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I have always believed that the debtor and the creditor tend to share responsibility for most financial crises. One borrows too much, the other lends too much. Wynne Godley (ideologically, no Hank Paulson), Dimitry Papadimitrriou and Genaaro Zezza seem to agree. They write:
"The process by which U.S. output was sustained through the long-period of growing imbalances could not have occurred if China and other Asian countries had not run huge current account surpluses , with an accompanying "savings glut" and a growing accumulation of foreign exchange reserves .... flooding the US market with dollars and thereby helping to finance the lending boom. Some economists have gone so far as to suggest that the growing imbalance problem was entirely the the consequence of the savings glut in Asian and other surplus countries. In our view, there was an interdependent process in which all parties played an active role. The United States could not have maintained growth unless it had been happy to sponsor, or at least permit, private sector (particularly personal sector) borrowing on such an unprecedented scale."
Thanks to Martin Wolf for highlighting the Godley et al paper.
Their argument seems right to me. Absent a large savings surplus in Asia and the oil exporters, rising US rates would have choked off the housing bubble much earlier. High long-term rates aren’t conductive to rising home prices -- and without rising home values it is hard to turn a home into an ATM. Felix Salmon writes:
it was the global liquidity glut, and the concomitant demand for a bit of extra yield on fixed-income assets, which encouraged the lax subprime underwriting which etc etc. If the world hadn’t been perfectly happy to throw trillions of dollars a year into America bottomless appetite for capital, the bubble would never have happened, and neither would the subsequent bust.
At the same time, US policy makers didn’t exactly try to reign in US borrowing or leverage in the financial sector. They were far more likely to cheer this process on than to try to get in the way.
Five additional observations:
There is little point denying that there was something of a "savings glut" in much of the emerging world. Just look at Table A16 of the statistical appendix of the IMF’s WEO. In 2006, 2007 and 2008 the developing world’s savings was around 33% of its GDP, well above its 24% average in the late 80s and 90s. That allowed emerging economies to both increase investment above their historic levels (think of all the construction in the Gulf and China) and at the same time lend unprecedented sums to the US and increasingly Europe. (Graph here)
There is actually much more evidence of a savings glut from 2006 to 2008 than there was back in 2003 and 2004. In 2003 and 2004, it was plausible to argue that the emerging world -- counting the Asian NIEs -- was suffering from investment draught. Savings rates in the developing economies were only a bit above long-term averages. That argument though didn’t work in 2007 and 2008. Average investment rates in the developing economies by then were well above their historical averages – around 29% in 06-08 v 25% in the 80s and 90s -- even as the developing economies were running record current account surpluses.
Global savings also rose above its long-term average in the 2005 to 2008 period, though not by as much -- as the offsetting deficit in the US reflected a fall in US savings far more than a rise in investment. US national savings was 14% of US GDP in 2007 -- and 12.5% in 2008; it was more like 16% of GDP in the late 80s and 1990s. As Godley, Papadimitriou and Zezza illustrate, high levels of household borrowing to support high levels of current consumption kept the US household savings rate down. US Investment by contrast wasn’t above its level in the late 80s or 90s, especially after residential investment started to fall.
Central banks reserve growth in the savings surplus countries carried this surplus to the US. Most emerging economies with large savings surpluses were, until recently, also attracting private capital inflows. Private investors globally, in other words, wanted to finance deficits in the high growth emerging world not in the US. In most of the big surplus countries, reserve growth (counting a sovereign fund if there was one) exceeded the current account surplus (See the WEO Statistical Appendix Table A13). That is telling.
Central banks didn’t buy many subprime mortgages or CDOs of CDOs, and thus were not directly financing the riskiest borrowers in the US economy. They needed some accomplices to finance high levels of US consumption when the US fiscal deficit came down after 2004. Central banks didn’t lend to borrowers trying to home that they really couldn’t afford, or to Americans borrowing against their homes to finance a vacation that they couldn’t really afford. The entire process could only be sustained as long as private intermediaries were willing to take the credit risk central banks generally speaking didn’t want to take.
The process that led to the boom in risky assets was indirect: Central bank demand for safe assets drove down the return on safe assets and encouraged private sector risk taking. Private banks, famously, didn’t want to sit out the dance. James Kwak of The Baseline Scenario writes:
All of the U.S. dollar reserves held by all of these countries were effectively loans to the U.S. Treasury bonds were loans to our government; agency bonds were loans to our housing sector. This large appetite for U.S. bonds pushed up prices and pushed down yields, lowering interest rates and thereby fueling the U.S. bubble. Even though the money didn’t go directly into subprime lending, it lowered the costs for all the investors who were investing in subprime. so at the same time that irrational beliefs about asset prices were driving those prices up, the increased availability of money looking for things to buy also drove prices up. Looking at it counterfactually, if there had not been so much global demand for U.S. assets, it’s unlikely that even the once-divine Alan Greenspan could have kept 30-year mortgage rates as low as they were, since the only lever he had control over, the Fed funds target rate, is an overnight rate. And if mortgage rates hadn’t been so low, the bubble couldn’t have been as big.
Of course, the US regulators didn’t exactly try to stop this process. Nor did the Fed try to counter surprisingly low long-term rates by raising short-term rates more. It was far easier to argue that low long-term rates (and a run-up in home prices) was a natural consequence of the Great Moderation.
