One of the most publicised theories regarding the current state of
the world economy, and the causes of the international financial
crisis, is that regarding 'global imbalances'. This thesis has been
presented at book length by Martin Wolf in Fixing Global Finance, as well as in numerous articles in his position as the Financial Times chief economics commentator, by Stephen Green of Standard Chartered, by David Cohen of Action Economics, by Brad Setser, by Michael Pettis, Professor of Finance in Peking University, and numerous other authors.[1]
This theory has however been described as erroneous
by Asian leaders. That they are right in this opinion will be shown
below. Specifically there is a logical incoherence in the theory in
that its policy prescriptions are not entailed by its analysis. This in
turn leads to it not being in accord with the facts of the world
economy as the global imbalances it describes are shrinking by quite
other mechanisms than the ones it outlines. As a result it is wrong in
its policy proposals - as shown by the fact that the most rapid
economic growth is being enjoyed by an economy, China, which is
pursuing policies which are the opposite of those prescribed by this
theory.
A theory which is deficient in coherence, and which
fails to foresee the possibility of reducing global imbalances by
mechanisms which are actually occurring, is evidently a theory which is
erroneous.
Given the wide range of those supporting variants of what will be termed
the 'global imbalances hypothesis' this theory naturally has a number of
secondary variations. But they have a common core consisting of an
analysis coupled with a policy conclusion which it is alleged is entailed by it.
On
this theory, the well known problems of the US financial system are
outward signs of a much more fundamental malaise of imbalances in the
world economy. In the words of Martin Wolf:
'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…. 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.'
The core analysis of this theory is that the world economy has
been characterised by two global imbalances, the first being the US
balance of payments deficit – ascribed to US lack of saving/over
consuming, the second being China's balance of payments surplus –
allegedly caused by China 'over saving'. The policy conclusion which
allegedly follows from this is that the US save more and China save
less.
As Brad Setser
put it: 'the global economy prior to the crisis was characterized both
by high levels of both savings and investment in Asia and the oil
exporters and by high levels of consumption and low levels of savings
in the US. 'Therefore, as Robert Skidelsky
phrased it: 'emerging market economies need to spend more and save
less, and mature market economies need to spend less and save more.'.
As Martin Wolf
put it specifically regarding China: ''does it make sense for China to
save so much or, for that matter, to invest so much?... Higher
consumption today would surely be desirable.'
It is unclear in some variants whether this theory is being put
forward merely prescriptively or whether it is stated that the trends
it proposes as desirable are actually occurring – or a combination of
the two. However it is clear that a number of its supporters believe
that the proposed policy prescriptions of this theory are actually
occurring. Thus for example Robert Skidelsky
argued in July: 'In fact the present financial meltdown is producing
the market-led adjustment that has eluded policy makers. Willy-nilly
Americans are having to spend less and save more.'
The 'global imbalances hypothesis' has become so prevalent it
may be described, in the phrase popularised by JK Galbraith, as a
'conventional wisdom'. Unfortunately, like many other previous
conventional wisdoms it is not true. There are a number of further
aspects of the 'global imbalances hypothesis' which are wrong, and
which have earlier been analysed
on this blog. But if a theory, as will be shown, is inconsistent and factually
wrong that constitutes adequate grounds why it should not be maintained. A new, more correct, conventional wisdom is required.
Inconsistency of the theory
The
economic inconsistency of the 'global imbalance hypothesis', that is
that the policy prescription does not logically follow from the
analysis, is easily demonstrated. A country's balance of payments is,
by basic accounting identity, equal to the difference between its
domestic savings and its domestic investment - the US deficit is
exactly equivalent to the degree that US savings are lower than its
domestic investment, China's surplus is exactly equivalent to the
degree that its savings are higher than its domestic investment.
It immediately follows from this identity that the only way to
correct such imbalances, if that is set as the overriding goal of
policy, is not at all, as the 'global imbalances hypothesis' suggests,
for the US to save more and China to save less. It is equally possible
to solve these imbalances, again if this is set as the policy goal , by
the US investing less and China investing more. Furthermore it is this latter
process affecting investment, not the ones foreseen by the 'global
imbalances hypothesis', that is actually occurring and leading to the
lessening of the global imbalances.
