of tremendous growth and what seemed like invulnerable balance sheets, experienced terrifying financial crises and viciously sharp economic slowdowns, which profoundly impressed Asian policy-makers and has affected policy decisions to this day.  

Since the main cause of the crisis seemed to be the sudden reversal in the early 1990s of current account surpluses into substantial deficits, along with highly unstable balance sheets in which large external obligations were mismatched with domestic assets and “hedged” with extremely low levels of foreign reserves, one of the main (if mistaken) lessons policy-makers learned was the need to run current account surpluses and to amass large foreign currency reserves to protect countries from a repeat of the disastrous crisis of 1997. 

These countries, consequently, but into place “mercantilist” policies in order to achieve both goals – persistent trade surpluses and large amounts of foreign currency reserves.  This (I think plausible) story is reinforced by another graph Bibow reproduces.  The global capital flow “paradox” to which he refers in his title is the fact that developing countries are exporting capital to rich countries.  According to his data, developing countries have almost always been net recipients of private capital flows – which is what one would have expected from most economic theory and history.   

They have generally been net providers of official capital as far as foreign currency reserve accumulation goes, but for most of the last fifty years reserve accumulation on average was significantly less than net private inflows, so developing countries were net recipients of capital.  (For much of the 1980s the balance on both was zero or close to zero, and I suspect that this reflects negative private flows to Latin American and others among the 32 defaulted or restructuring LDCs, as they were then called, netted against positive private flows to Asia.) 

It is only in 1998 that reserve accumulation among developing countries begins to take off and by 1999 it exceeds net private capital flows to developing countries.  This is when the “paradox” of net capital flows from developing to developed countries begins.  Except for a small decline in 2001 net flows from developing countries surge almost in a straight line to around $700 billion annually (combining $1.2 trillion of reserve accumulation versus $0.5 trillion of net private flows). 

I am sure there can be other competing explanations for the timing of these flows, but I am very impressed by the fact that Asian savings, as expressed in reserve accumulation, surge after 1997, as does the US trade deficit, although exacerbated by the second surge around 2004.  Given the virulence of the 1997 crisis and the tremendous shock it provided to Asian policy-makers (and policy-makers in developing countries elsewhere), it seems to me that a very plausible argument can be made that it was the effect of 1997 that caused the shift in developing-country policies that led to the surge in savings and the corresponding increase both in trade surpluses and reserve accumulation.   

The surge in the US trade deficit after 1997 is also more easily explained by a shift in Asian trade policies and currency regimes than by a shift in US consumer preferences.  Of course that doesn’t mean that nothing relevant happened in the US.  US monetary policy was clearly too accommodative, and especially in reaction to the Iraq war, so that it exacerbated the conditions created by the Asian savings glut.  If anyone is still looking for which country to blame, my understanding of the creation of the imbalances suggests that you can blame almost anyone you like and there is a good chance that you’ll be at least partly right. 

Why does this matter? 

The issue of what drove what is not simply of academic interest.  The consequences for the world of a system in which imbalances were driven by a sudden and self-perpetuating explosion in US consumption, which then forced higher savings onto Asian countries, are very different from a system in which imbalances were driven by a sudden and self-perpetuating increase in Asian savings, which then forced higher consumption onto non-Asian countries.   

Deciding whether or not the savings glut hypothesis is correct is important not just because it allows us finally to decide which country really is the evil predator, the US or China.  It matters for a very different reason. 

If it was an explosion in US consumption which drove the global imbalances, then we are likely to see a fairly benign resolution to the crisis for everyone, except maybe the US.  After all in that case the imbalances were driven by US consumption excesses, and since those excesses are, like it or not, going to be resolved by the need for US households to repair their badly-damaged balance sheets, the imbalances too will be resolved, and in a way that is mostly benign for everyone except recovering US households.  This process may be postponed by current US fiscal policy, and especially by recent policies that subsidize consumption, but it will only be postponed, not derailed. 

And just as Americans can no longer binge consume, their binge consumption will no longer force Asians to save such a high and rising portion of their income.  Asian growth, and especially Chinese growth, will be much more balanced. 

But if the global imbalances were driven by a surge in Asian savings, Asian and Chinese growth will still rebalance, but the rebalancing will be much more difficult.  Why?  Because too-high Asian savings, caused in large part by post 1997 policies that encouraged differential growth between consumption and production (as I discuss here, for example), have until now been matched by too-low US savings rates.  As long as the two imbalances balanced, the world economy could continue functioning without too much distortion. 

But now if we can expect net savings in the US (and perhaps in many other parts off the world) to rise, we need to see a rapid change in those policies that encouraged too-high Asian, and especially Chinese savings.  In that light there was an interesting and worrying OpEd article in today’s Financial Times by the Peterson Institute’s Fred Bergsten and Arvind Subramanian: 

The Obama administration is increasingly signalling that the US will not continue to be the world’s consumer and importer of last resort. The clearest statements came last month from Larry Summers , White House economics director, in a speech at the Peterson Institute for International Economics and in an interview with the Financial Times. The US, he said, must become an export-oriented rather than a consumption-based economy and must rely on real engineering rather than financial wizardry. Tim Geithner, the US Treasury secretary, and other top officials have spoken similarly of rebalancing US growth. 

If the US really is serious about this shift towards higher savings, and if the primary source of the imbalance was the Asian savings glut, and not an original US consumption “glut”, this means that in the future US policies will be in direct conflict with still-current Asian policies, and unless the US is unable to accomplish these goals, Asian countries will need to force through an adjustment in their development policies as quickly as possibly.  Asian and especially Chinese officials have acknowledged the need to increase consumption more quickly. 

But for now this adjustment in policies that encouraged too-high Asian, and especially Chinese, savings does not seem to be happening.  “The optimal choice is to expand household consumption,” PBoC governor Zhou Xiaochuan said in a speech last month.  ”That is, however, easier said than done. While the current income structure cannot be dramatically changed in the short term, the second-best choice is to maintain and expand investments.”  He is almost certainly right, at least except for his last statement. 

In fact as I have argued many times (for example here, and here), I suspect that most of the Chinese fiscal stimulus is exacerbating the imbalances – both by boosting current and future production and by creating conditions that will constrain future consumption growth.   

In that case there has been no significant rebalancing yet towards more rapid consumption growth taking a greater share of Chinese production – just a frenzied attempt to keep current growth rates high by boosting investment, which will almost certainly lead to capital misallocation and rising non-performing loans, and clearly unsustainable attempts by the Chinese government artificially (and unsustainably) to boost short-term consumption by subsidizing it heavily with government debt (something the US seems to have been doing too) which has the effective consequence of reclassifying fiscal expenditures as household consumption. 

The end result?  Planned increases in investment in China eventually become forced increases in investment – rising inventory – that ultimately must lead either to writing inventory off or closing down production facilities in the future.  This is, by the way, just another way of stating the excess capacity problem.  

Perhaps what we need is a real return to Confucian roots.  I recently read this quote from Lao-Tzu: “The sage does not hoard. Having bestowed all he has on others, he has yet more. Having given all he has to others, he is richer still.” 

Tags: Bibow

Demographic causes

• Declining dependency ratios, especially via decline in the number of young people. From the mid-1970s to roughly the middle of the next decade we know that China’s dependency ratio has contracted sharply. A much larger share of the population is of working age today than thirty years ago. Besides being a great source of rapid growth, I think this fact creates a bias towards savings since I think of working population as a proxy for production and total population as a proxy for consumption. This means that with China’s working population growing so much faster than total population (a process which will be reversed over the next three or four decades) Chinese production has grown much faster than Chinese consumption. The difference, of course, is the savings rate.

Structural causes

• Lack of social safety net. With a risky health care system, no social safety net, and limited ability to borrow, Chinese households have to self-insure. This means they save on average much more than they need on average to cover these costs.
• Rapid growth in wealth. When per capita wealth grows very quickly, it may take a while for people to change their consumption behavior as quickly, so growth in consumption lags growth in wealth. Of course the difference between the two is the rising savings rate.
• The generation of “little emperors.” I have heard not-always-satisfactory arguments that households save a huge amount because of the one-child policy — they are essentially spoiled, the argument goes, and parents will sharply limit their own consumption in order to provide everything for their only child. I am ambivalent about this explanation, but I do think the maturing of the one-child generations may have an impact on future savings. They are much more likely, it seems to me, to spend money on themselves, although this argument may be a little too glib.
• Lack of consumer credit. Without easy availability of consumer credit, households who want to borrow to purchase big-ticket items have little choice but to save today for a future purchases.

• Low exchange rates. The reasoning and causality are unclear, but there is evidence that countries with artificially low exchange rates tend to have high savings rates, perhaps because low exchange rates reduce real wages.
• Low interest rates. We also have a lot of evidence that low interest rates create higher savings rates in countries like China. This claim generates a lot of confusion, and I am often asked how this can possibly be true when the opposite is true in the West. My guess is that it occurs because of both portfolio effects and income effects. For the former, because Chinese don’t save in the form of stocks, bonds and real state, but rather in the form of bank deposits, declining interest rates do not increase the value of their savings portfolio, but actually reduces it. This is why reducing interest rates causes savings in the West to decline (Westerners feel richer) whereas it causes savings to increase in China (Chinese feel poorer). For the latter effects, with interest income such a large part of total income, low interest rates are similar to low wage rates in their impact on consumption.
• Policies aimed at running trade surpluses. This is generally a catch-all and must be true by definition. A trade surplus occurs when production exceeds consumption, so any policy aimed at growing production faster than consumption is also implicitly aimed at raising the savings share of income.
• Policies aimed at running fiscal surpluses. Of course this contributes by creating government savings.
• Policies aimed at forcing profitability in SOEs via interest rates and other policies. Another catch-all for policies that drive up corporate savings.

