The New Global Savings Glut and the Politics of Imbalances

Neil Irwin:

But it’s not just the United States and Japan. Name a country with three elements—a stable political system, a credible central bank to call its own, and a free flow of capital across its borders—and it has, right now, extraordinarily low interest rates. That’s true for Canada and Australia (10 year yields of 1.85 percent and 3.36 percent), of Switzerland and Sweden (0.55 percent and 1.6 percent). Britain, certainly (1.94 percent), but even some countries that don’t technically fit our classification because they lack their own central bank (Germany at 1.42 percent and France at 1.99 percent. That would be the same France that The Economist, in a cover story last month, called “the ticking time bomb at the heart of Europe.”).  

So what is going on? Interest rates are, essentially, the relative price of money today versus its value in the future. And investors are saying that they don’t need very much compensation to delay their spending for the future, as long as they can feel secure that they will get their money back and that the money they get back will be worth roughly what they put in. 

To put it a different way, around the world there are all sorts of savers—pension funds, wealthy individuals in emerging nations, governments that want to ensure they have reserves put aside in case there were to be a run on their currency—for whom the goal is not so much to get a big yield on their savings, but rather to ensure that they will get their money back when they need it.

I may have more to say about this over the coming weeks as I'm writing a book chapter related to the topic, but for now let me just mention that this isn't only about the domestic factors that Irwin describes. It is also related to broader developments in the global economy in recent decades. The only development model which has sustained success is export biased: emerging economies export resources and consumer goods to developed countries. Second, the opening up of global trade has increased reliance on comparative advantage, thus benefiting the owners of the abundant factor of production. Third, the decline in capital controls have allowed financial flows to increase markedly. These three factors have led to a world where trade flows constitute 60% of global GDP, international financial balance sheets are 150% of global GDP ($100 trillion), and income inequality has increased markedly.

But it also means that the global economy is fundamentally imbalanced: developing countries must run persistent current account surpluses, while developed countries must run persistent current account deficits. These must be offset by financial transactions: developed countries essentially hand over IOUs to developing countries. And this process must be indefinite; or, rather, they must continue until the whole world has reached roughly equivalent levels of development, until a new political system makes the export-biased development model impossible (restrictions on trade and/or capital movement), or until the imbalances reach a tipping point and a crisis ensues.

The question is what deficit governments should do in this environment. Irwin suggests that they should take advantage of cheap finance to make domestic investments in infrastructure and education. Another option is to try to reduce the probability of a future (domestic) crisis by balancing the books. In the 1990s they largely chose the latter, which ended up leading to crises in the developing world as imbalances unwound. In the 2000s they chose the latter, which ended up leading to crises in the developed world as imbalances fueled asset price bubbles in real estate and sovereign debt.

The story of the 2010s will be how these imbalances are managed.

Global Political Economy QOTD

Yglesias:

Whatever else [austerity] does, it should certainly succeed in persuading European governments that stockpiling foreign exchange isn’t just for Asians anymore. If the world succeeds in coming out through the other side of this crisis, you should expect to see even more countries joining the perpetual surplus brigades leading to even more demand for safe dollar denominated financial assets. That, in turn, means either big U.S. budget deficits or else some bold new innovations in financial engineering to meet the demand.

The rest of the post is well worth reading. I'm not sure this is the right way to think about the next 10 years, but it's certainly one way to do it. And it's a scary way to do it, since we don't seem to be good at channeling the global savings glut into productive uses.

Misc IPE Developments and Research...

... That I won't properly blog.

-- US and Mexico finally reach agreement on cross-border trucking. This issue has been festering since NAFTA's beginning, but came to a head a few years ago when Mexico got fed up and enacted retaliatory tariffs. To be clear: the US has been in the wrong here all along. Via Greg Weeks on Twitter, who also noticed Chomsky criticizing Chavez.

-- US, EU, and Mexico win case against China in the WTO over Chinese restrictions of exports of rare earth metals. China said the restrictions were for environmental reasons, but they were pretty clearly intended to benefit domestic manufacturers by subsidizing the price of an important input into production.

-- Brazil's real continues to rise, and they don't like it. Is this what adjustment looks like? And is it just me, or do all of Latin America's major economies look fairly fragile right now?

