Yesterday I criticized Mr. Krugman for saying that savings were in excess. I said that personal savings is down, and domestic savings are not enough to cover investment such that the US has to borrow from abroad. This post will explore the relationship between domestic savings, domestic demand and the Current Account balance.
I start with a story yesterday from Spiegel Online International that pointed to Germany's very large trade surplus, which is higher than China's.
"The Treasury's semiannual currency report criticized Germany's over-reliance on exports, a high current-account surplus and weak domestic demand. These factors "have hampered rebalancing at a time when many other euro-area countries have been under severe pressure," the report concluded, citing budget tightening in the euro periphery. "The net result has been a deflationary bias for the euro area, as well as for the world economy."
Why is Germany's high Current Account surplus a problem? and What is the connection to weak domestic demand?
To answer these questions, I refer to an article written by Michael Pettis back on May 21st, 2013. The title of the article was, "Excess German Savings, not Thrift, Caused the Euro-Crisis". Mr. Pettis is a professor in Beijing. He is an expert on the Chinese economy. He also has relatives in Spain, so he is very familiar with the situation in Europe. It is also a joy to write commentaries on his web site. His responses are respectful, timely and informative. He sets the standard for a true educator online. Ok... enough of my praise for him.
National Savings vs. Personal Savings
Here is a statement from his article, which is long, and should be read. I will quote many points in his article throughout this post.
"One of the reasons that it is been so hard for a lot of analysts, even trained economists, to understand the imbalances that were at the root of the current crisis is that we too easily confuse national savings with household savings."
So I criticized Mr. Krugman when he said that savings were awash in excess. I said that he must not be talking about personal savings. OK, so he must be talking about national savings. So what is the difference between personal and national savings?
"The national savings rate, on the other hand, includes not just household savings but also the savings of governments and businesses. It is defined simply as a country’s GDP less its total consumption."
One can also use the % of total consumption to GDP to assess national savings.
"In an open economy, if a country saves more than it invests it must export the excess savings. It must also export the excess production."
"What is more, by exporting excess savings, the country is providing the funding to foreigners to purchase its excess production. This is why the current account and the capital account for any country must always add up to zero."
The implication is that since the US is importing savings and importing production on balance, the US must be saving less than it invests. Consumption must be rising. However, when Mr. Krugman says that there is excess savings, it is logical to assume that consumption as a share of GDP must be falling. OK... so what is it? Is consumption in the US rising or falling? If we look at consumption in the US as a share of GDP we not only see that total consumption is rising, but so is consumption of domestic production.
So if consumption as a share of GDP is rising in the US, national savings must be falling as a share of GDP. (National savings = GDP - total consumption) So again, Mr. Krugman must be mistaken about savings. Where is the excess national savings that he is talking about? They aren't there. The US has less national savings, which is why it still has to import savings from other countries.
Labor Share affects National Savings
My research into effective demand centers upon labor share. And as Michael Pettis explains, labor share is at the heart of the imbalances in international flows...
"China’s extraordinarily high national savings rate, in short, is a function primarily of the extraordinarily low household share of GDP."
Many people get confused by this. They think that lower income should translate into lower savings. Actually, lower income translates into lower consumption, which translates into higher national savings.
One thing the US has to be very, very careful about is that low comparative labor share in China is being exported into the US and other countries. Labor share is falling in the US. Yet, our consumption as a share of GDP is rising because China is importing their larger comparative share of national savings. The US must lower domestic savings to absorb the savings from China. The problem is that the US has never been challenged by such a large increasingly productive economy with such a low labor share.
I don't think the US is aware of this dynamic yet. The US national savings as a share of GDP is falling as consumption rises. A falling labor share since 2000 is a dynamic to balance our comparative dis-advantage in labor share.
But let's keep moving.
Connecting National Savings to International Flows
"It is China’s national savings rate which is “monumental” and which drives China’s current and capital account imbalances, and the national savings rate is monumentally high because the national consumption rate (which consists mostly of the household consumption rate) is extraordinarily low."
Thus, the high national savings of China translates into a Current Account surplus. China then needs to export that savings surplus. China is capable of production far beyond its domestic demand. So it exports that excess production as well.
Michael Pettis says that Germany lowered its share of GDP to labor, which raised national savings to such an extent that Germany then exported their excess savings to Southern Europe. The result was the Euro-crisis. I should also say that Heiner Flassbeck from Germany also points to low wage share in Germany as a primary cause of the Euro-crisis.
I let Michael Pettis tell the story here... (source)
"In the 1990s Germany could be described as saving too little. It often ran current account deficits during the decade, which means that the country imported capital to fund domestic investment. A country’s current account deficit is simply the difference between how much it invests and how much it saves, and Germans in the 1990s did not always save enough to fund local investment."
"But this changed in the first years of the last decade. An agreement among labor unions, businesses and the government to restrain wage growth in Germany (which dropped from 3.2 percent in the decade before 2000 to 1.1 percent in the decade after) caused the household income share of GDP to drop and, with it, the household consumption share. Because the relative decline in German household consumption powered a relative decline in overall German consumption, German saving rates automatically rose."
"As national saving soared, the German economy shifted from not having enough savings to cover domestic investment needs to having, after 2001, such high savings that not only could it finance all of its domestic investment needs but it had to invest abroad by exporting large and growing amounts of savings. As it did so its current account surplus soared, to 7.5 percent of GDP in 2007."
"As German savings rose, eventually exceeding German investment by a wide margin, Germany had to export the difference, which its banks did largely by making loans into the rest of Europe, and especially those countries that were financially “shallower”. Declining consumption left Germany producing more goods and services than it could absorb domestically, and it exported excess production as the automatic corollary to its export of savings."
