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In This Crisis, Government Spending Isn't Likely to Do Us in -- But Private Savings Might.

In a crisis, the ratio of public debt to GDP must rise.
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Over the past few months, the dollar index has declined some 10 percent amidst repeated calls by leading creditor nations such as China for a new global currency. This has been a recurrent feature of Chinese-American financial diplomacy for several months now, as Beijing frets that their substantial dollar hordes will turn into the new equivalent of the Argentinean peso circa 2001, whilst US Treasury Secretary Geithner regularly kowtows and assures the Chinese monetary authorities that their investments are as good as the gold with which the Americans are no longer obliged to back their reserve currency.

To a large degree we sympathize with the views of former Federal Reserve Chairman Paul Volcker, who argued last month: "I think the Chinese are a little disingenuous to say, 'Now isn't it so bad that we hold all these dollars.' They hold all these dollars because they chose to buy the dollars, and they didn't want to sell the dollars because they didn't want to depreciate their currency. It was a very simple calculation on their part, so they shouldn't come around blaming it all on us."

Volcker is right. China is largely reaping the consequences of a mercantilist strategy in which a large proportion of their output was exported to the US in exchange for US financial claims. The consequences of this policy were made clear on a monthly basis as billions more dollars were added to the country's foreign exchange reserves. It is therefore more than a touch hypocritical for Beijing to complain about the consequences of a policy which they actively encouraged over a ten-year period, during the which the RMB (the local Chinese currency) was devalued by more than 50 percent against the greenback. A very easy solution to mitigate the impact of "dollar hegemony" would be for the Chinese (or the Europeans) to buy more American goods and hold the resultant financial claims in a different currency.

Of course, from an American perspective, the ongoing concern is that perpetual reliance on the Chinese to fund our deficits is inherently unstable, in effect allegedly placing the US in the position of being a "Blanche Dubois economy," forever dependent on the kindness of strangers.

We think this is predicated on a mistaken paradigm, which many economists seem determined to employ. The reality is that we are no longer operating under a fixed exchange rate regime or a quasi gold standard (much as some countries curiously want to recreate this in spite of the fact that billions of dollars of gold are vastly insufficient to create backing for trillions of dollars of financial claims). Dollars flow out through the trade deficit (which is a large part of the current account deficit) as the US spends more on imports than it earns on exports. Those dollars are net saved by our trading partners and they are reinvested in dollar denominated assets. If portfolio preferences of foreign net savers shift away from holding US dollar denominated assets, asset prices have to adjust until they are willing holders of the dollars they earn in trade (that is, interest rates must rise, equity prices must fall, until expected returns are attractive enough for foreigners to maintain their US dollar holdings). Also, if foreign net savers of dollars favor particular assets, like US Treasury bonds, for a variety of institutional reasons, then relative US asset prices can also be influenced.

The money that flows out through the current account deficit flows back in through the capital account. For a nation with a flexible exchange rate, there is no change in the money supply from trade activity. This is just the opposite of a fixed exchange rate system, of which gold based systems are one type, and that is why James Grant advocates leaving flexible exchange rate systems in the dustbin of history. In a fixed exchange rate system, money balances of trade deficit nations are drained off to the trade surplus nation, and the trade deficit can only be run until the existing money balances of the trade deficit are exhausted.

Neither foreign private or public entities can create US dollar reserves out of thin air. That is the charge of the US central bank and commercial banks. Foreigners have to earn dollars from sales of goods or assets to US dollar holders. So it seems to me that the imbalances you describe are almost a necessity as far as the US goes.

That means the ultimate source of the credit to support US trade deficit spending could not have come from abroad as some have alleged. Rather, credit was created in the US as households engaged in mortgage equity withdrawal during the housing boom, and spent more than they earned. Neither foreign savings nor foreign capital inflows were required to create this credit. All that was required was a household willing to borrow with identifiable equity in their home, and a bank willing to expand its balance sheet, with new home equity loans creating new deposits out of thin air. The loan is made, which shows up on the banks asset side of the balance sheet, and the homeowner has a credit line it can draw down, which shows up on the liability side of the bank balance sheet. Nobody here or abroad needed to save beforehand for this money deposit and credit loan to be created.

