I was just sent a very interesting paper by German economist Jorg Bibow of the Levy Economics Institute of Bard College (The International Monetary (Non-)Order and the “Global Capital Flows Paradox”). In it the author considers the “paradox” of high and rising capital flows from developing to developed countries during the past decade. This is a paradox because most economic theory (and history) suggests that developing countries are net recipients of investment, not net providers.
This paper came at a good time for me. About two weeks ago I had dinner with three senior Peking University finance professors and a well-known and very smart American economist from one of the world’s leading investment banks. Not surprisingly, much of our conversation during dinner was about China and current monetary conditions.
The American economist and I agreed on most things concerning the financial system in China (and the rest of the world, for that matter) but we did have one disagreement, and that was on the global savings glut hypothesis. As I understand it, this hypothesis argues that policies or conditions that have caused a systematic increase in savings in several countries, primarily Asia, have resulted in the necessary corollary of compensating reductions in savings – or increase in consumption – elsewhere. As the only country deep enough and with a sufficiently flexible labor market and financial system, the US is the natural equilibrator, and so US savings must decline and the US run a current account deficit.
For the American economist the hypothesis of the global savings glut made no sense, but as far as I could see his main criticism of it was that it represented a political view which tried to put the “blame” for the current global imbalances on China, Asia, OPEC and anyone else except the US, where, he believed, it belonged. This is the same position as that of one of the best-known criticisms of the global savings glut hypothesis, which came in the form of a research note published by Stephen Roach of Morgan Stanley in July 5, 2005, in which he said “There may be a deeper and potentially more sinister meaning behind the saga of the global saving glut. In my view, it is being used as a foil to deflect attention from one of the world’s most serious imbalances -- the excess consumption of America’s asset-dependent economy.”
The American economist also argued at dinner that there has been no real increase in global savings, so therefore the idea of a global savings glut made no sense. Again, Stephen Roach’s piece made the same argument:
IMF statistics provide our best gauge of global saving. In 2004, the IMF’s global flow-of-funds framework put the world saving rate at 24.9% of global GDP. While that marks the second consecutive yearly increase in this measure, it is only 1.9 percentage points above the 23% norm that prevailed from 1983 to 2000. Yes, the global saving rate has edged up from its longer-term average, but this hardly qualifies as a glut.
I have addressed both of those very common criticisms before in my blog, but let me summarize very quickly why I think neither of them is valid. To address the first, the idea that competing theories are proposed largely to assign blame is something that I find of little value in this or most other economic debates. Furthermore, unlike many other analysts I do not think that such a large US current account deficit is unsustainable over the medium term. I also think the US-China “imbalance” has actually been better for the US than for China, and so I do not think it is necessary to find someone to blame for US conditions.
At any rate it is obvious, I think, that any imbalance requires at least two players, both of whom are necessarily to “blame” for the resulting imbalance. The point is to try to understand why and how the imbalance occurs. There is no question in my mind that loose monetary policy in the US and the fiscal cost of the Iraq war made it easier for the savings glut in one part of the world to balance a consumption “glut” in another, but without the excess savings driving the process the financing of the Iraq war would have created a very different set of outcomes.
The second point is, I think, easier to dismiss. The idea of a savings glut necessarily requires not an increase in global savings but rather a shift in the composition of global savings, in which the share of savings in the “glut” countries increases while the share of savings in the equilibrating countries decreases. It does not require, and in fact cannot require, an increase in total savings. In a closed system, like that of the global economy, capital and trade flows must balance. The only precondition, and hard evidence, we would need for a global savings glut is a major shift in the share of savings within the global economy and, ironically, Stephen Roach provides this very evidence in the same piece quoted above.
Alas, the devil is in the detail -- or, in this case, in the shifting composition of global saving and investment. Two main forces have been at work in reshaping this mix -- namely, a record plunge in the US saving rate matched by an equally large increase in the saving rate of the developing world, especially Asia. On the IMF’s basis, the US gross saving rate fell to 13.6% of GDP in 2004…That represents a 3.3 percentage point plunge from the 16.9% average that prevailed over the 1983 to 2000 period. By contrast, the IMF puts the saving rate in the developing world at 31.5% of its GDP in 2004 -- up a whopping 6.5 percentage points from its 1983 to 2000 norm of 25%. Reflecting the sharp increase in Chinese saving, developing Asia has led the way on the saving front; its overall saving rate is estimated to have surged to 38.2% in 2004 -- up dramatically from the 28.8% norm of the 1983 to 2000 interval.
That is exactly the point. A surge in Asian savings, reflecting especially a surge in Chinese savings, must lead either to a reduction in savings elsewhere or a significant slowdown in global growth. That is the source of the global imbalance and the justification of the global savings glut hypothesis.
What does all of this have to do with the Jorg Bibow paper that I mention in the very first line of this entry? Bibow also rejects the global savings glut hypothesis, but my understanding of his paper is that he agrees with much of what I understand the theory to be but rejects it on much narrower technical grounds – he claims that the saving glut hypothesis is based on the “fatally flawed” (his words) loanable funds theory. However his narrative of events seems very close to the one I and people like Brad Setser (also a proponent, I believe, of the global savings glut hypothesis) have developed.
