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Yesterday’s nectar, today’s killer
Mr. S. Gurumurthy


A Two-part article by Mr. S. Gurumurthy, National Co-Convenor, SJM, that appeared in the Hindu Business Line on 23, 24th June 2009

Yesterday’s nectar, today’s killer

The US accessed the global savings glut to sustain its domestic consumption. The dollar’s dual role as the world’s reserve currency and as the national currency of the US made this possible, says S. GURUMURTHY.

The three-trillion- dollar-plus financial steroid digitally administered to financial markets keep the stock indices alive today; off and on, even kicking. But the facts masked by stock indices are scary. The McKinsey Quarterly magazine [June 2009] estimates the un-booked credit losses of banks at $2.13 trillion for the year 2010; the loss so far booked is only $930 billions. The US/Western economies are still in the $3 trillion Intensive Care. The stero ids-supported stock indices are holographic and nothing more.

Understandably, some think tanks are trying to figure out how and why did the US/West mess itself up and the world, to get at the remedy. These experts now point to the continuing global imbalances as the culprit.

The Council on Foreign Relations (CFR) an independent think tank in the US, in its recent report (March 2009), finds that “one of the root causes of today’s crisis is the imbalances between savings and investment in major countries”. It says that this will have to be addressed if the crisis were not to repeat. The CFR report also faults the G20 summit of November 2008 for not explicitly mentioning the global imbalance as the root cause of the crisis.

Surpluses, deficits

For the uninitiated, here is what global imbalance between savings and investment means. A nation’s account is very like a household’s. A country earns by exports of goods and services and spends by importing them. When it earns more than it spends, it is in surplus. When it is the other way round, it is in deficit.

If the surplus countries are unable to invest all their savings within, their savings are in surplus. The deficit nations need loans or investments from surplus nations to pay for their deficit and also for investment. If this trend persists long, with surpluses in some hands and the deficit in some others’, it is imbalance.

Economic laws rule that such surpluses and deficits normally even out over a period. The deficit economies face high interest, dip in their currency values which helps them to export more and import less, and turn into surplus that offsets past deficits; and the surplus economies move in the opposite direction, land in deficits that eats away past surpluses. But this law of economics failed to work for the US, which has been unfailingly in current account deficit from 1976; and between 1996 to 2008 alone, it had accumulated a deficit of $5.74 trillion.

In these very years, China and others had earned huge surpluses mainly by exporting to the US more than they had imported from it.

A small break here. The CFR report complains that the surplus economies like China did not allow their currencies to appreciate; thereby prevented the economic law of equalisation to work and perpetuated the imbalance. This charge is made redundant by the CFR admission that, as the supplier of the reserve currency, the deficit US chose to flood the world with dollars; thus did not allow its domestic interest rate to rise, its economy to contract and the dollar to depreciate and so did not even attempt to earn surplus to offset its deficit.

No other deficit nation has this privilege of printing dollars and forcing others to keep them, for, to transact global business they need to get dollar from the US and hold it as they cannot print them. The need to stock dollars accentuated by the absence of an alternative to the dollar. Now back to the sequence.

The savings glut

The surpluses of China and others, not absorbed by their investment needs within, added a huge stock of liquid money supply — the savings glut — to global financial market. This over supply of money pushed down global short term interest rates, which reduced the long term interest rates also.

This low interest global surplus, says the CFR, forced its way into the US. But, as The Economist magazine (May 30, 2009) says in ‘A special report on business in America’ [p14], no one forced the US to borrow, that is, let in the global savings glut. And yet the US did. Why?

The deficit US never wished to get into surplus; instead it chose to let the savings glut to flow in, to offset its burgeoning deficits. So its red-carpet invite for the global savings glut. The US was not playing marbles with dollars. The US mass-produced digital dollars, paid for trade its deficits and brought those very dollars back to US as investment.

It had strategically leveraged the dollar as world’s first reserve currency which all others need, but, only the US could supply. The story of imbalance masks the reality that the US was actually making credit purchases from others by substituting the dollars as reserve currency for IOUs. Read on.

After the dotcom collapse in 2000 and the 9/11 attack, the US economy had nose-dived. There was desperate need to generate mass economic activity to bring life back to the US economy. With a third of the Americans, who could not afford homes, not owning homes, a huge unexplored area of potential demand for homes invited the US government to exploit it.

Real estate bubble

Acting in tandem with the US financial system that had innovated multiple financial products to borrow and lend easily, the US Fed cut the interest rates to 1 per cent and triggered an artificial housing — read ‘real estate’ — boom which was bound to burst one day. With the cheap, abundant global money at their disposal, the US banks lured the Americans not owning homes with non-recourse, interest holiday, loans to buy houses.