So what happens when the housing bubble bursts? Equity in homes shrinks, mortgage equity withdrawal shrinks, bank balance sheet growth reverses, household deficit spending reverses as they begin to net save, the trade deficit begins to turn, foreign net saving is reduced, and foreign capital inflows to the US are also reduced. The trade deficit is the twin of the household deficit spending, and the household deficit spending was made possible by credit expansion by US financial institutions on the back of the housing bubble.

In other words, foreign saving and capital inflows are at the tail of the dog, not the head. The only way the tail wags the dog is if foreign portfolio preference shift suddenly or persistently against US dollar denominated assets or specific US asset classes, in which case asset prices must adjust to keep foreign investors willing holders of US dollar denominated assets. We must always be careful to distinguish between shifts in preferences with regards to existing holdings, and shifts in saving out of income flows. The two are not the same, but they often get conflated.

That is not to say the threat of foreign investors dumping US assets isn't a danger, but it may not be the central risk, which as far as I can see remains the concerns of people who fret about today's imbalances. To me, the central risk is that the US private sector is shifting to a net saving position in a dramatic way for the obvious reasons - loss of wealth, precautionary saving given recession, etc. Arguably, this needs to happen if households are going to pay down debt and reduce debt burdens, and if they are realizing capital gains are not guaranteed.

The risk of this necessary adjustment arises because if the private sector moves to a net saving position - spending less than it earns - the income level in the US will fall unless the trade deficit turns quickly enough, and unless the fiscal deficit expands commensurately. In other words, we should be applauding this increased fiscal deficit because the alternative would be disastrous, not just for the US, but the world as a whole.

For every net saver, there must be a net deficit spender, or else the net saving cannot be accomplished without an adjustment of incomes. This is where the so-called paradox of thrift comes from, as you well know. If incomes fall, debt defaults and delinquencies will increase more dramatically, and there is a good chance of heading into a debt deflation spiral, a la Irving Fisher.

The private sector is trying to net save more than is feasible given the shrinkage of the trade deficit and the expansion of the fiscal deficit, largely through so called automatic stabilizers, to date. This is also reflected in a private household savings rate of almost 7 percent, the highest since 1993 (which, interestingly enough, was also the last time the US government engaged in significant deficit expenditures).

Now, one could argue that from a US-only perspective, ideally all of the increase in the private sector net saving position would come from a reversal of the trade deficit, but this isn't going to happen. China earns about 10 times as much on its external sector than the domestic market, so its decision to become an export juggernaut, taken in isolation, was perfectly understandable. But in a world where global trade is collapsing, in part because export dependent economies have just had the rug pulled out from underneath them as US consumers (and others) try to save, it is a fantasy to think the adjustment process can be done entirely through trade.

The only way to avoid a debt deflation outcome, as long as the private sector is trying to increase its net saving, is through an expanding fiscal deficit. And the reality is that we don't need a G20 summit to accomplish this. The US can do this on its own. As the government spends more than it earns in tax revenue, private sector incomes are boosted, and the private sector can earn more than it spends. They are two sides of the same coin. In fact, this is what is happening today. In that sense, if you agree that private sector de-leveraging is a necessary part of the adjustment process, or at least important, it comes at the price of public sector re-leveraging, barring a heroic reversal in the US trade deficit (which would throw our trading partners into an even more severe recession unless they also pursued domestic demand-led polices, a la China).

To illustrate this, the current account deficit has already gone from about 6 percent of GDP to roughly 3 percent of GDP as of the end of Q1 2009. Let's say further consumer and inventory contraction gets us to 2 percent of GDP by year end. The CBO suggests the federal fiscal deficit will be out to 12 percent of GDP. I think that's a bit high, as it incorporates TARP. But even assuming a trailing deficit of 8 percent (which is roughly what we've got now in the US), the private sector can net save around 7-8 percent of GDP without nominal incomes falling in the economy. At the depths of the 1973-5 recession, private sector net saving hit a post WWII high of nearly 9 percent of GDP. Maybe it needs to go higher this time because of the larger shock to household balance sheets with home and equity price deflation. But at least we can say the fiscal deficit is now programmed to scale up fast enough to reduce or contain the risks of US income deflation, and hence a runaway debt deflation process. To me this is crucial to contain the worst of the credit crisis.

