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Global liquidity

August 19th, 2005

My column in yesterday’s Fin (over the fold) was about the idea, being argued by The Economist that the low interest rates currently prevailing are the product of monetary expansion rather than a real ‘savings glut’. Today’s Economist puts the point even more bluntly, arguing that capital markets are acting as a barrier to adjustment. It’s certainly striking when a voice of orthodoxy like The Economist reaches the conclusion that financial markets aren’t doing their supposed job.

Low interest rates are the centrepiece of the Howard government’s political and economic strategy. The claim that a Labor government would produce higher interest rates was the core of the government’s successful campaign strategy in 2004. Strong consumer demand, driven by low interest rates, has kept the economy growing through periods of weakness in the international economy, and despite stagnation in manufacturing exports.

The government claims credit for low interest rates on the basis that by keeping the budget in surplus, it has increased aggregate national savings. But if interest rates were simply determined the balance between national savings and investment demand, they would have to rise considerably.

In reality, national savings fall far short of our demands for investment capital. The difference is made up by capital inflows from overseas. In the national accounts this is measured by the capital account surplus, which is equal and opposite to the current account deficit of about 7 per cent of GDP.

The crucial factor leading to low levels of national savings is that, at prevailing interest rates, Australian households would rather borrow than save. National household savings have been negative for some years, largely because households have been able to borrow against increasing equity in owner-occupied homes. The rise in house prices has itself been driven by low-interest rates, creating an apparently self-sustaining cycle.

Australia has led the way to negative household saving, but others have followed. The household savings rate in the United States fell to zero for the first time recently, and would be negative if the statistics were calculated on the same basis as in Australia. In the US case, the government has joined the party, running consistent budget deficits, yet interest rates, particularly including the crucial 10-year bond rate, have remained at historically low levels.

The picture is the same in other English-speaking countries, and to a lesser extent in the eurozone. Although European households have not embraced debt to the same extent as their Anglophone counterparts, savings rates have generally declined, and most eurozone governments are in deficit.

If interest rates are too low to induce households in developed countries to save, how can they be sustained. One answer is that savings are coming from elsewhere. This is the ‘global savings glut’ analysis popularised by Chairman of the US Council of Economic Advisors Ben Bernanke.

Most of the discussion of this analysis has focused on Asian economies and particularly on China. In economic terms, however, this part of the analysis makes no sense at all. China is a rapidly growing economy with strong investment demand. On any standard analysis, Chinese households ought to be borrowing in anticipation of future growth in income, and China ought to be a net importer of investment capital.

A more plausible part of the story relates to the recycling of ‘petrodollars’ arising from higher oil prices. Oil-producing countries often have limited opportunities for domestic investment, and it is unwise to increase consumption much in response to what may be a temporary increase in income. So the proceeds of higher oil prices tend to be deposited in international banks, who then have to find borrowers.

Even taking account of petrodollar flows, it is hard to explain low interest rates in terms of equilibrium between the demand for investment capital and the supply of savings. An alternative explanation, recently proposed by The Economist magazine is that interest rates have been driven down by an expansion of liquidity, particularly in the United States. This is reflected in high rates of growth in monetary aggregates like M3, as well as in low interest rates.

A standard analysis would suggest that an expansionary policy of this kind cannot be sustained indefinitely without leading to inflation. Yet, although there has been massive inflation in a range of asset markets, particularly housing markets, consumer price inflation has remained low and shows no obvious signs of acceleration. One important reason for low inflation has been the downward price pressure arising from import competition.

So, we seem to have a perfect virtuous circle. Low interest rates are driven by expansionary monetary policy which maintains the supply of credit needed to sustain demand and maintain currency values in the face of massive current account deficits. A strong currency holds inflation down and allows low interest rates to be sustained.

It all sounds a bit too good to be true. But it’s worked so far, and we have to hope it keeps on working.

John Quiggin is an ARC Federation Fellow in Economics and Political Science at the University of Queensland.

