The Root Causes of Global Imbalances
For this week’s blog entry I want to go a little abstract in order to suggest how different countries that participate in the global imbalances are going to adjust. The debate over the root causes of global imbalances is as fierce and as confused as ever. The confusion isn’t helped by the vast army of moralizers who like to contrast the hard work and thriftiness of households in high-savings countries with the laziness and binge-buying behavior of households in high-consuming countries. The world cannot possibly rebalance, they argue, until the later become more like the former.
Ok, I admit there are good reasons to recommend this argument. There are few things in the world as satisfying as being able to deride the moral weaknesses of our neighbors, especially if we are lucky enough to have the very high savings rates that come automatically with very high income levels.
There are nonetheless some obvious flaws in the argument. First of all, if the high-consumers become as virtuous as the low-consumers, that just means that global demand will decline, and with it, global unemployment will rise. In that case global savings won’t go up. They will go down, since rising unemployment causes income to decline faster than consumption.
Second, lazy spendthrift Americans are actually more productive and work longer hours than people in almost any other rich country, including the harder-working and higher-savings counties in Europe. Still, the argument does anyway fit in with a lot of cultural stereotypes about Spaniards and Greeks, with their wild lifestyles, long siestas, and dissolute charm, or about Germans and Dutch, whose tasteless food, boring sex lives, and grim movies leave them no choice but to work away at office and factory.
But is this really why people in some countries love to save and people in other countries love to consume? No, it isn’t. Aside from the satisfaction it brings, this moralistic argument is almost meaningless. Individual preferences may cause some of us to save more of our income than others, but we have to be very careful about generalizing. When entire counties have abnormally high or low savings rates, individual preferences are never the reason. Abnormally high or low savings rates are almost always caused by trade, industrial or tax policies at home and abroad that distort the relationship between consumption and production.
It might help to explain why this is the case if we call all the high-savings countries “Germany” and all the high-consuming countries “Spain”. Giving them these names may seem a little provocative, and will probably generate some hate mail, but I guess less so than calling them “China” and “the US”.
It turns out that domestic policies by the German government can explain both high German savings and low Spanish savings. For example assume that Germany has an undervalued currency, low wages relative to productivity, high explicit or hidden consumption or income taxes (repressed interest rates, for example, or environmental degradation), and high quality infrastructure subsidized by these taxes.
Notice how these work. Undervalued currencies and low wages relative to productivity have the effect of reducing the real value of household income and subsidizing manufacturers and employers. Consumption and income taxes also reduce household income in real terms, and by using them to subsidize infrastructure they reduce production costs.
These aren’t necessarily bad things – they can generate real growth especially when there is excess labor and poor infrastructure, but they can also become too much of a good thing. The main point is that under these conditions it is very likely that German GDP growth will exceed the growth in household income.
Why? Because all of these things tend to siphon off household income (or raise the price of consumption, which is the equivalent of a reduction in household income) and use the proceeds to subsidize production. In that case production growth is goosed while household income growth is constrained.
Savings Must Rise
If the German financial sector is also repressed, with constraints on consumer credit, consumption growth will largely be determined by the growth in household income. German consumption, in other words, will rise in line with German household income, which will be less than the growth in German GDP. Remember that national savings is equal to national production of goods and services less national consumption, and as production rises faster than consumption, by definition the savings rate must rise.
As German GDP growth exceeds consumption growth, in other words, the German savings rate will rise automatically, and this will have absolutely nothing to do with whether or not Germans are ethnically or culturally programmed to save money, work hard, and lead boring lives. What’s more, since the trade surplus is the excess of domestic savings over domestic investment, Germany will run a large trade surplus.
By the way, for the many who are skeptical about the relationship between currency value and savings rate, it has to be of at least some interest that countries whose currencies are sharply undervalued tend to have very high savings rates, and those with overvalued currencies tend to have low savings rates. This isn’t a coincidence. The relative value of the currency can have a direct impact on the differential between household income growth and GDP growth, and if it does, by definition it must affect the level of savings.
What about Spain? Obviously if Spain has the opposite conditions, it is likely to have a low savings rate. But it turns out that Spain’s low savings rate might itself also be a consequence of German policies. After all, if Spaniards are as virtuous as Germans, and also produce more than they consume or invest domestically, then the world has a serious problem in the balance of trade. Both countries cannot possibly run trade surpluses.
To put it another way, if both Germans and Spaniards reduce their consumption and increase their savings, the global savings rate will rise. This is fine if the global investment rate rises, but with consumers cutting back on consumption there is no reason for producers to increase investment, so global investment is actually likely to decline.
But savings must equal investment, by definition, so the world is left with two options. It can fund an increase investment, even if it is wasteful and unnecessary, and simply put the day of reckoning off into the future, or it can force global savings to decline. How can it do that? Simple. Fire lots of workers, force up unemployment, and eventually savings and investment will once again balance, albeit at very low levels consistent with much higher unemployment.
Germany’s “virtue”, in other words, is simply the other side of the coin of Spain’s “vice”. One cannot exist without the other, and if they are both forced by German policies, it is hard to speak of virtuous high-savings households and vicious high-consuming households.