Tags: Barcelona

I have recently finished reading Martin Wolf’s latest book, Fixing Global Finance, and I strongly recommend it for its very clear laying out of the global balance of payments issues behind the global crisis. I should warn my readers that Wolf and I have come to very similar conclusions about the underlying root causes of the crisis – we are both in agreement, for example, about the distorting effect of Asian policies to constrain consumption and boost investment in manufacturing output – but I am mostly impressed by the fact that we come to the same conclusion from such different angles.

Wolf begins with a model based on analyzing the financial architecture of the past forty years and brings to his analysis a very US-centric view of the world, whereas my conceptual model is based on my obsessive reading in the history of financial flows between rich and poor countries and starts with a China-centric view. Somehow we end up in almost exactly the same place, which suggests to me that we may be right or, at the very least, onto something important.

I won’t try to summarize the book but I do want to set out two paragraphs in which Wolf explains, far more clearly than I have ever been able to, how it is that reserve accumulation in Asia “forced” US households into overconsumption. One of the most common fallacies in popular economic analysis is to assume that countries are somehow analogous to households, and the factors that lead a household to consume “beyond its means” are similar to those that cause a country to do so. In that case if the US over-consumed, it is no different than if a stereotypical welfare family maxed out on its credit cards, and while we can fret at the stupidity of the bankers who gave them their credit cards, ultimately the blame for the mess must rest with the innate profligacy of mom and dad.

But this is not true at all when we are talking about overconsumption at a country level. As I have tried to argue many times, the global balance of payments must balance, and significant change in any component of the balance necessarily requires adjustments elsewhere. If Country A enacts trade policies that result in a surging current account surplus, for example, Country B must see its current account deficit surge by the same amount, and the way that happens will reflect a number of factors including the structure of its financial system. Country B could try to resist the growing deficit by engineering a recession and so causing total demand to drop, but this can be very painful for both countries.

Let us assume, then, that a group of countries, perhaps in response to the 1997 crisis, decide that in order to protect themselves from a repeat of that disaster decide to engineer polices aimed at accumulating reserves and limiting external debt. The most obvious way would be to put into place policies that constrain consumption and boost savings (keep wages and interest rates low, limit credit availability to consumers, limit credit availability to small and medium enterprises and especially to the service sector, maintain an undervalued currency, etc.) and direct credit to the investment and manufacturing sector. As a consequence growth in production would exceed growth in consumption and the balance would represent the trade surplus. Trade surpluses, of course, have to be recycled as investment flows (or reserve accumulation) back to the country against which they are running these surpluses. This is not a choice, or even a real lending decision. It is the automatic and necessary consequence of running a trade surplus.

Since the US is the largest and most flexible economy in the world, and since the primary world reserve currency is the dollar (more on this later), in practical terms only the US can be the deficit country for any period of time, and so the surplus countries must accumulate US dollar assets as the obverse of their trade surplus. Martin Wolf explains what happens next:

The rest of the world’s capital outflow supports the dollar. At the resulting elevated real exchange rate for the United States, the output of the sectors in the US economy that produce tradable goods and services shrinks, other things being equal. The Federal Reserve cuts interest rates to expand the economy, thereby preventing excessive unemployment. As it does so, a large excess demand for tradable goods and services emerges in the United States. This finally, appears in the trade and current account deficits.

One consequence of all this is that US domestic demand has had to grow faster than real GDP, to ensure that the latter grows in line with potential. The difference between the two is, of course, the increase in the current account deficit, in real terms. With trend growth in GDP between 3 and 3.5 percent a year, domestic demand has to grow even faster. That is precisely what has happened. US real demand (or gross domestic purchases) grew faster than real GDP in 1993 and 1994 and then again every year from 1996 to 2004 inclusive. Cumulatively, between 1993 and 2004 US real GDP grew by 46 percent, while gross domestic purchases rose by 53 percent. That is how the current account deficit emerged. It is also how the United States absorbed the supply of excess capital from abroad.

In the face of a sharp contraction in those sectors of the US economy that compete with Asian manufacturers, in other words, the Federal Reserve must either permit a rise in US unemployment, in which case US consumption will decline and with it imports from Asia will decline too, or it must prevent the rise in unemployment by putting into place monetary policies that are consistent with rapid GDP growth. This argument, by the way, is not at all affected by the very common (and incorrect) argument that the main cause of the US trade deficit with China is the fact that China produces things that the US doesn’t want to produce, which I have tried to address in a March 9 blog entry.

Global savings glut

In either case US consumption must grow faster than US GDP, and the choice for the Fed is whether to target a “normal” growth in consumption, and permit rising unemployment, or a “normal” growth in GDP, and so permit rising indebtedness. The Fed must use US unemployment, in other words, as a tool to prevent Asian trade policies from leading to excess US indebtedness.

All this would have been bad enough if it hadn’t been for the need for the US to finance a very unpopular war, the Iraq invasion, in the way that unpopular wars have traditionally been financed – irresponsibly, through borrowing and money creation rather than taxes (remember that the Vietnam War was also associated with a credit bubble in the US). Asian policies, according to this view, definitely helped create the monetary distortions, but we must remember that there were plenty of bad domestic policies compounding the problem.

At any rate for the Fed to use US unemployment as a tool to prevent Asian trade policies from leading to excess US indebtedness is obviously politically very difficult, and it is also obvious that for the past ten year the Fed chose excess indebtedness. Since the 1997 crisis we have seen both household savings and the US trade deficit break out of their normal ranges and either collapse (household savings) or surge (trade deficit). This is a necessary consequence of the process that Wolf describes.

In that light, as U.S. fiscal spending surges in response to the crisis, increased attention will be placed on the way that U.S. fiscal spending leaks out through the current account to boost employment in China and elsewhere. And just as the Chinese complain bitterly, and rightly, that the West outsources polluting activity to China via the trade account, the U.S. will complain, as Martin Wolf pointed out in a March 31 editorial in the Financial Times, that China is outsourcing fiscal indebtedness to the U.S., also via the trade account. Surplus countries, he argues, “relied on the private sectors of deficit countries to do their irresponsible borrowing for them.” In response to the contraction in the borrowing among US households, the U.S. government, in other words, is currently choosing to borrow and spend the proceeds in order to generate job growth in the U.S. as well as in China. This can’t go on forever.

All of this is, of course, a variation on Ben Bernanke’s “global savings glut” hypothesis, and as everybody knows, Beijing wholly rejects this hypothesis as an explanation for the current global imbalances. For Chinese policymakers, the cause of the crisis lays firmly and totally within US monetary and financial policies (or lack thereof), and absolutely no blame can be apportioned to Asian trade policies.

Or is this really Beijing’s view? The extraordinary thing to me is that while Beijing has insisted almost desperately that any attempt to apportion blame to China is completely dishonest, they have nonetheless more or less welcomed Bernanke’s hypothesis, perhaps without realizing it, through the back door. I say this because the widely-discussed essay by PBoC Governor Zhou last week, in which he assailed the reserve status of the US dollar as being the main cause of global imbalances, is as far as I can tell nothing more than Ben Bernanke’s hypothesis viewed from a slightly different angle.

Why? Because Governor Zhou makes the claim that the reserve status of the US dollar gives the US an unfair advantage in that it can borrow nearly unlimited amounts simply as consequences of the need for foreign countries to accept dollars as reserves and for the purpose of international trade and investment. Of course he is almost certainly right, and he is just as certainly not the first person to make this claim. I think it was De Gaulle’s favorite economist, Jacques Rueff, who first discussed this “exorbitant privilege” as far back as the 1960s (NB: Martin Wolf corrects me — it was Valery Giscard D’Estaing who first said it — but I leave the mistake, and the correction, because it is one so commonly made).

But remember that if we make the very simple (and necessary) assumption that the ability of a country to run current account deficits is constrained mainly by a country’s ability to finance those deficits, then the ability to borrow unlimited amounts also means the ability to run unlimited trade deficits. It was the reserve status of the dollar that permitted the US to run the massive trade deficits it has during the past decade.

Had the US dollar not been the reserve currency of choice (in other words had Asian trade surplus countries not recycled their trade surpluses into purchases of US government bonds), the dollar would have had to decline against world currencies as a consequence of the rising deficit – Asian currencies too, and not just European – and the US trade deficit would have stabilized at much lower levels. This is also another way of saying, as Martin Wolf’s piece directly implies, that the Fed would not have had to choose between unemployment and indebtedness and that the binge borrowing that characterized US household behavior would have been much, much lower.

The world loves dollars because the US seems to love deficits

In fact I would go further. Because of the dollar’s reserve status, only the US could have possibly run the deficits necessary to absorb the huge surpluses that Asian trade policies were generating. Without the dollar’s status as a reserve currency, the Asian development model that stresses expanding production while constraining consumption – which among other things results in trade surpluses and net investment abroad (which of course is the same thing) – would have either required another reserve currency, or it would have failed.

Could there have been another reserve currency – and could it be that the dollar’s “exorbitant privilege” is something that Washington has enforced? Yes and no. The US economy comprises about one-quarter of the world’s economy and one-third of the rich-country economies. In principle it would have been very easy for any country to accumulate reserves of other rich countries – nearly all of whose currencies are easily convertible – so that there is no reason why the dollar portion of all developing-country central bank reserves might not have exceeded roughly one-third of the total, instead of the two-thirds or more that it currently occupies. Another third could be euros, and the rest a combination of the currencies of Japan, the UK, Switzerland, Canada, Australia, South Korea, and so on.

But it can’t just rest there. When a central bank chooses which currency to buy, unlike when you or I make our own portfolio decision, it is also determining the direction of net trade flows. Those other countries would have had to match the investment surplus (net inflows on the capital account) with an equally large current account deficit. If China had followed this balanced policy of reserve accumulation, in other words, the only thing that could possibly have stopped them, and a very big impediment it would have been, was the political or economic willingness and ability of those countries to run the corresponding trade deficits with China.

