“Savings Glut” Fables and International Trade Theory: An Autopsy

Yves here. If anything, Lance Taylor understates the significance of Ben Bernanke’s flogging of the bogus “savings glut” theory. We felt compelled to address it in ECONNED since it became Benanke’s excuse for the 2007-2008 financial crisis, after central bankers and orthodox economists had been preening for their supposed success in engineering the “Great Moderation”.

The savings glut theory posits that too many savings in the rest of the world flooded into the US and caused our low interest rates and nasty housing bubble. Needless to say this ignores our pet issue, that the so-called “wall of liquidity” was due tremendous leverage created by derivatives.

The savings glut theory also obscures how Greenspan had lowered interest rates to a negative real interest rate level for an unheard of nine quarters, when past Fed practice had been to drop interest rates for recession-alleviation purposes only for a quarter. Oh, and on top of that, Greenspan was reacting merely to the collapse of the dot-com bubble, and not anything approaching the early 1980s or early 1990s downturns. Finally, Bernanke conveniently overlooked that savings as a percent of global GDP had been as high as it was right before the crisis in the 1990s without causing the global financial system to have a near-death experience.

Taylor adds to literature of savings glut shellacking. One of the best came from Claudio Borio and Peti Disyatat of the Bank of International Settlements, but it was written so defensively as to be hard to parse. Our Andrew Dittmer translated it out of economese in a 2011 post. Borio himself buttonholed me at a conference to say he liked Dittmer’s precis.

By Lance Taylor, Arnhold Professor of International Cooperation and Development, New School for Social Research. Originally published at the Institute for New Economic Thinking website

The structure of the US economy began to shift markedly 40 or 50 years ago. The profit share of income grew across business cycles at 0.4% per year, or by more than 20% (that is, by eight percentage points) over five decades. Driven by rising profits, the size distribution of income shifted strongly toward households in the top one percent. The economy became increasingly dualistic, with big employment increases in low wage/low productivity sectors (Taylor with Ömer, 2020).

Foreign trade was part of this transformation. On the world stage Japan, Germany, and more recently, China exported far more than they import, creating gluts of traded goods and services. They accordingly built up stocks of “saving” which took the form of newly acquired liabilities (bonds and even money) from the rest of the world. For the USA, the process worked in reverse. The economy became an international sump with imports exceeding exports, financed by issuing liabilities such as Treasury bonds or dissaving, thus turning the country into a large net debtor.

Two decades after the process started, former Federal Reserve Governor Ben Bernanke was a canary in the world trade coal mine when he announced the presence of a “global saving glut.” The glut had already led to the 1985 Plaza Accord to devalue the dollar. By the turn of this century it was scarcely a surprise.

Bernanke (2015) is a recent reassessment, one of several shambolic mainstream explanations for the foreign trade situation. A new INET working paper (Taylor, 2020) describes their incoherence, employing Keynesian open economy macroeconomics. Here are takeaways (citations to authors mentioned here are in the paper).

National accounts show that flows of “net borrowing” (NB) or spending minus income for institutional sectors (households, business, government, rest of world) must sum to zero. This relationship, emphasized by Wynne Godley, is a version of Walras’s Law from general equilibrium theory. Positive NB represents a stimulus to aggregate demand.

As seen from the “home” economy, the rest of the world’s NB equals the current account surplus. As a share of US GDP, the current account took small absolute values of both signs prior to around 1980. It then became consistently negative, ranging down to below five percent.

Bernanke and other mainstream practitioners try to explain these observations using the IS/LM/BP model introduced by Robert Mundell and Marcus Fleming 60 years ago. It is supposed to include three independent equations for national income = expenditure (IS), financial balance (LM), and foreign balance (BP). This system allegedly determines the level of economic activity, interest rate, and exchange rate.

