The Real
Issues: Economics
The Conundrum of Global Saving/Spending Imbalances: Why It's so Hard to Stop the Flood
By Charles Kirchofer, Jan. 29th, 2009
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In
the realm of international relations, analysts often look at events on
three levels: deep causes, intermediate causes, and precipitating
causes. The deep causes are often systemic effects, like the structure
of the international system. The intermediate causes are often related
to policies of countries and alliances they form. The precipitating
cause is generally just one event. I'd like to spend a little time
today talking about the deep causes of the current financial and
economic crisis. First, let me just mention what some of the individual
causes were.
The precipitating cause was, of course, the
bursting of the housing bubble. The intermediate causes were many and
varied. They mostly relate to policy and regulatory decisions. Mr. Mohr
and I have spent most of our time talking about those, so if you'd like
to know more, just check out nearly the all the articles we've written
on the subject of the financial crisis on the economics page. The cause
I'm going to talk about today is the deep one. It is particularly
problematic because it is global and very hard to control. I'm talking,
as the title suggests, about global imbalances in spending and saving
(i.e. global differences in current account surpluses and deficits,
which can also roughly be related to global trade surpluses and
deficits).
Everyone
knows the United States is the world's
largest debtor. This is partly because of its size, however. To put
things into perspective, household debt in the U.K. is actually higher
than in the U.S., and the U.S. is by far not the most indebted country
in terms of debt in proportion to GDP. (It makes sense to look at debt
as a proportion of GDP because $100,000 of debt a lot for a person
earning $20,000 a year, but chicken feed for a millionaire. The United
States, luckily, fits into the latter category). Nonetheless, the fact
that American households' saving
rate has been negative (the average household has been borrowing more
than saving in the past couple years) is obviously problematic.
The
usual solution to too little saving is to raise interest rates. Higher
interest rates means it costs more to borrow money and you get a higher
return when you save, thus encouraging saving and discouraging
borrowing. But household
saving rates are not the primary interest of central banks. In the
past, households spending more than they were
earning translated into inflation. Central banks are charged with price
stability (controlling inflation), and the U.S. Fed is also charged
with promoting growth. This time around all that borrowing didn't
result in inflation. This
left central bankers scratching their heads wondering what to do, and
if they needed to do anything at all.
The answer, as we now know, was: yes, you probably needed to do something, but this wasn't completely clear.
Would
raising interest rates have helped? It probably would have at least
mitigated the effects of some of the intermediate causes. Higher
interest rates earlier may have slowed the inflation of the housing
bubble and made its bursting much less dramatic. In addition, higher
interest rates mean a higher return on money saved in bank accounts or
government bonds, and lower returns for investments in stocks,
commodities, and real estate. There are certainly indications that this
would have been a good thing. As I've explained in past articles,
however, the Federal Reserve tended not to bother with asset price
inflation, concentrating only on currency inflation. As I've also said
before, I think this was a mistake (as it also is to leave real estate
prices out of the core inflation rate).
Of course it's not that
simple. Low interest rates meant people were encouraged to spend money
rather than save it. Most of the money that was coming in was coming from
outside the United States, since people inside were saving less than borrowing. The
problem with raising interest rates is that it could even make that particular
problem worse. Getting a higher return on savings in the United States
might have encouraged more capital inflows from abroad. In addition, it
would have further strengthened the dollar, encouraging America to
import even more, and hurting American exports further. This could
actually exacerbate the current account problem, making the deficit
larger. One way it might work in reverse is with energy. A stronger
dollar means imported oil would get cheaper. Cheaper oil would make a
smaller contribution to the trade deficit. Normally, however, a central
bank might seek to weaken a currency if it wanted to reduce imports.
But the way to weaken a currency is by cutting
interest rates, which would potentially have been even more disastrous.
Left with thuis conundrum, it was difficult to say what direction the
rate setters shouls take.