So can the foreign trade and US household spending imbalances be adjusted? Yes, they can. Can that adjustment process create further challenges? Yes it can, to the extent massive fiscal deficit spending is required to allow the private sector to accomplish its net saving objective without cratering private incomes and setting off a debt deflation spiral.

Then the question really boils down to, can the massive Treasury bond issuance be placed, especially if a smaller US trade deficit means foreign investors have fewer dollars to reinvest in US assets?

Treasury bonds were once over 20 percent of commercial bank balance sheets. They were below 5 percent until recently. Default free securities might look attractive to banks these days, especially with a positively sloped yield curve (and there is no question of national solvency when one has a fiat currency system, as opposed to a gold standard). The Fed used to hold 70-80 percent of its assets in Treasuries, now down to 20 percent. The Fed will want to have plenty of Treasuries to sell into the market once the eventual recovery comes and private investor liquidity preferences fall.. Remember, the Fed has no budget constraint.

Does this imply an increase in liquid assets in the economy? Yes it can, but we are also undergoing a large financial sector de-leveraging, and we have begun a household sector de-leveraging as well for the first time in the post-WWII period. As loans are paid backed, deposits are canceled out, shrinking conventional measures of the money supply. Much of the credit in the shadow banking system has been obliterated and will not be coming back soon.

Is there nevertheless a risk of a flight from the dollar to the extent the US is willing to be the first mover, and an aggressive one at that, down these paths of quantitative easing? Yes there is. Is there a risk investors seeing the more central banks pursing the quantitative easing path will take flight into precious metals and other real assets as prospective inflation hedges, even if product price deflation is showing up in more countries? Yes there is. Could that complicate the policy exit strategy to the extent some of these commodities, like oil, are inputs to production, and so higher commodity prices could lead to an adverse shift in supply curves (to the left in price/quantity space, as in stagflationary periods)? Yes it could.

But I think the alternative of focusing first on the external imbalances between China and the US is the wrong way to go about it. Look at what happened to budget deficits during World War II: at its peak, the US budget deficit as a percentage of GDP went to 30.3 percent in 1943. Yet by the end of the war, US households and the private sector were once again in a position of massive savings surplus. This is the financial correlative to those huge government deficits on the side of the ledger.

The whole discussion about China and a new reserve currency, then, is a bit of a red herring in the current circumstances. As economist James Galbraith has noted:

"[A] stable ratio of debt to GDP is not a normal feature of modern history. Gradual drift in one direction or the other is normal. There seems no great reason to fear drift in one direction or the other, so long as it is appropriate to the underlying economic conditions.

History has a second lesson. In a crisis, the ratio of public debt to GDP must rise. Why? Because a crisis - and this really is by definition - is a national emergency, and national emergencies demand government action. That was true of the Great Depression, true of war, and true of the Great Crisis we're now in. Moreover, we've designed the system to do much of this work automatically. As income falls and unemployment rises, we have an automatic system of progressive taxation and relief, which generates large budget deficits and rising deficits. Hooray! This is precisely what puts dollars in the pockets of households and private businesses, and stabilizes the economy. Then, when the private economy recovers, the same mechanisms go to work in the opposite direction.

For this reason, a sharp rise in the ratio of debt to GDP, reflecting the strong fiscal response to the crisis, was necessary, desirable, and a good thing. It is not a hidden evil. It is not a secret shame, or even an embarrassment. It does not need to be reversed in the near or even the medium term. If and as the private economy recovers, the ratio will begin again to drift down."

And if the private economy does not recover, we will have much bigger problems to worry about, than whether we ought to have a new reserve currency.

To quote Galbraith again: "The only thing the scary foreign creditors can do, if they really do not like the returns available from the US, is sell their dollar assets for some other currency. This will cause a decline in the dollar, some rise in US inflation, and an improvement in our exports. (It will also cause shrieks of pain from European exporters, who will urge their central bank to buy the dollars that the foreigners choose to sell.) The rise in inflation will bring up nominal GDP relative to the debt, and lower the debt-to-GDP ratio. Thus, the crowding-out scenario Bob sketches will not occur.

I'm not particularly in favor of this outcome. But unlike Bob Reischauer's scenario, this one could possibly occur. If it did, it would lower real living standards across the board. This is unpleasant, but it would be much fairer than focusing preemptive cuts on the low-income and vulnerable elderly, as those who keep talking about Social Security and Medicare would do."

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