On September 11 Ben Bernanke, Chairman of the Federal Reserve, gave a very useful presentation at the Bundesbank Lecture in Berlin. It can be read at http://www.federalreserve.gov, and I strongly recommend that my Peking University students all read it.
Bernanke argues, as he has many time before, that the world is experiencing a savings glut. According to him a number of developing countries, especially China and the OPEC countries, along with Japan, are saving far more than they are investing. That means inevitably that they must export capital and run trade surpluses. As the US is usually considered the safest and deepest financial market in the world, the US is the recipient of the world’s global excess savings. The inevitable result is that the US must run substantial trade deficits as the counterpart to its capital surplus.
I have been a believer of this thesis for several years. Unfortunately Bernanke’s position has become much politicized and there are arguments back and forth about whether his hypothesis is merely an attempt to “blame” the US trade deficit on excess savings by foreigners rather than excess consumption by Americans. These sorts of arguments are idiotic. The fact is that any deficit country must by definition have “excess” consumption over savings, and any surplus country must have ”excess” savings over consumption, and it is not at all obvious which way the causality runs. At any rate in my opinion this global “imbalance” is probably a good thing in the long term because running trade surpluses against the US is the only way Europe, Japan, China and Russia will be able to pay for the very brutal demographic adjustments they must make over the next two to three decades – and make no mistake, these adjustments will be brutal.
But leaving aside the silly argument as to whose fault it is, does Bernanke’s argument do a good job of explaining the current US-China balance of payments? I think the answer is yes – in fact it seems to me that China is a particularly good example of Bernanke’s thesis. China does save too much – even the Chinese authorities acknowledge this, and they have made repeated and unsuccessful attempts to boost consumption. The resulting trade surplus with the US is the inevitable consequence of this excess savings.
There has been a series of decisions made at both the macro level and at individual levels that explain the high savings rate in China, and these decision lead inexorably to the accumulation of US assets (through central bank purchases). Of course if China is running a large capital account surplus with the rest of the world, it must run an equally large trade surplus, and as the only country capable of absorbing such large flows, it falls to the US, with its very open financial markets, to absorb China’s trade surplus (excuse me for fudging the distinction between a trade surplus and a current account surplus, but in this case the distinction is unnecessary).
Of the three most obvious reasons leading to this decision towards excess savings, in my opinion, the first and most obvious arose as a consequence of the Asian Crisis in 1997. China’s policy-makers, like those of many other countries, were horrified by the impact of the crisis on the affected countries. Unfortunately; also like many other policy-makers, they may have drawn the wrong conclusion about the cause of the crisis.
The Asian Crisis, like all financial crises, was caused because of serious mismatches in the national balance sheets that left the afflicted countries vulnerable to shocks that could quickly cause their balance sheets to unravel. These mismatches create what looks like a virtuous circle when conditions are good, but they quickly become vicious circles when conditions change. In the case of Korea, Thailand, Indonesia and Malaysia in 1997, this mismatch occurred in the form of having used highly liquid external capital for many years to fund less liquid domestic assets. As long as capital poured into these countries, as they did until 1997, the result was a boom in which both sides of the balance sheet improved simultaneously – domestic asset values rose while real appreciation in the value of local currencies eroded the cost of external debt. The process led to imbalances in asset values, however, which ultimately would cause capital to flow out – to devastating effect on the national balance sheets.
The incorrect lesson learned was that it was too much external debt and the lack of foreign currency reserves which left a country vulnerable to crisis (this lesson, of course, merely seemed to reinforce the lessons of earlier crises in Mexico, Brazil and elsewhere). The policy conclusion was that countries should limit highly liquid forms of capital inflow and systematically run trade surpluses to build the necessary reserves to protect them from the risks of future outflows. Unfortunately in their haste to implement policies that encouraged trade surpluses, financial authorities in China and elsewhere may have put into place the policies that led to equally severe, but largely domestic, balance sheet mismatches. (I strongly believe that next big round of global financial crises will be domestic banking crises.)
The second obvious cause of Chinese macro policies to boost savings was its very Asian reliance on export growth, and import constraint, to achieve sustainable growth in employment. Since exports are the excess of production over consumption, in a growing economy boosting net exports is the flip side of raising the total amount of savings. I think Joan Robinson’s investment multiplier explains how this happens. As Chinese authorities channeled investment into infrastructure and production facilities aimed at developing the export sector, the resulting increase in national income was separated into high savings and low consumption, and the growing difference between production and consumption was exported.
This decision to boost exports had particularly Chinese reasons. While most state-owned enterprises, which had dominated the economy until very recently, were inefficient and had too many useless workers, the export sector could take advantage of China’s natural advantages – cheap but dependable labor, a relatively strong infrastructure, and highly concentrated economic policy decision-making – to fuel an export boom that would absorb workers.
Among the policies put into place to support export growth was an undervalued currency within a rigid currency regime – it had to be rigid to reduce uncertainty among exporters. This export-orientation was exacerbated by the decision to join the WTO which, in my opinion was not about the benefits of free trade (the Chinese government has no natural predisposition to free trade) but rather about the need to use external constraints to open up the domestic markets, which were subject to a host of impenetrable trade barriers among provinces. In that sense I liken joining WTO to Argentina’s use of a currency board (an external constraint) to force discipline on the spending habits of provincial governors.
The third obvious source of excess savings was the transformation taking place in China that significantly increased uncertainty as it reduced the social safety net. As the cost and need for education rose, as medical services collapsed except for those with money, and as it became clear that there would be no protection for those that retired or were put out of work, worried Chinese families put an increasing portion of their rapidly rising income into savings, in an attempt, not yet wholly successful given the pace of the safety net collapse, to protect themselves from uncertainty.