That, of course, is the problem. Given their much more limited economic flexibility and their less ebullient financial systems, those other countries probably would have never been able to sustain the necessary levels of trade deficit, and they would have almost certainly moved aggressively against China to limit the development of unfavorable trade balances. China, in other words, chose to hold US dollars not because the US government has somehow enforced reserve status on the US dollar and denied it to other currencies (Washington could never have prevented China from buying euros or yen or anything else), but simply because no other country is able to run deficits of the necessary magnitude.

The argument, then, that the dollar’s status as the reserve currency and brings an exorbitant privilege is simply the other side of Ben Bernanke’s savings-glut coin. Without the dollar’s reserve status, the global savings glut would have never occurred, or rather it would have never resolved itself in the way it did, and Asian development models aimed at engineering trade surpluses would have had to fail.

So is Governor Zhou a closet Bernanke-ite? He would probably be surprised at this question, and even more surprised at my answer, I think, but I cannot see how you can separate the two arguments – his on the perils of the dollar’s dominant reserve currency status and Bernanke’s on the impact of high Asian savings on the US balance of payments. He and Bernanke agree fundamentally on the roots of the imbalance.

By the way, the model I have been using to explain the imbalances also addresses another contentious question between the US and China which I did not really think about until I read a fascinating short piece by MIT’s Simon Johnson on his blog, more in reference to Europe but relevant nonetheless. China, as we know, is very worried that the US will resort to monetary policy rather than fiscal policy to address collapsing demand in the US. The former hurts China (supposedly because it might cause an erosion in the value of the dollars the PBoC holds), whereas the latter helps by slowing the contraction in US net demand and giving China more time to adjust its overcapacity problem.

It turns out that there may be another reason, even more powerful, and as soon as I read this paragraph by Johnson I had one of those “Aha!” moments that means I am going to have think much more seriously about the implications:

Remember this. If you run an expansionary fiscal policy (building bridges), I have an incentive to free ride (selling you BMWs) and not engage in a similar fiscal stimulus. But if you run an expansionary monetary policy, your exchange rate will tend to depreciate, putting pressure on my exporters and I’ll be pushed – by BMW-type producers – towards providing a parallel monetary stimulus.

This may be why monetary rather than fiscal stimulus makes sense for the US, and less sense for trade surplus countries. It prevents, or at least reduces, the leaking-out of employment generation effects of US borrowing and spending.

The other China

Talking about BMWs, my argument, of course, is not so much about China and the US as it is about trade surplus and trade deficit countries. In that light there was a very interesting article in Monday’s Financial Times about the difficulties Germany is facing in adjusting to the changes in the global balance. Many people assumed that Germany, which was in a very “strong” position (high savings, large trade surplus, low debt – which are all more or less the same thing, really), would weather the crisis easily, but of course it should have been self-evident that a crisis that affects the deficit sides of the global balance of payments must also affect, by the same amount, the surplus sides:

The risk is that – like Japan in the 1990s – Germany faces a “lost decade”, or a protracted period of economic malaise as it waits for the global economic tides to turn and struggles to find domestically generated sources of growth. “I am convinced it is going to be a slow recovery,” says Mr Staake. “Who is going to be buying anything?”

This downfall is all the more galling because, even a year ago, the country could have expected to weather the global economic storms. There was no danger of a housing crash; prices had been flat for a decade. Consumers had saved; companies had not increased leverage dramatically. “From a structural point of view, this recession should never have happened,” says Commerzbank’s Mr Krämer.

With hindsight, however, Germany was a sitting target after the collapse of Lehman Brothers investment bank in mid-September. Its exports were equivalent to more than 47 per cent of GDP last year – compared with less than 20 per cent in Japan and about 13 per cent in the US. Its industrial base is skewed towards producing machinery and equipment – “investment goods” account for more than 40 per cent of its exports – and towards emerging European and Asian economies.

While the crisis was focused on US housing and capital markets, Germany was unaffected. But after Lehman’s failure paralysed banks, and confidence nosedived globally, companies around the world shelved investment plans – leaving German factories turning out goods nobody wanted to buy. Industrial production in January was more than 20 per cent lower than a year before; overseas orders for investment goods had almost halved.

“Who is going to buy anything?” Good question, and one that must be answered by policymakers planning to export their way out of the crisis.

I especially love the statement “From a structural point of view, this recession should never have happened.” One of my standard complaints about most economists, especially those who focus on a single country or group of countries, is that they ignore balance-sheet and balance-of-payments effects. Of course it should have been obvious that a crisis in the deficit countries would affect the surplus countries – in fact it should have been obvious that the impact on the latter should have been worse.

Meanwhile, and as a continuing part of how the crisis will evolve, there is an interesting article in today’s Bloomberg about one of the ways in which the Chinese fiscal response to the crisis risks making the imbalance, and China’s long-term adjustment, worse.

China’s shipbuilding industry may be about to get a bailout — from its customers. The government may force state-owned shipping groups to buy more vessels as foreign carriers scrap orders, according to Steve Man, an HSBC Holdings Plc analyst in Hong Kong. That risks increasing costs and overcapacity among shipping lines grappling with a collapse in global trade.

“They ‘encourage,’ but my thinking is it’s more of a directive,” said Man. “It hurts every player in the industry and creates excess capacity that will take longer to absorb after an upturn.”

As I have argued many times, the constraints of the Chinese development model and limitations in the financial system mean that it will be very hard for China to shift its behavior quickly enough to match the possible adjustment in the US and elsewhere. Bailing out the ship-building industry is one way in which Beijing’s fiscal reaction – while understandable from an employment point of view – may exacerbate the adjustment. Washington’s bailing-out of the automobile industry is the same sort of mistake, I think, but in the US case it is much easier to justify. The US must reduce its net consumption, and if boosting production is economically inefficient in the long term, at least it fits within the overall adjustment in the short term. This is not the case with China – it should be boosting consumption directly, and not indirectly by boosting capacity.

There is a lot more I wanted to discuss today, but this blog entry is getting to be way too long. But just one quick thing, yesterday I was having coffee with some visiting friends from Goldman when one of them received a notice that there were credible rumors on the March increase in new loans. We had all been expecting a very big March number – between RMB 1.3 and RMB 1.6 trillion.

It turns out that the true number may have been an astonishing RMB 1.9 trillion.

That means that for the first three months of the year we have had loan increases of RMB1.6 trillion, RMB 1.1 trillion, and RMB 1.9 trillion. This amounts to RMB 4.6 trillion for the first quarter of 2009, compared to RMB 4.5 trillion for all of 2008. Notice to my students: learn more about how to resolve and restructure bad loans. This will be a great career option for you over the next few years.

Tags: Exorbitant privilege, Zhou Xiaochuan

With the tense start of China’s parliamentary season this afternoon – and with the National People’s Congress meeting Thursday – there isn’t much incentive to try to figure anything new out in China since we are likely to be given a lot more information and proposals over the next few days. What are the major topics likely to be covered in the meetings? I suspect that this article from yesterday’s South China Morning Post, on the topic of unemployment, gives a pretty strong hint:

If this is not addressed, it will be even more difficult for the government to maintain social stability down the road if unemployment remains high. China’s official urban unemployment rate is expected to be 4.6 per cent this year, which would make it the highest since 1980 when figures first began to be collected.

But, economists, including Zhou Tianyong from the Communist Party’s Central Party School, forecast that the real unemployment rate could reach 14 per cent, counting migrant labourers.

Senior officials estimate that up to 20 million migrant labourers have already lost their jobs because of the global economic crisis. They were mostly laid off by private firms and foreign-funded enterprises, the hardest-hit sectors.

I was told privately by a friend of mine two days ago that the number of migrant laborers who have already lost their jobs is actually closer to 30 million, but nonetheless Mr. Zhou’s comments reinforce some other claims to which I refer in a piece by me in the current Newsweek:

Although official estimates put urban unemployment in China at just over 4 percent of the workforce, most unofficial estimates are much higher—closer to 8 percent—and nearly everyone agrees that the figure is set to rise significantly in the next few months. Some credible estimates suggest that even if China were able to achieve the 7.5 percent growth projected in 2009 by the World Bank, unemployment would nonetheless double before the end of the year.

Clearly unemployment is going to weigh heavily on the minds of policymakers in China, like in the rest of the world, and we will have to wait and see what specific new measures are proposed over the next few days. Meanwhile I did nonetheless want to make a few comments about interesting stuff I’ve seen recently.

The first is a reference to an article in yesterday’s Financial Times, “Asean split on protectionism,” which highlighted the difficulties of getting leaders to agree on free trade even during a conference whose primary goal was to defend free trade:

As south-east Asian leaders gathered on Friday for their annual summit, the region’s united front against protectionism was starting to crack under the pressure of the global economic crisis. The fight against protectionism is top of the agenda at this weekend’s meeting of the 10-country Association of South East Asian Nations, which on Friday signed an agreement cutting tariffs and other barriers with Australia and New Zealand.

However, the leaders appeared far apart in pre-conference comments on the balance to be struck between sustaining open markets and promoting economic activity at home. In the most forthright remarks, Abdullah Badawi, Malaysia’s prime minister, said every country had the right to encourage its citizens to buy local products.

“I think it is a normal reaction under this kind of situation. First of all we have to protect our people; we are doing the same thing. If we do not create projects by Malaysia, for Malaysians, then who will buy our products?” Mr Badawi told the Bangkok Post newspaper.

For some of my readers I may be beating a dead horse, but as usual I will put up my warning that we need to be very aware of the deterioration in global trade relations that is likely to be a consequence of the rising unemployment everywhere in the world. The fact that even in a region heavily dependent on exports it is so easy (and so natural) to make the case for protectionism doesn’t bode well for trade discussions in North and South America, Europe and Australia. The article goes on to say:

Lee Hsien Loong, Singapore’s prime minister, said Asean might miss its target of establishing a regional economic community along the lines of the European Union by 2015 if member states failed to maintain open markets. “In this global environment, if we give the impression that Asean is not fully open for business I think we will be the losers when the new landscape emerges,” Mr Lee told CNBC.