In addition, there's
evidence that suggests that the Fed no longer has complete control over
interest rates in America. As the Fed raised rates in 2004, Alan
Greenspan noticed that long term rates actually fell. This may be
because investors from China continue to want to offload money into the
United States and continue to offer cheap loans, regardless of what the
Fed does (and how low the return on the investment becomes).
Why
would China want to send so much money to the United States even though
interest rates were so low? This held the Chinese currency, the yuan,
lower and boosted Chinese exports. In addition, it made China stable.
Investors are less afraid to give someone money if the person (or in
this case, country) has a lot of money. The likelihood of the Chinese
Yuan collapsing was extremely slim, making China much safer than other
comparable developing countries.
For a while, however, it looked
like rebalancing might be
beginning. The dollar was sliding and the yuan
revaluing. U.S. exports were booming and holding the U.S. economy above
water. Then came the financial storm of October. After Lehman Brothers
collapsed, capital from all over the world fled from the smaller
currencies to the world's reserve currency, even though the crisis was
most acute in America and America was the world's biggest debtor. The
unexpected result: the dollar took off and nearly all
other currencies lost value against the dollar. That was it for
rebalancing and for the U.S. export boom (as an expensive dollar once
again made American exports too expensive and imports cheaper). The
yuan has also lost value
against the dollar, even though it, too, has gained considerably
against most other world currencies. The latter part is something
congressional leaders should keep in mind when considering any trade
tariffs or other protectionist measures.
As
I've illustrated, the
Fed is faced with an absolute conundrum. Raise interest rates, and the
trade deficit and inflows of capital increase, likely increasing
America's current account deficit. The incoming money then seeks
investments, quite possibly creating bubbles. Lower them, and Americans
save less and foreign investments from abroad must seek higher returns
(not in bank accounts or bonds),
possibly also leading to yet another bubble. What's a Fed Head to do? I
hate
to say it, but probably much as he has done, hopefully having learned
from the mistakes of the past eight years. The Fed should continue to
respond to domestic conditions. Right now that means keeping interest
rates low and fighting deflation and recession. Soon thereafter, it
could mean raising interest rates in response to inflationary fears,
but possibly also in response to asset price inflation or too-low
household saving rates. The Fed cannot control the U.S.'s current
account balance, so it must concentrate on sound policies for the areas
it can influence.
And
what about the imbalances? Sorry, there's no easy solution. With higher
interest rates the inflows might land in bank accounts and bonds, a
less dangerous place than stocks and other markets. I suspect
that as things right themselves in the financial markets, money will
begin moving to smaller currencies again, meaning the dollar will begin
to lose value again. A devaluing of the dollar while the Fed raises
interest rates to fight all-around inflation would be the perfect
scenario, but it is not alone within the Fed's power. Most of the time,
such
a development would be nearly impossible. It relies on net creditors
around the world seeing diminishing returns in America and slowly
investing their money somewhere else. Higher interest rates in China
with a smaller foreign currency reserve would allow the yuan to
revalue. This would make Chinese exports more expensive and increase
Chinese imports. This would do a lot to fix global imbalances and
increase global stability. China might have to accept lower growth
rates and higher interest rates, but in return it would gain a larger
domestic market and a more balanced (and therefore more stable, in the
long run) domestic economy.
It's important to note, of course, that this should all happen gradually. As I illustrated in my article on a dollar rout,
a rapid shift of investments away from the U.S. would present a
catastrophe of unbelievable proportions for the U.S. and the world.
So
it all comes down to the Chinese? Well, to them, the Americans, the
Saudis, and all others with massive current account imblances.. As much
as everyone else likes to blame the
Americans (and let's face it, the intermediate and precipitating causes
are
to be found in America), the entire world helped make the mess, and the
entire world must clean it up. I just hope that this will occur
naturally and gradually over time, without political fights and big
policy mistakes. The second part is definitely a big stretch, the first
part is hopeable.
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