-- John Quiggin has an excellent series of posts [1, 2, 3] on what remains of Marxism if we ditch the assumption that revolution is both necessary and sufficient for positive social change. The answer, it seems to me, is very little that we can't get elsewhere. I've been thinking about this a lot lately, prompted by this awful book by Terry Eagleton (and even worse promo essay). I will probably be returning to the topic eventually.

-- Chinn, Eichengreen, and Ito do a "forensic analysis" on global macro imbalances in the run-up to the crisis. They aren't very optimistic about corrections in the near future. And Chinn describes an important-looking paper by Rose and Eichengreen on the effects of abandoning currency pegs for gaining policy flexibility elsewhere.

-- Tim Harford explains what all the fuss about bank capital is about. Excellent intro for those unfamiliar with the topic.

-- An aggravated take on the current US political economy of banking and bailouts.

-- The BIS compares the internationalization of the 2008 banking crisis, as compared to the 1931 banking crisis. The takeaway is that we only got a Great Recession (Little Depression? What are we calling this?) in 2008 because the lack of a gold standard allowed large liquidity injections.

-- Ha-Joon Chang and Jagdish Bhagwati debate the merits of a strong manufacturing base in The Economist. I wonder if the vote tally is a sign of the times? Ryan Avent adds some levity.

-- Cosma Shalizi reviews the new Easley-Kleinberg book on networks in The American Scientist. A free pre-print of the book is still available here (very large pdf).

Why Imbalances Will Persist, For Awhile At Least

Martin Feldstein is bullish on macroeconomic imbalances, and walks through the relevant savings-over-investment accounting identities (pdf available here). I recommend reading the whole thing, as its short and gives a very good overview of the situation. Basically, what he's saying is that the U.S.' current account deficit can be, and likely will be, shrinking sharply over the coming years, and it may disappear entirely:

Feldstein imagines the U.S. national saving rate rising by 2% of gross domestic product and budget deficits declining to 3% of GDP from 8%, producing a combined saving rise of 7% of GDP.

“These assumptions about private and public saving may be too optimistic but they indicate that closing the U.S. current account deficit is potentially feasible,” he said.

Meanwhile, China is directing more investment internally–spending more on health care, education and housing–as it looks to raise living standards.

“If China reduces its national saving rate from the current 45% of [gross domestic product] to 40% without a corresponding fall in investment, the result would be to shift China from having a current account surplus to a current account balance or even a small deficit,” he said.

If savings increase in the U.S. and investment does not, our current account deficit necessarily narrows. Likewise, if savings shrink in China and investment does not, their current account surplus necessarily narrows. It's as simple as that, and yet the political and economic forces behind those movements are a bit more complex. So as an outline of what is feasible his analysis is correct. As an outline of what is likely I'm not so sure. I do think imbalances will shrink some over the coming years, but probably not as much as Feldstein alleges. Here's why.

It will likely take five or more years for the U.S. to get back to full employment, which means that the public deficit is not likely to shrink to 3% of GDP any time soon. Politicians talk a lot about that, and so do voters, but I haven't seen any real momentum to get it done. In the meantime, as the financial sector strengthens and the real economy stays weak (prompting the Fed to continue to make cash available at low rates), credit will likely become more available more rapidly than incomes rise. When that happens I would expect savings rates to grow less slow or even decline. Moreover, the continuing aging of the population means that more and more of us will be drawing down private (and public) savings rather than building them up.

It's true that China is allowing the RMB to appreciate at 5% a year, and that internal inflation changes the real exchange rate faster than that, but it's not clear how long those two things will persist. If China has its own property bubble that then pops, we may see savings rates there increase or at least hold steady. Or we may see lower growth rates that again cause savings to go up as wealth creation drops. To me, political reform will have to happen in China before major economic reform happens, and that doesn't seem likely over any short time horizon. In any case, China is only one country, so even if the bilateral Sino-U.S. imbalance lessens, U.S. imbalances with other countries might increase. If enough of that happens simultaneously the overall effect is not clear.

Consider Europe. Europe's real exchange rate has depreciated fairly significantly over the past few years, and Germany has benefited from that as an export-oriented economy. Is it likely that the euro will appreciate much over the next few years? It doesn't look that way to me. How about Africa? While not without problems, several African countries have been growing recently, and the medium-run prospects for the region appear to be improving. This development will likely occur by running current account surpluses with Europe and the U.S. Meanwhile, resource-exporters in the Middle East and elsewhere will continue to benefit from increasing demand and will maintain high current account surpluses.