Americans owning homes also were funded to buy additional houses, like they bought stocks, for speculative gains as the home values boomed. This generated artificial demand for homes, and led to the real estate bubble. For the next five years this bubble took the US economy on a high.

The new home prices soared by over 50 per cent in six years between 2001 and 2007. The home values to GDP rose from 123 per cent in 2001 to 156 per cent in 2006. Some two-thirds of the Americans had bought homes at less than $25,000 well before 1970. Their home values rose to over $2,90,000 by 2007 — almost 12 times. This unrealised asset value — celebrated as ‘home equity’ in the world of finance — became the collateral for the sudden ‘rich’ home owners to borrow money against. This virtually turned the homes into “ATM machines” for their owners to draw cash on and spend at will. In just five years, says The Economist [May 30, 2009], Americans borrowed $2.3 trillion against the home equity and splurged it on consumption (20 per cent), on sprucing up their homes (19 per cent) and for buying stocks (44 per cent, most of which they lost once the stocks bust). More. It says that the US household debt leapt from 71 per cent of the GDP in 2001 to 97 per cent of the GDP in 2008.

The borrowing against home equity accounted for 77 per cent of America’s huge economic growth from 2002 to 2007, which sustained the US consumption that accounted for 70 per cent of its GDP.

Borrowing, spending

In this period, the average American increased his consumption by 44 per cent; their household savings turned negative in 2005 [07 per cent of the GDP]. A “Shop for America” movement was launched in 2001, in the wake of the 9/11 terror strike, to perceive buying, even needlessly, to save America’s economy as a patriotic duty.

With borrowing and spending becoming the fashion, savings became unfashionable. The former US Fed chief Alan Greenspan proudly wrote in his book The Age of Turbulence [2008], that only insecure people of developing nations that do not provide for social security, need to save. He added that in modern countries — read the US — where enlightened state provides social security, people could confidently borrow and spend beyond their current income [pp.385/86].

The Americans confidently borrowed from the world, and happily spent on themselves. The US accessed the global savings glut to sustain its domestic consumption. The dollar’s dual role as the world’s reserve currency and as the national currency of the US made this possible. Result, the US registered an unprecedented GDP growth of 3 per cent during the years 2003 to 2007.

But the fall, which was inevitable, started in 2008. The US never faulted the global imbalance till it was useful to it. QED: The imbalance that kills the US economy today was the nectar sustaining it till yesterday.

Global imbalance: More cultural, less economic

Cultural convergence within nations causes economic divergence among them. As the Council on Foreign Relations (CFR) report [at pp15-18] traces the history and the facts of the imbalance, it ends up discoursing almost entirely about the US current account imbalance. A quick look at the statistics of latest current account balances around the world [The Economist, June 30, 2009] shows that the US accounts for more than two-thirds of the total current account deficits.

Printer of the dollar

What the CFR sees as global imbalance is actually the US imbalance with the rest of the world. The CFR correctly theorises that the principal culprit for the persisting global imbalances is the US itself. As the issuer of the reserve asset — read, the printer of the US dollar — it has been able to finance its own recurring current account deficits without having to face the pressures that a deficit nation has to.

And so long as the surplus countries needed and held their reserves in dollar assets, the US could sell its dollar-denominated securities to them and bring in the needed funds. As the global savings topped the world’s investment needs, the global and therefore the US interest rates actually fell instead of rising as it normally happens for a deficit nation.

The US treasury security yield, which was 8.5 per cent in 1990, halved in 2007; and the US could double its external borrowings to $5 trillions in 2007 at less, instead of more, interest. More, the US, as a trusted investment destination, also received substantial private investment — from almost nil in 1996 to over $450 billion in 2006 alone.

Who’s the culprit?

The CFR discourse laments that with the fall in domestic interest rates in the US and the entry of cheap global money, household savings plummeted and consumption rose in the US. But, was the culprit low interest rate? Or foreign money? Not exactly.

When Alan Greenspan, who headed the US Fed at that time, dismissed household savings as almost a waste, he was merely endorsing the firm trend among Americans to spend rather than save.

The US household savings as a percentage of their disposable income began falling long before 2001, the zero date in the CFR report. It was 9.6 per cent in 1970s; 9.1 per cent in 1980s; 5.2 per cent in 1990s; 2.1 per cent in 2000-04; and in 2006, it turned minus 0.4 per cent.

The fall in US household savings is not fully explainable by interest rate or economic rationale. It has more to do with the changes in the very substance of the relations, based on deepening individualism, within families and society; also between the state and the society.