"Of course the rest of the world had to absorb excess German savings and run the current account deficits that corresponded to Germany’s surpluses."
"Spain and the other peripheral European countries all saw their trade deficits expand dramatically or their surpluses (many were running large surpluses in the 1990s) turn into large deficits shortly after the creation of the single currency as their savings rates shifted to accommodate German exports of its excess savings."
"The way in which the German exports of savings were absorbed by Spain is at the heart of the subsequent crisis. As long as Spain could not use interest rates, trade intervention, or currency depreciation to block German exports, it had no choice but to balance the excess of German savings over investment. This meant that either its investment would have to rise or its savings would have to fall (or both)."
"Both occurred. Spain increased investment in infrastructure and in real estate, but it seems to have done both to excess, perhaps because of the sheer amount of capital inflows. After nearly a decade of inflows larger than any it had ever absorbed before, Spain, like nearly every country in history under similar circumstances, ended up with massive amounts of misallocated investment."
"The imbalance created within Europe by German policies to constrain (domestic) consumption forced Spain into increasing consumption and boosting investment, much of the latter in wasted real estate projects (as happened in every one of the deficit countries that faced massive capital inflows)."
"Germany had to export its excess savings, Spain had no choice except to increase investment or to allow its savings to collapse, with the latter either in the form of a consumption boom or a surge in unemployment. No other option was possible."
"For this reason the European crisis cannot be resolved except by forcing down the German savings rate. And not only must German savings rates drop, they must drop substantially, enough to give Germany a large current account deficit. This is the only way the rest of Europe can unwind the imbalances forced upon the region in a way that is least damaging to Europe as a whole. Only in this way can countries like Spain stay within the euro while bringing down unemployment."
"As long as it is part of the euro, Spain has no choice but to respond to changes in German savings rates. There is nothing mysterious about this process. It is simply the way the balance of payments works, and thrift has nothing to do with it. If Germany does not take steps to force down its savings rate by increasing the household share of GDP, then either all of Europe becomes like Germany, in which case growth slows to a crawl and some other country – maybe the US? – will be forced to resolve Europe’s demand deficiency either through higher unemployment or through higher debt, or Europe must break apart to free Spain and the other peripheral countries from German savings imbalances."
So now we can see why the US Treasury is upset with Germany for still running such high trade surpluses, and why it points to Germany's high savings rate and weak domestic demand as proof of internal polices that are detrimental to Europe as a whole. As it is, Europe is already moving at a crawl.
This story should sound familiar too. China is acting like Germany toward the US. We can also see why China pegging its currency to the US dollar can be a problem. It is easier for China to export its excess national savings to the US. The US cannot really block Chinese exports with trade intervention and currency depreciation. And now the US is limited in its ability to use interest rates due to the lower bound.
So... Where are those excess savings awash?
"If Spain were to make its workers more competitive by reducing wage growth relative to GDP growth, it would implicitly be forcing up its savings rate to generate employment. To whom would Spain export those savings? The world is awash in excess savings..."
There you have it. The World.... the world is awash in excess savings because of falling labor share in emerging countries, like China and India. Moreover, in comparative terms, the US is not awash in savings. Mr. Krugman does not seem to see this yet. The rest of the world has a comparative advantage in national savings by grace of much lower labor share rates.
We can see what happened to Europe when Germany decided to raise their employment by lowering labor's share. Now we can understand what China is doing to the US by being able to produce so much output while paying very low labor share. The situation would be different if China was still a backward country with production limits. But China has increased its productive capacity incredibly since the 1980's. The problem is that Chinese production using such low labor share is overwhelming the US economic balance. Another "victim" is Japan who also has a comparative dis-advantage to Chinese national savings in terms of labor share.
When Japan came along with such great production decades ago, the US found balance with the Japanese, because our labor share rates are comparable. Yet, China's labor share rate is so ridiculously low forcing up their national savings, that our economy is facing a real challenge.
Ultimately China must raise its domestic demand by raising labor share of its population. China is investing 50% of its GDP, which is not sustainable. At some point, someone is going to have to "sustainably" consume the increased productive capacity. It will have to come from increased domestic demand from a higher labor share. The natural flow in international trade is for labor shares among other factors to balance over time. So as labor share drops in the US, there is a dynamic for labor share to rise in China. But labor share in China has a long way to rise and there are political and economic challenges associated with that.
And Unemployment in the US?
Michael Pettis also mentions exporting unemployment in his article and I want to include some of what he said.
"If the savings that Germany exported into Spain could not be fully absorbed by the increase in Spanish investment, the only other way to balance was with a sharp fall in Spanish savings. There are two ways Spanish savings could have fallen. First, as the Spanish tradable goods sector lost out to German competition, Spanish unemployment could rise and so force down the Spanish savings rate (unemployed workers still must consume). Second, Spain could have reduced household savings voluntarily by increasing consumption relative to income."
Think of the US and China. China is exporting their comparatively high national savings to the US (due to comparatively very low labor share rates). According to Michael Pettis, the US must absorb those savings from China. The two currencies are effectively pegged. We either have to raise our investment or lower our national savings rates. Investment has been moderately health in the US. Also, we can see in the graph above that the US has lowered its savings rate by increasing the rate of consumption. Real GDP has had to fall to a new lower trend line so that consumption as a share of GDP would rise. The US economy has been shifted to a sub-optimal state.
The US has also lowered its national savings rate with more unemployment, a lower labor force participation rate and a lower personal savings rate. As well, the natural rate of unemployment has risen. The personal savings rate is back down around 4%. Truly, the US has a serious problem.
Next in the series is what the US could do with its Current Account deficit...