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  1. Terje
    August 19th, 2005 at 22:34 | #1

    Interest rates should float. Exchange rates should be fixed to some basket of commodites or to a single very monetary commodity.

  2. gordon
    August 20th, 2005 at 11:37 | #2

    Prof. Quiggin says: “One important reason for low inflation has been the downward price pressure arising from import competition”. Another reason is the deflationary effect of high taxes and large budget surpluses. Asset price inflation is protected from this deflationary environment through favourable tax treatment as well as protection from import competition (you can’t buy your house in China and have it shipped here – not yet, anyway).

  3. e sciaroni
    August 20th, 2005 at 12:53 | #3

    Yet in the US we have low taxes and large budget deficits and still low inflation; despite the surge in petroleum prices.

    Eventually we must stop consuming because our attics will be full of excess stuff. And our garages too. And our summer cottage by the river. This may be a cause for a slackening of demand that will end the “perfect virtuous circle”.

  4. Derick Cullen
    August 20th, 2005 at 14:46 | #4

    JQ: “The household savings rate in the United States fell to zero for the first time recently, and would be negative if the statistics were calculated on the same basis as in Australia.”

    What are they doing which we don’t do or vice versa?

  5. jquiggin
    August 20th, 2005 at 18:16 | #5

    They don’t take account of depreciation of the housing stock.

  6. Ian Gould
    August 20th, 2005 at 19:30 | #6

    >Eventually we must stop consuming because our attics will be full of excess stuff. And our garages too. And our summer cottage by the river. This may be a cause for a slackening of demand that will end the “perfect virtuous circle�.

    No that’ll just spark demand for larger houses.

  7. Ian Gould
    August 21st, 2005 at 10:18 | #7

    Terje,

    The essential problem with commodity-backed currencies is that if they’re issued by governments, there’s a millenia-long history of such governments repudiating the guarantee or debasing the currency at the first isng of economic difficulties, Hence the value of such currencies, if issued by government, are still ultimately dependent upon the whim of the issuing government.

    It is, of course, possible for currency to be issued by private companies – Hong kong being the best example of this in the contemporary world. However, if the Hong Kong issuing banks were ever in serious financial trouble the Hong Kong government would have ot bail them out. If the Hong Kong dollar was gold-backed, that would probably involve legislation relieving the companies of the requirement to redeem dollars for gold.

    The only way in which a gold-backed currency could be regarded as clearly more secure than fiat currencies would be if the entire money supply was backed by physical gold – preferably stored in warehouses in several different countries and subject to regular external audit.

    The money supply of even a smallish economy like Australia runs into the hundreds of billions of dolalrs – are you proposing that the Australian government should spend that amoutn acquiring a stockpile of a non-income-producing commodity?

    I will also point out that there are gold-backed bearer bonds and other financial instruments that closely mimic what a private gold-backed currency would look like – I don’t see these instruments playing any major role in the world economy suggesting the markets don’t see any great need for them.

    Another problem with commodity-backed currencies is that commodity prices can shift drastically due to supply and demand changes regardless of the economic circumstances.

    Assume the Saudi Rial was linked to the oil price – the country’s currency would have crashed to about 1/3 of its previous value in the 1990′s and appreciated by several hundred percent in the last couple of years. swings of this magnitude have enormous implications for trade and investment.

  8. August 21st, 2005 at 15:52 | #8

    IG, there’s a significant difference between “gold backed” and gold currency. The latter is no longer susceptible to the kind of repudiation you describe. For practical purposes, a silver currency would work better today, and then the repudiation of instruments – whether government or private, like credit cards or literally bank notes – wouldn’t have the same across the board effect on currencies as a whole.

    I admire (as opposed to approve of) what the Dutch did in creating a debased copper currency to help build their exploitation system in the East Indies. They got all the necessary benefit without resorting to continuing debasement, since they used the one off gain to acquire and improve a revenue yielding resource base.

  9. Derick Cullen
    August 21st, 2005 at 16:42 | #9

    JQ: They (USA) don’t take account of depreciation of the housing stock.

