Why it is misleading to blame financial imbalances on a saving glut
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Credit glut vs savings glut: US financial sector balance sheets surge vs GDP. Data points to domestic credit creation, not foreign savings, as key driver of financial imbalances.
Economist Staff, "Why it is misleading to blame financial imbalances on a saving glut,"The Economist, November 28, 2020, https://www.economist.com/finance-and-economics/2020/11/28/why-it-is-misleading-to-blame-financial-imbalances-on-a-saving-glut
Read it and found it underwhelming, given the massive rise in gross flows prior to the crisis correlate with large scale global reserve growth in surplus countries. BIS also didn’t seems to acknowledge anywhere in the paper that the global financial system was intimidating the savings glut which allowed/forced them to expand credit.
Just an FYI, Economistwrite up of new paper from BIS making the case for a “credit glut” (paper attached) maybe better characterized as a banking glut that in the writers view offers a better explanation than the savings glut case.
Core of their credit glut hypothesis, “…Furthermore, while the global saving glut hypothesis argues that foreign saving financed the US current account deficit, our results clearly highlight the entirely distinct behavior of foreign saving and foreign financing…The credit glut view instead appeals to domestic credit and creation of purchasing power as the driving force of the divergence, and the impulse response in Figure 9 is at least qualitatively consistent with the divergence - output and inflation increase and lead to an increase in the real policy rate, while the lending spread decreases very significantly. In fact the lending spread shown in Figure 9 is the net effect of an increase in the regulatory spread of around 60 basis points (due to higher bank leverage) and a decrease in the retail lending spread of around 120 basis points (due to lower perceived household credit risk).…”
“… This analytical framework allows us to shed new light on four important policy debates that are associated with international capital flows. The first debate concerns the pervasive use of current accounts as indicators of financial vulnerability. The issue with this practice is that in a financial crisis lenders, who can be domestic as well as foreign, do not stop financing current accounts, they stop financing debt. Even with a zero current account and net foreign liabilities position, an economy can exhibit very large gross debt positions that are vulnerable to reversals. Furthermore, there are many different categories of debt. Some of these categories could be far more vulnerable to reversals than others pre-crisis, and post-crisis the effects of reversals on vulnerability depend on their differential effects on different categories of debt. Interpreting the current account as the principal indicator of financial vulnerability therefore misses almost all relevant information. The second debate is the global saving glut hypothesis. Here the issue is similar, in that US non-banks do not finance imports and current account deficits using physical saving provided by foreign non-banks. Instead, current account deficits are financed using digital purchasing power, provided by banks that are more likely to be domestic than foreign. In the latter case, a US credit glut becomes a plausible alternative explanation for the saving glut to traditional foreign saving or technology shocks. To help distinguish between these alternatives,we show that foreign saving shocks imply changes in financial sector balance sheets that are about as large as the simultaneous changes in GDP, while credit supply shocks imply far larger changes to financial than to real variables. As has been amply documented in the literature, the latter did characterize the saving glut episode. The fact that the financing bank can be located in the domestic as well as the foreign economy emphasizes that the current account or foreign physical saving contain no information about the source and direction of the financing flows that allow domestic residents to finance current account deficits. This matters for policy recommendations, because the global saving glut hypothesis puts the onus of adjustment on surplus countries, while the US credit glut hypothesis does the opposite. The third debate is Triffin’s current account dilemma. The issue here is that the creation of dollars as an international medium of exchange requires financing, or credit creation, denominated in dollars, by US or foreign banks. It does not require the setting aside, or saving, of foreign physical resources by foreign non-banks. In other words, the creation of a sufficient quantity of US dollars is completely independent of US current account deficits. There is therefore no dilemma. The fourth debate concerns interpretations of the high correlation of gross capital inflows and outflows. The issue here is that all financial flows necessarily consist of a pair of gross inflows and gross outflows that are inseparable as a matter of accounting, and that are therefore necessarily perfectly correlated. Correlated flows therefore do not represent, as in many interpretations, the result of synchronized economic decision-making by domestic and foreign investors. The only two ways in which the correlation between inflows and outflows could be lower than one is “errors and omissions”, whereby some gross financial flows are not captured in the balance of payments statistics, and a significant role for net payment flows, where only one of the flows is financial while the other is physical…”.
They don’t have additional specific language on this point.
Re: “….3) their view that banks inflate demand-side pull?...”