Most of the regional economies have built their prosperity on the back of export growth, and the slowdown in the US, Europe and Japan has hit them hard. “I think we all worry about protectionism, and not just from traditional channels,” said Mari Pangestu, trade minister for Indonesia. In spite of Mrs Pangestu’s reservations, Indonesia is encouraging civil servants to buy Indonesian products, an echo of Barack Obama’s Buy American campaign that angered so many both within and outside Asia.

It may seem like a non sequiter to follow up with a second Financial Times article from yesterday, this one called “Emerging market finance: a gap to fill,” but bear with me:

Two years ago, nearly a trillion dollars flowed into emerging markets as investors in rich countries toured the globe in the hunt for yield. Now there is a melancholy long, withdrawing roar as private capital flees to safer havens.

…Net capital flows to emerging markets will drop to just $165bn (£115bn, €130bn) this year, down from $929bn as recently as 2007, according to estimates by the Institute of International Finance, which represents the world’s leading financial companies. Net lending from commercial banks, the IIF says, is likely to go into reverse. The reasons for this are not altogether straightforward. Some accuse rich governments, particularly the US, of “crowding out” emerging markets, sucking up all the available capital to finance their stimulus packages. But Brad Setser, a former International Monetary Fund and US Treasury official, notes that as the private sector retrenches, the US current account deficit – and hence its need for outside financing – has actually been declining.

More likely, he says, is that emerging markets are being hit by a general decline in demand for riskier assets, as banks and investors haul money back home to shore up balance sheets and reduce borrowings. Similarly, the global shortage of the trade credit that finances cross-border commerce reflects a general desire of banks to reduce leverage, not the rich countries hogging all the available loans.

Why is this relevant to a blog on Chinese financial markets? Because if annual net capital flows to emerging markets drop by the projected $700-800 billion, an inevitable consequence is that foreign currency reserves plus net imports for those emerging market countries will also have to decline by exactly the same amount. In other words while some of this decline will be accommodated by a running down of central bank reserves, we should expect a very large decline in net imports among those developing countries, to add to the decline in net imports from North America, non-German-Europe and other trade-deficit-countries. Needless to say this decline in net imports must have as a necessary corollary an equal decline in net exports in the trade surplus countries.

My final comment – hinted at in the title – is on Paul Krugman’s Op-Ed piece in today’s New York Times. he starts off by discussing the viciousness of the global crisis and then goes on to ask (and answer):

How did this global debt crisis happen? Why is it so widespread? The answer, I’d suggest, can be found in a speech Ben Bernanke, the Federal Reserve chairman, gave four years ago. At the time, Mr. Bernanke was trying to be reassuring. But what he said then nonetheless foreshadowed the bust to come. The speech, titled “The Global Saving Glut and the U.S. Current Account Deficit,” offered a novel explanation for the rapid rise of the U.S. trade deficit in the early 21st century. The causes, argued Mr. Bernanke, lay not in America but in Asia.

In the mid-1990s, he pointed out, the emerging economies of Asia had been major importers of capital, borrowing abroad to finance their development. But after the Asian financial crisis of 1997-98 (which seemed like a big deal at the time but looks trivial compared with what’s happening now), these countries began protecting themselves by amassing huge war chests of foreign assets, in effect exporting capital to the rest of the world. The result was a world awash in cheap money, looking for somewhere to go.

Most of that money went to the United States — hence our giant trade deficit, because a trade deficit is the flip side of capital inflows. But as Mr. Bernanke correctly pointed out, money surged into other nations as well. In particular, a number of smaller European economies experienced capital inflows that, while much smaller in dollar terms than the flows into the United States, were much larger compared with the size of their economies.

I have written often about the savings glut hypothesis and my very strong belief that it lies at the heart of the fundamental global imbalance of the past decade, and I think it has extremely important consequences both for our understanding how the crisis will evolve and what are the likely consequences to the major players involved in the imbalance. I am a big admirer of Krugman’s and have been for fifteen years – in the 1990s I used to read everything he wrote, and often within days of his publishing it – so I am delighted that he seems to agree with Bernanke’s thesis, but I should add that I believe the evidence in support is so overwhelming that even if Krugman decided to deride the whole notion, I would remain convinced that the sudden and massive rise in Asian net savings following the 1997 Asian crisis was a prime cause of the corresponding and necessary decline in US savings.

I know I know, this is going to be considered a very controversial statement – and inevitably someone will very stupidly demand to know why I am blaming China when obviously the full blame for the crisis should fall on the US – but there it is. I just don’t see how recent events can be explained without the Asian Crisis of 1997 having played a major role. At least Krugman seems to agree. At any rate he finishes worryingly with:

And the saving glut is still out there. In fact, it’s bigger than ever, now that suddenly impoverished consumers have rediscovered the virtues of thrift and the worldwide property boom, which provided an outlet for all those excess savings, has turned into a worldwide bust. One way to look at the international situation right now is that we’re suffering from a global paradox of thrift: around the world, desired saving exceeds the amount businesses are willing to invest. And the result is a global slump that leaves everyone worse off.

Tags: Krugman, NPC

On September 11 Ben Bernanke, Chairman of the Federal Reserve, gave a very useful presentation at the Bundesbank Lecture in Berlin.  It can be read at http://www.federalreserve.gov, and I strongly recommend that my Peking University students all read it.

Bernanke argues, as he has many time before, that the world is experiencing a savings glut.  According to him a number of developing countries, especially China and the OPEC countries, along with Japan, are saving far more than they are investing.  That means inevitably that they must export capital and run trade surpluses.  As the US is usually considered the safest and deepest financial market in the world, the US is the recipient of the world’s global excess savings.  The inevitable result is that the US must run substantial trade deficits as the counterpart to its capital surplus.

I have been a believer of this thesis for several years.  Unfortunately Bernanke’s position has become much politicized and there are arguments back and forth about whether his hypothesis is merely an attempt to “blame” the US trade deficit on excess savings by foreigners rather than excess consumption by Americans.  These sorts of arguments are idiotic.  The fact is that any deficit country must by definition have “excess” consumption over savings, and any surplus country must have ”excess” savings over consumption, and it is not at all obvious which way the causality runs.  At any rate in my opinion this global “imbalance” is probably a good thing in the long term because running trade surpluses against the US is the only way Europe, Japan, China and Russia will be able to pay for the very brutal demographic adjustments they must make over the next two to three decades – and make no mistake, these adjustments will be brutal.

But leaving aside the silly argument as to whose fault it is, does Bernanke’s argument do a good job of explaining the current US-China balance of payments?  I think the answer is yes – in fact it seems to me that China is a particularly good example of Bernanke’s thesis.  China does save too much – even the Chinese authorities acknowledge this, and they have made repeated and unsuccessful attempts to boost consumption.  The resulting trade surplus with the US is the inevitable consequence of this excess savings.

There has been a series of decisions made at both the macro level and at individual levels that explain the high savings rate in China, and these decision lead inexorably to the accumulation of US assets (through central bank purchases). Of course if China is running a large capital account surplus with the rest of the world, it must run an equally large trade surplus, and as the only country capable of absorbing such large flows, it falls to the US, with its very open financial markets, to absorb China’s trade surplus (excuse me for fudging the distinction between a trade surplus and a current account surplus, but in this case the distinction is unnecessary).

Of the three most obvious reasons leading to this decision towards excess savings, in my opinion, the first and most obvious arose as a consequence of the Asian Crisis in 1997. China’s policy-makers, like those of many other countries, were horrified by the impact of the crisis on the affected countries.  Unfortunately; also like many other policy-makers, they may have drawn the wrong conclusion about the cause of the crisis.

The Asian Crisis, like all financial crises, was caused because of serious mismatches in the national balance sheets that left the afflicted countries vulnerable to shocks that could quickly cause their balance sheets to unravel.  These mismatches create what looks like a virtuous circle when conditions are good, but they quickly become vicious circles when conditions change.  In the case of Korea, Thailand, Indonesia and Malaysia in 1997, this mismatch occurred in the form of having used highly liquid external capital for many years to fund less liquid domestic assets.  As long as capital poured into these countries, as they did until 1997, the result was a boom in which both sides of the balance sheet improved simultaneously – domestic asset values rose while real appreciation in the value of local currencies eroded the cost of external debt.  The process led to imbalances in asset values, however, which ultimately would cause capital to flow out – to devastating effect on the national balance sheets.

The incorrect lesson learned was that it was too much external debt and the lack of foreign currency reserves which left a country vulnerable to crisis (this lesson, of course, merely seemed to reinforce the lessons of earlier crises in Mexico, Brazil and elsewhere). The policy conclusion was that countries should limit highly liquid forms of capital inflow and systematically run trade surpluses to build the necessary reserves to protect them from the risks of future outflows.  Unfortunately in their haste to implement policies that encouraged trade surpluses, financial authorities in China and elsewhere may have put into place the policies that led to equally severe, but largely domestic, balance sheet mismatches.  (I strongly believe that next big round of global financial crises will be domestic banking crises.)

The second obvious cause of Chinese macro policies to boost savings was its very Asian reliance on export growth, and import constraint, to achieve sustainable growth in employment.  Since exports are the excess of production over consumption, in a growing economy boosting net exports is the flip side of raising the total amount of savings.  I think Joan Robinson’s investment multiplier explains how this happens.  As Chinese authorities channeled investment into infrastructure and production facilities aimed at developing the export sector, the resulting increase in national income was separated into high savings and low consumption, and the growing difference between production and consumption was exported.

