LOSING CONTROL (9 page)

Ben Bernanke, the Chairman of the Board of Governors of the Federal Reserve, famously referred to these imbalances as ‘The Global Savings Glut’.
²
The argument boils down to a matter of supply and demand in the capital markets.
If the rapidly expanding US current-account deficit reflected a rise in US demand for global capital, that increased demand should have raised the ‘price’ of capital.
In other words, US interest rates should have gone up to attract the additional funds US borrowers wanted to suck in from abroad.

This didn’t happen.
For the most part, US interest rates have not only been low but persistently lower than the vast majority of economists expected.
³
Put another way, the US borrowed in size precisely because interest rates were so low.
Interest rates were low, in turn, because countries elsewhere in the world were generating huge amounts of surplus savings.
It wasn’t so much, then, that a rising demand for loans in the US was driving interest rates up, but, rather, that a rising
supply
of loans outside the US was driving interest rates down.
Americans may have a reputation as spendthrifts, but, on this interpretation, their high levels of indebtedness were merely a response to high levels of saving elsewhere in the world which lowered the cost of borrowing.

One of the big messages from the Asian economic crisis in 1997 and 1998 was that emerging economies could sometimes struggle under the burden of huge capital inflows.
At that time, many emerging economies ran current-account deficits.
In other words, domestic
investment was higher than domestic saving, requiring inflows of capital from abroad to balance the books.
These capital inflows were too often invested in unsound property deals or corrupt business ventures, leading to accusations of ‘crony capitalism’.
As foreign investors took fright, capital left Asia and headed elsewhere.
Without the inflows, Asia could no longer maintain its earlier standard of living: demand fell, imports dropped, exchange rates plummeted and economies collapsed.

The Asian crisis demonstrated two things.
First, in their hunt for yield, Western investors were happy to chase returns regardless of the risks involved.
Second, Asian countries were not able to offer the depth or sophistication of capital markets that could easily handle the inflows associated with the hunt for yield.
⁴

For some Asian policymakers, the Asian crisis offered a remarkably simple lesson (through both the law of unintended consequences and the hunt for yield, this lesson undoubtedly contributed to the 2007/8 sub-prime crisis and the credit crunch that followed).
Many Asian leaders – and, indeed, policymakers in other emerging economies – decided to build war chests of foreign-exchange reserves to protect themselves against the risk of future balance-of-payments and currency crises.
Their motives were entirely understandable.
In some cases, their economies had shrunk in the late 1990s at a double-digit rate.
They needed the economic equivalent of a force field to prevent any reoccurrence.
The force field came in the form of persistent – and, in some cases, persistently rising – current-account surpluses.
Domestic savings started to outstrip domestic investment.
The surplus savings had to go somewhere.
Ultimately, through rising foreign-exchange reserves, they were invested by emerging-market central banks in safe and liquid US Treasuries, demonstrating a level of risk aversion not normally shown by private-sector investors.
Yields dropped, US households borrowed more and consumer spending boomed.

This is a neat argument, but it doesn’t quite let policymakers off the hook.
Knowing that American consumers were borrowing more because interest rates were lower does not mean they
should
have been borrowing more.
After all, no one argues that the increase in drug usage that follows a fall in the street price of crack cocaine is a good thing, even though it’s a perfectly reasonable example of the market at work.

The influence on the world’s capital markets of savings behaviour in emerging economies is, in fact, considerably more complicated than the simple global savings glut thesis suggests.
And, because this influence has not been properly recognized, the Western world has been subject to increasing financial shocks.

While many countries shifted from current-account deficit to surplus, one emerging Asian economy started with a large current-account surplus and saw the surplus get bigger and bigger over time.
China wasn’t significantly affected by the Asian crisis.
Why, then, did it allow its current-account surplus to rise so much?
Why did it resist exchange-rate appreciation, at the risk of facing the wrath of an angry US Congress?
Why was it seemingly unable to stimulate domestic demand sufficiently to bring its current-account surplus down to a level that would have made the US happier?

The answer that finds favour in a US Congress with its finger on the protectionist trigger is that China has deliberately manipulated its exchange rate in the pursuit of a mercantilist trade policy.
According to this argument, the rise in China’s foreign-exchange reserves in recent years demonstrates that China has deliberately undervalued its exchange rate in the pursuit of a rising share of global trade.
⁵

It is certainly true that China’s share of world trade has risen.
It’s equally true that, had the Chinese allowed the renminbi to rise
further in value, Chinese foreign-exchange reserves would probably be a lot lower.
But are these really signs of a mercantilist policy or, instead, are they indications of something more fundamental?

One of the most striking features of China’s economy is the combination of a very high level of capital spending within total gross domestic product together with a substantial current-account surplus.
Many countries with high investment shares in total domestic expenditure do not have sufficient domestic funds to support the investment and, as a result, they depend on inflows of foreign savings.
In other words, they run current-account deficits.
China has such high domestic savings that it can afford to fund huge amounts of domestic capital spending and still have more than loose change to send abroad in the form of what, post-millennium, proved to be the single biggest current-account surplus in the world.

Arguing that the high level of domestic savings stems from a deliberately undervalued exchange rate is, at best, misleading and, at worst, no more than protectionist posturing.
China’s labour costs are dramatically lower than those in the developed world.
No amount of nominal exchange-rate appreciation is going to change this simple fact of economic life.
Indeed, were the renminbi to rise dramatically, the chances are either that Chinese wages would fall (because of the greater difficulty in exporting products) or that US wages would rise (in response to higher import prices).
Chinese wages are low because of China’s lack of development over hundreds of years.
Chinese workers do not expect to be paid, and nor can they command, the wages received by Americans: exchange-rate manipulation will not be enough to change this underlying economic fact.

