My Blog

June 4, 2008

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.

Comments (18) for "Chinese savings and US defic...

While there was a savings glut after the Asian Crisis (something that we ought to be mindful of for americans after the current crisis), net impact of that on the US economy was exaggerated by policy mistakes. In their effort to soften the blow of the tech bubble and to singlehandedly solve the world's deflationary problem in the early 2000s, the Fed kept rates too low to disincentivize US domestic savings and led to overconsumption. These overseas savings came in and they got primarily deployed in the capital markets (the shadow banking system as opposed to the real banking system) leading to the current crisis. Therefore, while savings glut was the cause, Fed policies were the facilitator. This is the opposite of what the ECB is doing right now. By keeping rates higher, they are curtailing domestic consumption and making sure that domestic savings remain high and the savings from asia do not get deployed there. By livingston - 6/3/2008 10:13 PM

<i>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</i> Don't you mean "must lead either to a reduction in savings elsewhere or an increase in global investment"? By Richard Warfield - 6/3/2008 11:33 PM

Interesting post. One question (perhaps the subject of a future post?) is the expected endgame. What happens? Would the yuan fall? But this is what the 1.4 trillion in US treasuries the PBoC has is for, no? On the other hand, has there been any time in history where a financial crisis led a country's currency to appreciate, up to 6/USD (or whatever the 'fundamental' value is), to make imbalances disappear? By A Chan - 6/4/2008 12:08 PM

Stimulating post. I am siding with Stephen Roach and common sense on this issue. With my fellow US bloggers (dollarcollapse, sudden debt, undollars and quite a few others) against most US academia and Wall Street. High deficits and most specifically high external ones - whatever their nature - have no place in a rich country (that applies to mine as well...). There is no significant value per se at "over-consuming". It is the natural inclination of human nature, both on an individual and a collective basis and bears no value in itself even when properly distributed (not even the case anymore). The richest country in the world, by all standards of wealth, should be providing net cash against long term investment around the planet. It did in the 20s. I challenge China to get its money back from the boomer-centered-as-well US demography. Just a decent percentage on the principle (inflation-free). It won't. No more than US got its money back from Europe and South America at the beginning of the 30s. By François - 6/4/2008 4:49 PM

Our enormous trade deficit is rightly of growing concern to Americans. Since leading the global drive toward trade liberalization by signing the Global Agreement on Tariffs and Trade in 1947, America has been transformed from the weathiest nation on earth - its preeminent industrial power - into a skid row bum, literally begging the rest of the world for cash to keep us afloat. It's a disgusting spectacle. Our cumulative trade deficit since 1976, financed by a sell-off of American assets, is now approaching $9 trillion. What will happen when those assets are depleted? Today's recession may be just a preview of what's to come. Why? The American work force is the most productive on earth. Our product quality, though it may have fallen short at one time, is now on a par with the Japanese. Our workers have labored tirelessly to improve our competitiveness. Yet our deficit continues to grow. Our median wages and net worth have declined for decades. Our debt has soared. Clearly, there is something amiss with "free trade." The concept of free trade is rooted in Ricardo's principle of comparative advantage. In 1817 Ricardo hypothesized that every nation benefits when it trades what it makes best for products made best by other nations. On the surface, it seems to make sense. But is it possible that this theory is flawed in some way? Is there something that Ricardo didn't consider? At this point, I should introduce myself. I am author of "Five Short Blasts: A New Economic Theory Exposes The Fatal Flaw in Globalization and Its Consequences for America." To make a long story short, as population density rises beyond some optimum level, per capita consumption begins to decline. This occurs because, as people are forced to crowd together and conserve space, it becomes ever more impractical to own many products. Falling per capita consumption, in the face of rising productivity (per capita output, which always rises), inevitably yields rising unemployment and poverty. This theory has huge ramifications for U.S. policy toward population management (especially immigration policy) and trade. The implications for population policy may be obvious, but why trade? It's because these effects of an excessive population density - rising unemployment and poverty - are actually imported when we attempt to engage in free trade in manufactured goods with a nation that is much more densely populated. Our economies combine. The work of manufacturing is spread evenly across the combined labor force. But, while the more densely populated nation gets free access to a healthy market, all we get in return is access to a market emaciated by over-crowding and low per capita consumption. The result is an automatic, irreversible trade deficit and loss of jobs, tantamount to economic suicide. One need look no further than the U.S.'s trade data for proof of this effect. Using 2006 data, an in-depth analysis reveals that, of our top twenty per capita trade deficits in manufactured goods (the trade deficit divided by the population of the country in question), eighteen are with nations much more densely populated than our own. Even more revealing, if the nations of the world are divided equally around the median population density, the U.S. had a trade surplus in manufactured goods of $17 billion with the half of nations below the median population density. With the half above the median, we had a $480 billion deficit! Our trade deficit with China is getting all of the attention these days. But, when expressed in per capita terms, our deficit with China in manufactured goods is rather unremarkable - nineteenth on the list. Our per capita deficit with other nations such as Japan, Germany, Mexico, Korea and others (all much more densely populated than the U.S.) is worse. In fact, our largest per capita trade deficit in manufactured goods is with Ireland, a nation twice as densely populated as the U.S. Our per capita deficit with Ireland is twenty-five times worse than China's. My point is not that our deficit with China isn't a problem, but rather that it's exactly what we should have expected when we suddenly applied a trade policy that was a proven failure around the world to a country with one sixth of the world's population. Ricardo's principle of comparative advantage is overly simplistic and flawed because it does not take into consideration this population density effect and what happens when two nations grossly disparate in population density attempt to trade freely in manufactured goods. While free trade in natural resources and free trade in manufactured goods between nations of roughly equal population density is indeed beneficial, just as Ricardo predicts, it’s a sure-fire loser when attempting to trade freely in manufactured goods with a nation with an excessive population density. If you‘re interested in learning more about this important new economic theory, then I invite you to visit my web site at OpenWindowPublishingCo.com where you can read the preface, join in the blog discussion and, of course, buy the book if you like. (It's also available at Amazon.com.) Please forgive me for the somewhat "spammish" nature of the previous paragraph, but I don't know how else to inject this new theory into the debate about trade without drawing attention to the book that explains the theory. Pete Murphy Author, Five Short Blasts By Pete Murphy - 6/4/2008 8:43 PM