This decision to boost exports had particularly Chinese reasons.  While most state-owned enterprises, which had dominated the economy until very recently, were inefficient and had too many useless workers, the export sector could take advantage of China’s natural advantages – cheap but dependable labor, a relatively strong infrastructure, and highly concentrated economic policy decision-making – to fuel an export boom that would absorb workers. 

Among the policies put into place to support export growth was an undervalued currency within a rigid currency regime – it had to be rigid to reduce uncertainty among exporters.  This export-orientation was exacerbated by the decision to join the WTO which, in my opinion was not about the benefits of free trade (the Chinese government has no natural predisposition to free trade) but rather about the need to use external constraints to open up the domestic markets, which were subject to a host of impenetrable trade barriers among provinces.  In that sense I liken joining WTO to Argentina’s use of a currency board (an external constraint) to force discipline on the spending habits of provincial governors.

The third obvious source of excess savings was the transformation taking place in China that significantly increased uncertainty as it reduced the social safety net.  As the cost and need for education rose, as medical services collapsed except for those with money, and as it became clear that there would be no protection for those that retired or were put out of work, worried Chinese families put an increasing portion of their rapidly rising income into savings, in an attempt, not yet wholly successful given the pace of the safety net collapse, to protect themselves from uncertainty.

Separating these three factors may unnecessarily imply different operating processes, but of course they are all intertwined and part of the same process.  At any rate because of these three processes, and undoubtedly others, the Chinese economy was focused primarily on producing and hoarding.  But for this policy to work for such a large economy, it needed the rest of the world (i.e. the US, whose markets were huge, whose financial system was extremely flexible, and whose consumers proved very easily convinced) to play along, and the China-US balance of payments relationship was the obvious result.

China has now found itself stuck in a savings trap.  The currency regime has been so successful at boosting the trade surplus that the trade surplus has run out of control and every attempt to rein it in has failed.  Unfortunately the currency regime has put into place a self-reinforcing system in which rising trade surpluses cause too-rapid expansion of the money supply, which is funneled by the banking system into greater industrial production, which causes further upward pressure on the trade surplus.  It is difficult for China to escape from this trap without a sharp adjustment in the currency, but aside from the continuing need to boost employment, one of the consequences of the currency regime and its subsequent impact on monetary conditions may have been the creation of a very shaky banking system and overinvestment into both production and speculative assets.  Since all of these are funded by the banking system, any sharp adjustment, aside from the adverse short term impact on employment, could have significant unintended consequences for the country’s very rigid and opaque financial system.

Much of the argument about the impact of the currency regime on China’s trade surpluses or the US trade deficit misses the point.  Many economists argue that China should not revalue because revaluing the RMB would have no impact on net US-China trade.  They say that since 40% of China’s exports are reprocessed imports, a change in the value of the currency would simply net out in the final export prices for a large fraction of Chinese exports.  They also argue that China competes largely with other Asian countries, so even if a revaluation caused its export prices to rise significantly, the only effect would be to shift its trade surplus to other Asian countries, which would leave the US and European trade deficits with Asia unchanged.  Finally, since China is the dominant player in many of its foreign export markets, it has sufficient pricing power that a rise in its export prices would have a minimal impact on its sales volumes, and in fact could actually cause the monetary value of its exports to rise further.

In spite of the fact that all but the first of these arguments are intellectually dubious for a number of reasons, and in fact really argue in favor of a currency revaluation (after all, if raising the value of the RMB will have little impact on China’s export volumes, and may even boost them, why not revalue and so improve China’s terms of trade?), they miss the main currency argument.  China is running a rising trade surplus because, by definition, it produces more than it consumes, and production is growing faster than consumption.  The root cause of the excess and growing Chinese production – as I see it, anyway, and have repeated ad nauseum in my blog – is China’s out-of-control monetary expansion.  This is itself caused by the rising trade surplus and augmented by FDI, attracted by the impact of an undervalued currency on real assets, and hot money inflows, aimed at taking advantage of the expected currency rise.  A revelaution will not reduce the trade surplus because of its direct impact on export prices.  It would reduce the trade surplus if it caused a reversal of capital flows sufficient to eliminate the monetary expansion that is at the root of the growing surplus.

As long as China is locked into this system, the trade surpluses will not go away.  Until there is a sharp adjustment – voluntary on the part of the financial authorities in the form of a maxi-revaluation, or involuntary in the form of a banking or investment crisis, which I fear is increasingly likely – it is not possible for China to get out of this trap.

In China consumption levels are not nearly enough to absorb the level of production needed to maintain employment (unemployment is actually rising, especially among college graduates).  This is just another way of saying that Chinese savings are too high.  This is also just another way of saying that China must run a trade surplus, and if China must run a trade surplus, and if it invests almost all of its reserves directly or indirectly (as in when it purchases oil stocks) in US assets, it is almost inevitable that the US run a trade deficit.  The only logical alternative would be for Europe or Japan to replace the US in that role, and for structural and political reasons I think this will be difficult.

If you agree that Bernanke is right – the world is saving too much – then the argument that we need to boost US savings could be a very dangerous one.  A world with excess savings does not need its largest economy to save more.  Of course a sudden rise in US savings would quickly reduce the US trade deficit, but it would do so not by boosting US or global demand for US products but rather by depressing US demand for imports.  Since US exports are highly correlated with US imports, a reduction in US import demand would probably also lead to a reduction in US exports (the US sells the machinery used to make the goods that are sold to the US), meaning that total US imports would have to decline by more than the current trade deficit in order to bring it into balance, because US exports would also decline. 

Global and US consumption and production, in other words, would have to fall, and the US and the world must become poorer for the US trade deficit to go away.  It is no secret that one way of eliminating the US trade deficit would be for US consumption to collapse and unemployment to rise, and I worry that this is exactly what a boost in US savings means.  If you think that growing foreign claims on the US are such a severe problem that it is worth increasing unemployment in the short term to correct the imbalance, then you might still support boosting US savings, and the short-term consequences be damned, but if you are not worried, as I am not, it seems like too high a price to pay.

By the way, the reason a country should save is so that its investment needs are met.  The US is an exception.  Its financial system is able to draw on global savings for all its domestic investment needs.  I am not sure “excess” consumption is as much a problem for Americans as it would be for other countries, although I would never say this in polite company for fear of getting hit on the head with bricks by all the millions of puritans and contrarians out there.

The real problem in the US-China relationship is not in the US, I think.  It seems to me that China has the bigger problem.  China cannot afford an interruption of this system, but unfortunately it is locked into a series of what I think are unsustainable processes.  It cannot afford such rapid monetary growth but it has no easy way in which to turn it off.  It cannot continue to channel so much money into speculation and overinvestment, but again there is no way to slow things down.  Because the financial authorities are so reluctant to make tough decisions now, the decisions are very likely to be forced onto them by adverse events in the markets, and it is almost certain that these will come at the worst possible time.  China simply does not have the flexibility the US economy has, and its ability to absorb shocks is limited.

There is an interesting, if perhaps predictable, June 17 Bloomberg article by Patricia Lui that discusses China’s holding of US dollar reserves. According to the article:

China is adding to its holdings of U.S. assets, data from the U.S. government showed yesterday, easing concern the Asian nation will sell dollar investments.  Total holdings of U.S. equities, notes and bonds among foreign investors rose by a net $115.1 billion in April from $79.6 billion the previous month, the Treasury Department said yesterday in Washington. China’s holdings of Treasuries gained $11.4 billion to $502 billion, holdings of U.S. agency debt rose $11.9 billion and U.S. corporate bond investments increased $6.9 billion, data showed.

The discussion about whether or not China will continue funding the US deficit by buying dollar assets has been going on for a long time, and has caused an unnecessary amount of alarm among analysts worried about the consequences of a possible Chinese decision to stop buying dollar assets – without Chinese purchases of US securities, they worry, how can the US possibly finance its ballooning trade deficit?  Yet time after time the data show that China continues to add to its dollar hoard – sometimes in amounts close to or even greater that the US deficit, as Brad Setser recently implied – and so for a little longer those concerns “ease”.

If you believe that the explosive growth in the US trade deficit since the late 1990s was caused primarily by a sudden massive increase in the desire of US consumers to consume, then it may make sense to worry about how the deficit must be financed.  After all according to this view, the cost of out-of-control consumption by Americans exceeds American income, and so this requires some foreign saver to finance the consumption.  At the individual level it was the wealth effect of rising stock markets and real estate prices that allowed Americans to increase their consumption, but in the aggregate a country running a current account deficit by definition needs external financing.  Should this financing stop, US consumption would have to drop drastically in order to eliminate the current account deficit, and with it the US (and world) economy would slow sharply.

But if you believe, as I do, that the global balance of payments disequilibrium is driven primarily by the increase in external savings of a number of developing countries – mostly East Asian and OPEC, with China being by far the largest player – then worrying about how the deficit will be financed shouldn’t take up a lot of anyone’s time.  The deficit exists primarily because of the need for China and other countries to invest the current account surpluses their monetary and fiscal policies were designed to create (or the windfall current account surpluses from high commodity prices, if they are commodity exporters).

I have explained why I think the latter is a better description of the global balance of payments disequilibrium several times in my blog, the last time in a June 4 entry (“Chinese savings and US deficits”) and in two longer entries on September 15 (“China and the savings glut” Parts One and Two).  As I pointed out in those entries, I think a very plausible argument can be made that the 1997 Asian financial crisis created such a strong impression on Asian policy makers that their decision to protect themselves from a reoccurrence prompted them to put into place very strong mercantilist policies guaranteed to save them from a future external debt crisis.  This implied substantial trade surpluses and rising reserves.  It also required that some other country or countries be willing and able to run corresponding current account deficits.