    On the other hand I think the USA does take into account depreciation on “consumer durables” (cars, fridges, and other household capital) which we in Australia do not; we assume services delivered by such items are consumed instantly on acquisition.

    To make a really nit-picky point: although depreciation of capital assets used in production should count as an expense in estimation of saving, it is not a financial expense. Amounts charged for depreciation are not paid to anyone, and therefore leave notional financial resources available.

    The national accounting aggregate which shows the financial surplus / deficit of a country (or sector of the economy) is net lending / borrowing. This is the measure of saving appropriate for analysis of international liquidity. For a country net lending/borrowing is the balance on the financial account of the balance of payments (with the sign changed). / end tutorial/

  10. Ian Gould
    August 22nd, 2005 at 16:57 | #10

    I spent a few minutes last night considering the issue of currencies with intrinsic rather than implied value – e.g. gold rather than gold-backed notes.

    Silver has one obvious drawback – it currently sells for around US$7 an ounce. Assuming that price remained roughly constant, a silver coin worth US$100 would weight about a pound. This, and the relative bulk, would pose certain practical problems.

    It seems to me that if you ignore the problems I mentioned earlier (i.e. tying up a lot of valuable material in a non-income-producing form) you want a currency which is fungible, light weight, difficult to fake and easy to validate; durable and possessing practical uses which underpin its value.

    The best option that occurred to me was industrial diamonds of say 0.1-1 carats.

  11. Terje
    August 22nd, 2005 at 18:28 | #11

    Ian,

    I DO NOT advocate backing any currency 100% with gold. I do support the idea of private currencies that are commodity denominated (not backed).

    The point is that today we use consumer goods as the monetary benchmark in assessing stability in the value of MONEY. However consumer prices are slow moving due to institutional factors and only slowly reveal policy errors. Commodity prices respond much faster and quickly reveal a policy slip.

    A case in point is the 1970s. We saw lots of consumer price inflation during this period. However the policy slip first showed up in the gold price, then in the oil price and only later in the price of consumer goods.

    The current inflation management regime uses a feedback signal that has a lot of delay in it. As such the system is subject to destabilising oscillations and the like. As a student of Engineering system theory I have frequently seen such feedback issues in other systems.

    Assuming that we stick with fiat based currencies then I would propose the following change to monetary policy:-

    CURRENT MONETARY POLICY

    1. Measure the VALUE for national CURRENCY relative to domestic Consumer Prices (the CPI)
    2. On this basis set an Interest rate target for the medium term.
    3. Use daily open market operations to achieve the Interest rate target.
    4. Periodically return to Step 1.

    TERJEs REVICED MONETARY POLICY

    1. Measure the VALUE of national CURRENCY relative to international Commodity Prices.
    2. Define stability as being no change in the relevant commodity price (or basket of prices).
    3. Use daily open market operations to maintain stability.

    Even under the gold standard of old, central banks could revise the target price if they saw it as necessary. The system was flexible although sometimes the adjustments made were unnecessarily extreme.

    Under my revise monetary policy Interest rates would float to reflect the changing demand for credit and the associated risk. And whilst I would advocate gold as a benchmark for VALUE you could use a commodity basket much as we do today with a consumer basket.

  12. Terje
    August 22nd, 2005 at 18:31 | #12

    P.S. Two points:-

    Paper notes are superior to a weight of GOLD as a “medium of exchange”.
    A weight of GOLD is superior to Paper notes as a “unit of account”.

    A gold standard gives you the best of each.

  13. still working it out
    August 23rd, 2005 at 09:22 | #13

    A great article. It sums up what is really happening quite accurately.

    One minor quibble.

    “On any standard analysis, Chinese households ought to be borrowing in anticipation of future growth in income, and China ought to be a net importer of investment capital.” – JQ

    Even though China is rapidly growing, its savings rates is so unbelievably high that it does actually have a substantial savings surplus that cannot be invested domestically. Their investment rate is already 45% of GDP so its fair to say that this cannot go higher. But their savings rate is over 50% of GDP (contrast that with Australia!) so there is a substantial savings surplus. Its not huge amount in global terms so I don’t think it really helps the Savings Glut arugment.