Murphy: Our workers have labored tirelessly to improve our competitiveness. Yet our deficit continues to grow. Our median wages and net worth have declined for decades. Our debt has soared. One problem here is that the world no longer divides clearly into "us and them." Wages and net worth are booming in some parts of the United States, decreasing in others. Same is true in China. The concept of "competitiveness" in which countries "compete" with each other like racers in the Olympics doesn't make sense any more. If you look at the economic divisions today, they are almost all between group A which consists of people both in the US and China versus group B which also consists of people both in the US and China. I really can't think of any economic issue that is expressible in terms of US versus China anymore. Murphy: Falling per capita consumption, in the face of rising productivity (per capita output, which always rises), inevitably yields rising unemployment and poverty. Actually it doesn't. If you have low consumption and high productivity, then you have massive savings which can be used to spend on infrastructure or public goods which then reduce employment and poverty. Most moral codes encourage low consumption and high productivity, but they need to be matched by economic policies that take advantage of the surplus. By Twofish - 6/4/2008 9:56 PM

"If you have low consumption and high productivity, then you have massive savings which can be used to spend on infrastructure or public goods which then reduce employment and poverty. Most moral codes encourage low consumption and high productivity, but they need to be matched by economic policies that take advantage of the surplus." I assume you are referring to the surplus of labor that will be available as a result of not having enough domestic consumption to gainfully employ your workers. If you have low consumption and high productivity, it is impossible to have anything other than high unemployment and poverty, unless you export that unemployment by preying on the markets of less densely populated nations while offering nothing in return - the solution employed by grossly overpopulated nations like China, Japan, India and so many others. In effect, nations like the U.S. are forced to pay the price of these nations' overpopulation. The American people are wising up and this won't go on much longer. By Pete Murphy - 6/4/2008 10:11 PM

thank you for the terrific reference to the Bibow paper By DMG555 - 6/5/2008 4:37 AM

Why is it "impossible to have anything other than high employment and poverty with low (per capita) consumption and high productivity"? How else can we sustain our ever increasing global population and insatiable demand on non-renewable resources. Had the utilization of oil per capita not dropped proportionately with the increasing population over the last 20 years, we WOULD have had poverty and high employment. Lower per capita consumption and higher productivity will shift economic activities from manufacturing and resource depletion to expanding and spawning new services, not unlike the birth of Broadway musical industry during the Great Depression, or the explosion of IT services in last 20 years. We can also expect and, more significantly, afford much more investment in scientific research and exploration, health management, technical innovation, education and even entertainment. If everyone consumes a little bit less but produces a little more, how can that be bad? By kelaido - 6/5/2008 8:56 AM

kelaido, please consider your last sentence: "If everyone consumes a little bit less but produces a little more, how can that be bad?" If everyone produces a little more, who will consume those products if everyone is consuming less? This is the very crux of the issue. Once an optimum population density has been breached - the point at which people are forced to crowd together to conserve space - then all of economists' pro-growth theories break down. Rising unemployment and poverty are inescapable without a return to a smaller population. Very densely populated countries can thrive for a while by manufacturing products for export, but the trade deficit imposed upon the importing countries will eventually collapse their economies, as is currently happening in the U.S., now close to bankruptcy. By Pete Murphy - 6/5/2008 7:24 PM