The politics of current account imbalances is clear: there is no coordination now, and as the global economy remains weak there is not likely to be. Everyone wants everyone else to adjust. Eventually this will change, since things cannot persist this way forever. But over the time period Feldstein is talking about I'm not so sure.

Interesting New Research

Monday is the day that the NBER releases its working papers for the week, and sometimes there's some interesting stuff. This week, for example. I haven't had the chance to actually, you know, read any of these papers, but here's a few abstracts that caught my eye:

Why Have Economic Reforms in Mexico Not Generated Growth?

Timothy J. Kehoe, Kim J. Ruhl
NBER Working Paper No. 16580

Following its opening to trade and foreign investment in the mid-1980s, Mexico’s economic growth has been modest at best, particularly in comparison with that of China. Comparing these countries and reviewing the literature, we conclude that the relation between openness and growth is not a simple one. Using standard trade theory, we find that Mexico has gained from trade, and by some measures, more so than China. We sketch out a theory in which developing countries can grow faster than the United States by reforming. As a country becomes richer, this sort of catch-up becomes more difficult. Absent continuing reforms, Chinese growth is likely to slow down sharply, perhaps leaving China at a level less than Mexico’s real GDP per working-age person.

This analysis jives with my priors, and also with a lot of things I've been thinking about lately. One point is that we probably expected too much from Mexico, which never had as much room for development as China or the Asian Tigers. Another is that not all development is the same. China has been able to mobilize large factors of production that were essentially idle a generation or so ago. Mexico was not in the same position. Yet another is that we cannot, and should not, expect China's meteoric rise to continue at pace indefinitely. Michael Pettis wrote a good post on this point recently, drawing the obvious analogy to Japan. Mexico has problems with inequality and the environment, but they pale in comparison to China's. Right now China's state is more consolidated than Mexico's, but we should probably expect it to become more sclerotic over time. Mexico's demographics are also much more favorable for future stable economic performance. Obviously comparing the development record of any two countries is problematic, but we should recognize that Mexico has done fairly well over the past generation, and has a good opportunity for sustained growth in the future.

An ungated version of this paper is available from the Minneapolis Fed here.

Classification, Detection and Consequences of Data Error: Evidence from the Human Development Index

Hendrik Wolff, Howard Chong, Maximilian Auffhammer
NBER Working Paper No. 16572

We measure and examine data error in health, education and income statistics used to construct the Human Development Index. We identify three sources of data error which are due to (i) data updating, (ii) formula revisions and (iii) thresholds to classify a country’s development status. We propose a simple statistical framework to calculate country specific measures of data uncertainty and investigate how data error biases rank assignments. We find that up to 34% of countries are misclassified and, by replicating prior studies, we show that key estimated parameters vary by up to 100% due to data error.

Measurement problems with the HDI have been well-known for a long time, but this is the first paper I've seen that tries to reestimate the index after correcting some of these problems. Also note that the 2010 HDI report uses a new methodology than previous reports. Didn't hear much about that? Perhaps it's because the U.S. moved up to #4 (behind only Norway, Australia, and New Zealand) in 2010, from #13 in 2009. I strongly favor using a variety of well-being measures to rank outcomes in countries; GDP is too crude to be used for everything. But other indices have their own problems, among them measurement errors and the necessity of a "philosophy of weights", i.e. how much importance to give what factors in creating the index. These choices are often motivated by normative concerns. A more open and nuanced discussion of these issues is good.

An ungated pdf is here.

Financial Crises, Credit Booms, and External Imbalances: 140 Years of Lessons

Òscar Jordà, Moritz Schularick, Alan M. Taylor
NBER Working Paper No. 16567

Do external imbalances increase the risk of financial crises? In this paper, we study the experience of 14 developed countries over 140 years (1870-2008). We exploit our long-run dataset in a number of different ways. First, we apply new statistical tools to describe the temporal and spatial patterns of crises and identify five episodes of global financial instability in the past 140 years. Second, we study the macroeconomic dynamics before crises and show that credit growth tends to be elevated and natural interest rates depressed in the run-up to global financial crises. Third, we show that recessions associated with crises lead to deeper recessions and stronger turnarounds in imbalances than during normal recessions. Finally, we ask if external imbalances help predict financial crises. Our overall result is that credit growth emerges as the single best predictor of financial instability, but the correlation between lending booms and current account imbalances has grown much tighter in recent decades.