But what interests me most is the data he provides in his paper (and you can see the accompanying graphs by following the link to his paper). First off, Bibow discusses the evolution of the US current account deficit over the past fifty years. Why is the US current account important? Because according to the global savings glut hypothesis, the US current account deficit is the almost automatic counterpart to the rise in Asian savings.
Basically, according to the data quoted in Bibow’s paper, the US current account has been within a range of a surplus of 1% of GDP and a deficit of 1% of GDP for most of last fifty years with two exceptions. The first exception occurred in the mid-1980s when the US current account deficit rose to nearly 3.5% of GDP in 1986-87 before declining sharply and running into a small surplus in 1990. The second exception began technically in 1994, around the time of the Mexican crisis, when the US current account deficit climbed to around 1.6% of GDP, before it began to decline again, but it really took off in 1997-98, when it raced forward in almost a straight line to peak, in 2006, at 6.2% of GDP.
If the US trade deficit was driven simply by an out-of-control US consumption binge, it is a little hard to see why it would have followed a pattern of general stability marked by two surges – a small one from 1984-1988 and a very large one after 1997. If it was driven by Asian savings, this pattern becomes a little easier to understand – or at least, what amounts to the same thing, we can posit a more plausible story to explain it.
I will ignore the 1980s surge because this post is already too long, but again one can tell a very plausible story based on Japanese trade policies and domestic savings. The post-1997 surge is much larger and more interesting. 1997 was, of course, the year in which several Asian countries, after years of tremendous growth and what seemed like invulnerable balance sheets, experienced terrifying financial crises and viciously sharp economic slowdowns, which profoundly impressed Asian policy-makers and has affected policy decisions to this day.
Since the main cause of the crisis seemed to be the sudden reversal of current account surpluses into substantial deficits, along with highly mismatched balance sheets in which large external obligations were mismatched with domestic and “hedged” with extremely low levels of foreign reserves, one of the main (if mistaken) lessons policy-makers learned was the need to run current account surpluses and to amass large foreign currency reserves to protect countries from a repeat of the disastrous crisis of 1997.
These countries, consequently, put into place decidedly mercantilist policies in order to achieve both goals – persistent trade surpluses and large amounts of foreign currency reserves. Unfortunately, these policies simply transformed the balance sheet risk and in many cases – that of China being the most notable – locked the countries into positive feedback loops in which trade surpluses and accumulating reserves (or, rather, the domestic monetary consequence of accumulating reserves) fed into and reinforced each other.
This (I think plausible) story is reinforced by another graph Bibow reproduces. The global capital flow “paradox” to which he refers in his title is the fact that developing countries are exporting capital to rich countries. According to his data, developing countries have always been net recipients of private capital flows – which is what one would have expected from most economic theory and history.
They have generally been net providers of official capital as far as foreign currency reserve accumulation goes, but for most of the last fifty years reserve accumulation on average was significantly less than net private inflows, so developing countries were net recipients of capital. (For much of the 1980s the balance on both was zero or close to zero, and I suspect that this reflects negative private flows to Latin American and others among the 32 defaulted or restructuring LDCs, as they were then called, netted against positive private flows to Asia.)
It is only in 1998 that reserve accumulation among developing countries begins to take off and by 1999 it exceeds net private capital flows to developing countries. This is when the “paradox” of net capital flows from developing to developed countries begins. Except for a small decline in 2001 net flows from developing countries surge almost in a straight line to around $700 billion annually (combining $1.2 trillion of reserve accumulation versus $0.5 trillion of net private flows).
I am sure there can be other competing explanations for the timing of these flows, but I am very impressed by the fact that Asian savings, as expressed in reserve accumulation, surged after 1997, as did the US trade deficit. Given the virulence of the 1997 crisis and the tremendous shock it provided to Asian policy-makers (and policy-makers in developing countries elsewhere), it seems to me that a very plausible argument can be made that it was the effect of 1997 that caused the shift in developing-country policies that led to the surge in savings and the corresponding increase both in trade surpluses and reserve accumulation. The surge in the US trade deficit after 1997 is also more easily explained by a shift in Asian trade policies and currency regimes than by a shift in US consumer preferences.
I am less familiar with the consequences of these policies elsewhere, but it seems to me that for now China has found itself locked into these mercantilist policies, except that in the past year we have seen a major shift take place that must force a sharp adjustment. The policies aimed at eliminating the risk of a 1997-style financial crisis have worked, but they have not eliminated the risk of crisis. Instead they have only transformed the risk of an external crisis into the risk of a domestic banking crisis.
What is worse, China’s reserve accumulation is no longer being driven by its trade surplus and is increasingly being driven by very unstable private (speculative) capital flows. I don’t have the data at hand, but I suspect (and this was also argued in the Reinhart/Rogoff paper, on which I commented three weeks ago) that when a developing country receives so much speculative capital, balance sheet vulnerability rises inexorably and the likelihood of a shock large enough to force an adjustment also rises. What happens to global savings and the US current account deficit after that, I am not really sure, but it is something I am trying to figure out.