The Global Savings Glut Argument

Brad Setser has musings on Ben Bernanke's "global savings glut" argument:

Brad Setser's Web Log: Bernanke's global savings glut: Bernanke's global savings glut argument is quite subtle, more subtle than I perhaps have recognized in the past. Bernanke's argument goes beyond the 'US current account deficits don't matter since there is a global savings glut' headline that I occasionally push.

Bernanke takes his argument that there is a global savings glut to its logical conclusion. He argues that without a federal budget deficit, the global savings surplus that was invested in US government debt over the past few years would instead have been invested in other US assets. Real interest rates would be even lower, housing prices would be higher, investment in housing would be higher, and consumption in the US would be even stronger. As a result, the US current account deficit would not be much different:

The weakening of new capital investment after the drop in equity prices did not much change the net effect of the global saving glut on the U.S. current account. The transmission mechanism changed, however, as low real interest rates rather than high stock prices became a principal cause of lower U.S. saving. In particular, during the past few years, the key asset-price effects of the global saving glut appear to have occurred in the market for residential investment, as low mortgage rates have supported record levels of home construction and strong gains in housing prices. Indeed, increases in home values, together with a stock-market recovery that began in 2003, have recently returned the wealth-to-income ratio of U.S. households to 5.4, not far from its peak value of 6.2 in 1999 and above its long-run (1960-2003) average of 4.8. The expansion of U.S. housing wealth, much of it easily accessible to households through cash-out refinancing and home equity lines of credit, has kept the U.S. national saving rate low--and indeed, together with the significant worsening of the federal budget outlook, helped to drive it lower. As U.S. business investment has recently begun a cyclical recovery while residential investment has remained strong, the domestic saving shortfall has continued to widen, implying a rise in the current account deficit and increasing dependence of the United States on capital inflows...

I find it easier to think about these issues if we formalize them. Start with the savings-investment side of the national income identity:

I = S_p - D_G + D_T

Investment I is necessarily equal to private savings S_p minus the government deficit D_G plus the trade deficit D_T. And start with the premise that savings outruns investment elsewhere in the world, and this shows us as a large U.S. trade deficit as savers abroad soak up the dollar earnings of foreign exporters and invest them in the United States.

As long as investment is still high--as long as we are still in the dot-com boom--then, Bernanke says, U.S. private savings can be normal. But after the dot-com boom ends and investment falls, the savings-investment identity no longer balances: with lower-than-normal investment (especially business investment) as a share of GDP and a large capital inflow associated with the trade deficit, something else has to change in order to keep the savings-investment identity in balance. One thing that changes is the government deficit. But the rise in the government deficit is not sufficient--the private savings term S_p has to fall as well.

What makes S_p fall? Well:

S_p = Y - T - C = Y - T - (C₀ + C_y(Y-T) + C_wW(r)) = (1-C_y)(Y-T) - C₀ - C_wW(r)

Private savings, in Bernanke's implicit model, is equal to a fraction (1-C_y) of disposable income (Y-T), minus a term C₀ that depends on consumer confidence, minus a term C_wW(r) that tells us that private savings drops when household wealth W increases--and household wealth increases when the interest rate falls.

Thus the chain of causation in Bernanke's model runs roughly like this:

After the end of the dot-com boom, U.S. domestic investment falls as a share of GDP and the capital inflow rises. Excess savings thus appear in the flow-of-funds market. These excess savings push down interest rates. As real interest rates fall wealth--especially household real estate wealth--rises. Rising wealth induces households to cut their savings until the flow-of-funds is back in balance.

In this model the federal budget deficit is a minor player. As Brad Setser says, the implicit prediction is that it does not affect the trade deficit. Had the Bush administration pursued a balanced-budget policy there would still have been a fall in investment and there would still have been a rise in the capital inflow. With a balanced budget, excess supply of savings in the flow-of-funds would have been greater. Interest rates would have fallen further. Housing prices would have risen further. And private savings would have fallen further. After all:

I - D_T = S_p - D_G

And if D_G does not grow as D_T grows, then S_p must fall by more--and the only thing that can make S_p fall is an increase in household wealth W, which is the result of falling interest rates r.

This is Bernanke's argument. What do we think of it?

I'm very skeptical. It is of a brand of macro that I think of as one-identity-economics. You take an accounting identity. You assume that certain terms of it are fixed. And you then derive conclusions--in this case, that the growth of the budget deficit has moderated the fall in private savings.

The problem with one-identity-economics lies with the assumption that certain terms in it are fixed. There are lots of channels of adjustment in the world economy, and it is a safe bet that with different levels of interest rates and different levels of wealth we would see different levels of corporate investment and of net exports.

Comments

[edward]

Adroitly sidestepping the issue you raise Brad, I think Bernanke's speech does introduce one very important idea into the debate: that the 'global savings glut' may in part be produced by demographic changes. I think this recognition marks an important step forward in getting to grips with the 'global imbalances', 'shortage of growth engines' problems.

I think the evidence is abundantly clear that consumer spending in high average age societies like Japan, Germany , Italy and Switzerland is flatlining. These societies can now only achieve sustained growth by exporting.