To take this in detail, factually global imbalances are indeed
rapidly declining – the US balance of payments deficit is shrinking and
China's balance of payments surplus is declining. But they are doing so
for reasons that are the the opposite to those outlined in the theory above.
Far from US saving rising it is declining. The US balance of payments deficit is therefore not
shrinking because US saving is rising but because US investment is
falling even more rapidly than US saving. China's balance of payments
deficit is not declining primarily because it is consuming more but
because it is investing more – that is, because China is moving
its investment level up to its savings level, and in so doing
generating the most rapid rate of growth in the world .
These factual trends have previously been outlined both regarding the US and China
on this blog. The latest data which allows a major testing of the
different theories is the publication of the second quarter US GDP
figures together with data for the equivalent period for China's trade
and GDP. All US data below therefore, unless specifically stated
otherwise, is calculated from the tables accompanying the US second
quarter 2009 GDP figures published by the US Bureau of Economic Analysis.
The data shows clearly that the trends taking place in the world's two
largest economies are not those in the 'global imbalances hypothesis'.
The rise in US consumption
Taking
first the fundamental trend in US consumption, it is clear that under
the impact of the international financial crisis US consumption has not
fallen but risen further as a percentage of GDP. This is shown in
Figure 1.
As may be seen total US consumption, the sum of
personal and government consumption, rose rapidly as a proportion of
GDP from 1997 until the end of 2003, then stabilised until the end of
2007, and then began to rise sharply again from the beginning of 2008
under the impact of the developing financial crisis.
Figure 1
Taking precise figures, between the
last quarter of 2007 and the second quarter of 2009 US consumption rose
from 85.8% of GDP to 87.6% - an increase of 1.8% of GDP. Between the
second quarter of 2008, the last before the opening of the entirely
open financial crisis with the collapse of Lehman's, and the second
quarter of 2009 US consumption rose from 87.0% to 87.6% of GDP. Between
the first and second quarters of 2009 US total consumption rose from
87.2% to 87.6% of GDP. The trend of rising US consumption under the
impact of the financial crisis is therefore clear. More detailed
breakdown of this rising share of consumption in US GDP may be found in
the footnote. [2]
If US consumption has risen as proportion of GDP why,
therefore, has the US balance of payments deficit been shrinking? By
accounting identity this deficit is necessarily equal to the shortfall
of US savings compared to domestic investment. Therefore shrinkage of
the deficit means the gap between saving and investment is narrowing
despite consumption rising. The explanation is that US savings are not
increasing but falling, but US investment is falling even more rapidly than US saving.
The decline in US investment and saving
Analysing
first investment, for which the necessary detailed data is available in
the US second quarter GDP figures, these show that US total investment
fell between the fourth quarter of 2007 and the second quarter of 2009
from 19.1% of GDP to 14.8% - a decline of 4.3% of GDP.[3] In the period
between the second quarter of 2008 and the second quarter of 2009 US
investment fell from 18.3% to 14.8% of GDP.
Turning to savings, ideally one would wish to have direct
measurement of total savings for the second quarter of 2009, which were
not published with the GDP figures, and figures for the US balance of
payments for the same period – which are also not yet published.
Fortunately, however, the shifts in the US trade balance are so large
that it is relatively easy to work out the trends.
Savings equal the sum of total investment, for which full US
figures are available, minus the balance of payments deficit – for
which second quarter figures are not yet available. But shifts in the
US balance of payments are dominated by changes in the trade balance.
Provided, therefore, that it is being used to establish a qualitative
direction of change, and is not projected as an exact statistical
calculation, it is perfectly possible to use the major shift in the US
trade balance to show the change in the direction of US savings.
If 2008 is taken as the year in which the financial crisis
unfolded then the US balance on trade in goods and services fell
between the last quarter of 2007 and the second quarter of 2009 from
4.9% of GDP to 2.5% - an improvement of 2.4% of GDP (see Figure 2).