A fatal flaw in Mundell-Fleming is already built into the Godley-Walras national accounting relationship mentioned above (illustrated in the paper in the form of a social accounting matrix or SAM proposed by Godley for two trading economies). If household, business, and government NB are determined by macroeconomic forces, then the external current account (exports minus imports) will be a residual – there cannot be an independent BP equation. Moreover, the sum of all countries’ current accounts must equal zero. Mutually offsetting “saving” gluts and sumps (really countries’ own levels of positive and negative NB by the rest of the world) are inevitable in a general equilibrium system in which they are all determined. US experience shows that an economy’s negative or positive trade position can persist for an extended period of time.

In attempting to determine the exchange and interest rates from flows of income and output, Mundell-Fleming resembles the “loanable funds” approach to macroeconomics which John Maynard Keynes thought he had demolished forever in his General Theory. Yet it came swooping out of the 19th century to bewitch American new Keynesian economists in the twenty-teens. Taylor (2016) and Servaas Storm set out reasons why they were hoaxed. Institutionally, loanable funds modeling makes no sense.

In the theory, interest rates supposedly adjust to equate business investment and household saving as uses and sources of funds. Excess potential saving worldwide then should force rates down to a “natural” level ensuring macroeconomic balance. This process ignores revenue and spending by government (the main net borrowing sump in the USA) and the rest of the world, making simple household vs business funding beside the point.

A more coherent rationale for currently low American rates is the Greenspan-Bernanke-Yellen-Powell Federal Reserve “put” holding borrowing costs down to prop up high asset prices. The put has been extended with quantitative easing and recent discussion about yield curve control. As during WWII, pegged low interest rates benefit the Treasury’s accounts – a point that suddenly became compelling with the explosion of debt-financed spending to combat the corona virus pandemic.

In fact, in international financial markets interest rate parity (arbitrage) and the carry trade (borrowing in one low interest rate currency to invest in another at a higher interest rate) tend to bring countries’ rates together. These transactions involve jumps up or down of financial stocks held in portfolios of investors and banking systems.

IS/LM has its problems with representing “what Keynes really really said,” but can still be useful in sorting out macroeconomic links. Godley proposed a two-economy version. For given interest rates and exchange rate, the IS side is based on the SAM mentioned above. It sets cost-driven price levels, demand-driven real outputs, and trade. The LM relationships involve demand-supply balances for two forms of money along with bonds issued by the home and foreign governments. Each country’s private sector has a portfolio containing money and the two flavors of bonds (with foreign liabilities scaled to home prices by the exchange rate). Money supplies are set as sums of bonds held by the two banking systems.

Interest and exchange rates emerge from portfolio shifts subject to accounting restrictions on the financial stocks. For example, assume that the banking systems intervene to set interest rates. All money and bond demand levels will thereby be determined. Also assume that the foreign banks hold a given quantity of foreign bonds. The exchange rate then becomes endogenous or it “floats.” There would be an “instantaneous” capital inflow to the home economy if the foreign private sector sold foreign bonds to buy home’s paper. To restore financial balance the exchange rate would have to appreciate. Alternatively, assume that home banks sell from their local bond stock as did the Fed after the Plaza Accord. Then one can show that the exchange rate would have to depreciate, the point of the exercise.

The key is that these financial stock transactions are “fast,” as compared to “slow” adjustments in trade flows (door-to-door sea freight from China to the USA takes 30-40 days). Even if it existed, using a Mundell-Fleming BP relationship to deal with capital flows would be anachronistic.

We can examine the factors underlying the persistence of trading gluts and sumps. As with any long-lasting politico-economic situation, the current combination of trade and financial flows is over-determined. To try to sort out crucial economic links, it is helpful to begin with labor productivity growth, or increases in the output to employment ratio. “Real” output of a macroeconomy or producing sector is estimated as its value of output at market prices divided by an “appropriate” price index. For given nominal output growth, real growth will be higher if the price index increases more slowly. If one sector’s real output grows faster than another’s, then relative prices or the terms of trade will shift against the former.

