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Global glut

April 27th, 2005

The big question in global macro policy today is : Why are long-term interest rates so low. I had a go at this topic over at Institutional Economics and i thought I’d reprint it here. Very preliminary, needless to say.

A general comment on why so few economists trust the market on bubbles. It’s obvious that low interest rates are crucial, and that current asset prices make sense if and only if sustained low interest rates are a market-driven response to changes in the real economy.

But in an environment with near-zero savings in the English-speaking countries, and large unfunded state obligations in the rest of the developed world, interest rates should be high, not low.

The proximate cause of low interest rates is the willingness of Asian countries to run large current account surpluses (that is, capital account deficits), but there is no convincing micro story as to why people in poor countries should want to save massive amounts to lend to fund consumption in rich countries.

The leading optimist on all this is Bernanke, but he sees the surpluses as the product of macro policy, governments building up reserves in reaction to the crises of the 1990s. This source of surpluses presumably won’t be sustained, since the countries concerned are incurring huge unrealised losses on their US dollar holdings. So the ‘global savings glut’ is a temporary one, and is being squandered by borrower nations in high levels of consumption.

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  1. e sciaroni
    April 27th, 2005 at 09:08 | #1

    I think that a ‘global savings glut’ may actually be the case here. But I think that these imbalances are based on an unrealistic belief in the stability of the current world economic system. If trust in the US were to fall sharply, the result would be the “mother of all currency crises”.

    I’m too young to remember the Great Depression. But that is how the market corrects great imbalances. If we wait for the market to correct things.

  2. Alan
    April 27th, 2005 at 11:30 | #2

    I recall 10 year Treasuries geting down to 3.3% in ’03? How did people rationalize bond prices at those levels?

    My guess at whats happening at the moment is the market projects that short term US real rates will be negative or even for the remainder of the decade. The maket is also assuming that inflation remains low over this period.

    My understanding is that 10 year treasuries are priced not at some level relative to projected inflation but to the projected level of short term interest rates(over say 5 years). How leveraged are the holders of 10 years bonds? How do you measure the size of the carry trade?

    In summary I have no idea what I am talking about.

    What I dont understand is why a foreign central bank would buy gov bonds and not just keep lend the money on deposit (I dont know the name of it, whats the short term market that banks lend/borrow in? The one that the rba uses to move the cost of lending?) Wouldn’t that then have zero effect on the price of long term rates?

    As far as saving and consumption goes, if somebody were willing to lend to you on extremely favourable terms, why would it not make sense to borrow? (I am talking about the US situation now the AU one).

    Don’t American companines investing in China generate much higher returns than the treasury bonds the chinese central bank had to buy to keep the currency price stable? Isn’t that a win for the US? (The trade deficit is another matter)

    I’ll stop now, this post started off out of focus and its getting worse after each sentence.

  3. simon
    April 27th, 2005 at 11:52 | #3

    John, there is NO glut … we need to approach thisproblem as economists and not journalists … China and the rest of Asia is engaged in export-driven gowth strategies on an enormous scale. This policy decision drives interest rates down in the US ( they loan but do not buy goods and services in large quantities). This in turn creates a positive feedback loop that spurs greater consumption and in turn more capital available for lending. This will continue until US consumers cannot borrow more or China and the other Asian nations slow down.

    US companies likely make a greater return on their China investments than treasuries. The market drives their rational behavior. The same cannot be said of China … No one is driving them to behave “rationally” … the argument that they are playing the long-term is just an excuse for not thinking … Chinese cannot make their own choices … they would not take the risk that China is taking on …

    An unintended consequence of China and Asia driving this wedge is a possible down turn in the US economy. Slow down in economic growth in the US will make Chaina and Asian nations buyers of US companies at cheap prices … GM and Ford are on the way to great buys as the economy slows down. China may soon be the owner of GM or Ford …

  4. still working it out
    April 27th, 2005 at 12:47 | #4

    “but there is no convincing micro story as to why people in poor countries should want to save massive amounts…”

    I don’t think that the reasons for the high saving rate in certain poor countries can be deduced from economics. Fundamentally it is about how the individuals in those countries feel the best utility is obtained. If they feel that their best utility is obtained by reducing consumption today in return for higher consumption in the future (ie higher savings) then there is not much for the economist to study or explain here. The question is why those individuals have that particular set of values and that is a psychological or cultural question, not an economic one.