The data show that after 1997-1998 Asian current account surpluses grew so quickly, and central bank reserve accumulation along with it, that for the first time developing countries as a group became net exporters of capital when reserve accumulation exceeded net private capital inflows (you can find the actual numbers in Jorg Bibow’s “The International Monetary (Non-)Order and the Global Capital Flows Paradox”).  China was by far the biggest factor in this process, and of course as long as China was running such a policy, it needed to invest those surpluses.  They were invested in the US.

The point is that China had no choice but to finance the US current account deficit.  As long as it ran mercantilist policies aimed at generating trade surpluses only four things could happen:

1.        China finances the US current account surplus directly by buying US dollars assets.

2.        China finances the US current account surplus indirectly by buying euros and yen, and Japanese and European investors (most probably their central banks), buy US dollar assets.

3.        China buys euros and yen and Europeans don’t compensate by buying dollars, in which case China’s current account surpluses shift to Europe and Japan, who end up running current account deficits to replace the rapidly declining US current account deficit.

4.        China stops buying foreign assets, in which case its current account surplus disappears.

Since the whole point of the exercise was to generate current account surpluses and foreign currency reserves, China could not choose Option 4.  In addition, as its currency regime locked it into a self-reinforcing system in which rising trade surpluses forced more surpluses (I explain why in “The value of the RMB does matter to the trade balance” Parts One and Two) there was no way for China to choose Option 4 without a serious adjustment to the currency regime and the possibility of a sharp and difficult collapse in exports.

Either China had to finance the US trade deficit, or it had to find someone else willing to accommodate its trade surpluses.  The only important question, then, was whether Europe could absorb the necessary current account deficits or not.  If so, China could begin to shift its reserve holdings into euros and so cause enough strength in the euro relative to the dollar that the US trade deficit would shift to Europe.  To a certain extent this has been happening, but I am not sure it can continue for too much longer.

So as I see it, the question of whether the US trade deficit can be financed or whether China can suddenly “change its mind” about financing the deficit is not a very worrying one because the US trade deficit and, increasingly, the European trade deficit are consequences of foreign financing, not their cause.  However something very important has changed recently, and I am not completely sure about its implications.

Specifically, for many years China’s burgeoning reserves were powered primarily by its burgeoning trade surplus (with net FDI playing a secondary role).  In that case it was pretty easy to trace out the balance of payments flows and their consequences.  I agree with most pessimists that the balance of payments numbers were becoming unsustainable, but not mainly because the US current account deficit was unsustainable.  In fact I don’t think it is, for reasons I explain partly in “Demographic projections and trade implications”.  For me the biggest problem with the existing balance of payments relationships was that China’s reserve accumulation was becoming unsustainable because of its domestic monetary impact.

Recently this has become an even bigger problem.  In the past few quarters China’s reserve accumulation has mushroomed to levels that make the 2006 and 2007 numbers, as incredible as they seemed back then, almost laughably small today.  And yet China’s trade surplus and net FDI have not grown to nearly the same extent – in fact the trade surplus, while still incredibly high, has actually shrunk, and FDI, which is much smaller but has grown sharply, probably includes a healthy dose of speculative inflows disguised as FDI (as does, many of us suspect, the trade surplus).

It now seems that China’s rate of reserve accumulation, seemingly unsustainable even two years ago, has reached even higher levels, but what is powering it now is not the (relatively) stable trade surplus and FDI accounts but rather highly unstable speculative inflows (for an explanation of how reserve accumulation has been generated see “What? $74.5 billion? Is this a mistake?”).  If I am right, it seems to me that there has not just been a quantitative change in China’s and the world’s balance of payments accounts in recent months (i.e. even more rapid growth in an already unsustainable rate of Chinese foreign currency reserve growth), but also a qualitative change – the cause of China’s reserve growth has shifted significantly.  The old mechanism, large trade deficits in some countries balanced by rapid reserve accumulation in others, has been converted into something much more complex and maybe even pro-cyclical (hence volatility enhancing): large trade deficits in some countries plus massive speculative inflows in others are being balanced by even more massive reserve accumulation in the latter countries.

I still need to work out in my mind what some possible implications are, but I would be lying if I said I didn’t find this change worrisome.  My instinct is that because of the intensely pro-cyclical nature of speculative inflows, this new system is a lot less stable than the old one.

I was just sent a very interesting paper by German economist Jorg Bibow of the Levy Economics Institute of Bard College (The International Monetary (Non-)Order and the “Global Capital Flows Paradox”).  In it the author considers the “paradox” of high and rising capital flows from developing to developed countries during the past decade.  This is a paradox because most economic theory (and history) suggests that developing countries are net recipients of investment, not net providers.

This paper came at a good time for me.  About two weeks I had dinner with three senior Peking University finance professors and a well-known and very smart American economist from one of the world’s leading investment banks.  Not surprisingly, much of our conversation during dinner was about China and current monetary conditions. 

The American economist and I agreed on most things concerning the financial system in China (and the rest of the world, for that matter) but we did have one disagreement, and that was on the global savings glut hypothesis.  As I understand it this hypothesis argues that policies or conditions that have a caused a systematic increase in savings in several countries, primarily in Asia, have resulted in the necessary corollary of compensating reductions in savings – or increase in consumption – elsewhere.  As the only country deep enough and with a sufficiently flexible labor market and financial system, the US is the natural equilibrator, and so US savings must decline and the US run a current account deficit.

For the American economist the hypothesis of the global savings glut made no sense, but as far as I could see his main criticism of it was that it represented a political view which tried to put the “blame” for the current global imbalances on China, Asia, OPEC and anyone else except the US, where, he believed, it belonged.  This is the same position as that of one of the best-known criticisms of the global savings glut hypothesis, which came in the form of a research note published by Stephen Roach of Morgan Stanley in July 5, 2005, in which he said “There may be a deeper and potentially more sinister meaning behind the saga of the global saving glut.  In my view, it is being used as a foil to deflect attention from one of the world’s most serious imbalances — the excess consumption of America’s asset-dependent economy.”

The American economist also argued at dinner that there has been no real increase in global savings, so therefore the idea of a global savings glut made no sense.  Again, Stephen Roach’s piece made the same argument:

IMF statistics provide our best gauge of global saving.  In 2004, the IMF’s global flow-of-funds framework put the world saving rate at 24.9% of global GDP.  While that marks the second consecutive yearly increase in this measure, it is only 1.9 percentage points above the 23% norm that prevailed from 1983 to 2000.  Yes, the global saving rate has edged up from its longer-term average, but this hardly qualifies as a glut. 

I have addressed both of those very common criticisms before in my blog, but let me summarize very quickly why I think neither of them is valid.  To address the first, the idea that competing theories are proposed largely to assign blame is something that I find of little value in this or most other economic debates.  Furthermore, unlike many other analysts I do not think that such a large US current account deficit is unsustainable over the medium term.  I also think the US-China “imbalance” has actually been better for the US than for China, and so I do not think it is necessary to find someone to blame for US conditions. 

At any rate it is obvious, I think, that any imbalance requires at least two players, both of whom are necessarily to “blame” for the resulting imbalance.  The point is to try to understand why and how the imbalance occurs.  There is no question in my mind that loose monetary policy in the US and the fiscal cost of the Iraq war made it easier for the savings glut in one part of the world to balance a consumption “glut” in another, but without the excess savings driving the process the financing of the Iraq war would have created a very different set of outcomes.

The second point is, I think, easier to dismiss.  The idea of a savings glut necessarily requires not an increase in global savings but rather a shift in the composition of global savings, in which the share of savings in the “glut” countries increases while the share of savings in the equilibrating countries decreases.  It does not require, and in fact cannot require, an increase in total savings.  In a closed system, like that of the global economy, capital and trade flows must balance.  The only precondition, and hard evidence, we would need for a global savings glut is a major shift in the share of savings within the global economy and, ironically, Stephen Roach provides this very evidence in the same piece quoted above.

Alas, the devil is in the detail — or, in this case, in the shifting composition of global saving and investment.  Two main forces have been at work in reshaping this mix — namely, a record plunge in the US saving rate matched by an equally large increase in the saving rate of the developing world, especially Asia.  On the IMF’s basis, the US gross saving rate fell to 13.6% of GDP in 2004…That represents a 3.3 percentage point plunge from the 16.9% average that prevailed over the 1983 to 2000 period.  By contrast, the IMF puts the saving rate in the developing world at 31.5% of its GDP in 2004 — up a whopping 6.5 percentage points from its 1983 to 2000 norm of 25%.  Reflecting the sharp increase in Chinese saving, developing Asia has led the way on the saving front; its overall saving rate is estimated to have surged to 38.2% in 2004 — up dramatically from the 28.8% norm of the 1983 to 2000 interval.

That is exactly the point.  A surge in Asian savings, reflecting especially a surge in Chinese savings, must lead either to a reduction in savings elsewhere or a significant slowdown in global growth.  That is the source of the global imbalance and the justification of the global savings glut hypothesis.

What does all of this have to do with the Jorg Bibow paper that I mention in the very first line of this entry?  Bibow also rejects the global savings glut hypothesis, but my understanding of his paper is that he agrees with much of what I understand the theory to be but rejects it on much narrower technical grounds – he claims that the saving glut hypothesis is based on the “fatally flawed” (his words) loanable funds theory.  However his narrative of events seems very close to the one I and people like Brad Setser (also a proponent, I believe, of the global savings glut hypothesis) have developed.

But what interests me most is the data he provides in his paper (and you can see the accompanying graphs by following the link to his paper).  First off, Bibow discusses the evolution of the US current account deficit over the past fifty years.  Why is the US current account important?  Because according to the global savings glut hypothesis, the US current account deficit is the almost automatic counterpart to the rise in Asian savings. 