Generalizing from experiences of raw material exporters, W. Arthur Lewis argued that if productivity growth in a poor country’s exporting sector is greater than the economy-wide average then the external terms of trade will tend to shift against that economy (an offsetting factor would be relatively fast productivity growth in a trading partner’s export sector). That is, generalized productivity growth is desirable if a country is to avoid a worsening trade position. Luigi Pasinetti re-invented Lewis’s idea, calling it a “principle of comparative productivity change advantage.” If the principle fails in a specific country, then via deteriorating terms of trade that country forfeits benefits of productivity growth to its partners.

Joseph Halevi and Peter Kriesler argue that during its post-World War II growth spurt Korea violated the principle, initially relying on Japan with its high productivity growth to provide imports of intermediates and capital goods. Later, it substituted many of these imports. Around the turn of this century, China followed in turn with Japan, Korea, and Taiwan providing imports to be assembled into final goods for sale in the USA, Europe, and Asia. Meanwhile, the combined East Asian economies run a trade surplus. Both economic and not strictly economic (including military!) interventions by the USA helped create and sustain the existing international trade and net lending configuration.

Pasinetti further pointed out that at the industry, national, or regional level, the ratio of employment to population will rise if growth of demand per capita exceeds growth of productivity. For Asia, increasing exports help satisfy this demand condition. The USA itself provides the key source of demand. At home, it violates the productivity growth principle, leading to hollowing out of production with low wage sectors having relatively robust demand but slow productivity growth.

Even in higher wage sectors consistent increases in profit shares have been the rule. To a large extent they have been driven by institutional changes supporting wage repression. Perhaps the pandemic will create enough harm to ordinary Americans to drive them to increase labor militancy and spark cost-push inflation. Then the game for the interest and exchange rates could change dramatically.

Existing trade and production relationships all support the dollar’s role as the world’s hegemonic currency subject to Robert Triffin’s paradox. Even with robust offshore currency markets, an increasing supply of dollar liabilities is needed to finance trade and serve as central bank reserves. The US economy must run an external deficit to grow that supply. With a little help from friends in East Asia and Northern Europe, American structures of production and trade have evolved to meet Triffin’s needs.

See original post for references

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  1. Sound of the Suburbs

    In the US, the 1920s roared with debt based consumption and speculation until it all tipped over into the debt deflation of the Great Depression.
    No one realised the problems that were building up in the economy as they used an economics that doesn’t look at debt, neoclassical economics.

    At the end of the 1920s, the US was a ponzi scheme of over-inflated asset prices.
    The use of neoclassical economics and the belief in free markets, made them think that over-inflated asset prices represented real wealth accumulation.
    1929 – Wakey, wakey time

    Why did it cause the US financial system to collapse in 1929?
    Bankers get to create money out of nothing, through bank loans, and get to charge interest on it.
    What could possibly go wrong?
    Bankers do need to ensure the vast majority of that money gets paid back, and this is where they get into serious trouble.
    Banking requires prudent lending.
    If someone can’t repay a loan, they need to repossess that asset and sell it to recoup that money. If they use bank loans to inflate asset prices they get into a world of trouble when those asset prices collapse.
    As the real estate and stock market collapsed the banks became insolvent as their assets didn’t cover their liabilities.
    They could no longer repossess and sell those assets to cover the outstanding loans and they do need to get most of the money they lend out back again to balance their books.
    The banks become insolvent and collapsed, along with the US economy.

    When banks have been lending to inflate asset prices the financial system is in a precarious state and can easily collapse.
    If you don’t want a Great Depression, you had better save those bust banks.

    The ponzi scheme of inflated asset prices that collapsed in 2008.
    “It’s nearly $14 trillion pyramid of super leveraged toxic assets was built on the back of $1.4 trillion of US sub-prime loans, and dispersed throughout the world” All the Presidents Bankers, Nomi Prins.
    When this little lot lost almost all its value overnight, the Western banking system became insolvent.
    Western taxpayers had to recapitalise the banks and make up for all the losses the bankers had made on bad loans they had made to inflate asset prices.

    What can the central bankers do to save the financial system from collapse?
    Keep pumping up asset prices.
    When asset prices collapse, so does the financial system.

