On Aug 22, 2007, at 6:30 PM, Julio Huato wrote:
> In today's FT, Martin Wolf has a column in which he exculpates the Fed
> from the credit bubble -- at least partially. He lays some of the
> blame on the "savings glut."
Which is, of course, Bernanke's favorite explanation. It absolves the U.S. of any responsibility for consuming 70% of GDP, and attributes the U.S. c/a deficit mainly to forces outside the U.S.
> The article is worth reading, because he
> breaks down the "savings glut" into its component parts.
> Unfortunately, I can't fetch the article online now. (If somebody
> can, please post.)
The Federal Reserve must prolong the party By Martin Wolf
Published: August 21 2007 18:58 | Last updated: August 21 2007 18:58
“Over the past decade a combination of diverse forces has created a significant increase in the global supply of saving – a global saving glut – which helps to explain both the increase in the US current account deficit and the relatively low level of long-term real interest rates in the world today.” Ben Bernanke, chairman of the Federal Reserve.*
Has the Federal Reserve been a serial bubble-blower? Or has it been responding to exceptional macroeconomic conditions? Not surprisingly, the implication of Ben Bernanke’s celebrated speech on the global “savings glut” implies the second view. Yet his self-exculpatory perspective is far from universally shared. So who is right? My answer is both. The Fed can indeed be accused of being a serial bubble-blower. But this is not because it has been managed by incompetents. It is because it has been managed by competent people responding to exceptional circumstances.
The savings glut is a palpable reality. But it is important to be precise about what it means. What one means by a global savings glut is an excess of savings over investment (or income over spending) in much of the world, largely offset by an excess of investment over savings (or spending over income) in a limited number of countries among which the US is predominant. In 2006, the current account surpluses – or excess of savings over investment – in the countries with surpluses was about $1,300bn, or a sixth of the gross savings of the world, excluding the US. The US current account deficit absorbed close to two-thirds of this surplus. The US has been the world’s spender and borrower of last resort.
Since global long-term real interest rates have been modest, the argument that profligate US spending has been crowding out spending elsewhere is not credible. It is more plausible that excess savings elsewhere have been “crowding in” US spending.
How has this worked? Foreigners have been buying US assets on a vast scale. Between the first quarter of 2002 and the first quarter of 2007, foreign governments did supply as much as 48 per cent of the net financing of the US current account deficit. This should be viewed as “vendor finance”, intended to provide the US with money needed to buy the exports from countries providing the capital. To this extent, the US current account deficit has driven the capital inflow. But the US is still receiving a capital inflow that finances its vast current account deficit.
If foreigners are net providers of funds, some groups in the US must be net users: they must be spending more than their incomes and financing the difference by selling financial claims to others. The challenge for US policymakers is to ensure that these groups also spend enough to absorb the economy’s potential output. This required spending is in excess of potential gross domestic product by the size of the current account deficit. At its peak that difference was close to 7 per cent of GDP. More recently, it has come down to 5 per cent, as the dollar has tumbled, but also as the economy has slowed.
Who did the offsetting spending since the stock market bubble burst in 2000? The short-term answer was “the US government”. The longer- term one was “US households”.
The US government moved massively from financial surplus into deficit, the total swing being 7 per cent of GDP, between the first quarter of 2000 and the third quarter of 2003. It is right to criticise the structure of the Bush tax cuts. Yet once the stock market bubble burst, how could a deep recession have been avoided without a fiscal boost?
Now look at US households. They moved ever further into financial deficit (defined as household savings, less residential investment). Household spending grew considerably faster than incomes from the early 1990s to 2006. By then they ran an aggregate financial deficit of close to 4 per cent of GDP. Nothing comparable had happened since the second world war, if ever. Indeed, on average, households have run small financial surpluses over the past six decades.
The recent household deficit more than offset the persistent financial surplus in the business sector. For a period of six years – the longest since the second world war – US business invested less than its retained earnings. Businesses had become net sources, not users, of finance. One way of thinking of the private equity boom is as a tax-efficient way of extracting cash no longer needed by US (and other countries’) businesses.
What has all this meant for policy? The answer is simple: the Fed has, willy nilly, pursued a monetary policy capable of inducing a huge and unprecedented financial deficit among US households. This has, not coincidentally, also meant a rapid rise in household indebtedness. The vehicle through which this policy has worked has been asset-backed borrowing and lending, the activity that has so spectacularly derailed this year. To put the point more broadly, monetary policy normally works via asset markets. In the latest cycle, the most affected sector has been households, the vehicle asset market has been housing and transmission has been via securitised lending.
Nothing that has happened has been a product of Fed folly alone. Its monetary policy may have been loose too long. The regulators may also have been asleep. But neither point is the heart of the matter. Assume that the US remains a huge net importer of capital. Assume, too, that US business sees no reason to invest more than its retained profits. Assume, finally, that the government pursues a modestly prudent fiscal policy. Then US households must spend more than their incomes. If they fail to do so, the economy will plunge into recession unless something else changes elsewhere.
This is why the Fed is sure to cut interest rates if today’s crisis seems likely to reduce the supply of credit (as surely it will). Would that work or might the Fed find itself “pushing on a string”, as the Bank of Japan did so painfully in the 1990s and early 2000s? A good guess is that the policy would work. But if it did not, there would be only two ways out: a huge fiscal expansion in the US or a huge reduction in the US current account deficit. The former looks undesirable and the latter inconceivable.
Today’s credit crisis, then, is far more than a symptom of a defective financial system. It is also a symptom of an unbalanced global economy. The world economy may no longer be able to depend on the willingness of US households to spend more than they earn. Who will take their place?
* The Global Saving Glut and the US Current Account Deficit, March 10 2005 <http://www.federalreserve.gov/boarddocs/speeches/2005/200503102/ default.htm>