Basically, according to the data quoted in Bibow’s paper, the US current account has been within a range of a surplus of 1% of GDP and a deficit of 1% of GDP for most of last fifty years with two exceptions.  The first exception occurred in the mid-1980s when the US current account deficit rose to nearly 3.5% of GDP in 1986-87 before declining sharply and running into a small surplus in 1990.  The second exception began technically in 1994, around the time of the Mexican crisis, when the US current account deficit climbed to around 1.6% of GDP, before it began to decline again, but it really took off in 1997-98, when it raced forward in almost a straight line to peak, in 2006, at 6.2% of GDP.

If the US trade deficit was driven simply by an out-of-control US consumption binge, it is a little hard to see why it would have followed a pattern of general stability marked by two surges – a small one from 1984-188 and a very large one after 1997.  If it was driven by Asian savings, this pattern becomes a little easier to understand – or at least, what amounts to the same thing, we can posit a more plausible story to explain it.  

I will ignore the 1980s surge because this post is already too long, but again one can tell a very plausible story based on Japanese trade policies and domestic savings.  The post-1997 surge is much larger and more interesting.  1997 was, of course, the year in which several Asian countries, after years of tremendous growth and what seemed like invulnerable balance sheets, experienced terrifying financial crises and viciously sharp economic slowdowns, which profoundly impressed Asian policy-makers and has affected policy decisions to this day. 

Since the main cause of the crisis seemed to be the sudden reversal of current account surpluses into substantial deficits, along with highly mismatched balance sheets in which large external obligations were mismatched with domestic assets and “hedged” with extremely low levels of foreign reserves, one of the main (if mistaken) lessons policy-makers learned was the need to run current account surpluses and to amass large foreign currency reserves to protect countries from a repeat of the disastrous crisis of 1997.

These countries, consequently, but into place decidedly mercantilist policies in order to achieve both goals – persistent trade surpluses and large amounts of foreign currency reserves.  Unfortunately, these policies simply transformed the balance sheet risk and in many cases – that of China being the most notable – locked the countries into positive feedback loops in which trade surpluses and accumulating reserves (or, rather, the domestic monetary consequence of accumulating reserves) fed into and reinforced each other.

This (I think plausible) story is reinforced by another graph Bibow reproduces.  The global capital flow “paradox” to which he refers in his title is the fact that developing countries are exporting capital to rich countries.  According to his data, developing countries have always been net recipients of private capital flows – which is what one would have expected from most economic theory and history. 

They have generally been net providers of official capital as far as foreign currency reserve accumulation goes, but for most of the last fifty years reserve accumulation on average was significantly less than net private inflows, so developing countries were net recipients of capital.  (For much of the 1980s the balance on both was zero or close to zero, and I suspect that this reflects negative private flows to Latin American and others among the 32 defaulted or restructuring LDCs, as they were then called, netted against positive private flows to Asia.)

It is only in 1998 that reserve accumulation among developing countries begins to take off and by 1999 it exceeds net private capital flows to developing countries.  This is when the “paradox” of net capital flows from developing to developed countries begins.  Except for a small decline in 2001 net flows from developing countries surge almost in a straight line to around $700 billion annually (combining $1.2 trillion of reserve accumulation versus $0.5 trillion of net private flows).

I am sure there can be other competing explanations for the timing of these flows, but I am very impressed by the fact that Asian savings, as expressed in reserve accumulation, surge after 1997, as does the US trade deficit.  Given the virulence of the 1997 crisis and the tremendous shock it provided to Asian policy-makers (and policy-makers in developing countries elsewhere), it seems to me that a very plausible argument can be made that it was the effect of 1997 that caused the shift in developing-country policies that led to the surge in savings and the corresponding increase both in trade surpluses and reserve accumulation.  The surge in the US trade deficit after 1997 is also more easily explained by a shift in Asian trade policies and currency regimes than by a shift in US consumer preferences.

I am less familiar with the consequences of these policies elsewhere, but it seems to me that for now China has found itself locked into these mercantilist policies, except that in the past year we have seen a major shift take place that must force a sharp adjustment.  The policies aimed at eliminating the risk of a 1997-style financial crisis have worked, but they have not eliminated the risk of crisis.  Instead they have only transformed the risk of an external crisis into the risk of a domestic banking crisis.

What is worse, China’s reserve accumulation is no longer being driven by its trade surplus and is increasingly being driven by very unstable private (speculative) capital flows.  I don’t have the data at ahnd, but I suspect (and this was also argued in the Reinhart/Rogoff paper, on which I commented three weeks ago), that when a developing country receives so much speculative capital, balance sheet vulnerability rises inexorably and the likelihood of a shock large enough to force an adjustment also rises.  What happens to global savings and the US current account deficit after that, I am not really sure, but it is something I am trying to figure out.

As I have mentioned many times on this blog I am one of those who sees the great global imbalances of the present period as largely a consequence of a global savings glut, and as the biggest saver China is one of the most important players in this process.  As the system is currently undergoing a great deal of stress, it is going to be forced to change one way or the other, and there is no reason to believe this change must be benign, either for the world or for China.

How does the savings glut work?  In recent years we have seen a combination of a structural savings glut (mercantilist policies in a number of countries, especially in Asia, have included a rigid currency regime which exports high domestic savings) and a cyclical savings glut (commodity exporters, especially oil exporters, have seen export earnings grow much faster than imported consumption).  The combination of these two has resulted in a vast building up of foreign currency reserves among the saving countries.  The accumulation of foreign reserves is largely the consequence of accumulated trade surpluses, which because they imply total consumption that is less than total production, is the way in which domestic savings – forced or otherwise – is exported to the rest of the world.

In a system in which most countries of the world are tied together by trade and capital flow links, a savings glut of course does not mean that there has been a net increase in global savings.  It means that excess savings in one part of the system will automatically lead another part of the system into excess consumption so as to keep the overall system in balance.  With its very flexible financial system, its deep pockets, and the high credibility of its financial markets (not to mention the eagerness of many of its citizens to increase consumption), it is no surprise that the US economy and financial system have been the great equilibrator, running the significant trade deficits over the past several years needed to match the mercantilist and commodity-export-related surpluses of those countries with surplus savings.

But falling house prices and slowing demand are forcing the US to increase its own savings rate and so to reduce its ability to balance the excess savings abroad – we can see this by noting the rapidly declining US trade deficit.  A world of excess savings, in other words, is being forced into an adjustment in which the savings of its largest economy is set to grow – and it cannot be a good idea to increase savings in a world that is already experiencing a savings imbalance of this sort.  

Of course this adjustment cannot happen in a vacuum, and either the excess savers must cut savings and increase consumption, or another very large and credible economy must take up the US consumption slack.  The former certainly does not look like it is happening, and in fact it cannot happen as long as the excess-savers’ central banks keep intervening in the markets to keep their currency values low – their intervention is the very process by which high domestic savings are exported to the rest of the world.

So the latter is happening.  Europe is being forced to absorb an increasing share of the savings imbalances as the US reduces its share.  As I have often written here, I am very skeptical about whether Europe has the financial or economic flexibility, or the political flexibility for that matter, to replace the US as the great equilibrator.  But what is the alternative?  Even if global savings are eventually reduced by declining commodity prices, I see little evidence that the mercantilist savers are bringing their consumption levels up quickly enough to enable the global economy to regain some balance.

That suggests to me that at some point, perhaps quite soon, European trade imbalances will be high enough to cause significant problems at home.  Either Europe will react by trying to limit imports, or the euro will crash against the dollar, sending the role of equilibrator back to the US, or mercantilist savings will decline sharply and maybe even reverse.  As I see it these are the only three likely options to restore balance.  Neither is likely to be benign, but I guess the trick is to figure which of these is likely to be the less damaging and work towards that direction.

Meanwhile, and as an aside, Friday’s South China Morning Post has a story on QDIIs, a subject I have covered a lot in this blog because QDIIs act as a sort of proxy for speculative interest and they indicate one of the ways in which China is trying to diversity the exporting of its excess savings.  China’s QDII’s, which are funds specifically designed to allow Chinese investors to invest abroad (capital controls prevent foreigners from easily investing in China and Chinese from easily investing abroad) seem to be under continued pressure from disgruntled investors who are fed up with the losses they have taken.  An article titled “Mainland funds deny QDII cash pressure,” has this to say:

Beleaguered mainland fund managers have denied they are facing pressure from investors who want to cash out of their qualified domestic institutional investor products in Hong Kong.  The QDII scheme, which allows mainlanders to invest in foreign markets such as Hong Kong through approved funds, has come under close scrutiny after Minsheng Bank was forced to liquidate a product late last month after the net asset value fell by more than 50 per cent.

“We don’t feel redemption pressure,” the article quotes Zhang Houqi, the deputy president of China Asset Management, as saying.  China Asset Management was one of the first mainland fund houses to embark on the QDII scheme.  The story goes on: “Analysts said QDII funds were being forced to increase their cash positions before potential heavy redemptions since the first batch of buyers wanted to cut losses.”

When managers are busy assuring the market that they don’t feel redemption pressure, that is usually a sign that there is redemption pressure, isn’t it?  After all it is not hard to think of the name of one or two banks who recently told us that they were not under liquidity pressure, only subsequently to find that indeed they were.

If there are sufficient redemptions in the next few weeks or months that force these funds to liquidate, I suppose we will see a jump in the already high monthly increases in central bank reserves, as money which previously left the country (and so relieved the PBoC from mopping it up) returns to the perceived safety and relative high returns of Chinese bank deposits.

One of the comments on one of my earlier posts had me search out a quote from Steven Roach about there being no growth in global savings to support the global-savings-glut thesis.  There were also several interesting comments on the topic following the initial comment.  But rather than keep the discussion buried in the comments section, I thought I might pull out the Roach piece and discuss my reaction a little more fully. 

I have no doubt that this subject will elicit a flurry of comments – some brilliant and some cantankerous – but even though many of Brad’s readers may disagree, I do not think the savings-glut hypothesis has been fully demolished.  I, for one, still find it very illuminating (and no, I am not trying to shift the blame to the damned foreigners – as I said in another post, I don’t think there is any blame to apportion out).