    …to lend to fund consumption in rich countries”

    Following the Japanese model does not fit in with conventional views about economic growth but no-one can deny it has been spectacularly successful. I wonder if the Japanese could explain why it works.

    To me it seems like their some sort of giant hole in economic theory here as there is a huge discrepancy between what conventional economic wisdom suggests and the results obtained over a considerable period of time and in a number of different countries. There must be a Nobel prize in that for someone, maybe an Asian economist?

  5. Econowit
    April 27th, 2005 at 13:03 | #5

    I dont know how relative it is but oil is priced in US dollars and the US dollar is the dominant world currency.

    The Asian and US economies are highly dependent on reasonably priced oil. This could be a motivating factor for the Asian economies to support the US dollar.

    If the dollar collapsed or the nexus between the US dollar and oil were to be broken it might cause oil to skyrocket and a run on the US dollar- or an end to the US dollar as the major global currency.

    Changes in dominant world currencies usually correspond with major economic down turns.

  6. April 27th, 2005 at 15:47 | #6

    If somebody might correct my understanding of this thread so far, please. (Poor form, I know.)

    China is producing lots of stuff for US consumers.
    The US is printing lots of dollars in exchange.
    China saves these dollars because they’re hoarders.
    Much of their savings re-enter the US where these Chinese dollars keep interest rates low.

    One day, the Chinese gets sick of making all the stuff, ask for their cash back and look around for something to buy. Except there isn’t much to buy because they were the only ones making stuff.

    The US dollar declines because nobody needs any more. They’ve already got more than enough, especially as they have now tested its purchasing power.

    One thing stops it spiralling downwards and out of control. Everybody MUST pay for their oil and Microsoft upgrades in dollars. The currency is finally saved albeit a bit bruised.

  7. April 27th, 2005 at 16:13 | #7

    There is no glut in China, or in other developing countries. Rather, there is a shortage of opportunity. Mathematics teachers who earn $2 per day; doctors who don’t earn much more. (And here we are, bemoaning the fact that the bar is so low for people to become teachers. How about outsourcing education?)

    China needs all the foreign investment that US can offer, because it is the only way for them to achieve rapid modernisation. Think of it as the Great Leap Forward done right. It is going to take another generation before China achieves a world class standing in R&D, and if it has to fund the Western countries in the meantime, so be it.

  8. michael.burgess
    April 27th, 2005 at 16:25 | #8

    still working it out – Re your views on the Japanese model. If you accept Paul Krugman’s argument Japan and other Asian grew rapidly because they accumulated inputs rapidly and invested their profits rather than consumed. This input driven growth model largely ran out of steam as they matured and reached the limits of this strategy. Consequently, the so-called economic miracles were nothing of the sort. I think Krugman is largely right on this. Whether all this has any implications for understanding the Chinese experience, I haven’t the foggiest.

  9. April 27th, 2005 at 18:33 | #9

    Thanks for discussing this important question. It seems that too many economists have been too wrong in their predictions for

    A “convincing micro story as to why people in poor countries should want to save massive amounts” may not really be what we need here. I mean, there are economists find or even ask for convincing stories behind peoples preferences. And still they lack a convincing story for the unwillingness of people to hold stocks, calling it the “equity premium puzzle”.

    Should not one rather ask if there is a convincing macro story as to if there is really a possibility for the Asian government to force people to save these “massive amounts”?

    http://blogofpandora.blogspot.com/2005/04/why-are-asian-savings-this-high.html

    http://blogofpandora.blogspot.com/2005/04/why-are-interest-rates-this-low.html

  10. April 27th, 2005 at 18:34 | #10

    meaning …too wrong in their predictions for really bothering to take up the question again.

  11. Andrew Reynolds
    April 27th, 2005 at 18:45 | #11

    In the case of China I do not think it is necessarily because they want to save the money, it is because the government, by various means, gives them no choice. The Chinese government is terrified of the future where they can see the ‘weakness’ of the other dictatorial governments caused them to be thrown out. They do not want to experience a similar weakness. Financial laxness, as they see it, was part of the reason why the other dictators lost power – they do not want to the same for themselves.
    IMHO they will continue this policy until they feel secure or lose power – I think the latter is more likely than the former.