The 'structural reform' argument, whilst valid per se, simply doesn't address this issue. Bottom line, whatever the weaknesses in Bernanke's argument, I was really pleased to read the speech since I have been pushing this part of the argument for some time now, and it seems to be gaining traction.

[Lee A. Arnold]

"one-identity economics." Is Pareto optimality one-maximum economics?

[anne]

Much to my concern, I am increasingly drawn to Edward High's demographic arguments. Friends in Japan are entirely sympathetic. I have discounted the effects thinking demographic changes simply occur too slowly for there not to be adjustment, and yet....

[MTC]

The key line is this one:

"And start with the premise that savings outruns investment elsewhere in the world..."

If you start with this premise--that the non-English speaking world is chained to a treadmilll of thrift, incapable of devising any means of enjoying the fruits of its labors, non erit finis--then the mathematical entities balance in the way described.

[anne]

"And start with the premise that savings outruns investment elsewhere in the world, and this shows up as a large U.S. trade deficit as savers abroad soak up the dollar earnings of foreign exporters and invest them in the United States."

Remember, this is Brad DeLong modelling Ben Bernanke's comments.

[MTC]

I am not criticizing. I am merely noting that this is the crucial assumption, the one that Edward feels is demographically determined. It is more than a little odd that the countries running the largest current account deficits (i.e., where I > S-Dg) are all the big English-speaking advanced industrial economies (the exception being Canada, the NAFTA dollar co-dependant).

[Robert Waldmann]

One problem I have with the Bernanke story as interpreted by Brad and Brad (the bb via bb story) is that it doesn't mention the huge role played by East Asian central banks.
I guess Bernanke thinks that they are buying dollar denominated assets, because they have to export, because they consume too little. However, if his story about real interest rates causing high consumption applied in East Asia the story could go US profligacy puts downward pressure on the dollar, the chicoms are not totally convinced by bourgious critics of mercantilism, so they support the dollar. This huge capital deficit keeps interest rates high in the PRC restraining consumption and investment (so they only gorw 7% a year). That is, they could absorb their product perfectly well if they weren't making themselves feel poor by buying dollar denominated assets and locking them up.

Now Bernanke knows a bit about banking, so he probably has good reason to think that low real interest rates have a big effect on demand in the US and not in East Asia. In fact, I think I understand his view (helps to know how banks in flat lining countries behave).

Brad's further asks above, why does anyone but East Asian central bankers accept low returns on dollar denominated assets ? This is a more convincing criticism than mine.

[Robert Waldmann]

Ooops I mean below (when dumping on Ben Stein)

[anne]

Criticize away :) but Australia in addition to America is running a sizeable trade deficit and has long done so despite being a natural resource rich economy. There is a sizeable government deficit in Australia, and consumption exceeds production and is made up by importing savings. What is interesting to note is how well Australia fared during the Asian currency crisis, and how rebust the Australian dollar continues to be. What then do we make of Australia?

[bakho]

Left out of his model is any discussion at all about INCOME DISTRIBUTION. If incomes in Asian and developing countries were distributed more equally or if more money was directed at building infrastructure in those foreign homes, the money would not be pouring into the US. Instead it would be going to build water and sanitation projects, developing health care infrastructure and improving education. If trade deficits are causing dislocations in the American economy, maybe it is time that we start reviewing world economic policy that allows such large schisms between haves and have nots?

[tea]

Anne,

Australia does NOT run a bidget deficit. In fact, it has been running a surplus the past three years! Also, Australia's government debt at less than 20% of its GDP is one of the lowest in the world.

[pgl]

His argument might be seen as two-sided if one were to accept the implicit premise of a very large elasticity of savings with respect to interest rates. But then would this implicit assumption of high elasticity be reasonable?

[kharris]

I understand that the actual performance of the US housing/mortgage sector offers some support to Bernanke's argument. Still, it seems odd to me that in Bernanke's model, the quality "US asset" is more important that qualities of risk, liquidity, valuation or just about anything else. Is that what we expect from rational portfolio decisions? Or do foreign investors have reason to think that the bundling of mortgages provides very Treasury-like qualities? Or that foreigners would simply bid for a constant supply of Treasury debt, no matter the supply, thereby forcing US investors out of Treasuries and into mortgages? Why is it that any old US asset is preferable, in Bernanke's argument, to non-$-denominated assets similar in most other regards to Treasuries? Why wouldn't the glut of savings end up to a far greater extent in Europe (where 10-year rates are only about 80 bps away from US rates, and would arguable be even closer if the US had no federal deficit) or Canada or Brazil?

[Jean-Philippe Stijns]

Thinking of China, isn't it odd that this poor but high growh rate country is lending to the US, the richest country in the world with a comparatively low growth rate, and one facing a demographic crisis (think health care) at that. Pardon my candeur but I can't see this kind of flows as the result of the aggregation of rationally optimizing behaviors. As some have hinted above, this anomaly can only be explained and sustained by the reciprocaly enabling government policies of China and the US. Besides, I am surprised that Bernankee does not seem to think (from what I have read) that, high-brow theory apart, low private saving rates in the US might have anything to do with the Fed's monetary policy. Mmmm.