There is no glut of global saving. Yes, global saving has risen steadily over the past several decades, but contrary to widespread belief, the rise in recent years has been no faster than the expansion of world GDP. In fact, the overall global saving rate stood at 22.8% of world GDP in 2006 – basically unchanged from the 23.0% reading in 1990. At the same time, there has been an important shift in the mix of global saving – away from the rich countries of the developed world toward the poor countries of the developing world. This development, rather than overall trends in global saving, is likely to remain a critical issue for the world economy and financial markets in the years ahead.

So says Steven Roach, Morgan Stanley’s Chief Economist, in a very interesting piece last year about the shift in global savings that has taken place over the past ten years.  Basically Roach points out that the advanced countries of the world, which accounted for 80% of global GDP in 1996, have seen their share of global savings drop from 78% in 1996 to 65% in 2006.  Part of this decline can be explained by their declining share of world GDP – the US share has remained fairly constant, but the rise of China and India has been accompanied by the relative decline of Europe and Japan. 

I am not sure, however, that the global savings glut thesis requires a rise in total global savings.  Bernanke’s argument, as I interpret it, is that there is an excess of savings in certain parts of the world – specifically in East Asia and the oil-exporting countries.  This explains the US current account deficit because as these excess savings pour into the US economy – the only market deep and secure enough to absorb them – they automatically cause a counteracting adjustment in the US balance of payments.

Against this Roach, and others, have argued that since global savings have been constant as part of world GDP over the past decade (around 23%), where can we find these excess savings?  To describe a system, in which savings has remained constant as a share of GDP, as experiencing a savings glut seems, at first, to make little sense.

But not necessarily.  Leaving aside the possibility that there can easily be a savings glut even in a system that sees a decline in savings, if investment demand is declining more quickly, I think there is another explanation that fits current conditions well.  If Bernanke is right, one part of the global system creates through the balance of payments mechanism an excess consumption in another part of the system.  If every part of the global system were completely rigid, a rise in savings in one part would result in a global rise in savings.  But if at least one part of the system has a highly open and flexible financial system, it will act as the residual whose changes force the overall system back into balance.  In the aggregate total savings and consumption may seem to have changed little, but what has happened is that an imbalance in one part has forced an equivalent but opposite imbalance in the other. 

Not only does this seem to me an automatic outcome of excess savings, but it also seems to describe reality quite well.  The US financial system is global in scope and so astonishingly flexible that it shifts very easily to accommodate global changes.  If the rest of the world must produce more than it consumes (which is to say it saves more than it invests), the balancing entity must consume more than it produces as it absorbs those excess savings.

Roach finishes his piece by saying:

From the start, the concept of the global saving glut was very much a US-centric vision (see the March 10, 2005, speech of then Federal Reserve Board Governor Ben Bernanke, “The Global Saving Glut and the U.S. Current Account Deficit”). From America’s myopic point of view, it believes it is doing the world a huge favor by consuming a slice of under-utilized saving generated largely by poor developing economies. But this is a very different phenomenon than a glut of worldwide saving that is sloshing around for the asking. The story, instead, is that of a shifting mix in the composition of global saving – and the tradeoffs associated with the alternative uses of such funds. I suspect those tradeoffs are now in the process of changing – an outcome that is likely to put downward pressure on the US dollar and upward pressure on long-term US real interest rates. If the borrower turns protectionist – one of the stranger potential twists of modern economic history – those pressures could well intensify. Don’t count on the saving glut that never was to forestall these outcomes..

I am not sure I agree with this except to agree that to call it a savings glut is US-centric, although I am not sure I would have expected anything else coming from the head of the US central bank in a speech on the US trade balance.  But to say that we are seeing a “shift” in savings rather than a glut of savings doesn’t add much to this particular picture.  Excess savings can very easily resemble a global “shift” in savings through changes in the international balance of payments.  It is not obvious to me that these two things are necessarily different.

I am guest-blogging on Brad Setser’s site.  This is what I posted today.  I apologize if it covers some ground from some of my earlier posts, but I put it up here anyway:

Post on Brad Setser’s Blog

One of my tricks when I want to look smart on the topic of global financial flows and monetary conditions is to check out the latest entries in Brad’s blog, which is the only blog I read nearly every day.  Now that I am guest blogger, of course, this trick isn’t going to work nearly as well, although some of the comments from some of Brad’s regular readers should help somewhat.  My background is in emerging markets, which until 2002 generally meant Latin America but since then, when I moved to Beijing, has largely meant China.  I will try as much as possible to discuss global conditions, like Brad does, but I suspect I will be spending far more time on China and emerging markets in general than he normally does.

So with that caveat, let me post my first blog on – what else? – China, and more specifically what we know or think we know about the soon-to-be-established but already operational sovereign wealth fund.  I will use as my crib sheet a very interesting report prepared by Xinxin Li, chief China analyst for the G7 Group, a New-York-based consulting and research firm.

I have been spending a lot of time thinking about the impact of these funds.  In early August, just as the sub-prime crisis was really getting going, I wrote an op ed piece for the Wall Street Journal that argued that, in spite of the problems we were facing, not only was this not going to be the end of the world – I expected spreads to be back by October – but that the crazy party we have been living through would go on at least a few years longer.  A lot of my friends on Wall Street (I am a former emerging markets bond trader) wrote me very patient emails explaining that I had finally lost all my market sense – it was obvious that this time around the crisis was so severe that it was going to derail the whole liquidity boom.  This, according to them, really was going to be the big one.  I still disagree.

An important part of the reason for my believing this has to do with the reserve management strategies of China, Japan, the OPEC countries, and other, mostly Asian, central banks.  It is a basic assumption on my part that globalization cycles, of which by my count there have been six in the past two hundred years, are driven largely by new developments or structural changes in the financial system that cause a significant increase in global liquidity and a concomitant increase in risk appetite. 

Because of rising risk appetite this newly-abundant capital flows into a variety of risky countries or ventures – financing canals in the 1820s, railroads in the 1860, long-distance communication media in the 1920, the internet in the 1990s – and sets off the growth in international trade, capital flows, technological development (and, for some reason, the rebirth of liberal economic theory) that we associate with globalization.  I write about this history extensively in my book, The Volatility Machine, which Brad was nice enough to plug, and in articles in various journals.

These liquidity cycles were never smooth sailing but were often interrupted by sometimes shockingly severe crises in the form of temporary liquidity panics which, after scaring the hell out of everyone, eventually reverted to benign conditions.  Some well-known examples might be the Overend Gurney Crisis in 1866, the Panic of 1907, or the 1976 Peso Crisis and, I am willing to bet, the sub-prime mortgage crisis of 2007.  Each of these crises was severe and frightening, and each resulted in significant subsequent changes in regulations and banks, but each also ended with minimal damage to the economy and a quick reversion of the earlier optimal liquidity conditions.  The jury is still out, of course, but I expect the same will occur over the next few weeks and months as the impact of the sub-prime mortgage crisis fades away.

These liquidity cycles do eventually end, of course.  Typically when they do end they end badly.  The 1873-80 depression, the Great Depression, and the Latin American Lost Decade are all examples of a real close to the liquidity cycle, but these real endings are very different from the liquidity panics that interrupt them.

We are pretty certainly living through a major liquidity expansion cycle, and in my opinion there have been two important causes of the current expansion.  The first was the beginning of the massive securitization of illiquid assets, especially of mortgages, in the 1980s, which had the effect of turning a huge amount of illiquid assets into extremely liquid and widely-traded securities.  I believe that Robert Mundell would argue that increasing the “money-ness” of an asset is analogous to increasing the money supply, and this massive securitization process had that very impact. 

More important than securitization, especially in recent years, has been the Asian recycling of the massive and growing US trade deficit.  To me this recycling process is a machine that converts a big chunk of US consumer spending into Asian savings, leading to what Bernanke has called the global savings glut, and may have had some similarities with the petro-dollar recycling that fueled the LDC lending boom of the 1970s.

If you agree with this model of globalization, the trick to projecting financial markets is then to predict the evolution of the US trade deficit and to follow the way in which it is being recycled.  I am not smart enough to tell you what is going to happen to the US trade deficit, but whatever happens it is likely to change fairly slowly.  Unlike most commentators, I think, I do not believe the US trade deficit is very serious problem for the US and I do think that there are very strong structural reasons that will cause it to reverse significantly over the next few decades, so as far as I know this could continue for a few more years.  I can however make some higher quality guesses about the recycling process, and here I think China, because it has the largest hoard of reserves, is in the front line of the global change in central bank reserve investment strategy.

As we all know, China is accumulating reserves at a furious pace, and I would argue that the whole process has gone so far out of control that there is nothing the financial authorities can do to stop it.  It will take a fairly nasty “adjustment” of some sort or other to reverse conditions, and until we do get this shock, the reserve accumulation process will continue and even speed up.  It has become pretty clear, however, that whatever the appropriate amount China needs to keep in liquid, safe, and therefore low-yielding assets, it is far less than what they actually have at China’s central bank, the People’s Bank of China (PBoC).  That has prompted the authorities to move part of their reserves into some kind of sovereign wealth fund where it can be more actively managed (and to manage more actively, according to rumors, the portion that has remained at the PBoC).  Active management, of course, is another way of saying that it will be deployed to buy a much wider range of riskier assets.

As China and the rest of the high-reserve countries increasingly recycle the US trade deficit into riskier assets, the sheer size of funds under management will appreciably drive global risk appetite up.  This, as I wrote in my WSJ piece, will keep this crazy party (which has already gone on long enough) going for at least a few more years.  This is also why I think it is extremely important to keep an eye on what these sovereign wealth funds are doing. 

Because this posting is already long enough, tomorrow I will discuss the Chinese SWF and what Xinxin Li and others are suggesting about its evolution.