Figure 2
It follows from the data above
that US investment has fallen by 4.3% of GDP since the beginning of the
financial crisis while the US balance of trade has improved by only
2.4% of GDP - a difference of 1.9% of GDP. If all other components of
the balance of payments had remained the same then this would
necessarily mean that US savings had also declined by 1.9% of GDP – if
savings had remained static, and other components of the US balance of
payments had remained constant, then a 4.3% of GDP fall in investment
would have translated into a an equivalent 4.3% improvement in the
balance of payments figures. The 1.9% of GDP gap between the 4.3%
decline in investment and a 2.4% fall in the balance of payments would
necessarily mean that US savings had fallen by 1.9% of GDP.
Evidently
no such precise quantitative assertion can be made as what is being
calculated above is the trade balance and not the overall balance of
payments. But it means that for US savings not to have fallen
components of the US balance of payments other than trade would have
had to improved by 1.9% of GDP or $269 billion. This is completely
implausible and it is therefore evident that US savings have been
falling.
This is confirmed by taking the latest figures for
which there is measured data on total savings, that is for the first
quarter of 2009. Between the fourth quarter of 2007 and the first
quarter of 2009, US total savings fell from 13.9% of GDP to 11.5% of
GDP. These trends of falling US savings are shown in Figure 3.
Figure 3
The reason some media commentators
have claimed US saving is rising, when it is actually falling, is
because they confuse household saving (which rose from 1.1% of GDP to
4.0% of GDP between the last quarter of 2007 and the second quarter of
2009) with total saving (the sum of household, company and government
saving). The rise in US personal saving is however being more than
offset by the decline in company and government saving – hardly
surprising given the scale of the US budget deficit. Robert Skidelsky's
statement, cited above, that US saving is rising is therefore
inaccurate - it appears he may be making an incorrect generalisation
from personal saving to total saving.
Michael Pettis
claims that US consumption is falling more rapidly than GDP, which
would imply saving is rising, but unfortunately makes two errors –
first he confuses personal consumption with total consumption, and
second he fails to note that shifts in relative prices mean that
although in volume terms US personal consumption fell more rapidly than
GDP in the second quarter of 2009 it increased as a percentage of GDP.
From the point of view of global imbalances, that is the US balance of
payments deficit, it is the proportion of GDP devoted to consumption
which is determining and not movements in volume.
It is therefore clear that the first part of the 'global
imbalances hypothesis' regarding the US is wrong. The imbalance of the
US balance of payments deficit is not falling because US saving is
rising but because US investment is falling even more rapidly than US
saving is falling. Now consider China.
China's rising investment and declining trade surplus
While
the macro-economic data available for China for the second quarter of
2009 is not as detailed as for the US nevertheless, again, the shifts
are so large it is relatively easy to ascertain the trends.
The first trend is that China's investment is rising as a
percentage of GDP. Second China's balance of payments deficit is
declining. These will be considered in that order.
First, taking the rise in China's investment as a percentage of
GDP, the components of the 7.1% rise in GDP in the first half of 2009
were 6.2% rise in investment, 3.8% rise in consumption, and minus 2.9%
fall in net exports. Unless China's savings were increasing
equivalently such a rise in the percentage of investment in the economy
necessarily means that China's balance of payments surplus must fall.
As
with the US balance of payments figures for China for the second
quarter of 2009 are not yet available. But the drop in the trade
surplus, which dominates China's balance of payments position, is of
sufficient magnitude that it is clear that China's balance of payment
surplus is falling.
Figure 4 shows China’s monthly trade surplus since 1992 up
to June 2009. Figure 5 shows the same
data calculated as a three monthly moving average in order to avoid any
purely short term distortions.
Figure 4
Figure 5
The trend is clear. China’s trade surplus rose
steadily from 2005 onwards and then temporarily rose even further under
the impact of the onset of the international financial crisis in
September 2008. The peak was reached in January 2009 with a monthly
surplus of $42.1 billion. Since then China’s surplus has fallen
steadily. The surplus for June was $8.25 billion.