Thomas may find this one interesting. I have a feeling that when I read it I'll be asking for a political explanation for the growth in credit and imbalances pre-crisis. I'll reserve more substantive comment until I've had a better chance to look it over.

An ungated pdf is here.

Balancing Act

Just to piggy-back off of Dr. Oatley's post below. Geithner wants to cap current account surpluses or deficits at 4% of GDP. What effect would that have? Well, U.S. GDP is roughly $14tn. 4% of that is $560bn. In other words, a persistent 4% deficit in the current account is still quite large. Large enough that during most periods the U.S. was well within that boundary, though not during the mid-2000s. As the picture above shows, only in the last few years has the U.S.'s balance of payments been that sharply out of balance. (Note: that is nominal yearly data.)

What's interesting to me about the G20 kicking around these types of proposals are the distributional implications:

Representatives of the world’s largest economies, meeting in South Korea, reached tentative agreement early Saturday on the need to rein in trade imbalances, as part of an American-brokered compromise on calming exchange-rate tensions that have threatened to disrupt the uneven global recovery.

The Obama administration on Friday urged the other economic powers that make up the Group of 20 to agree to curb persistent surpluses and deficits that could contribute to the next financial crisis.

The proposal, which included a numerical limit, was backed by South Korea and quickly drew support from Britain, Canada and Australia. But it met with resistance from Germany and ambivalence from Japan, both major export countries. China, whose currency battle with the United States has threatened to derail the process of global economic cooperation, did not formally weigh in.

So after a marathon negotiating session that stretched into the predawn hours Saturday, the G-20 representatives agreed on the goal of “reducing excessive imbalances” — without a specified limit — and called on the International Monetary Fund to examine the causes of “persistently large imbalances.” The draft statement, to be ratified later Saturday, will also call on countries to “refrain from competitive devaluation” of their currencies, officials said. ...

Four countries have current-account surpluses exceeding 4 percent: Saudi Arabia (6.7 percent), Germany (6.1 percent), China (4.7 percent) and Russia (4.7 percent.) But under the American proposal, countries like Russia and Saudi Arabia that are “structurally large exporters of raw materials” would be exempt from the 4 percent limit, so the pressure would have fallen on China and Germany.

Two G-20 countries have current-account deficits larger than 4 percent: Turkey (5.2 percent) and South Africa (4.3 percent). The United States is next, at 3.2 percent.

A lot of stuff in here. First note that, once again, the expansion of the G7 to the G20 seems to have made it practically impossible to reach meaningful agreements with actionable language. How to reduce these imbalances? Umm... How much should they be reduced? No hard limit. What is the consequence of not reducing imbalances? None that I can see.

Of course the most important thing is who is reducing imbalances. As Dr. Oatley noted, it doesn't matter what countries like Turkey and South Africa do. Nor Russia or Saudi Arabia. It only matters what the U.S., China, and Germany do. The U.S. is under the proposed 4% limit, so is it any surprise that that is the level Geithner picked? It's the number that directly targets China and Germany, and to a lesser-extent Japan. The U.S. is trying to make China, Germany, and Japan pay for international macroeconomic adjustment. No wonder that those countries immediately rejected a firm requirement.

Meanwhile, Justin Fox notes that Keynes proposed something very similar during the Bretton Woods discussions:

Not impossible-to-enforce targets, but a system with incentives built in that would have made big trade imbalances unattractive to both sides. There’s that little matter of creating a new global currency and getting everybody to accept it, but this was at the tail end of World War II. If the U.S. had decreed that the International Clearing Union was a go, the International Clearing Union would have been a go. But at the time, the U.S. ran big trade surpluses and assumed it would do so forever. Its delegates at the Bretton Woods meetings were vehemently opposed. So the idea went nowhere.

Imagine that! Powerful governments decided not to pursue actions that went against their domestic interests. Who could have foreseen it?

The same dynamics are still at play even if some of the roles have reversed, so asking the IMF to investigate causes is a waste of time. China, Germany, and Japan have strong domestic political incentives to pursue policies that generate large current account surpluses. Their political survival depends on continued economic growth, and their economies are so structured that growth has to come largely from exports. The IMF will surely highlight the policies that lead to these outcomes, including exchange rate machinations, but it won't matter because they won't address the underlying political processes that generate the policies in the first place. Even if leaders wanted to bite the bullet and reverse these policies, their domestic constituents wouldn't allow it.

