Lecture 5 - The Great Thrift Shift

The US trade deficit of >$800 billion seems unsustainable. It requires the US to borrow from foreign nations. At some point they may not want to continue funding our trade deficit.

Ben Bernanke argued that we don't need to worry about it because foreigners have a lot of money to lend.

It now appears that he was wrong due to the financial markets crisis. Perhaps we can't pay it back, just like the housing crisis shows.

Why didn't interest rates rise?

Around 2000 in the US:
(i) Fed cut interest rate very aggressively
(ii) Bush administration: Taxes down, Govt spending up
Decline in private savings and govt budget deficit

Since US is 1/4 of world economy, it should have a major impact - an inward shift of world savings. See Economist article.

This should have caused an increase in interest rates, but it didn't!

The explanation is that world investment collapsed much more than the world savings fell.

Now the question remains:
Why did Investments, I, collapse more than Savings, S?

(i) Look to East Asia

Recall: S-I = NX

Since this region was growing rapidly (10%) in the 1990s, investors were happy to invest (despite risks). Example: Samsung going into auto manufacturing. However, the investment market reached a peak in 1996 and the beginning of 1997. 40-50 companies went bankrupt every day. It was bad quality investing. Default risk was high and came about. The risk of changing currencies and interest rates also caused insolvency.

After the financial crisis in 1997, investment has gone down by 10% of GDP in the region.

(ii) Japan: they're in a >10 year economic slump. Due to consumer and corporate default on loans. Investment remains low. Their engine of growth is foreign exports.

Economic strategy: Japan grew spectacularly after WW2 due to increasing exports. To sustain this, they made sure their currency wasn't overvalued. They intervened in foreign markets by buying foreign assets and selling domestic currency.

East Asia and China learned from this lesson of Japan. China's consumption is only about 38% of GDP.

(iii) US & Europe: IT investment boom collapsed around 2000-01.

8% (trade deficit of GDP??) is the dividing line for risk to foreign investors.

Why the global imbalances?

i.e. How does the US trade deficit boom while many nations are running a trade surplus? The US trade deficit has only gone over 3% over the last 5-6 years.

A - US
(i) Fed's low interest rate
(ii) Taxes down, govt spending up
1 personal savings is way down, consumption up: on the back of low interest rates, low taxes - causing housing boom and stock market investment increase
2 Govt savings way down. therefore overall S is way down and I is down, leading to NX down. i.e. increase in trade deficit

B - East Asia and Japan: investment collapse, I down. So, S-I=NX and NX is down too.

It started from the US policy reaction, but was fueled by the foreign willingness to invest.

Since 2000, two new elements:

1. China. In 2000, S=12% of GDP. In 2004, I=46% of GDP, S=50% of GDP. China invests a tremendous amount, but they save even more! They run a massive trade surplus.

2. Middle East and Latin America. Oil revenue and other commodities (raw materials) boomed. They learned from other countries not to squander the windfall gains.

Question: How do we define a global economic balance?
Answer: When every country has more or less balanced trade. But the extremes that we are experiencing these days is very imbalanced.