Expressed in terms of three monthly moving averages China’s monthly
trade surplus was $22.5 in August 2008, immediately before the collapse of Lehman brothers, rose to $38.1
billion in January 2009, and has since dropped to $12.5 billion.
Shifts
in other components of China's balance of payments sufficient to offset
the rapid decline in the trade surplus are not credible so it is clear
that China's overall balance of payments surplus has shrunk - meaning
the gap between China's savings and investment has narrowed.
While
savings figures are not available for China at present it is clear from
the data above that they have not risen to match China's rise in
investment. There are reasons to believe China's savings may have
declined somewhat – China's budget is projected to move into a 3% of
GDP deficit, profitability of export and other industries is under
pressure from the international financial crisis, and given a 15% rise
in retail sales there is no reason to believe household saving has
risen significantly (if at all).But it is clear that China is fundamentally
responding to the financial crisis by raising its rate of investment.
The result has been the most rapid rate of growth in the world.
The
logical lacunae in the global imbalances hypotheses, that it did not
point out that China could just as much reduce its balance of payments
surplus by increasing investment as by reducing saving, is therefore
the actual course of China's economic policy - with the most successful
results of any country in the world.
Indeed it is quite probable that this year, in net terms,the whole of
world growth will be accounted for by the expansion of China's economy.
Compared to this level of economic success all discussion of 'green
shoots' in other economies is insignificant.
The errors of the 'global imbalances hypothesis'
For
the reasons set out above it is therefore not material that the 'global
imbalances hypothesis' is conventional wisdom - many things that are
conventional wisdom turn out to be false, nor that a number of those
supporting it are outstanding economists, nor that Martin Wolf is one
of the world's outstanding economic journalists with a deep knowledge
of economic statistics etc. A theory which lacks internal coherence,
which is factually wrong, and which leads to wrong policy prescriptions
is a theory that does not meet the test of scientific rationality. It
should therefore be set aside.
Instead the realities of the world
economy should be recognised. The US balance of payments deficit has
been shrinking not because US saving has been rising but because US
investment has been declining more rapidly than US saving has been
falling. China's balance of payments surplus has been declining
primarily because its investment level has been rising. That is, the
logical gap which existed in the 'global imbalances hypothesis'
corresponds to the actual course taken by the world economy. As always
when the facts and a theory do no coincide it is the theory which
should give way.
Notes
[1] The wide circulation of this analysis may be traced to a speech by Ben Bernanke, now Chairman of the Federal Reserve,
[2] Breaking these figures down into their detailed components
US personal consumption rose from 69,9% of GDP to 70.6% between the
fourth quarter of 2007 and the second quarter of 2009. In the period
from the second quarter of 2008 to the second quarter of
2009 US personal consumption rose from 70.3% of GDP to 70.6%. US
personal consumption increased between the first and second quarters of
2009 from 70.4% of GDP to 70.6%.
To
calculate precisely how much US government consumption has risen it is
necessary to note that the US is unusual in that in its main aggregate
GDP statistics it groups together government consumption and government
investment – most countries statistically treat government investment
simply under overall investment. If the two components (consumption and
investment) of US government expenditure are taken together they
increased from 19.2% of GDP in the last quarter of 2007 to 20.7% of GDP
in the second quarter of 2009. It is necessary to eliminate from this
the rise of government investment from 3.3% of GDP to 3.6% of GDP in
the same period. Government consumption rose from 15.9% of GDP to 17.0%
of GDP. In the period since the second quarter of 2008 US government
consumption has risen from 16.4% to 17.0% of GDP.Government consumption
rose from 20.3% to 20.7% of US GDP between the first and second
quarters of 2009.
Considering, therefore, both total
consumption and its breakdown the rising proportion of consumption in
US GDP since the beginning of the financial crisis is clear – indeed
consumption has risen as a proportion of US GDP both as regards
personal consumption and government consumption.
[3] Private fixed investment declined from 15.8% to 12.3% of GDP,
inventories fell from plus 0.1% of GDP to minus 1.1.% of GDP, and government
investment rose from 3.3% to 3.6% of GDP.