Separating these three factors may unnecessarily imply different operating processes, but of course they are all intertwined and part of the same process. At any rate because of these three processes, and undoubtedly others, the Chinese economy was focused primarily on producing and hoarding. But for this policy to work for such a large economy, it needed the rest of the world (i.e. the US, whose markets were huge, whose financial system was extremely flexible, and whose consumers proved very easily convinced) to play along, and the China-US balance of payments relationship was the obvious result.
China has now found itself stuck in a savings trap. The currency regime has been so successful at boosting the trade surplus that the trade surplus has run out of control and every attempt to rein it in has failed. Unfortunately the currency regime has put into place a self-reinforcing system in which rising trade surpluses cause too-rapid expansion of the money supply, which is funneled by the banking system into greater industrial production, which causes further upward pressure on the trade surplus. It is difficult for China to escape from this trap without a sharp adjustment in the currency, but aside from the continuing need to boost employment, one of the consequences of the currency regime and its subsequent impact on monetary conditions may have been the creation of a very shaky banking system and overinvestment into both production and speculative assets. Since all of these are funded by the banking system, any sharp adjustment, aside from the adverse short term impact on employment, could have significant unintended consequences for the country’s very rigid and opaque financial system.
Much of the argument about the impact of the currency regime on China’s trade surpluses or the US trade deficit misses the point. Many economists argue that China should not revalue because revaluing the RMB would have no impact on net US-China trade. They say that since 40% of China’s exports are reprocessed imports, a change in the value of the currency would simply net out in the final export prices for a large fraction of Chinese exports. They also argue that China competes largely with other Asian countries, so even if a revaluation caused its export prices to rise significantly, the only effect would be to shift its trade surplus to other Asian countries, which would leave the US and European trade deficits with Asia unchanged. Finally, since China is the dominant player in many of its foreign export markets, it has sufficient pricing power that a rise in its export prices would have a minimal impact on its sales volumes, and in fact could actually cause the monetary value of its exports to rise further.
In spite of the fact that all but the first of these arguments are intellectually dubious for a number of reasons, and in fact really argue in favor of a currency revaluation (after all, if raising the value of the RMB will have little impact on China’s export volumes, and may even boost them, why not revalue and so improve China’s terms of trade?), they miss the main currency argument. China is running a rising trade surplus because, by definition, it produces more than it consumes, and production is growing faster than consumption. The root cause of the excess and growing Chinese production – as I see it, anyway, and have repeated ad nauseum in my blog – is China’s out-of-control monetary expansion. This is itself caused by the rising trade surplus and augmented by FDI, attracted by the impact of an undervalued currency on real assets, and hot money inflows, aimed at taking advantage of the expected currency rise. A revelaution will not reduce the trade surplus because of its direct impact on export prices. It would reduce the trade surplus if it caused a reversal of capital flows sufficient to eliminate the monetary expansion that is at the root of the growing surplus.
As long as China is locked into this system, the trade surpluses will not go away. Until there is a sharp adjustment – voluntary on the part of the financial authorities in the form of a maxi-revaluation, or involuntary in the form of a banking or investment crisis, which I fear is increasingly likely – it is not possible for China to get out of this trap.
In China consumption levels are not nearly enough to absorb the level of production needed to maintain employment (unemployment is actually rising, especially among college graduates). This is just another way of saying that Chinese savings are too high. This is also just another way of saying that China must run a trade surplus, and if China must run a trade surplus, and if it invests almost all of its reserves directly or indirectly (as in when it purchases oil stocks) in US assets, it is almost inevitable that the US run a trade deficit. The only logical alternative would be for Europe or Japan to replace the US in that role, and for structural and political reasons I think this will be difficult.
If you agree that Bernanke is right – the world is saving too much – then the argument that we need to boost US savings could be a very dangerous one. A world with excess savings does not need its largest economy to save more. Of course a sudden rise in US savings would quickly reduce the US trade deficit, but it would do so not by boosting US or global demand for US products but rather by depressing US demand for imports. Since US exports are highly correlated with US imports, a reduction in US import demand would probably also lead to a reduction in US exports (the US sells the machinery used to make the goods that are sold to the US), meaning that total US imports would have to decline by more than the current trade deficit in order to bring it into balance, because US exports would also decline.
Global and US consumption and production, in other words, would have to fall, and the US and the world must become poorer for the US trade deficit to go away. It is no secret that one way of eliminating the US trade deficit would be for US consumption to collapse and unemployment to rise, and I worry that this is exactly what a boost in US savings means. If you think that growing foreign claims on the US are such a severe problem that it is worth increasing unemployment in the short term to correct the imbalance, then you might still support boosting US savings, and the short-term consequences be damned, but if you are not worried, as I am not, it seems like too high a price to pay.
By the way, the reason a country should save is so that its investment needs are met. The US is an exception. Its financial system is able to draw on global savings for all its domestic investment needs. I am not sure “excess” consumption is as much a problem for Americans as it would be for other countries, although I would never say this in polite company for fear of getting hit on the head with bricks by all the millions of puritans and contrarians out there.
The real problem in the US-China relationship is not in the US, I think. It seems to me that China has the bigger problem. China cannot afford an interruption of this system, but unfortunately it is locked into a series of what I think are unsustainable processes. It cannot afford such rapid monetary growth but it has no easy way in which to turn it off. It cannot continue to channel so much money into speculation and overinvestment, but again there is no way to slow things down. Because the financial authorities are so reluctant to make tough decisions now, the decisions are very likely to be forced onto them by adverse events in the markets, and it is almost certain that these will come at the worst possible time. China simply does not have the flexibility the US economy has, and its ability to absorb shocks is limited.
