Martin Wolf, in a Financial Times comment, “Villains and victims of global capital flows,” looks at the two competing theories of the causes of global imbalances. One is the savings glut story, in which parsimonious Chinese and Japanese force the US to consume to keep the world from falling into recession. This view is favored by the Fed, doubtless because this Keynesian version has the Fed as hapless victim. The other version, the money glut interpretation, holds that serial bubbles in the US have led to asset price distortion, excess liquidity, excessive borrowing by consumers, which in turn has led to excessive consumption, huge US trade deficits, which in turn produce huge trade surpluses in certain trading partners, who then inevitably have high domestic savings rates.
Martin Wolf favors the savings glut theory, largely because he deems that Asian savers do want to save; this is their preference, not an accommodation to the West. He also thinks monetary growth and inflation expectations in the US are moderate, which he sees as fitting that story.
Now I hate to differ with someone as knowledgeable as Wolf, but I believe the truth lies somewhere in the middle, a 60/40 or a 70/30 split skewed in favor of the money glut rather than the savings glut view.
My belief is, absent US monetary excesses, we would have a pattern of global imbalances similar to the one in play, but operating at a much lower amplitude. US indifference to monetary policy has amplified this tendency (which at a low level is not overly troublesome and in fact benefits most of the participants) to a destabilizing and unsustainable pitch.
Based on my knowledge of Japan (which somehow manages to be overlooked for the most part in the global imbalances story despite running large trade surpluses), the Japanese as a matter of policy like having trade surpluses and a high domestic savings rate. Indeed, they regard the latter as necessary due to their aging population. Observers have charged Japan with pretending to be a basket case so as to keep the West from pressuring it to reduce its trade surpluses.
China similarly has a marked preference run trade surpluses because it is eager to industrialize rapidly, and its economy was too small for it to grow quickly if it relied only on domestic demand.
However, acknowledging the desire of certain trading partners to run trade surpluses does not let the US off the hook. Wolf is incorrect when he says that monetary growth in the US has been reasonable. Huh? The Fed is using inflation targeting rather than money supply targets as its primary tool. In fairness, that may be due to the fact that the Fed’s ability to control money supply is low. Nevertheless, broad money supply (M3 or what is now called M Prime) has been running at double digit rates, well above economic growth. Hence the phenomenon of asset bubbles in many markets and abnormally low risk premia.
Wolf tells us that moderate inflation growth is another sign of the validity of the savings glut story. But the savings glut theory doesn’t sit well with the widespread asset bubbles. Moreover, inflation is running at a high rate in the Gulf and is increasing in China. We have pointed out that inflation in the US is running at a higher rate that commonly presented due to the reliance on “core inflation” which in many respects is misleading.
Economists find the absence of a 1970s wage-price spiral reassuring. We think that is false comfort. First, unions are weak and job security is low, so labor has almost no bargaining power. Cost pressures in the economy would have to be much more pronounced than in the past to produce wage increases. Second, it takes longer than one might think for inflationary pressures to build up in an economy. The US had robust growth in the late 1960s, plus deficit spending to fund the Vietnam War, but it took years of fiscal stimulus, plus an oil shock, for inflation to become self-sustaining.
Wolf sagely notes that which story you believe also suggests whether this picture is good or bad. If you subscribe to the money glut version, the result will be a dollar collapse and perhaps even global inflation. Now since we hold to a somewhat weaker form of that theory, the future of the dollar and inflation will reveal which view was more accurate.
Fast growth, huge current account “imbalances”, low real interest rates and risk spreads, subdued inflation and easy access to finance characterise the world economy. Is this party about to end? Probably not. But to identify the risks we must first decide what drives the strange world economy we see around us.
The two interesting alternative explanations are the “savings glut” and the “money glut”. Both share common themes: globalisation; the revolution in finance; the rise of China; low inflation; and macroeconomic stability. Beyond this, however, they diverge. In particular, they reverse the role of victim and villain: in the savings-glut story, the thrifty are the villains and profligate the victims; in the money-glut story, it is the other way round. This is a contemporary version of the old Keynesian versus monetarist dispute.
