The Federal Reserve Must Prolong the Party

The Federal Reserve must prolong the party

By Martin Wolf

Published: August 21 2007 18:58 | Last updated: August 21 2007 18:58

“Over the past decade a combination of diverse forces has created a significant increase in the global supply of saving – a global saving glut – which helps to explain both the increase in the US current account deficit and the relatively low level of long-term real interest rates in the world today.” Ben Bernanke, chairman of the Federal Reserve.*

Has the Federal Reserve been a serial bubble-blower? Or has it been responding to exceptional macroeconomic conditions? Not surprisingly, the implication of Ben Bernanke’s celebrated speech on the global “savings glut” implies the second view. Yet his self-exculpatory perspective is far from universally shared. So who is right? My answer is both. The Fed can indeed be accused of being a serial bubble-blower. But this is not because it has been managed by incompetents. It is because it has been managed by competent people responding to exceptional circumstances.

The savings glut is a palpable reality. But it is important to be precise about what it means. What one means by a global savings glut is an excess of savings over investment (or income over spending) in much of the world, largely offset by an excess of investment over savings (or spending over income) in a limited number of countries among which the US is predominant. In 2006, the current account surpluses – or excess of savings over investment – in the countries with surpluses was about $1,300bn, or a sixth of the gross savings of the world, excluding the US. The US current account deficit absorbed close to two-thirds of this surplus. The US has been the world’s spender and borrower of last resort.

Since global long-term real interest rates have been modest, the argument that profligate US spending has been crowding out spending elsewhere is not credible. It is more plausible that excess savings elsewhere have been “crowding in” US spending.

How has this worked? Foreigners have been buying US assets on a vast scale. Between the first quarter of 2002 and the first quarter of 2007, foreign governments did supply as much as 48 per cent of the net financing of the US current account deficit. This should be viewed as “vendor finance”, intended to provide the US with money needed to buy the exports from countries providing the capital. To this extent, the US current account deficit has driven the capital inflow. But the US is still receiving a capital inflow that finances its vast current account deficit.

If foreigners are net providers of funds, some groups in the US must be net users: they must be spending more than their incomes and financing the difference by selling financial claims to others. The challenge for US policymakers is to ensure that these groups also spend enough to absorb the economy’s potential output. This required spending is in excess of potential gross domestic product by the size of the current account deficit. At its peak that difference was close to 7 per cent of GDP. More recently, it has come down to 5 per cent, as the dollar has tumbled, but also as the economy has slowed.

Who did the offsetting spending since the stock market bubble burst in 2000? The short-term answer was “the US government”. The longer-term one was “US households”.

The US government moved massively from financial surplus into deficit, the total swing being 7 per cent of GDP, between the first quarter of 2000 and the third quarter of 2003. It is right to criticise the structure of the Bush tax cuts. Yet once the stock market bubble burst, how could a deep recession have been avoided without a fiscal boost?

Now look at US households. They moved ever further into financial deficit (defined as household savings, less residential investment). Household spending grew considerably faster than incomes from the early 1990s to 2006. By then they ran an aggregate financial deficit of close to 4 per cent of GDP. Nothing comparable had happened since the second world war, if ever. Indeed, on average, households have run small financial surpluses over the past six decades.

The recent household deficit more than offset the persistent financial surplus in the business sector. For a period of six years – the longest since the second world war – US business invested less than its retained earnings. Businesses had become net sources, not users, of finance. One way of thinking of the private equity boom is as a tax-efficient way of extracting cash no longer needed by US (and other countries’) businesses.

What has all this meant for policy? The answer is simple: the Fed has, willy nilly, pursued a monetary policy capable of inducing a huge and unprecedented financial deficit among US households. This has, not coincidentally, also meant a rapid rise in household indebtedness. The vehicle through which this policy has worked has been asset-backed borrowing and lending, the activity that has so spectacularly derailed this year. To put the point more broadly, monetary policy normally works via asset markets. In the latest cycle, the most affected sector has been households, the vehicle asset market has been housing and transmission has been via securitised lending.

Nothing that has happened has been a product of Fed folly alone. Its monetary policy may have been loose too long. The regulators may also have been asleep. But neither point is the heart of the matter. Assume that the US remains a huge net importer of capital. Assume, too, that US business sees no reason to invest more than its retained profits. Assume, finally, that the government pursues a modestly prudent fiscal policy. Then US households must spend more than their incomes. If they fail to do so, the economy will plunge into recession unless something else changes elsewhere.

This is why the Fed is sure to cut interest rates if today’s crisis seems likely to reduce the supply of credit (as surely it will). Would that work or might the Fed find itself “pushing on a string”, as the Bank of Japan did so painfully in the 1990s and early 2000s? A good guess is that the policy would work. But if it did not, there would be only two ways out: a huge fiscal expansion in the US or a huge reduction in the US current account deficit. The former looks undesirable and the latter inconceivable.

Today’s credit crisis, then, is far more than a symptom of a defective financial system. It is also a symptom of an unbalanced global economy. The world economy may no longer be able to depend on the willingness of US households to spend more than they earn. Who will take their place?

