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THE FED’S WILD IMAGINATION
by Kurt Richebächer
In his testimony to Congress on July 20, 2005, Mr. Greenspan declared it quite likely that the world is currently experiencing a global savings glut. Agreeing with Ben Bernanke, he mentioned this glut as one of the factors behind the so-called interest conundrum, i.e., declining long-term rates despite rising short-term rates.
Having read a lot from the Fed’s luminaries, their inability to distinguish between rampant global credit excess and a global savings glut does not surprise us. In this view, the Federal Reserve has come to the rescue of a world where excessive saving is threatening depression by eliminating savings.
Attracted by superior rates of return on U.S. assets, investors around the world have been scrambling to pour their excessive savings into direct investments, stocks, bonds and real estate in the United States, in this way financing the resulting huge U.S. trade deficit.
While this explanation may seem to make sense, there is one big snag: Not one word of it is true. First of all, in reality, private foreign investors have drastically curbed their investments in the United States. According to the Bank for International Settlement - the international organization of the world’s central banks - Asian central banks financed 75% of the U.S. current account deficit in 2004.
First, private capital flows into the United States have slumped. Without the massive interventions by the Asian central banks, the dollar would have collapsed long ago.
Second, the dollars with which these central banks have been buying U.S. Treasury and agency bonds have definitely nothing to do with Asian savings. Evidently, the central banks are recycling the dollars, no more, no less, which they receive from U.S. trade and capital flows. These dollars have come into the central banks’ possession through their interventions in the currency markets, to prevent a rise of their currencies against the dollar.
To speak of a global savings glut as a possible cause of the surprisingly low U.S. long rates in the face of these blatant facts is truly the height of insolence and absurdity. That this opinion comes from the leading figures of the Federal Reserve is more than shocking.
True, Asian countries have very high savings rates. For China, it is reported to be as high as 45% of disposable income. But this does not necessarily imply an existing savings surplus be lent to America. The bulk of available savings in China domestically is locked up in an even higher domestic investment ratio.
Looking at the global financial system, a straightforward fact to see is that central banks have been amassing foreign exchange reserves at an accelerating pace since the early 1970s. Rising in several large waves, their main source is plainly the soaring U.S. trade deficits.
Having no use for dollars in general, the first dollar recipients in the surplus countries sell them to their banks against their own currencies. These banks, in turn, found ready dollar buyers in firms and investors around the world, wanting to acquire direct investments or other assets in the United States, at least until 2000. Since then, though, capital inflows on private accounts into the United States have drastically receded, while U.S. trade deficits have exploded. In order to prevent a rise of their currencies against the dollar, central banks had to step in as buyers of last resort.
Apparently, it is not widely realized that this big shift in dollar recycling from private accounts to central banks essentially has far-reaching monetary implications for the participating countries and even for the world economy and world financial markets. Buying dollars, the central banks credit the commercial banks in their country with interest-free deposits.
Now, the critical point to see is that the banks, on their part, regard these deposits as their liquid reserves to be used for profitable lending or investment. Inundated with liquid reserves by the dollar buying of their central bank, the commercial banks in these countries embark on faster credit expansion. Shifting the rising surplus of liquid reserves between them, they create credit for consumers, businesses and speculators many times the amount of the liquidity injection by the central banks.
Our focus in particular is on China. As in the United States, the resulting credit deluge is boosting components out of proportion to the whole economy. In China, however, the specific components are real estate and manufacturing investment, while in the United States, it is consumer-spending excess.
What the Asian central banks truly recycle is the U.S. credit excess. But in flooding their banking system through the dollar purchases with liquid reserves, they transplant the virus of credit excess to their own economies. For U.S. policymakers and economists, this is a reasonable and sustainable division of labor. The U.S. economy runs on wealth creation through asset inflation with a high rate of consumption, while China and Asia run on wealth creation through saving and investment with a high rate of investment.
We are fearful of this development, because it affects more or less all industrialized countries with high wage levels. In this way, overconsuming America is force-feeding the rapid mutation of China’s backward economy into a first-class manufacturing power. When China’s credit and investment boom started, in 2000-01, its central bank had foreign exchange reserves in the amount of $165.4 billion. Today, they exceed $700 billion.
We are wondering what is worse for the whole world, China’s further rapid manufacturing growth or a disastrous hard landing. Observing the same monetary and economic follies as in the late 1980s in Japan, we consider the second possibility highly probable.
A persistent, sharp slowdown in China’s imports strikes us as ominous. The general comforting explanation is inventory liquidation. But how to explain, then, the continuous oil and commodity boom? We suspect speculation far more than economic growth as the reason.
With all the talk about a savings glut, we feel obliged to make some remarks about the subject. First, please take another look at the Wicksell quote on the first page, stating, “The supply of real capital is limited by pure physical conditions, while the supply of money is in theory unlimited.” “Supply of real capital” is actually a synonym for available savings.
At an international conference in 1953 about savings in the modern economy, with many heavyweights in economics in attendance, the famous former chief economist of the Fed E.A. Goldenweiser gave a rare precise definition of saving. He said: “Saving means the withdrawal of sufficient resources from the production of consumption and services to have enough for maintenance, expansion and improvement of the plant.” Then, he complained, “that ever since Wesley Mitchell’s Business Cycles there has been a tendency to concentrate too much on the monetary expression of economic developments, and it has become reactionary to think in physical terms.”
From the macro perspective, “saving” provides the physical resources for the production of capital goods in that consumers abstain with part of their income from consumption. Of course, this also involves money flows, but saving’s decisive distinguishing feature is the partial abstention from current consumption to make real resources available for the production of capital goods.
It is ludicrous, therefore, when American economists claim that rising asset prices, increasing consumption, should by counted as saving. When we read decades ago that Mr. Greenspan, long before he became Fed chairman, had expressed precisely this view, he was once and for all finished for us as a serious economist.
The world economy seems to be flooded with liquidity. But there are two diametrically different kinds of liquidity: earned liquidity and borrowed liquidity. The former comes from surplus income or savings; the latter comes from credit and debt creation.
In a country with virtually zero savings like the United States, any liquidity essentially arises from debt creation. This is really fake liquidity depending on permanent, prodigious borrowing facilities, presently the housing bubble. Once this bubble evaporates or bursts, the U.S. economy loses its chief liquidity source - with disastrous effects on asset prices.
The crucial question concerning the U.S. economy is whether it is slowing or accelerating. As explained in detail, we see a lot of fudge in the recent economic data. Our main critical consideration is that a self-sustaining recovery would absolutely require a strong rebound in business investment. But that is not in sight. On the other hand, the turnaround in the housing bubble is only a question of time. A fairly short time, we think.
The consensus expects that the U.S. economy has the "soft spot" behind it and will surprise positively. We expect shocking economic weakness. All asset prices, depending on carry trade, are in danger, including bonds.
Regards,
Dr. Kurt Richebächer
for The Daily Reckoning
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