The “savings glut” hypothesis is associated with Ben Bernanke, now chairman of the Federal Reserve. But the idea was floated earlier by others. Brian Reading, of Lombard Street Research, lays out the line of argument in a recent note*. A substantial excess of savings over investment has emerged, he says, predominantly in China and Japan and the oil exporters (see chart). This has led to low global real interest rates and huge capital flows towards the world’s most creditworthy and willing borrowers, above all, US households. The short-term effect is an appreciation of real exchange rates and soaring current account deficits in destination countries. To sustain output in line with potential, domestic demand in those countries must also be substantially higher than gross domestic product. A country must choose fiscal and monetary policies that bring this result about.
Not only has the US absorbed 70 per cent of the rest of the world’s surplus capital, but consumption has accounted for 91 per cent of the increase in gross domestic product in this decade. Thus excess saving in one part of the world has driven excess consumption in another.
What Mr Reading calls a “liquidity tsunami” is the result of the savings glut. Low nominal and real interest rates encourage robust credit growth, a worldwide shift into risky assets and compression of risk spreads. Hedge funds and private equity boom as investors seek high returns, though buoyant asset prices and low real interest rates decree the opposite.
In the savings-glut world, governments are responsible for much of the capital outflow. This is either because domestic residents are not allowed to hold foreign assets (as in China) or because most of the export revenue accrues to governments (as in the oil exporters). Either way, governments end up with vast foreign currency assets as the counterpart of domestic excess savings.
In this world, the US is passive victim, excess savers are the villains and the Federal Reserve is the hero. In the money-glut world, however, the world’s savers are passive victims, profligate Americans are villains and the Federal Reserve is an anti-hero. In this world the US central bank is a serial bubble-blower, has distorted asset markets and visited excess monetary emission on trading partners around the world, above all, on those who seek monetary stability through pegged exchange rates.
This is the line of argument of Richard Duncan, a well-known financial analyst**. The argument is that US monetary excess causes low nominal and, given subdued inflationary expectations, real interest rates. This causes rapid credit growth to consumers and a collapse in household savings. The excess spending floods across the frontiers, generating a huge trade deficit and a corresponding outflow of dollars.
The outflow weakens the dollar. Floating currencies are forced up to uncompetitive levels. But pegged currencies are kept down by open-ended foreign currency intervention. This leads to a massive accumulation of foreign currency reserves (up $3,445bn between January 2000 and March of this year). It also creates difficulties with sterilising the impact on money supply and inflation.
In this view of the world economy, savings are not a driving force, as in the savings-glut hypothesis, but a passive result of excess money creation by the system’s hegemonic power. Profits (and so measured corporate savings) rise simply because of increased exports and output under economies of scale. Governments of countries that possess the huge trade surpluses then follow the fiscal and monetary policies that sustain the excess savings needed to curb excessive demand and inflation.
It is no surprise that the Federal Reserve is a believer in the savings-glut hypothesis. But many Asians blame their present predicament on “dollar hegemony”, which is the core of the “money-glut” hypothesis. The big questions, however, are which is true and whether it matters.
My answer to the first is that the savings-glut hypothesis is truer, for several reasons. First, monetary growth in the US is not unreasonably high. Second, inflationary expectations in the US have remained contained, as real interest rates have started to rise. Third, the weakness of the US dollar looks modest, though that is distorted by the interventions. Fourth, it is hard to believe that the soaring savings in Asia and the oil exporters are passive responses to excess demand from outside, rather than deliberate choices. Finally, the pegged rates themselves are policy choices.
My answer to the second is that indeed it does matter. If we live in the savings-glut world, the US current account deficit is protecting the world from deep recession. If we live in the money-glut world, that very same deficit is threatening the world with a dollar collapse and, ultimately, even a return of worldwide inflation.
The savings-glut view is far more comforting. Excess savers will learn to spend, in the end – sooner rather than later, if US spending were to weaken dramatically. But if we live in the money-glut world, the great gains in monetary stability of the past quarter century are at risk.
Either way, the present world cannot continue indefinitely. Moreover, either way, it makes little sense for emerging-market economies to write a blank cheque to the US. The era of massive currency intervention and dependence on excess spending by US households must end. Might that end be nigh?