Strange things are happening in the world economy: falling interest rates on long-term securities, declining spreads between returns on safe and riskier assets, large fiscal deficits and huge global current account “imbalances” should not, in normal circumstances, coincide. So what is going on?
The answer, in a nutshell, is a global excess of desired savings against the background of weak investment, low inflation and ever more integrated economies.
To understand the present we need to go back to the 1930s. The “paradox of thrift” was the most counterintuitive and, to the classically trained economist, morally, theoretically and practically objectionable idea in John Maynard Keynes’ General Theory of Employment, Interest and Money, published in 1936, in response to the Great Depression.
Martin Wolf Financial Times June 13 2005
It is possible, he argued, for the private sector to want to save more than it wishes to invest. That is the paradox: what is good for individuals can be bad for an economy. Today, at the beginning of a new millennium, Keynes’ warning is again apposite.
Unfortunately, in certain circumstances, even lower interest rates may fail to clear the market for investible funds. This is particularly likely if inflation is low – and still more likely if it is negative, as has been the case in Japan for many years.
Large fiscal deficits may then be needed to mop up the excess savings, as has also been the case in Japan. Otherwise, the economy may fall into a slump.
We are living once again in such a Keynesian world.
We can identify only realised, rather than desired, savings.
Despite the fiscal deficits, rough and ready estimates suggest that real long-term interest rates are below 2 per cent in Japan and Germany. But real interest rates are low worldwide.
According to the International Monetary Fund’s latest World Economic Outlook, they have not been this low since the 1970s
Then, real interest rates were low because of unexpected inflation. This time, however, low real interest rates are expected: US and UK government index-linked government bonds are yielding only 1½ per cent, which is less than half their level prior to the late 1990s.
As Maurice Obstfeld of the University of California at Berkeley and Kenneth Rogoff of Harvard point out, “incredibly, the US current account deficit is currently soaking up about 75 per cent of the combined current account surpluses of Germany, Japan, China and all the world's surplus countries
Consider the structure of the global balance of payments in 1996 and 2004. Between these years, the US current account deficit rose by $549bn, to $666bn.
One way of thinking about this is that in a global economy with no global government, the most important regional power – the US – has been following the Keynesian recommendation by offsetting excess desired savings elsewhere. The US authorities did not intend to do that. But that is what they have had to do to generate a decent recovery at home.
This analysis allows us to turn to our third big question: what are the dangers of this way of managing the desired excess savings?
The answer is: large.
The reason for this is that the solution the world has found to the excess desired savings involves an explosive increase in US current account deficits and net external liabilities.
Large exchange rate changes will also be needed, to facilitate the adjustment process. All academic analyses of global balance of payments adjustment conclude that this will require large changes in relative prices or, to put it more precisely, in real exchange rates
Under plausible assumptions, the required adjustment is two times larger than the real depreciation of the dollar that has occurred so far. Some estimates are much larger still.
A way out must be found. Every year additional US liabilities amount to about half its total exports.
“Everyone wants to think they’re smarter than the poor souls in developing countries, and smarter than their predecessors,” says Carmen M. Reinhart
Ms. Reinhart and her collaborator from Harvard, Kenneth S. Rogoff, have spent years investigating wreckage scattered across documents from nearly a millennium of economic crises and collapses.
New York Times July 2, 2010