Richard, I would assume that if a rise in Asian savings weren't met with a decrease in savings elsewhere, we would get a "forced" increase in investment, i.e. rising inventories, that would eventually lead to a cut in production and employment, with a con-commitant cut in demand. Savings would eventually get back into balance because of a forced decline in savings that comes with a cut in production. That is why I don't think the solution to the current BoP imbalances is a forced increase in US savings (reduction in consumption). In my model that would only lead to a sharp global slowdown. By Michael Pettis - 6/6/2008 4:28 PM

As I argue in a recent post on my blog ( http://reservedplace.blogspot.com/2008/05/enigma-inside-conundrum.html ), if Asian reserves accumulation was the driver of global imbalances, spread product should have been relatively cheap when reserve inflows were strongest, because these flows tend to be directed into treasuries and agencies. I agree with Bibow that US booms have been a more plausible explanation. And if Asia has taken advantage of US booms to save more, that seems sensible to me, given the speed of the increase in Asian income and the ageing population in Japan and China. In fact the US would have been wise to prepare for the retirement of its baby boom. Providing that output can be shifted from consumption to investment, I do not see why a global increase in savings (which, in the absence of interplanetary trade, implies an increase in investment) should cause a reduction in growth at all. In fact, quite the opposite - the increase in capital stock should generate more output (although not consumption, as more output is required to maintain the capital stock until the time comes to run it down to provide for the elderly). By RebelEconomist - 6/7/2008 5:02 AM

By the way, as a citizen of the UK, I am highly sceptical of Pete Murphy's idea that a deficit in manufactured goods follows population density. We seem to have similar economic problems to the US, but we are twice as densely populated as China. By RebelEconomist - 6/7/2008 5:23 AM

Murphy: I assume you are referring to the surplus of labor that will be available as a result of not having enough domestic consumption to gainfully employ your workers. If you have low consumption and high productivity, it is impossible to have anything other than high unemployment and poverty. Or if you follow the Keynesian model of using government spending to employ people to work on public goods. Build schools, build roads, tear down the old roads and build new ones. Hire half of China to bury money and the other half to dig it up again. Set up an agricultural system that makes it intentionally difficult to combine plots of land thereby forcing people to use human labor instead of machine labor to do agriculture. The problem that you mentioned is known as the "paradox of thrift" and was pointed out by Keynes in the 1930's. It's hardly an unsolvable problem. By Twofish - 6/7/2008 8:04 AM

What you're suggesting is merely a redistribution of income across an ever larger population, and paying them with ever-more-worthless money. You're suggesting a dramatic reduction in productivity. That's not a solution. You may be able to claim that your people are employed, but the consequence of poverty remains. That's a "solution" that only an economist could come up with. By Pete Murphy - 6/7/2008 8:36 AM

Why does increased savings lead to lower consumption and employment? Are you talking about the short term as the economy transitions? If people are investing rather than consuming, their money is still being spent, except it is spent by business and entrepreneurs on productive goods, which will lead to higher growth in the future. Instead of working to satisfy current wants, many workers would be employed to satisfy future wants. By Matt - 6/9/2008 9:22 PM

pete murphy, take off your blinders By questioner - 6/9/2008 10:05 PM

"If people are investing rather than consuming, their money is still being spent, except it is spent by business and entrepreneurs on productive goods, which will lead to higher growth in the future." You don't get it. If people are unable to consume because of gross over-crowding (like in Japan, for example), it's not a matter of saving money now to consume in the future. They can never consume because there is no room to use and store products! The only way a nation like Japan can sustain its bloated labor force is by manufacturing for export. That's a nice solution for Japan but makes them a parasite for the rest of the world. The same goes for Korea, Germany, China and every other overpopulated nation that is feeding on the markets of less densely populated nations like the U.S. By Pete Murphy - 6/9/2008 11:34 PM