from Follow the Money

The comfortable road to ruin …

April 27, 2005

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Read Martin Wolf’s latest column. His focus on emerging economies -- particularly in Asia -- is dead on.

The "glut" of global savings originates there, far more than in Europe. The Euro zone’s current account surplus actually has fallen from around $100 billion in 1997 (when the US current account deficit was only $136 billion) to $36 billion in 2004.

The big current account surpluses of the world right now are in Asia and the oil exporting countries.

Wolf has called the US the world’s borrower of last resort -- the country that is most willing to absorb the rest of the world’s excess savings and make up for the (relative) lack of consumption in the rest of the world -- running up its external debtin the process. That puts him in Dr. Bernanke’s camp, though he worries far more than Dr. Bernanke about the consequences of ever increasing US current account deficits and rising US external debt.

Wolf argues that the US external deficit is largely the product of other countries policies, not the US fiscal deficit:

For some years a number of non-US observers, including Cambridge University’s Wynne Godley (and me), have argued that US current account deficits are explained more by the behaviour of the rest of the world than by that of the US. Ben Bernanke’s Homer Jones lecture, in March, marked official recognition of what the Federal Reserve governor called the "somewhat unconventional view" that it is the surplus savings of the rest of the world that have created US deficits.***

If foreign savings was not flowing into treasuries to finance the government, it would be flowing into the mortgage market to finance US housing, or into US corporate debt to finance investment ...

Maybe.

I suspect that the expanding US fiscal deficits has played some role in the expanding current account deficit, though I’ll grant that some things seem a bit different this time around than in the twin deficits of the 1980s. When Reagan ran large fiscal deficits, the dollar appreciated and US interest rates were high -- the US sucked in global savings by offering a high return. That obviously is not the case now.

No doubt the world’s willingness to lend the US its savings at low rates has made the road to fiscal ruin far more comfortable. I still think the stimulus to US demand created by a fiscal deficit has contributed to the current US external deficit, particularly since the fiscal deficit has stayed large even after private investment recovered from the .com/ .bomb shock. A different fiscal policy = less US domestic demand = fewer US imports = fewer exports for the rest of the world, and given fixed exchanges in some US trading partners, fewer exports to the US would translate into less reserve accumulation on their part, not fewer imports.

One thing should be clear: the US current account deficits of the past two years have not primarily stemmed from the behavior of private investors abroad. Massive central bank intervention (which keeps intervening countries’ currencies from rising against the dollar) clearly played a significant role in the current equilibrium.

My latest bit of evidence?

Add up the 2004 current account deficits of the major deficit countries, the US, the UK, Australia and Eastern Europe. According to the IMF, they total $804 billion (the US accounts for over 80% of the total deficit). Total 2004 reserve accumulation in current account surplus countries: something like $625 billion, if you net out valuation gains. Including Japan, around $500 billion of that came from Asia.

No doubt there were plenty of private flows too. But by and large the private flows around the world cancelled each other out. US citizens invested in European, European citizens invested in the US, but European investors did not invest substantially more in the US than US citizens invested in Europe (That simplifies things a bit, only a bit). Consequently, reserve accumulation by the world’s central banks was the major source of the (net) financing needed to sustain ongoing current account deficit.

As I have argued before, private investors wanted to finance a $100 billion current account deficit in East Asia (excluding Japan) -- see the data in this World Bank report. Instead the countries of East Asia (excluding Japan) ran a $200 billion surplus. A policy decision -- or a series of policy decisions -- deflected private flows attracted to East Asia back into the US fixed-income market, in the form of central bank reserves.

Assume there is a global savings glut. Private investors still did not want to finance US on anything like the scale needed to sustain US external deficits of the current scale. Net private flows into the US in 2004 -- by my calculations -- were only around $175 billion. (I am assuming the world’s central banks added $490 billion to their dollar reserves, and invested those dollars in the US, not in the dollar-denominated debt some other countries issue).

East Asia’s (excluding Japan) total reserve accumulation has gone from $136 to $200b to $312 b (9.3% of its GDP) over the past three years (See Table 6 of the World Bank report, along with appendix table 6). East Asia’s reserve accumulation accelerated in 2004, long after the global recession ended. Wolf argues that the expansion of the US fiscal deficit from 2001 to 2003 was needed to avoid a collapse of global demand. Perhaps. But East Asia has kept on financing the US long after the US recovery started.

East Asian (excluding Japan) reserve accumulation could well reach $400 b this year, barring a policy change. And remember, East Asia imports lots of oil and other commodities. Its soaring external surplus is coming despite an adverse shock to its terms of trade. There is no global oil glut ...

Want another conundrum? Try to explain why China’s savings has surged along with Chinese investment. After, there is no shortage of investment in China; rather the contrary (See Exhibit 12 of the World Bank report). China could easily have absorbed some of the world’s savings surplus over the past few years. That’s what usually happens in a boom. And China is not small -- if China was drawing on the rest of the world’s surplus savings to finance its investment boom, I suspect that would have an impact on the global equilibrium.

We don’t know if East Asia would still supply the savings the US lacks if Asian central banks let the market set exchange rates, and let their citizens decide weather to spend or save their greater global purchasing power. We also don’t know if private citizens in Asia would be as willing to finance the US as Asian central banks.

Personally, I think that creates two big qualifications to the "don’t worry about the current account deficit, there is a global savings glut" hypothesis of Dr. Bernanke.

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