    Brad Setser has a bit more on this here
    http://www.rgemonitor.com/blog/setser/91432

  14. still working it out
    August 23rd, 2005 at 09:30 | #14

    Can someone please answer me the question of why interest rates are set according to CPI inflation while asset price inflation is ignored?

    It seems to me that the whole problem of our housing boom could have been avoided if the Reserve Bank took into consideration asset price inflation as well as the CPI inflation when setting interest rates. I am not an economist and I just do not understand why Asset Price inflation is not a factor, especially when the Reserve Bank governor spends so much time complaining about housing prices.

  15. Ian Gould
    August 23rd, 2005 at 09:53 | #15

    >Under my revise monetary policy Interest rates would float to reflect the changing demand for credit and the associated risk.

    Actually those factors would probably be swamped by commodity price changes – see my earlier comments abotu Al Saud.

    Are you familiar with the expression “the Dutch Disease”?

  16. August 23rd, 2005 at 10:17 | #16

    IG, silver is superior to more valuable commodities for ordinary coin based transactions. For larger amounts, that’s where silver backed bills used to come in – but the silver itself was the long stop. As for the practical difficulties of obtaining the reserves and the circulating bullion, that’s a transitional difficulty rather than a fundamental one – and it can be overcome by establishing a pre-depreciated rate of exchange, a one off initial and non-repeatable devaluation on introduction. (although there are yet other difficulties with that.) But having a stock with low carrying cost brings me to…

    Terje, economics tends to emphasise flow rather than stock, a process of abstracting out inessentials. However stocks matter in some areas, and one is the real balance effect. With a bullion based currency this produces a slow acting automatic stabiliser for an economy. Being slow makes it stable, but unfortunately it makes it incapable of responding well enough to distortions like government interference – so, if Keynesian policies are followed, they stop this automatic stabiliser being practical and add to the practical reasons for fiat currency.

  17. Katz
    August 23rd, 2005 at 12:54 | #17

    “So, we seem to have a perfect virtuous circle. Low interest rates are driven by expansionary monetary policy which maintains the supply of credit needed to sustain demand and maintain currency values in the face of massive current account deficits. A strong currency holds inflation down and allows low interest rates to be sustained.”

    It would appear that the virtuous circle described by JQ remains viable only so long as prices for consumer goods remain low.

    Imagine a revolution in expectations among Chinese workers wherein they cease to be the world’s champion producers and savers and instead join the swollen ranks of major consumers and borrowers. This revolution in expectations has overtaken every society at a certain level of industrial take-off. And I think I’m correct in asserting that each succeeding industrial economy has achieved this point more quickly than any of the economies that preceeded it.

    Such a situation might quickly soak up excess capital in the world and drive up the price of Chinese exports, allowing price rises in import substitution industries in the US and elsewhere.

    Inflation may well result from this scenario, resulting in more restrictive credit conditions and a squeeze on asset prices.

    [The interesting corollary of this scenario is that, for whatever reason, the revolution in consumerist expectations in the West seems to be more or less over. It is difficult to conceive of a realistic scenario which involves a sudden upsurge in fresh demand for more expensive products of the type experienced by the US in the 1950s and 1960s.]

  18. Ian Gould
    August 23rd, 2005 at 13:20 | #18

    “Imagine a revolution in expectations among Chinese workers wherein they cease to be the world’s champion producers and savers and instead join the swollen ranks of major consumers and borrowers. This revolution in expectations has overtaken every society at a certain level of industrial take-off. And I think I’m correct in asserting that each succeeding industrial economy has achieved this point more quickly than any of the economies that preceeded it.”

    Katz, three points:

    Germany and Japan spent decades to make that transition, so more recently did Malaysia and south Korea. The change may well happen more quickly in China but I think that may mean it takes 20 years rather than 30.