Traditional relations

The traditional family declined due to divorces, unwed motherhood, single parentage, live-in lifestyle and the like, and this forced a rise in state-provided social security. In substance, it meant nationalisation of household functions. The state take over of homes made it needless, as Greenspan said, for the American households to save for future. The state filling the space the traditional families had vacated clearly indicated that America had matured into largely a contract-based society that derecognised traditional relations in public policy.

These changes also brought about collateral effect, besides fall in savings. In the last few decades, the American households began investing more in risky assets. Just about 6 per cent of the US households had stocks in 1980s; this rose to 25 per cent in 1990 and to over 50 per cent in 2001.

Not just households, even pension and other funds began accessing stock markets for better returns as the interest rate which was 21 per cent in 1981 was cut to 8 per cent in 1990 and became 1 per cent in 2001.

Consumption boom

Most Americans had stopped making term deposits in banks. With each interest cut, the stock markets boomed leading to asset inflation. This led to the famous consumption boom in US via borrowing against unrealised stock appreciation. When the stocks collapsed in 2000, the housing boom, that originated in low interest global funds, took over via borrowing against home equity. This resulted in highly leveraged low income households in US.

The advent of the credit card made it easier to spend. The total number of credit cards in use in US now is 1.2 billion — four times the US population. These critical differentials influence the economic behaviour of the Americans to the effect that the US is facing today. Yet, the CFR report reduces the whole discourse to interest rates, imbalances, reserve currency, capital inflow, consumption, asset price inflation and the like. But is the American phenomenon fully explainable by only such economic technicalities?

Japan, a contrast

Asia presents a contrast to the US. Take the representative case of Japan which is as developed as, also nearer to, the US from Asia. In Japan, thanks to the huge surplus, the interest rate was nil during the period from 2000 to 2005; now it is 0.5 per cent. There has been no undue asset appreciation; no boom in consumption. The households have substantial accumulated savings. The Japanese banks offer 0.8 per cent interest for five-year deposits, but still have $7 trillion of such deposits from households. More than 51 per cent of the Japanese household savings are with banks. Their household investment in equities is less than a tenth of their savings. And home mortgages constitute less than 12 per cent of the household liabilities as the Japanese make large down payment to buy houses.

So, the Japanese households are not leveraged like the US households. A paper of Bank of International Settlement [BIS Paper No 46] says that this conservative approach of the Japanese households to debt mitigated the effects of decade-long economic slump [1990s]; household bankruptcies were less because the safe and liquid assets such as bank and postal deposits were greater than debts on household balance-sheets.

The paper adds: “The Japanese household sector far from being a shock originator, is a shock absorber.” In contrast, the highly leveraged US households, which had very little savings and which had defaulted on mortgage payments, were the originators of the current crisis.

With the same low interest regimes in Japan and the US, how do the Japanese households act as shock absorbers, and the US households as shock originators? The reason is far from economic. The culture of a society does not allow the economic policies or interest rates to change its well-established habits.

Social security

Japan too has instituted social security by pensions. But it is different from the social security in the US. In the Japanese pension model, the present generation sacrifices for itself, not the younger or future one for the present one. It therefore promotes savings; does not eliminate the need for it as does the US model.

The social security in the US is unfunded and future generation is exposed to heavy taxes to de-risk the present. A “notable feature of Japanese public policy is the emphasis placed on minimising the potentially crippling tax burden on the younger and future generation. Current generations, including retirees, appear more than willing to make sacrifices despite the greater hardships involved, in their ‘current daily lives’. Perhaps, this is because of the greater social cohesion that is the hallmark of Japanese society” [Jagdish Gokhale and Kent Smetters, Measuring Social Security’s Financial Outlook Within and Ageing Society].

It is the traditional family and the social norms which safeguard it that make the Japanese economy socially cohesive. This social cohesion is non-formal and cultural where an individual yields to the non-formal collective discipline. Here economics works with, and is not destructive of, culture.

Comparing the individualistic Anglo-Saxon West with family-oriented societies, Francis Fukuyama said, in his book Trust, that culture is the missing 20 per cent element in economics. Culture influences the collective behaviour of the people and so matters. Family-oriented cultures have dynastic qualities. Even their savings, says Barry Bosworth, an economist at the Brooking Institution, are dynastic; the savers save, not for themselves, but for generations to come. Traditional families are culturally continuing units; not terminable contractual arrangements. The economic laws designed in, and for, pure contract-based economies do not seem to work as well in relation-based — read family oriented — societies.

The micro and macro economics of a nation converge via its culture; this cultural convergence within nations causes economic divergence among them. This is what the CFR, like most economic technicians, has missed out. To conclude: Global imbalance is really US imbalance with Asia; the cause of it seems more cultural, less economic.


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