    The recipe for disaster:
    1) The belief that you are creating wealth by inflating asset prices.
    All that price discovery stuff gets everyone thinking you are creating wealth by inflating asset prices.
    2) Letting bank credit flow into inflating asset prices.
    Neoclassical economics doesn’t consider debt and so no one notices the private debt building up in the economy.

    1. Sound of the Suburbs

      The fundamental flaw in the free market theory of neoclassical economics that was discovered by the University of Chicago in the 1930s.
      The money creation of bank loans can inflate asset prices.

      The US trusted free markets in the 1920s, but by the 1930s, the free market thinkers at the University of Chicago were in the doghouse. The free market thinkers at the University of Chicago were just as keen as anyone else to find out what had gone wrong with their free market theories in the 1920s.
      In the 1930s, the University of Chicago realised it was the bank’s ability to create money that had upset their free market theories.
      The Chicago Plan was named after its strongest proponent, Henry Simons, from the University of Chicago.
      He wanted free markets in every other area, but Government created money.
      To get meaningful price signals from the markets they had to take away the bank’s ability to create money.

      Henry Simons was a founder member of the Chicago School of Economics and he had worked out what was wrong with his beliefs in free markets in the 1930s.
      Banks can inflate asset prices with the money they create from bank loans.
      Henry Simons and Irving Fisher supported the Chicago Plan to take away the bankers ability to create money.
      “Simons envisioned banks that would have a choice of two types of holdings: long-term bonds and cash. Simultaneously, they would hold increased reserves, up to 100%. Simons saw this as beneficial in that its ultimate consequences would be the prevention of “bank-financed inflation of securities and real estate” through the leveraged creation of secondary forms of money.”
      Real estate lending was actually the biggest problem lending category leading to 1929.
      Richard Vague had noticed real estate lending balloon from 5 trillion to 10 trillion from 2001 – 2007 and went back to look at the data before 1929.

      Henry Simons and Irving Fisher supported the Chicago Plan to take away the bankers ability to create money.
      “Stocks have reached what looks like a permanently high plateau.” Irving Fisher 1929.
      This 1920’s neoclassical economist that believed in free markets knew this was a stable equilibrium.
      He became a laughing stock, but worked out where he had gone wrong.
      Banks can inflate asset prices with the money they create from bank loans, and he knew his belief in free markets was dependent on the Chicago Plan, as he had worked out the cause of his earlier mistake
      Margin lending had inflated the US stock market to ridiculous levels.

      The IMF re-visited the Chicago plan after 2008.
      It looks like they did have some idea what the problem was.

      You just need to keep bank credit out of the markets.

      1. Sound of the Suburbs

        In the 1930s, Hayek was as the London School of Economics trying to put a new slant on old ideas, while the Americans were working out what had gone wrong in the 1920s.
        In the 1940s, Hayek put together his theories of the markets being a mechanism for transmitting the collective wisdom of market participants around the world through pricing. It was never going to get into the mainstream until nearly everyone had forgotten what happened last time they believed in the markets.
        In 1950, Hayek left the London School of Economics. After spending the 1949–1950 academic year as a visiting professor at the University of Arkansas, Hayek was brought on by the University of Chicago.
        Here comes trouble.
        Hayek threw his weight around and forced the University of Chicago to accept his own half-baked ideas about the markets. He had learnt nothing from the problems of the markets in the 1920s.

      2. skippy

        All lending is secondary to contractual standards and government laws E.g. control frauds, predatory behavior, et al, all whilst wage earners saw their PPP as a ratio of productivity go whoosh and the top income strata go parabolic.

        Banks are a symptom of the ideology which enabled all the above and then some, something the Chicago school was a primary agent of change.

        LSE and Hayek is a bit of pettifoggery considering his effect on the CS and his elite funded international perches.

        1. Sound of the Suburbs

          Hayek and “The Road to Serfdom” are very important in the story.
          You see both crop up, time and time again.

          Why did the University of Chicago move away from their earlier understanding of the markets?