* The Global Saving Glut and the US Current Account Deficit, March 10 2005, www.federalreserve.gov

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August 22, 2007

The Federal Reserve must prolong the party

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August 22, 2007 in Global economy, US economy, US policy | Permalink

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Tito Boeri: I am bit less optimistic than Martin. First because the legacy of the low interest rate policy followed by the Fed is more serious than hinted by Martin as it changed dramatically incentives of financial intermediaries, induced to extend credit to families and companies with only limited financial strength. There is a need of a strong signal that things are changing. And here it comes my second concern. If I am not wrong, it was precisely Ben Bernanke, who was at that time member of the Board of Governors, to strongly argue in favour of a low interest rate policy fearing a major recession in 2002-3. Last Friday’s communication from the Fed didn’t clarify the intent behind the ½ point decrease in the discount rate. It may just be a prelude to yet another overreaction to the market crisis. I do hope that this is not the case. We do not need new overreaction sowing the seeds of a future crisis today.

Posted by: Tito Boeri | 22 Aug 2007 17:18:16 | Report this comment

Akio Mikuni: I agree with Martin that today’s credit crisis is telling the world that US consumers will no longer be able to play the role of injecting global demand, and should be replaced by somebody else.

I am tempted to say that Japan might be able, unwittingly, to expand demand.

At the last upper house election, the Democratic Party of Japan (DPJ), the opposition party, won a majority of the upper house for the first time. Needless to say, it has yet to win an election of the lower house in order to organise its cabinet and run the country. DPJ’s success has been generally ascribed to the failures of Abe’s administration in handling properly public outcry associated with missing records of the National Pension Fund, and scandals surrounding his cabinet ministers.

After the dust has settled, it has become somewhat clear that there was another pertinent reason. DPJ’s election campaign promised to give policy priority to higher and better living standards of voters, together with concrete items the DPJ would deliver. This “revolutionary” strategy won the heart of voters, and was identified as a relevant reason for the DPJ victory even by the Liberal-Democratic Party (LDP) and Komeito, its coalition partner.

In past Japanese elections, voters voted for those candidates recommended by employers. LDP is supported by banking and industry. The employees’ entitlement of lifetime employment had been traded for voting for recommended candidates.

The financial crisis forced Japanese corporations to give up such arrangements, and coincided with the end of cross-shareholdings, which was instrumental for management to control shareholders’ voting.

The DPJ exploited these unleashed votes by offering what voters longed for individually and duly won the election.

Probably, Japan’s living standards could be improved by letting the yen to appreciate. However, there are many arguments within and outside Japan to say the appreciation of the yen will drive Japan’s fragile economy back into deflation. But I could argue otherwise.

First, the Bank of Japan could normalise or raise interest rates. If done sufficiently, the BOJ would see hoarded cash or “savings under the tatami” return to bank deposits, recovering reserve deposits of the banking system to the order of 30 trillion yen, which would result in more aggressive lending in the domestic market. Higher interest income accruing from the vast savings of older citizens would be translated into higher consumer spending.

Second, higher interest rates would drive the yen to appreciate. A strong yen would reduce capital export and bring back purchasing power from abroad and reduce import costs substantially, thereby freeing more purchasing power and expanding consumer spending.

Third, reductions in production by export manufacturers would be more than offset by rising domestic service production necessitated by increased consumer spending, provided effective incentives were given.

We should observe more intensely and carefully how Japan’s politics develop in coming months.

Posted by: Akio Mikuni | 23 Aug 2007 09:23:37 | Report this comment

Ronald McKinnon: Martin Wolf has provided a masterly summary of US sectoral imbalances. The huge net deficit of the household sector, including residential construction, of the order of 4 per cent of GDP is indeed without historical parallel. With the subprime crisis and new restraints on mortgage lending, coupled with a fall in home prices, the American household’s sector should turn around fairly quickly and become a normal surplus.

Should we worry? Martin certainly does when he puts on his Keynesian hat toward the end of his column and frets about a deficiency in global aggregate demand. However, on the positive side, the long overdue righting of the financial imbalance in American households is both opportune and necessary in the long run to reduce the huge American current account deficit. But how can this be accomplished in the near term without falling into a pit of deficient global aggregate demand?

Instead of nattering about the dollar’s exchange rate, which is the wrong variable to adjust, the US Secretary of the Treasury should now approach his counterpart finance ministers in East Asian countries and possibly Germany to expand aggregate demand jointly. In China, for example, household consumption has been lagging behind the very rapid growth in GDP; and China’s recent success—not fully anticipated—in collecting taxes could be generating an as yet unrecognized fiscal surplus. Similarly, Japan has actually been running public sector surpluses over the past four years. So these governments, and Germany’s, can afford to be fiscally expansive over the next two years or so as part of a world wide countercyclical policy. Apart from international altruism, each of these countries has an individual incentive to expand fiscally because their exports will decline as the American consumer is forced to retrench.