“..A closely related notion to Triffin’s current account dilemmais the idea that current account surpluses “fund” the accumulation of foreign exchange reserves(Bernanke (2005), Bernanke et al. (2011), Gros (2009)). This view is based on the accounting identity whereby the current account equals official reserve accumulation plus other gross outflows minus gross inflows. But the accumulation of foreign exchange reserves (a gross financial outflow) is a purely financial transaction, and must therefore automatically generate an offsetting reduction in private sector gross outflows or an increase in private sector gross inflows, without requiring any changes to the current account. For example, consider the increase in reserve assets associated with a central bank foreign exchange purchase financed by the sale of domestic government securities off its balance sheet. This gross outflow is offset either by a reduction in private-sector gross outflows if the counterparty of the central bank is a domestic seller of foreign exchange, or an increase in gross inflows if the counterparty is a nonresident seller of foreign exchange…”
Re: “…2) growing demand for saving that pull it in…”
Here is the core language, “Such shocks, along with technology shocks, have been frequently used in net flow models to study the global saving glut. But in our framework they cannot reproduce a key feature of the saving glut episode:gross domestic and cross-border balance sheet positions increased by far more than GDP, and were much more volatile, than implied by such shocks. Furthermore, we show that for these shocks the current account contains no information about the direction of foreign financing flows, which in fact decline. Meanwhile a domestic credit supply shock, an increase in US credit to US households that stimulates US demand, provides a very plausible alternative explanation of the saving glut phenomenon. This shock gives rise to a US current account deficit, but in this case accompanied by a US credit glut, with changes in balance sheet positions that are an order of magnitude larger than changes in GDP, congruent with the data. This shock emphasizes financing, the access to existing or newly created purchasing power, rather than foreign saving, as the factor that allows domestic households to pay for additional imports. But that financing can be obtained domestically as well as abroad. This shock suggests very different remedies to the saving glut phenomenon, because it identifiesUS credit rather than non-US physical savingas its trigger….”
Re: “…1) a glut of excess saving offshore that push their way into the US…”
I don’t buy it.
They totally disagree with my view of what the decline in interest rates is saying, “…A key aspect of the saving glut was the “Greenspan bond conundrum” (Greenspan (2005)), the observation that US long-term bond yields declined during the height of the saving glut episode in 2004-2005 despite continuous policy interest rate increases. The saving glut hypothesis appeals to foreign physical saving as an explanation for such a divergence. However, at least in our impulse response in Figure 8 the opposite occurs following a physical saving shock - a drop in output and inflation leads to a drop in the real policy rate, while the lending spread does not change by much, and in fact increases by around 10 basis points. The latter is consistent with the fact that foreign financing, unlike foreign saving, decreases. The credit glut view instead appeals to domestic credit and creation of purchasing power as the driving force of the divergence, and the impulse response in Figure 9 is at least qualitatively consistent with the divergence - output and inflation increase and lead to an increase in the real policy rate, while the lending spread decreases very significantly. In fact the lending spread shown in Figure 9 is the net effect of an increase in the regulatory spread of around 60 basis points (due to higher bank leverage) and a decrease in the retail lending spread of around 120 basis points (due to lower perceived household credit risk)….”