[anne]

Tea

I know, I know. I was playing at being a little ironic about the comment on the sameness of English speaking economies. Australia has a government budget surplus and has had, nonetheless there is a trade deficit. Quite a different mix from ours. Thank you, Tea.

[rjw]

"And start with the premise that savings outruns investment elsewhere in the world, and this shows up as a large U.S. trade deficit as savers abroad soak up the dollar earnings of foreign exporters and invest them in the United States."

A couple of earlier comments picked this paragraph up. This is indeed a key point. If you start from accounting identities, and you have a large trade deficit, then of course you can diagnose this by saying that the problem is savings outrunning investment elsewhere in the world - a savings "glut". The problem with this is that it is, as Brad notes, arguing causality on the basis of an identity.

In other words, if the US runs a deficit then, by definition, the net increase in US assets held by those outside US the over a period counts as 'saving' to them - but this is just an accounting identity and does not tell you anything (behaviourally) about why the deficit came about. For that you have to look at the shifts in stocks and flows and the behaviour that underpins them.

As I see it there are two (at least) mechanisms in the savings ‘glut’ story - one related to stocks, and one related to flows.

The first possible story (stocks) is the 'big pool of money' theory - that there was a big pool of money 'out there' that decided to land in the US, driving up the exchange rate, lowering interest rates, and allowing a US consumer boom as part of an asset allocation adjustment by the “rest of the world”. Here the savings "glut" is another term for excess demand for US assets.

The obvious question though is - where did this excess demand for assets come from? In other words, how come the “rest of the world” found its portfolio in disequilibrium and decided to effect a massive shift into US assets, driving down yields and kicking off a boom? Well - to dig deeper you have to ask: Who holds these US assets? Why have they chosen to increase their holdings? Is this really an active or a residual shift into US assets?

The second (flow related) story is the 'structurally spendthrift american' story (or the structurally thrifty foreigner story?). Here we see the US consumer, buoyed up by the good years of the 90s and a serial liking for imported goods racking up huge bills on credit, while demand elsewhere is sluggish, and the rest of the world accumulates dollars by default. Here the savings "glut" essentially means that others are not spending enough. Here we could point to evidence on saving rates, world demand growth, import propensities and so on, to reach a view.

Now, a problem in discussing these things is that these two mechanisms – stocks and flows - are not entirely independent. There are feedbacks.

To see this, suppose the real initial driver is “excess” American consumption – a very low saving rate and unusually rapid growth leading to a current account deficit. This leads the rest of the world to accumulate dollars as the counterpart to the current account deficit. But of course – they don’t have to hold the extra dollar assets – they could dump them – thereby driving down the dollar and pushing up interest rates. This would put a brake on the “excess” US consumption.

But now suppose this does not happen – suppose that the accumulation of US assets by foreigners occurs steadily without any noticeable effect on the dollar or rise in US interest rates. One might then argue that the “real” driver of the current account deficit is foreigners “demanding” US assets, keeping interest rates down, which drives the spending flows through both income and wealth effects, and thereby widens the current account deficit.

My own view – for what it is worth – is that the flows have driven the stocks. The US has a strong propensity to low saving rates and high consumption of exports. The long boom of the 90s pumped the economy up so far that you sucked in huge amounts of exports due to the very rapid relative demand growth. The rest of the world accommodated this via an elastic demand for US assets. In some cases this elastic demand is the counterpart of the desire to maintain an under valued exchange rate peg against the dollar.

What is a little surprising is that the rest of the world has carried on doing this amount of financing of the US even as the economy dipped and the administration reacted to the downturn with a massive (if misdirected) fiscal stimulus and a ballooning budget deficit, in tandem with the Fed keeping short rates low. It’s surprising because the key conditions for foreigners to have an elastic demand for dollar assets – a degree of fiscal discipline, policy credibility, a prospect of a dollar appreciation…. Well – none of these things seem well anchored right now.

[Alex]

maybe Bernanke is partially correct in that his theory explains one of the current dynamics in world economics even as there are other dynamics ongoing at the same time.

doesn't the solow growth model say that there is an optimum level of savings that allows the world economy to grow = to the % change in productivity + the % growth in population. If world savings are above that level (for whatever cultural/demographic/economic reaons) then for a certain amount of time the global cost of capital declines, investment intensity increases until a new equilbrium is reached? and if certain parts of the world economy are unnatractive to capital becuase of lack or transparancy, property rights, or some other economic factor, that just drives more savings/investment and/or consumption to the rest of the world (like the US)

[nate]

observations:
1. people in U.S. have lots of debt and low savings.
2. the fed govt passed new entitlement spending for prescription drugs

possible investment hypothesis:
look for obscure drug companies that sell insomnia drugs. this market may grow tons in the future - the growth may surprise pro analsyts- (please do not automatically start writing about Luskin because I am applying macro insights to investing)