  12. Homer Paxton
    April 27th, 2005 at 21:17 | #12

    The weight of money theory is always wheeled out to justify skyrocket PE multiples which always backfire as it does on Bond markets when inflation eventually rises.

  13. anne
    April 28th, 2005 at 06:03 | #13

    Finally, I am no longer impressed by the developing country savings glut argument. What is keeping long term interest rates low in America is not Chinese household saving pouring in, but Central Bank bond purchases. The answer is the currency peg against the dollar of China and the informal pegs of Japan and Korea and other Asian countries. I finally understand, thanks to Brad Setser for insisting.

  14. still working it out
    April 28th, 2005 at 08:00 | #14

    Michael Burgess,

    Krugman is right that there is nothing miraculous about economic growth due to accumulating inputs rapidly and investing the profits rather than consuming. But the interesting point is just how hard doing this has turned out be in practice. The only model that has successfully acheived this consistently is the Japanese one of artificially low currencies etc.

    As far as the implications go the problem is basically that China is just too big to rely on export based growth as the other East Asian countries have done. Its economy is already approaching the size of the the US. Small countries like Korea, Taiwan, Singapore, Malaysia can export to their hearts content, but China has to export so much for this model to work that there are not enough consumers in the rest of the world to buy all of its exports for much longer.

  15. still working it out
    April 28th, 2005 at 08:04 | #15

    anne,

    But the PBoC would not be able to purchase all those US bonds if Chinese households were not pouring lots of money into Chinese banks (ie saving lots). Where does the PBoC get its funds from?

  16. still working it out
    April 28th, 2005 at 08:42 | #16

    wbb,

    I am not an economist but my understanding (mainly from reading Brad Setser and Nouriel Roubini) is that

    “China saves these dollars because they’re hoarders.”

    is really

    China buys these dollars to keep its currency low compared to the US dollar to make sure its exports stay cheap

    And the really scary one.

    “One thing stops it spiralling downwards and out of control. Everybody MUST pay for their oil and Microsoft upgrades in dollars. The currency is finally saved albeit a bit bruised.”

    Unfortunately not so. The Microsoft upgrades are part of America’s exports and the fundamental problem is that America is not exporting enough to pay for its imports. A lower currency will fix that eventually but it would take years for that to happen which is not fast enough to stop a currency crisis. US is a net importer of oil so oil being priced in dollars won’t help. Oil will just be repriced higher to make up for the fact the dollar is worth less.

  17. April 28th, 2005 at 23:36 | #17

    thanks swiot,

    China buys these dollars to keep its currency low compared to the US dollar to make sure its exports stay cheap

    They want to keep their exports cheap so that they can provide employment?
    Tariff protection in reverse.

  18. kyangadac
    April 30th, 2005 at 02:00 | #18

    more specifically, china buys dollars to contain inflation within China that would result if the profits from their exports were spent locally. Containing inflation while growing at 10% is the point of maintaining relatively low currencies. But this is only a partial fix because there are still inflationary pressures due to the demand for real goods – witness iron ore pries etc. Which brings me to the IMHO the most salient point – economies don’t collapse because their currencies collapse but because the supply of real goods and services is disrupted or exhausted.

    I feel quite hopeless for the world and my children while economists and politicians continue to discuss the global economy as if it comprised of nothing more than currencies and ever increasing cycles of exchange whereby all goods are valued by a single measure.

    Water, food, air, health, sanity, etc are just some of things that have values independent of their monetary value. And although, they may be bought and sold, the resources that are required to produce and reproduce them are finite, and often fragile and yet utterly critical for our survival. Where is the accounting of our food resources?
    If our farcical attempts to account for water are anything to go by then don’t hold your breath. By farcical, I mean the recent decision to purchase six, (i think it was) desalination plants to deal with Sydney’s water supply crisis? Crisis, what crisis? I can feel an album coming on? What’s an album, grandad? Go back to sleep son, you’ll wake up the chooks.

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