          You need to know how things really work to see the potential problems.
          When policymakers think banks are financial intermediaries, they can’t see the potential problems.

          Our knowledge of banking has been going backwards since 1856.
          Credit creation theory -> fractional reserve theory -> financial intermediation theory
          “A lost century in economics: Three theories of banking and the conclusive evidence” Richard A. Werner
          Today’s policymakers could convince themselves “debt doesn’t matter” as it doesn’t appear to when banks are financial intermediaries, but they aren’t.
          They don’t know banks create money, so they can’t see how they can inflate asset prices.

  2. Sound of the Suburbs

    The Americans used to enjoy the exorbitant privilege of having the global reserve currency.
    Then they forgot how it used to work and felt they needed to balance the budget.
    US Government bonds (US Government debt) are actually the main saving instrument in the global economy and so they could just run up Government debt to cover their trade deficit, but they forgot.
    Trump keeps going on about the trade deficit, because he’s forgotten all about the exorbitant privilege the US used to enjoy having the global reserve currency.

    This is the US (46.30 mins.)
    The private sector going negative is the problem as you can see in the chart. This is when the financial crises occur.
    When the Government deficit covered the trade deficit they were fine, but then they tried to balance the budget
    As the Government goes positive, into Bill Clinton’s surplus, the private sector is going negative causing a financial crisis.
    The current account deficit/surplus, public deficit/surplus and private deficit/surplus are all tied together and sum to zero.

    Richard Koo used to work in the Federal Reserve Bank of New York and is only too familiar with the flow of funds in the economy.
    Central banks use the flow of funds to see what is going on in the economy, it sums to zero.
    It’s essentially the same as the chart of the US above (46.30 mins.), but divides the private sector into household and corporate sectors to give more information on what is happening in the economy in monetary terms.

    This is Japan when they had a financial crisis in the early 1990s, the Government was running a surplus.
    Richard Koo shows the graph central bankers use, and it’s the flow of funds within the economy, which sums to zero (32-34 mins.).
    Richard Koo’s graph of the flow of funds shows the Japanese Government ran a surplus as the financial crisis hit.
    The terms sum to zero so, as one is going positive, another is going negative.
    The Government was going positive, as the corporate sector was going negative into a financial crisis.

    The equation
    The current account deficit/surplus, public deficit/surplus and private deficit/surplus are all tied together and sum to zero.

    The old rules of thumb
    Balanced Government budgets AND balanced current accounts
    This is OK.

    If you run a large current account deficit (trade deficit) and balance the Government budget; the private sector will be driven into debt, and this will cause a financial crisis.

  3. Jesper

    it would appear that the ‘savings glut’ includes the assumption that it does not matter how the savings are distributed. A ‘savings glut’ where the savings are held by the few differs quite a lot from a savings glut where the many have savings.
    As an example: the people working in iPhone factories might not agree (with the fairly common opinion among economists) that they have saved too much and not spent enough….. The workers might say that they have no savings at all as they are so underpaid and spending more would be a dream.

    Possibly another assumption was that if savings aren’t producing high enough of a return then the people at the top would pay higher wages as it wouldn’t matter. But it does matter, the people at the top are in it for the power and keeping others poor is a way of keeping themselves in power. What we saw instead was making it easier for people to get into debt and by keeping people in debt then an additional measure of control is introduced – more power.

    Simplified models can be useful and they can be dangerous. The simplified model of ‘savings glut’ is in my opinion of the more dangerous kind.

    1. eg

      In “Trade Wars are Class Wars” Klein and Pettis describe how Chinese workers (for example in the iPhone factories) are vastly underpaid compared to their productivity(40% of production goes to pay labour there compared to the average of 70% outside China) — the outsize profits accruing therefore to the firms, which renders Chinese workers unable to consume what they produce, resulting in production “dumping” into the deficit countries.

      There’s more to it than this, but it’s an important piece of the puzzle.