And Savings Must Decline
But how are Spanish savings affected by Germany? The most obvious way is through the currency. If Germany’s currency is undervalued, then by definition Spain’s must be overvalued. It doesn’t matter if they share a currency, or if one is pegged to the other. What matters is relative prices and productivity at the exchange rate.
In that case there is an implicit tariff on imports into Germany, which is used to subsidize German manufacturers. This is matched by a tax on Spanish manufacturers, which is used to subsidize Spanish imports. Not surprisingly under these conditions Germans will tend to save and under-consume relative to production and Spaniards to borrow and over-consume. Both are necessary to keep the economy in balance.
But there is more. Since German policies force domestic savings to exceed domestic investment, there are only four ways Spain can respond to German anti-consumption policies. First, it can force up the investment rate. Since German policies are likely to erode the profitability of Spanish manufacturing, private investment is unlikely to rise, but public investment can, funded by German capital exports. This means a rise in government debt. If Spain starts the game with very poor infrastructure, this is a viable policy choice, although it doesn’t really solve the imbalances. It merely pushes off the solution into the future, at which time Germany will be forced to stop being virtuous.
Second, Spain can allow consumption to soar, which means a declining Spanish savings rate. This is usually caused by rising consumer financing funded, again, by German capital exports. If Spain has no control over its interest rates because of manipulation by Germany, this outcome is almost guaranteed.
Third, Spain can allow unemployment to rise as German manufacturing replaces Spanish manufacturing. Rising unemployment of course causes the savings rate to fall as income falls faster than consumption. This allows low Spanish savings to balance high German savings at the expense, of course, of rising Spanish unemployment, which will remain high until wages have declined sufficiently to allow Spain to compete.
And fourth, Spain can devalue its currency against Germany’s currency or impose trade barriers. In either of the two latter cases Germany must adjust with either a rise in domestic unemployment or with an increase in investment.
Notice that these are automatic consequences of policies that constrained the growth of German consumption. The savings rates of the two countries turn out to have nothing to do with siestas and fine dining or with engineers and protestant work ethics. They have to do with policies in Germany.
The opposite can occur too. If Spain puts into place policies that force low savings onto Spaniards, Germany will be forced into high savings. It is pretty rare for this to occur, however, because most policymakers want to increase employment growth in their economies, not reduce it.
Planes and Savings
Let me make another example of how policies affect savings rates – this time perhaps more controversial. Let’s say that Germany, the maker of Airbus, decides to provide such large subsidies to the company that Airbus is able to cut the price of planes in half, and Spain (the maker of Boeings, of course) does not retaliate. This subsidy will probably come from taxes on the household sector. The increase in taxes will reduce European household income (relative to the growth in production, that is – if Germany has high unemployment consumption might actually rise), and with it European consumption, but the Airbus subsidies will almost certainly cause a net rise in European production as the world dumps Boeings and buys Airbuses.
How does this impact German savings? If German production goes up and consumption goes down, savings, which is the difference between the two, must go up by definition. And savings went up not because Germans suddenly decided to become even more German, work harder, and save more. It went up automatically.
And what happens in the Spain? Clearly Boeing goes out of business, so Spanish production drops. On the other hand the fact that planes are so cheap means that Spaniards probably travel more, and so consumption might even rise, or at least drop more slowly than production (again, it depends on the level of unemployment). In that case the Spanish savings rate, of course, must automatically drop. This doesn’t require any increase in the viciousness or laziness of Spaniards. It is an automatic consequence of German subsidy of Airbus.
Trade and industrial polices, in other words, can force savings rate to change regardless of cultural or individual preferences. For this reason the solutions to the global imbalances will not come from exhortations that Spaniards become as virtuous as Germans. Virtue has nothing to do with it. The world requires a combination of policies that force domestic GDP growth to outpace household income growth in Spain and the reverse in Germany. It is just as important that Germany eliminates its anti-consumption policies as it is that Spain restructures its economy and lower wages.
If only Spain adjusts, the consequence must be a rise Spanish debt or a rise in global unemployment. In the latter case, and especially if Spain is unwilling or unable to borrow more, Spain will be forced to consider one of two alternatives. It can intervene in trade, and so force most of the rising unemployment onto Germany. Or it can refuse to intervene, in which case most of the increase in unemployment will take place in Spain. It would be exceedingly virtuous of Spain to choose the latter path.
The world needs less moralizing and more focus on why savings rates vary among countries. Perhaps if the moralizers can go back to discussing teenage promiscuity or President Obama’s birth certificate, policymakers can concentrate on resolving trade imbalances in a useful way. Will this happen? Probably not. My guess is that we will try to resolve the global imbalances by intervening in trade. This is clearly a suboptimal solution from an economic point of view, but it allows moralizing to continue full throttle, and this clearly has substantial value.
Source: China Financial Markets
This is an abbreviated version of the newsletter that went out last week. Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at firstname.lastname@example.org, stating your affiliation, please. Investors who are clients of Shenyin Wanguo Securities will already receive the newsletter. Investors who are not clients but who want to buy a subscription should write to me. also at that address.
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