The impact of US policies to restrain domestic demand on global adjustment is complicated by the the fact that the large savings surplus countries peg to the dollar. Suppose the US takes steps that restrain domestic demand growth (tighter regulation of risky lending, tighter fiscal policy, higher policy interest rates). The result would tend to be slower US growth -- and less US import demand. Less import demand translates into a smaller current account surplus in the exporting countries. Their income falls a bit, and unless spending or investment falls, their savings would fall too. That is the first effect. But a US slowdown -- at least one not induced by a strong rise in US rates -- tends to put downward pressure on the dollar. The US imports a lot, but a US slump still has a bigger impact on activity in the US than activity in the world. And a slowdown in the US -- especially one that leads to lower rates -- tends to put downward pressure on the dollar. If say China (or any other major emerging economy) pegs to the dollar, their currencies go down too -- and that tends to push up exports to places like Europe that let their currencies float. That keeps Chinese income and savings up.
And if a weaker dollar leads to higher commodity prices even as the US-- still a big commodity importer -- slows, that helps support savings in the commodity exporters.
That dynamic, remember, is more or less what happened from 2006 to 2008. The US slowed -- and US domestic demand growth no longer was the engine of global demand growth. The trade deficit was still big, but it wasn’t growing -- and the non-oil deficit shrank. US domestic demand growth lagged European demand growth in 2007 and 2008 (IMF WEO Table A3). But the savings surplus of the emerging world remained large -- driven by an expansion of China’s savings and current account surplus and by high commodity prices. The dollar’s depreciation -- in a context where China depreciated against the dollar and restricted demand growth to avoid over-heating -- helped to shift the deficit that offset China’s surplus to Europe. If China didn’t depreciate along with a slowing US, the dynamics could have been different. Rather than relying on exports to Europe and the commodity exports to keep export growth up even as exports to the US slowed, China might have been pushed to take steps to support its own domestic demand earlier. At a minimum, it wouldn’t have needed to restrain lending and run a tight fiscal policy to limit inflation.
The emerging world’s savings surplus should fall in 2009; among other things, that implies that most the rise in the fiscal deficit of the advanced economies will need to be financed domestically. The oil exporters won’t be saving much at all at current oil prices. Big fiscal surplus will in some cases turn into big fiscal deficits. And I doubt that China’s savings rate will rise enough to offset the fall in the commodity exporters’ savings. In other words, the windfall to commodity importers won’t all be saved. Aggregate emerging economy savings -- relative to emerging economies’ GDP -- should fall. That would, absent a commensurate fall in investment, bring down the emerging world’s current account surplus. And that, in turn, implies a fall in the offsetting deficit of the advanced economies. The only real risk here is that a huge fall in investment in places like China and Russia keeps the aggregate surplus up ... in other words, the investment drought might reemerge.
What then should the world do now that the process where rising consumption and falling savings in the US and Europe supported export-led growth in the emerging world has come to an end? The US has taken the lead in adopting macroeconomic policies to try to offset what most expect to be a sharp slowdown in US -- and global -- activity. That could, if big enough, eventually trigger a recovery in the emerging world’s exports and thus bring up their income and savings. After a harsh down cycle, the old relationship could be restored -- with large US fiscal deficits playing the same role that the large increase in borrowing by US households formerly played. But, as Martin Wolf ably illustrates, it would be a mistake to rely too heavily on a US stimulus to support world demand. Far better if surplus countries do their part. Dr. Wolf writes:
The US and a number of other chronic deficit countries have, at present, structurally deficient capacity to produce tradable goods and services. The rest of the world or, more precisely, a limited number of big surplus countries – particularly China – have the opposite. So demand consistently leaks from the deficit countries to surplus ones. In times of buoyant demand, this is no problem. In times of collapsing private spending, as now, it is a huge one. It means that US rescue efforts need to be big enough not only to raise demand for US output but also to raise demand for the surplus output of much of the rest of the world. ....
Now think what will happen if, after two or more years of monstrous fiscal deficits, the US is still mired in unemployment and slow growth. People will ask why the country is exporting so much of its demand to sustain jobs abroad. They will want their demand back. The last time this sort of thing happened – in the 1930s – the outcome was a devastating round of beggar-my-neighbour devaluations, plus protectionism. Can we be confident we can avoid such dangers? On the contrary, the danger is extreme. Once the integration of the world economy starts to reverse and unemployment soars, the demons of our past – above all, nationalism – will return. Achievements of decades may collapse almost overnight.
Yet we have a golden opportunity to turn away from such a course. We know better now. The US has, in Barack Obama, a president with vast political capital. His administration is determined to do whatever it can. But the US is not strong enough to rescue the world economy on its own. It needs helpers, particularly in the surplus countries. The US and a few other advanced countries can no longer absorb the world’s surpluses of savings and goods. This crisis is the proof. The world has changed and so must policy. It must do so now.
The alternative to global adjustment is a world that relies on huge and sustained fiscal deficits in the US to sustain an acceptable level of global demand. That isn’t very appealing. It works for a year or two. But not for ten.
Godley, Papadimitrriou and Zezza argue -- quite correctly -- that the more a fall in the US (non-oil) deficit contributes to the United States’ recovery, the less the burden on fiscal policy. But the US external deficit won’t fall unless the world steps up to pull itself out of trouble. It won’t happen without policies to support global demand growth.