Buyers, not savers, caused America's deficit
Saturday, 16 February 2008
Richard Duncan
It is clear from Alan Greenspan's autobiography, The Age of Turbulence - chapter 18, "Current Accounts and Debt" - that the former Federal Reserve chairman misunderstood the causes and underestimated the consequences of the extraordinary growth in the US's current account deficit. Today's policymakers must see through his mistaken analysis and adopt policies to restore balance to the global economy.
According to Mr Greenspan, the deficit was caused by the high savings rate of countries with current account surpluses, combined with their inability to find sufficiently attractive domestic investment opportunities. High savings and unattractive investments at home, occurring at a time of declining "home bias" in investment, resulted in a massive increase in investments from those countries into US assets, we are told. In other words, high savings abroad resulted in increased consumption in the US.
Here is an alternative view. As globalisation made trade between high-wage and low-wage countries possible, consumers in the US began buying more products made in low-wage countries such as China because those products were cheaper. Meanwhile, people in low-wage countries continued to buy their own products for the same reason. Consequently, the US's current account went from balance in 1991 to a deficit of $850bn in 2006.
At the same time, in order to prevent their own currencies from appreciating, the central banks of the surplus countries printed their currencies and bought (literally) thousands of billions of dollars to sustain their low-wage competitive advantage.
Those central bank dollar reserves represented the bulk of the savings Mr Greenspan refers to in his chapter, although he makes no mention of the fact. Having "saved" so many dollars, central banks needed to invest them in US dollar assets to earn a return. This, rather than a decline in home bias, drove the surge of capital inflows required to finance the US's soaring trade deficit.
In a nutshell, then, we have two competing theories of the causes of the US current account deficit and all the related imbalances created by it. Mr Greenspan's explanation is that it is all the result of a savings glut and a decline in "home bias" in the surplus countries. The alternative explanation is that the US trade deficit has been caused by free trade with low-wage countries and financed by paper money creation by the central banks of the surplus countries. You decide which is more plausible.
Mr Greenspan contends that no real harm has been done by these imbalances. In fact, he believes that "in a market economy, rising debt goes hand in hand with progress".
The truth is that the US current account deficit and the paper money creation that has financed much of it have fuelled an unsustainable economic bubble in the US and around the world that is precariously close to imploding.
Liquidity injections into the credit markets of well over $500bn by a range of central banks (in Europe, the US and the UK) have been required to stave off the complete systemic meltdown of the global financial sector. Meanwhile, the Fed has been panicked into an aggressive round of interest rate cuts, Fannie Mae and Freddie Mac, the US government-sponsored mortgage lenders, have expanded their balance sheets at an unprecedented pace and the US administration has been compelled to rush through a $150bn emergency fiscal stimulus package, all in the attempt to keep the US slump from dragging the world into a global recession.
Mr Greenspan has obviously confused cause and effect in claiming that a savings glut in the surplus countries caused the current account deficit. It is equally obvious that he has drastically underestimated the destabilising consequences of that deficit. In his words: "I would place the US current account far down the list" of imbalances to worry about. It is now clear just how great his misjudgment was.
The current account deficit must quickly be brought to the top of the list of things for our current policymakers to worry about - and to resolve. If this imbalance is permitted to grow, or even to persist at current levels, the outcome can only be new and greater credit-induced economic convulsions that will require ever larger government bailouts and ever-increasing government encroachment into the economic sphere.
.....................................................
The writer, author of The Dollar Crisis: Causes, Consequences, Cures, is a partner at Blackhorse Asset Management
It is clear from Alan Greenspan's autobiography, The Age of Turbulence - chapter 18, "Current Accounts and Debt" - that the former Federal Reserve chairman misunderstood the causes and underestimated the consequences of the extraordinary growth in the US's current account deficit. Today's policymakers must see through his mistaken analysis and adopt policies to restore balance to the global economy.
According to Mr Greenspan, the deficit was caused by the high savings rate of countries with current account surpluses, combined with their inability to find sufficiently attractive domestic investment opportunities. High savings and unattractive investments at home, occurring at a time of declining "home bias" in investment, resulted in a massive increase in investments from those countries into US assets, we are told. In other words, high savings abroad resulted in increased consumption in the US.
Here is an alternative view. As globalisation made trade between high-wage and low-wage countries possible, consumers in the US began buying more products made in low-wage countries such as China because those products were cheaper. Meanwhile, people in low-wage countries continued to buy their own products for the same reason. Consequently, the US's current account went from balance in 1991 to a deficit of $850bn in 2006.
At the same time, in order to prevent their own currencies from appreciating, the central banks of the surplus countries printed their currencies and bought (literally) thousands of billions of dollars to sustain their low-wage competitive advantage.
Those central bank dollar reserves represented the bulk of the savings Mr Greenspan refers to in his chapter, although he makes no mention of the fact. Having "saved" so many dollars, central banks needed to invest them in US dollar assets to earn a return. This, rather than a decline in home bias, drove the surge of capital inflows required to finance the US's soaring trade deficit.
In a nutshell, then, we have two competing theories of the causes of the US current account deficit and all the related imbalances created by it. Mr Greenspan's explanation is that it is all the result of a savings glut and a decline in "home bias" in the surplus countries. The alternative explanation is that the US trade deficit has been caused by free trade with low-wage countries and financed by paper money creation by the central banks of the surplus countries. You decide which is more plausible.
Mr Greenspan contends that no real harm has been done by these imbalances. In fact, he believes that "in a market economy, rising debt goes hand in hand with progress".
The truth is that the US current account deficit and the paper money creation that has financed much of it have fuelled an unsustainable economic bubble in the US and around the world that is precariously close to imploding.
Liquidity injections into the credit markets of well over $500bn by a range of central banks (in Europe, the US and the UK) have been required to stave off the complete systemic meltdown of the global financial sector. Meanwhile, the Fed has been panicked into an aggressive round of interest rate cuts, Fannie Mae and Freddie Mac, the US government-sponsored mortgage lenders, have expanded their balance sheets at an unprecedented pace and the US administration has been compelled to rush through a $150bn emergency fiscal stimulus package, all in the attempt to keep the US slump from dragging the world into a global recession.
Mr Greenspan has obviously confused cause and effect in claiming that a savings glut in the surplus countries caused the current account deficit. It is equally obvious that he has drastically underestimated the destabilising consequences of that deficit. In his words: "I would place the US current account far down the list" of imbalances to worry about. It is now clear just how great his misjudgment was.
The current account deficit must quickly be brought to the top of the list of things for our current policymakers to worry about - and to resolve. If this imbalance is permitted to grow, or even to persist at current levels, the outcome can only be new and greater credit-induced economic convulsions that will require ever larger government bailouts and ever-increasing government encroachment into the economic sphere.
.....................................................
The writer, author of The Dollar Crisis: Causes, Consequences, Cures, is a partner at Blackhorse Asset Management