Moreover, even if Chinese wages did rise to American levels over time, there is no particular reason to believe that China’s current-account surplus would materially decline.
To understand why, you need only look at economic developments in Japan, China’s near neighbour and long-term rival.

Japan is a rich country.
Despite the economic problems of the last two decades, the Japanese enjoy per-capita incomes that compare very favourably with rich countries elsewhere in the world.
Over the last forty years, the Japanese yen has steadily appreciated against the world’s other major currencies.
In the early 1970s, a dollar would buy more than ¥300.
By the 1980s, a dollar would buy, on average, around ¥200.
In the new millennium, a dollar was sufficient to buy a paltry ¥114.
If nominal exchange-rate appreciation is supposed to remove global imbalances, Japan’s experience should surely support this claim.

But it doesn’t.
In the 1970s, Japan’s current-account surplus averaged 0.7 per cent of gross domestic product (GDP).
In the 1980s, the surplus had risen to 2 per cent of GDP.
In the first eight years of the twenty-first century, the surplus averaged approaching 3.5 per cent of GDP.
Despite, therefore, persistent gains in the yen’s value on the foreign-exchange markets, Japan’s rising current-account surplus has added to global imbalances over the last forty years.

Those who believe in the efficacy of exchange-rate moves would doubtless argue that Japan should have allowed its exchange rate to rise even further.
This argument doesn’t wash.
Had the revaluation protagonists entered the medical profession, they’d still be advocating amputation to deal with early signs of gangrene when a dose of antibiotics would be more effective and less painful, and carry fewer side effects.
The evidence is overwhelming: over the long term, movements in nominal exchange rates do little to alter global imbalances.

People in China and other emerging countries save a lot (or borrow very little which, in net terms, amounts to much the same thing) primarily because they lack the institutions that have dramatically lowered savings rates in the industrialized world.
What we call
the ‘savings industry’ is, in theory, a brilliant way of spreading risk and allowing people to smooth their consumption patterns over their lifetimes.
Even with radical advances in genetic knowledge in recent years, none of us can predict how long we’ll live.
Those who die before reaching retirement (or soon after) effectively subsidize the pension incomes of those who live for many more years.
Insurance works on much the same basis (indeed, pensions are a form of insurance: everyone contributes, but those who end up six feet under a day after retirement gain little financial benefit).
For those who cannot afford to pay into private-sector pension and insurance schemes, most Western economies offer ‘social insurance’ in the form of state pensions, unemployment benefit, tertiary education and the like.
The spread of social security was a direct response to the impact of the Great Depression in the 1930s: as nation states took on the burden of providing insurance to those who were at risk of economic disadvantage, so the need for individuals to save for ‘precautionary’ reasons fell.
Meanwhile, with the rise of consumer credit, Western individuals have increasingly been able to borrow from ‘future’ income to fund current consumption.
In response to all these changes, savings ratios (the ratio of household income not consumed to total income) declined through much of the post-war period.

This process has yet to happen in China and many other emerging economies.
Why should it?
The declines in household saving ratios in the Western world over the last forty years may have been a response to the spreading benefits of pensions, insurance and state education, but the ability of nations to deliver these benefits has, in turn, depended on hundreds of years of per-capita income growth and financial evolution, from the diamond traders of Antwerp and the share dealers of London coffee houses in the eighteenth century through to the modern-day alchemists of global finance.
It’s not realistic to expect emerging economies to compress three or four centuries of economic and financial development into a
handful of years.
Americans may be able to walk into the nearest car showroom and drive off with the latest model just by taking out a loan, but for the vast majority of workers in the emerging world that option does not exist, whatever the level of the exchange rate.

This, in turn, implies that policymakers on either side of the Atlantic have been looking at the problem of global imbalances from entirely the wrong perspective.
Demanding that China, for example, should dramatically reduce its current-account surplus is all very well, but there is no obvious mechanism to achieve this outcome.
Cyclically, China’s surplus will decline every time the US has a recession, for the simple reason that around 20 per cent of China’s exports of goods go to the US.
But to reduce global imbalances through a US recession is an unattractive outcome that creates misery for all concerned.

The correct and constructive way of thinking about global imbalances is to consider how they influence cross-border capital flows and how those flows, in turn, distort capital allocation across countries and within nations.
Policymakers should not merely indulge in a spot of wishful thinking that, one morning, global imbalances will just disappear.
They are, instead, a fact of economic and political life.
They also carry all sorts of implications for economic stability – or the lack of it – in the developed world.

Excess savings in the emerging economies create two problems.
First, if emerging economies save large amounts of money, the rest of the world must borrow large amounts of money.
Second, the excess savings in the emerging world have tended to be invested in a narrow range of seemingly ‘safe’ assets such as US Treasuries, primarily because the vast majority of excess savings are held in the form of foreign-exchange reserves.
Reserve managers do not share the investment objectives of a typical New York or London fund manager.
They focus on liquidity rather than return.
The reserves are held as a cushion against ‘sudden stops’, whereby inflows of
capital from abroad dry up.
They are, therefore, designed to be not just a nest egg for future generations but also a tool to deliver macroeconomic stability in the short run.
Moreover, as we shall see in Chapter 7, the diversification options for many emerging nations are rather narrow, in part because the West is unwilling to sell controlling interests in its companies and resources to state investors elsewhere in the world.