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Bernanke's savings glut
Wednesday, 04 March 2009 12:47

As we dig through the debris of the global financial crisis, it is instructive to go back over some of the warnings that were made -- like US Fed Chairman Ben Bernanke's 2005 speech on "The Global Saving Glut and the US Current Account Deficit". 


In 2004, the US current account deficit stood at close to $700 billion or 6% of GDP.  It had progressively ballooned from a modest $120 billion (1.5% of GDP) in 1996.  It is a regrettable reality that such a deficit on international transactions requires borrowing an equivalent amount.

Most people focus on the fact that a current account deficit represents a deficit in international trade in goods and services, and investment income.  It also represents the excess of national investment over savings, the shortfall of which is made up by net national borrowing. 

So, Bernanke asks why should the US, as the world's biggest and richest economy, be borrowing so much, rather than lending.  In short, he argues that a global saving glut developed over the decade, with low global interest rates.  This enabled the US to borrow more, and save less.  In 1985, US gross national saving was 18% of GDP.  By 2004, it had fallen to less than 14%!  Bernanke dismisses the argument that the expansion in the current account deficit was due to the government budget deficit.  For the first half of the period when the current account deficit was expanding, the federal budget was actually in surplus.

What caused the savings glut?  Savings for ageing populations in countries like Japan and Germany made some contribution.  But the main factor was a major turnaround in capital flows of developing and emerging economies which became borrowers instead of lenders.

In the mid-1990s, most developing countries were net importers of capital.  However, policy errors, inefficiencies and corruption led to financial crisis in Russia, and certain countries in Asia and Latin America.  In response to these crises many of these economies began building up foreign exchange reserves.  This necessarily means having a current account surplus. 

China also built up a war chest of foreign reserves as a buffer against potential capital outflows.  It was also a consequence promoting export-led growth by preventing exchange rate appreciation.  Much of these reserves ended up being used to buy US Treasury securities and other assets, rather than being used for domestic investment or consumption.  The rise in oil prices was another factor pushing countries from the Middle East, but also Russia, Nigeria and Venezuela, into current account surplus.

This tendency for developing and emerging economies to generate current account surpluses and capital outflows provoked adjustments in developed countries, particularly the US.  Capital flowed into the US, initially attracted by the technology boom, which boosted stock prices and the US$.  These factors created a rising trade deficit.  The other side of the coin was that investment rose, while the need to save declined. 

After the stock market decline beginning in 2000, investment waned while savings remained strong, so interest rates fell.  Then, low interest rates rather than high stock prices became the cause of lower US savings.  A major effect of these low interest rates was to support residential investment and to induce strong gains in housing prices.  Then the stock market recovery that began in 2003, and together with higher home values, this boosted wealth, and reduced the perceived need to save -- with the result of a rising current account deficit and increased dependence on foreign capital.

So, in short, events outside USA border have played a major role in the widening of the US current account deficit.  But why did so much of this global savings glut end up in the US.  There are a number of plausible reasons -- technoogy boom, financial market sophistication, US$ reserve country status.  But other countries which also experienced housing price booms also saw their current accounts move toward deficit -- countries like France, Italy, Spain, Australia and the UK. 

Is it desirable for developing and emerging economies to be lending so much money to developed countries.  In short, no!  First, workers in advanced countries already have large quantities of high quality capital with which to work.  Second, advanced countries should be saving for the ageing of their populations.  Third, when tax and financial systems encourage home owenership, such lending which ends up in real estate may not be the most efficient investment -- all the moreso, given that this debt has to be serviced and repaid by exports.    

Advanced countries should be running current account surpluses and lending to the developing world, not the other way around.  But for this to happen, developing countries would need to improve the conditions for investment by measures such as increasing macroeconomic stability, strengthening financial institutions, improving property rights, reducing corruption and removing barriers to capital flows.

What worried Bernanke most was how this current account deficit would unwind.  Although he was betting on a smooth adjustment, he was concerned about the risk of a disorderly adjustment. 

He was probably worried about a loss of confidence in the US$ provoking an adjustment in the current account deficit.  Little did he realise that all this housing investment was not only less productive than business investment, but it was plain lousy investment.  So, we are now seeing an adjustment in the US current account deficit, not through the $US, but through the biggest recession since the 1930s.

As Paul Krugman noted in his New York times column the other day, European miracle economies like Iceland, Ireland and Estonia also got dowsed by this glut and are suffering the pains now.  He goes on to argue that there is still a savings glut which has in fact created a paradox of thrift.  Shell-shocked consumers are hanging on to savings.  But since desired savings exceeds the amount businesses want to invest, this is dragging us further into the global slump.     





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