The other theory (money glut)
The more popular (and easier to understand) theory (which Im not going to cover in this blog) is called the “money glut” theory…which basically says that American Central Bank kept interest rates too low for too long, which led to too much money, too much credit and encouraged too much risk taking by banks and greedy people on wall street. This is the popular version of the story that most people hear every night from their local news commentator. This is NOT the theory that Im going to review in this blog posting. Savings glut (summarized)
The less well known (and more difficult to understand) theory of what-went-wrong…is the “savings glut theory”….which basically says that the root of the problem lies not within the US, but with the fundamental imbalance of international finance.
While finance is risky (borrow short, lend long), it is even more risky when it crosses borders. Countries in Asia and Latin America learned the lesson not to accept deficits after punishing recessions in the 1990’s and early 2000’s. Since then, nearly all emerging nations (and most developed ones, minus USA) have fought hard to keep current account surpluses. In an effort to keep away from risky deficits, many central banks (especially in emerging Asia) have purposefully chosen to (a) keep their currencies undervalued, and (b) to accumulate foreign exchange reserves to buffer against potential shocks. Note that the countries with large reserves in 2009 are the ones most likely to survive this latest crisis with their economies in tact. After seeing the prescriptions given by the IMF after the last round of crises, most emerging countries said “no thanks” to foreign capital, and instead have chosen to run massive surpluses.
The key to understanding the “savings glut” theory is to first understand that the nations “balance of payments“, by definition, must BALANCE. That means that if a country chooses not to accept foreign capital, and therefore if they choose to run a capital account deficit…then they must by definition also run a current account surplus (the current account is physical goods exports). That means that in order to export capital, they must also export products (I know, it gets a bit confusing, sorry). The net result = they must keep the currency undervalued for this to work. And the currency of choice = the US dollar (as a target peg). “Ok, so what is the problem?” you might ask…
Well, due to the rules of global accounting…if one country runs a current account surplus, then others must run a current account deficit. That part is easy to understand….if one country exports, another must import. Ok, but what is less obvious is that if one country runs a capital account surplus (think China), then another MUST run a capital account surplus (think USA). This is the root of the “savings glut” theory…
The savings glut theory states that sometime in the late 1990’s to early 2000’s…there was a massive amount of countries that all decided “thats enough”…no more foreign capital can come in. It was too risky, and led to too many crises. As Martin Wolf says, they chose to “smoke, but not inhale” from international finance…and so began a massive financial recycling program, whereby money that came in quickly was sent back to sender. Money no longer flowed from rich countries to poor ones…instead money was borrowed on a massive scale from poor ones to rich ones.
Why did this happen? The theory is that international finance proved to be too risky, and so developing countries almost unanimously chose to reject international finance and send it back. (the only emerging markets that did not follow this prescription seems to have been the emerging Eastern European nations, many of which are now facing crisis…on a much deeper scale than emerging Asia). Enter the “borrower of last resort”
But, with all of these emerging countries sending money back, unfortunately, there was only ONE country on the planet that was willing and able to accept it: the USA. (note that economists that subscribe to this theory are extremely critical of Germany / Japan and other developed nations that did not take some of this capital that was flooding the USA).
The US, as the theory goes, was uniquely capable to absorb this flood of “savings” because the US dollar was the global reserve currency, and the US could borrow in its own currency on a massive scale (with no chance of foreign exchange crisis).
Who Believes this theory?
Surprisingly, the “savings glut” theory has some pretty impressive followers…
- Ben Bernanke is the most famous. He outlined this exact position in a famous speech in 2005: http://www.federalreserve.gov/boarddocs/speeches/2005/200503102/default.htm
- Another is Martin Wolf (FT.com chief columnist). Take a chance and read his book on “Fixing Global Finance” see link below… it is a very well documented, and well thought out summary of the global “savings glut” theory (with his recommendations for the future)… a summary (brief) can be found here: http://www.ft.com/cms/s/0/f7d97f0c-1901-11dc-a961-000b5df10621.html
- Another is Greenspan…who in 2005, called the mixture of low long-term interest rates and high productivity growth a “conundrum”, which could only be explained by a flood a cheap credit from abroad… see http://www.federalreserve.gov/Boarddocs/hh/2005/february/testimony.htm
- Even the Economist magazine seems to have jumped on board with this theory as of late. (see the special report on fixing global finance here and here)
- the list goes on and on….
Who is to right? Who is to blame?
The reality is that both “savings glut” theorists and “money glut” practitioners are probably each 1/2 right. I read somewhere…”the Chinese may have supplied the noose, but it was the US that strangled themselves”…Thats probably the most accurate way of reconciling the “savings glut” vs “money glut” theories… More on the “Savings Glut”