They focus on purchasing power created by banks, they don’t seem to address, in our view that purchasing power was driven by the banks role intermediating the savings glut, indeed they argue the credit glut is presumably sucking in those savings“…we note that foreign saving cannot play a direct role in financing domestic imports. Foreign saving is a goods market concept and a national accounts residual, it is the current account deficit by definition (ignoring investment for simplicity). What is required to pay for a current account deficit is not physical resources set aside by foreigners. Instead it is purchasing power created by banks…”
“…possibility that theonus of adjustment should be on deficit countries, if their “excessive credit” is the main culprit behind their large current account deficits. Under this changed perspective, foreigners are no longer seen as investors of physical resources into the domestic economy, but as recipients of payments from that economy…”
Ed Comment:“ Obviously, this is a positive feed back loop. How do the authors differentiate between 3 scenarios: 1) a glut of excess saving offshore that push their way into the US, 2) growing demand for saving that pull it in, and 3) their view that banks inflate demand-side pull? I said that we should see interest rates rise in scenario 2 as trade deficits grow. We see the opposite. I also said the we should see business investment out bid demand by homeowners to borrow savings. We didn’t. In their scenario 3, banks cut rates without an increase in the supply of savings—odd but maybe. With lower rates, homeowners increase their demand to borrow—ok. But the increased demand for savings doesn’t increase interest rates to increase the supply of savings (rates fell)—implausible. How do they reconcile to these facts? If anything I would say that prior to the crisis a glut of saving pushed it’s way in. But now, with the government running large deficits funded with guaranteed debt, it’s more plausible that we are pulling in offshore savings. When the government takes risk by borrowing, I don’t think there is full Ricardian equivalence in the private sector—i.e. an corresponding decrease in risk-taking. So if the economy is not taking enough risk, the government can theoretically increase risk-taking by running deficits. I say theoretical because it think it’s highly unlikely the government will take risks that payoff. Were the government to cut the taxes of the rich, who are predominantly investing at the margin, the government would, in effect, be funding those investments with debt—a good thing. But they are largely cutting middle-class taxes or redistributing income, both of which just increases consumption. Or they are “investing” in some horrible run, hopeless mired in rent seeking “investment” like education for the least likely to succeed, which lines the pockets of the teacher’s union, expanding medical research that extends unproductive lives beyond 85 years, or funds universities who collect all smartest brain power but don’t use it productivity. With the government at 35% of GDP, the question is whether more resources in the government are more productive than more resources in the private sector. My guess is that the private sector is more productive at the margin. Summers deceives the listener by pointing to theoretically productive infrastructure projects, but he doesn’t account for the fact that a tunnel in new York costs 10x. That’s why I think summer and furham are wrong in their prior argument. They don’t have productive uses for the borrowing except in theory.. That said, cheap offshore labor is attractive and gets pulled into the US to the extent surplus exporters are willing to export savings. When the savings flow in they have to be used or we end up with a Keynesian paradox of thrift, which happened after the financial crisis and before the gov started running big deficits. Prior to the crisis, the private sector risk of borrowing would have slowed borrowing as it did in the business sector. But wall street solved the problem by finding subprime borrowers with rising home prices and little to lose because they were extracting all the equity and lenders who were willing to take (the last dollars of) US residential real estate risk—namely German banks who were taking Greek risk. This held the system in equilibrium, at least until it didn’t….”
“….So how does saving, properly defined, flow across borders? Any output that is not consumed meets one of two fates: it is either invested or exported. It follows that anything that is neither consumed nor invested at home must be exported. (A farmer might, for example, export wheat to a barn overseas.) What flows across borders are the unconsumed goods and services themselves. “Other countries are not sending saving to America to give it ‘funds’ to finance their imports,” argue Mr Kumhof and Mr Sokol. “Their net exports are the saving, by definition.”An excess of saving, then, determines neither the geographical source nor the scale of cross-border financing. Nor is excess saving necessarily the right causal starting point. The paper by Mr Kumhof and others models what they call a “credit glut”: an abundance of lending by American banks to the country’s citizens. In spending this fresh money, Americans would no doubt suck in goods from abroad. This leads other countries to increase their saving, since America cannot import goods that are being consumed or invested elsewhere. But in this case, the increase in foreign saving and surpluses is a side-effect of a financial boom within America, not a cause of its overspending. The authors believe a credit, rather than a saving, glut is a more convincing explanation for the pre-2008 imbalances identified by Mr Bernanke, although they have less to say about more recent developments….For many people (including some economists), it is natural to think that saving must precede investment and that deposits must precede bank lending. It is therefore tempting to see saving as a source of funding and the prime mover in many macroeconomic developments. Mr Kumhof and his co-authors see things differently, giving banks a more active, autonomous role. They give less credit to saving and more to credit…”
Steve Comment: In terms of your questions, I don’t think the paper manages to reconciles them. The BIS guys don’t really believe there is a “glut” of “excess” savings, “…US credit rather than non-US physical savingas its trigger…”
Re:“…How do the authors differentiate between 3 scenarios: 1) a glut of excess saving offshore that push their way into the US, 2) growing demand for saving that pull it in, and 3) their view that banks inflate demand-side pull? I said that we should see interest rates rise in scenario 2 as trade deficits grow. We see the opposite. I also said the we should see business investment out bid demand by homeowners to borrow savings. We didn’t. In their scenario 3, banks cut rates without an increase in the supply of savings—odd but maybe. With lower rates, homeowners increase their demand to borrow—ok. But the increased demand for savings doesn’t increase interest rates to increase the supply of savings (rates fell)—implausible. How do they reconcile to these facts?...”