    2. The lingering dirigist tendencies of the Chinese government may also retard this process – see for example the common practice in the 80′s of forcing Chinese workers to accept multi-year government bonds for part of their wages. Arguably China has a serious long-term deficit in retirement and health savings since to date private saving for these purposes hasn’t kept pace with the withdrawal of the old state welfare system.

    3. China is effectively several separate economies. The coastal strip may be near the transition you mention but the vast hinterland is probably a long way from it,

  19. Terje
    August 23rd, 2005 at 15:15 | #19

    QUOTE PML: With a bullion based currency this produces a slow acting automatic stabiliser for an economy. Being slow makes it stable, but unfortunately it makes it incapable of responding well enough to distortions like government interference – so, if Keynesian policies are followed, they stop this automatic stabiliser being practical and add to the practical reasons for fiat currency.

    RESPONSE:-

    True. But I would much prefer that we ditch the Keynesian policies and go with a gold standard.

    The problem with so much government is that it makes necessary extra bits of government to compensate for problems created by the first part. Its a self perpetuating mess.

  20. August 23rd, 2005 at 20:40 | #20

    Terje, as you state, it is self perpetuating – or at any rate self multiplying, if there is any grit that set of this pearl, it would have to be engineered out too (but the rat catcher has no interest in catching every last rat and working himself out of a job). But that converts the problem into one of finding a transition. I think it might be helpful to quote from Geoffrey Budworth’s Knot Book, on untangling line:-

    ‘No matter how methodically you stow away line, when you go to use it again, it looks like a bird’s nest. To sort out such a muddle, there is an effective trick. First, keep the tangle as loose as possible. Do not pull experimentally or impatiently so that the whole thing jams up. Locate the point where the end enters the tangle. Enlarge the opening around it, so that the tangle resembles a doughnut [presumably a torus, not an honest British doughnut]. Rotate this “ring” outwards so that the lengthening end of the rope continues to emerge from the center [sic] of the mess.

    ‘This method of untangling knots often works and is always worth a try… If the rope is too snarled up to use this method, there is no alternative but to go through the laborious process of pulling the loose end through again and again.’

    In his section on untying knots, Geoffrey Budworth also writes “Occasionally it may be necessary to cut line. Never hesitate if it will prevent or reduce loss or harm to someone.

    I trust the moral of all this is not lost on readers.

  21. August 23rd, 2005 at 21:03 | #21

    Oh, and there would be huge transitional problems getting onto a gold or silver standard. If the whole world did it, there would be the problem of introducing enough, and if only individual countries did, they would be vulnerable to speculative attack. The problems would vary with the initial conversion rates. The history of Denmark shows the problems of going onto gold with only foreign trade as a source (it managed it in the early 19th century, with much cost and difficulty, to avoid being marginalised as other countries went onto a gold standard).

  22. Terje
    August 24th, 2005 at 07:05 | #22

    The image below shows that Australia has been proximate to a gold standard for a decade now. I just want the thing formalised. And interest rates liberated.

    http://members.optusnet.com.au/terjep/GOLD/PRICES/gold-aussie.gif

  23. gordon
    August 27th, 2005 at 11:27 | #23

    Brad deLong’s weblog (see under the “Economist Blogs” in sidebar) has had some interesting and relevant posts recently – see under Prudence, Market Liquidity and more recent.

  24. Ian Gould
    August 30th, 2005 at 19:21 | #24

    Indonesia has raised interest rates by 75 base points in response to a run on the currency caused by a soaring current account deficit. The deficit is largely the result of higher oil prices.

    http://www.abc.net.au/news/newsitems/200508/s1449475.htm

    Question: is this an isolated event or could it mark the beginning of the end of the gloal capital glut?

  25. SJ
    August 30th, 2005 at 22:16 | #25

    Indonesia is one of a number of oil producing countries that subsidise domestic oil prices. Indonesia became a net importer of oil last year, so the domestic subsidies become unsustainable. This is unrelated to the global capital glut question.

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