If the U.S. wants to address this issue, it's going to take much more than a vaguely-worded G20 communique. It will have to build a large constituency of other large economies. It will have to find a way to appease Germany and Japan while isolating China. It will have to massively boost domestic savings. And it will have to push a binding agreement through the IMF or WTO. That's a very tall order right now, and I don't see how they can pull it off. As the NYT article linked above notes:

Desmond Lachman, a former I.M.F. official now at the American Enterprise Institute in Washington, praised Mr. Geithner’s message. “It’s a constructive and imaginative proposal and it broadens the discussion away from an exclusive focus on currency to the wider set of policies needed to bring balance about,” he said. “But if you don’t have the Germans and the Chinese, this isn’t going to go very far.”

He added: “They want the U.S. to reduce its deficits, but they don’t want to reduce their surpluses.”

And vice versa.

Politics of Hard Times - Macroeconomic Imbalances Edition

Yesterday morning I attended a panel at the annual American Political Science Association meeting on the macroeconomic and global responses to the financial crisis. Organized by Jeff Frieden of Harvard, the purpose of this panel was to discuss ways to revitalize theory building around the political economy of adjustment. Speakers included former chief IMF economist Raghuram Rajan , former Mexican president Ernesto Zedillo, and UNC professor Layna Mosley (MA thesis advisor to Will, Alex, and me). Overall, I found the discussion fascinating, although I wish that there had been more discussion about whether current conceptual and methodological tools are adequate for this task. Here's a quick run down of some main themes that emerged:

1) Current explanations of the Great Recession tend either to be mainly a macroeconomic imbalance story (without much political economy) OR a political story about regulatory failure due to rent seeking at the domestic political level. IPE scholars need to spend more time thinking about the political economy behind macro imbalances, and the complex interests and institutions that lead to variation in national economic policies. The question hear is why do some structurally important states become borrowers and why do others become lenders? Why do some governments adjust in time to structural imbalances and why don't others?

2) What are the political and economic consequences of an international political economy characterized by some states running persistent current account deficits while others run persistent current account surpluses? Rajan is particularly worried that an increased focus on export-oriented growth is creating a vicious cycle in which countries that would normally be in the best position to stimulate counter-cyclical AD can't because of enduring weakness in the domestic market. If I'm not mistaken, this point speaks to a running debate between Will and Thomas. (Perhaps someone wants to weigh in?)

3) How does growing inequality affect the politics of adjustment? Discussion on inequality focused mostly on the US and stems from Rajan's argument in his recent book, Fault Lines: How Hidden Fractures Still Threaten the World Economy. Rajan argues that technological changes are decreasing the wage advantages traditionally afforded by a college education, and that this effect is particularly important in thinking about inequality more around the 80/20 divide (I have no data on this - I'm assume this is in his book which I'm planning on reading after taking my Methods Comp). For him, the story here is that politicians have dealt with this growing inequality in the most politically expedient way - extending credit to those down the bottom of the distribution. Of course, the point here is that dealing with inequality this way leads to asset bubbles as we saw this time around. (This is the response to Will's post yesterday about performance pay and wage inequality. Rajan's take on this would be that democratic governments have to deal with inequality some way (even if some of rising inequality is merit based, as the 2007 NBER working paper suggests), and the problem is that the quick fix for elected officials is to pursue policies that do not change underlying structural inequality but also lead to increased demand for imports and financial instability.)

4) How has the Great Recession changed the way we study how governments choose to engage markets? This is Layna's main question and speaks to questions about how governments manage their debt, the role of official entities that hold sovereign debt on the rates states must pay to borrow, and whether the idea that advanced industrial countries have "room to move" still holds.

5) What are the prospects for macroeconomic policy coordination and global governance of capital markets when governments are dealing with the domestic politics of adjustment? Zedillo is particularly pessimistic about the future of economic interactions, especially between the US, the Eurozone, and China. Audience member Dan Drezner voiced concern about the politics of fiscal policy as more politically insulated monetary policy tools become less effective at managing downturns.

From my perspective, the take-away from this panel was that we just don't have a robust understand of the political implications of an international political economy with such deep structural macroeconomic imbalances. In order for IPE gain some explanatory purchase over the question panel members raised, we really have to re-conceptualize how to study IPE as a complex dynamic system. It is too easy to revert to a domestic political explanation. What states can do is constrained both by domestic and international politics and economics.