The Conundrum of Global Saving/Spending Imbalances: Why It's so Hard to Stop the Flood

By Charles Kirchofer, Jan. 29th, 2009

In the realm of international relations, analysts often look at events on three levels: deep causes, intermediate causes, and precipitating causes. The deep causes are often systemic effects, like the structure of the international system (i.e. anarchic, with x number of great powers... it doesn't matter though, just keep reading). The intermediate causes are often related to policies of countries and alliances they form. The precipitating cause is generally just one event. I'd like to spend a little time today talking about the deep causes of the current financial and economic crisis. First, let me just mention what some of the individual causes were.

The precipitating cause was, of course, the bursting of the housing bubble. The intermediate causes were many and varied. They mostly relate to policy and regulatory decisions. Mr. Mohr and I have spent most of our time talking about those, so if you'd like to know more, just check out nearly the all the articles we've written on the subject of the financial crisis on the economics page ( The cause I'm going to talk about today is the deep one. It is particularly problematic because it is global and very hard to control. I'm talking, as the title suggests, about global imbalances in spending and saving (i.e. global differences in current account surpluses and deficits, which can also roughly be related to global trade surpluses and deficits).

Everyone knows the United States is the world's largest debtor. This is partly because of its size, however. To put things into perspective, household debt in the U.K. is actually higher than in the U.S., and the U.S. is by far not the most indebted country in terms of debt in proportion to GDP. (It makes sense to look at debt as a proportion of GDP because $100,000 of debt a lot for a person earning $20,000 a year, but chicken feed for a millionaire. The United States, luckily, fits into the latter category). Nonetheless, the fact that American households' saving rate has been negative (the average household has been borrowing more than saving in the past couple years) is obviously problematic.

The usual solution to too little saving is to raise interest rates. Higher interest rates mean it costs more to borrow money and you get a higher return when you save, thus encouraging saving and discouraging borrowing. But household saving rates are not the primary interest of central banks. In the past, households spending more than they were earning translated into inflation. Central banks are charged with price stability (controlling inflation), and the U.S. Fed is also charged with promoting growth. This time around all that borrowing didn't result in inflation (at least of the kind the Fed was concerned about, namely asset inflation (like stocks and housing), it was probably a mistake not be concerned with these features). This left central bankers scratching their heads wondering what to do, and if they needed to do anything at all.

The answer, as we now know, was: yes, you probably needed to do something. But this wasn't completely clear.

Would raising interest rates have helped? It probably would have at least mitigated the effects of some of the intermediate causes. Higher interest rates earlier may have slowed the inflation of the housing bubble and made its bursting much less dramatic. In addition, higher interest rates mean a higher return on money saved in bank accounts or government bonds, and lower returns for investments in stocks, commodities, and real estate. There are certainly indications that this would have been a good thing. As I've explained in past articles, however, the Federal Reserve tended not to bother with asset price inflation, concentrating only on inflation of other consumer goods. As I've also said before, I think this was a mistake (as it also is to leave real estate prices out of the core inflation rate).

Of course it's not that simple. Low interest rates meant people were encouraged to spend money rather than save it. Most of the money that was coming in was coming from outside the United States, since people inside were saving less than borrowing. The problem with raising interest rates is that it could even make that particular problem worse. Getting a higher return on savings in the United States might have encouraged more capital inflows from abroad. In addition, it could have further strengthened the dollar, encouraging America to import even more, and hurting American exports further. This could actually exacerbate the current account problem, making the deficit larger. One way it might work in reverse is with energy. A stronger dollar means imported oil would get cheaper. Cheaper oil would make a smaller contribution to the trade deficit. Normally, however, a central bank might seek to weaken a currency if it wanted to reduce imports. But the way to weaken a currency is by cutting interest rates, which would potentially have been even more disastrous. Left with this conundrum, it was difficult to say what direction the rate setters should take.

In addition, there's evidence that suggests that the Fed no longer has complete control over interest rates in America. As the Fed raised rates in 2004, Alan Greenspan noticed that long term rates actually fell. This may be because investors from China continue to want to offload money into the United States and continue to offer cheap loans, regardless of what the Fed does (and how low the return on the investment becomes).

Why would China want to send so much money to the United States even though interest rates were so low? This held the Chinese currency, the yuan, lower and boosted Chinese exports. In addition, it made China stable. Investors are less afraid to give someone money if the person (or in this case, country) has a lot of money. The likelihood of the Chinese Yuan collapsing was extremely slim, making China much safer than other comparable developing countries.

For a while, however, it looked like rebalancing might be beginning. The dollar was sliding and the yuan revaluing. U.S. exports were booming and holding the U.S. economy above water. Then came the financial storm of October. After Lehman Brothers collapsed, capital from all over the world fled from the smaller currencies to the world's reserve currency, even though the crisis was most acute in America and America was the world's biggest debtor. The unexpected result: the dollar took off and nearly all other currencies lost value against the dollar. That was it for rebalancing and for the U.S. export boom (as an expensive dollar once again made American exports too expensive and imports cheaper). The yuan has also lost value against the dollar, even though it, too, has gained considerably against most other world currencies. The latter part is something congressional leaders should keep in mind when considering any trade tariffs or other protectionist measures.

As I've illustrated, the Fed is faced with an absolute conundrum. Raise interest rates, and the trade deficit and inflows of capital increase, likely increasing America's current account deficit. The incoming money then seeks investments, quite possibly creating bubbles. Lower them, and Americans save less and foreign investments from abroad must seek higher returns (not in bank accounts or bonds), possibly also leading to yet another bubble. What's a Fed Head to do? I hate to say it, but probably much as he has done, hopefully having learned from the mistakes of the past eight years. The Fed should continue to respond to domestic conditions. Right now that means keeping interest rates low and fighting deflation and recession. Soon thereafter, it could mean raising interest rates in response to inflationary fears, but possibly also in response to asset price inflation or too-low household saving rates. The Fed cannot control the U.S.'s current account balance, so it must concentrate on sound policies for the areas it can influence.

And what about the imbalances? Sorry, there's no easy solution. With higher interest rates the inflows might land in bank accounts and bonds, a less dangerous place than stocks and other markets. I suspect that as things right themselves in the financial markets, money will begin moving to smaller currencies again, meaning the dollar will begin to lose value again. A devaluing of the dollar while the Fed raises interest rates to fight all-around inflation would be the perfect scenario, but it is not alone within the Fed's power. Most of the time, such a development would be nearly impossible. It relies on net creditors around the world seeing diminishing returns in America and slowly investing their money somewhere else. Higher interest rates in China with a smaller foreign currency reserve would allow the yuan to revalue. This would make Chinese exports more expensive and increase Chinese imports. This would do a lot to fix global imbalances and increase global stability. China might have to accept lower growth rates, but in return it would gain a larger domestic market and a more balanced (and therefore more stable, in the long run) domestic economy.

It's important to note, of course, that this should all happen gradually. As I illustrated in my article on a dollar rout, a rapid shift of investments away from the U.S. would present a catastrophe of unbelievable proportions for the U.S. and the world.

So it all comes down to the Chinese? Well, to them, the Americans, the Saudis, and all others with massive current account imbalances. As much as everyone else likes to blame the Americans (and let's face it, the intermediate and precipitating causes are to be found in America), the entire world helped make the mess, and the entire world must clean it up. I just hope that this will occur naturally and gradually over time, without political fights and big policy mistakes. The second part is definitely a big stretch, the first part is hopeable.


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