  4. Michael Hudson

    Taylor’s thesis has been used a despicable defense of U.S. Cold War military policy, by distracting attention from its role. It avoids looking at the actual balance-of-payments statistics, which show the U.S. private sector to be in balance, and almost ALL the deficit resulting from U.S. military spending.
    Table 5 of the Commerce Department’s balance of payments reports used to bring this out, but stopped – I was told specifically because of my analysis in Super Imperialism.
    The US spends military money abroad. This ends up in foreign central banks, above all China, Germany, etc., with whom countries receiving U.S. military spending run deficits.
    Central banks don’t buy stocks and bonds or companies. There is only one real vehicle for their reserves: U.S. Treasury securities.
    So the U.S. military spending deficit actually is recycled to FINANCE the U.S. federal budget deficit.
    My book Super Imperialism (a new edition will be out this winter) explains this in detail.

    1. Anon II, First of its Name


      I have read a lot of your work and generally find it quite informative, but I don’t quite understand your point above (which , I realize, you have made many times before)

      My understanding is that foreign capital inflows into the US force the US dollar up and interest rates down. This forces the US to run some sort of deficit to balance the equations (Savings = Investment globally, and if other countries have an imabalance in their domestic savings and investment levels, the difference must be made up by the countries that are silly enough to accept the foreign savings inflows, even though they cannot do anything productive with the money).

      For whatever reason, the US chooses to “counter” of “offset” some of this capital surplus by military spending abroad. Therefore, foreign US military spending is a dependent, not an independent variable.

      So I guess I am very genuinely curious as to why you believe that the military spending is the independent variable instead of the dependent one. Also, is there a way to test your hypothesis?

      Thank you!

  5. JTMcPhee

    So we can derive from the above, the following:

    1. A lot of some stuff called money happens.

    1(a). There’s no agreement on what money actually is, but somehow it works.

    2. A lot of material stuff and thought-up stuff happens.

    3. A lot of complicated shit happens in the movement of that stuff called money and the movement of the material stuff and thought-up stuff.

    4. A lot of people generate a lot of words in the process of claiming credit for understanding all the stuff that goes on in connection with 1, 2, and 3, though they pretty much don’t agree to one degree or another.

    5. A very few people understand enough about what goes on in 1, 2, and 3, and also direct how 1, 2 and 3 go, to end up with ownership of almost all the money and material and thought-up stuff.

    6. The people in 4 get paid a lot of money and stuff for explaining how 5 comes about.

    7. Somehow all the resources of the planet are getting used up.

    Seems clear enough to this observer.

  6. Chauncey Gardiner

    Appreciate this post and regret that I came to it late. Feel that Taylor’s final paragraph is particularly noteworthy, but that he does not adequately consider the role of the global bank network in the global eurodollar system or financial markets, which gives them enormous geopolitical and policy power leverage globally, including within the US itself. Seems to me there is a not insignificant price being paid for the work-around to Triffin’s paradox.

    Based on this article in Reuters yesterday, it appears that China’s monetary policy makers are quite aware of the power of the banking network:


    In negotiations it might be useful to keep Napoleon’s observation in mind:

    “When a government is dependent upon bankers for money, they and not the leaders of the government control the situation, since the hand that gives is above the hand that takes. Money has no motherland…”

  7. Spoofs Desu

    Whenever these kinds of dynamics and issues are discussed in detail, what never seems to be addressed is “why is there a reserve currency in the first place?” What problem is it solving? Clearly the article discusses the current problems it is creating.

    A few days ago NC posted yet another article of why the dollar will remain a reserve currency. Answer: because there is nothing to replace it as a reserve currency.

    So, why do we need a reserve currency? If we dont need it, in any economic sense, then doesnt it portend that we don’t need anything to replace it? Especially in light of all the social costs?

    1. UserFriendly

      Not having one would seriously hinder our ability to come out of depressions and would trigger frequent bank runs, lock us into a deflationary bias, it would also drastically roll back international trade. (and by drastically I mean more than we actually want to roll it back to the point where there would often be shortages of various items.)
      Alternatively, we could have an extra national organization (probably the BIS or IMF) with its own currency be the reserve.

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