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by Brian Butler

The “savings glut” that may be to blame…

2009/02/10 in credit crisis, macro trends

The “savings glut” theory is one of the two main competing theories to explain some of the bigger mysteries of global finance in recent years (including the credit crisis of 2007 ).  The basis of this theory is that there are underlying fundamental “global imbalances” which are causing all of the trouble (and which need to be fixed in order for the crises to stop).  In this blog post, Im going to quickly outline “savings glut” theory…

The other theory (money glut)

The more popular (and easier to understand) theory (which Im not going to cover in this blog) is called the “money glut” theory…which basically says that American Central Bank kept interest rates too low for too long, which led to too much money, too much credit and encouraged too much risk taking by banks and greedy people on wall street.  This is the popular version of the story that most people hear every night from their local news commentator.  This is NOT the theory that Im going to review in this blog posting.

Savings glut (summarized)

The less well known (and more difficult to understand) theory of what-went-wrong…is the  “savings glut theory”….which basically says that the root of the problem lies not within the US, but with the fundamental imbalance of international finance.

While finance is risky (borrow short, lend long), it is even more risky when it crosses borders.  Countries in Asia and Latin America learned the lesson not to accept deficits after punishing recessions in the 1990′s and early 2000′s.  Since then, nearly all emerging nations (and most developed ones, minus USA) have fought hard to keep current account surpluses.   In an effort to keep away from risky deficits, many central banks (especially in emerging Asia) have purposefully chosen to (a) keep their currencies undervalued, and (b) to accumulate foreign exchange reserves to buffer against potential shocks.  Note that the countries with large reserves in 2009 are the ones most likely to survive this latest crisis with their economies in tact.   After seeing the prescriptions given by the IMF after the last round of crises, most emerging countries said “no thanks” to foreign capital, and instead have chosen to run massive surpluses.

The key to understanding the “savings glut” theory is to first understand that the nations “balance of payments“, by definition, must BALANCE.  That means that if a country chooses not to accept foreign capital, and therefore if they choose to run a capital account deficit…then they must by definition also run a current account surplus (the current account is physical goods exports).  That means that in order to export capital, they must also export products (I know, it gets a bit confusing, sorry).  The net result = they must keep the currency undervalued for this to work.  And the currency of choice = the US dollar (as a target peg).

“Ok, so what is the problem?” you might ask…

Well, due to the rules of global accounting…if one country runs a current account surplus, then others must run a current account deficit.  That part is easy to understand….if one country exports, another must import.  Ok, but what is less obvious is that if one country runs a capital account surplus (think China), then another MUST run a capital account surplus (think USA).  This is the root of the “savings glut” theory…

The savings glut theory states that sometime in the late 1990′s to early 2000′s…there was a massive amount of countries that all decided “thats enough”…no more foreign capital can come in.  It was too risky, and led to too many crises.  As Martin Wolf says, they chose to “smoke, but not inhale” from international finance…and so began a massive financial recycling program, whereby money that came in quickly was sent back to sender.  Money no longer flowed from rich countries to poor ones…instead money was borrowed on a massive scale from poor ones to rich ones.

Why did this happen?  The theory is that international finance proved to be too risky, and so developing countries almost unanimously chose to reject international finance and send it back.   (the only emerging markets that did not follow this prescription seems to have been the emerging Eastern European nations, many of which are now facing crisis…on a much deeper scale than emerging Asia).

Enter the “borrower of last resort”

But, with all of these emerging countries sending money back, unfortunately, there was only ONE country on the planet that was willing and able to accept it:  the USA.  (note that economists that subscribe to this theory are extremely critical of Germany / Japan and other developed nations that did not take some of this capital that was flooding the USA).

The US, as the theory goes, was uniquely capable to absorb this flood of “savings” because the US dollar was the global reserve currency, and the US could borrow in its own currency on a massive scale (with no chance of foreign exchange crisis).

economist-image

Who Believes this theory?

Surprisingly, the “savings glut” theory has some pretty impressive followers…

  • the list goes on and on….

Who is to right?  Who is to blame?

The reality is that both “savings glut” theorists and “money glut” practitioners are probably each 1/2 right. I read somewhere…”the Chinese may have supplied the noose, but it was the US that strangled themselves”…Thats probably the most accurate way of reconciling the “savings glut” vs “money glut” theories…

More on the “Savings Glut”

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by Brian Butler

Bill Gates and China…

2009/01/28 in BRIC - emerging markets, currency, macro trends

China’s wealth of reserves is massive, impressive.  Some analysts estimate the value of China’s foreign reserves to be in near $2 trillion (with about a trillion of that in US treasuries).  Yes, China has way more wealth than Bill Gates ….so where is the connection?   Hang on, I’ll get there, but first…lets look at the data from Brad Setser blog:

In 2008, my best estimate  is that China bought $374.6 billion of the $1684.8 billion increase in the outstanding stock of marketable Treasuries not held by the Fed.

China currently has — in my judgment — about $900 billion of Treasuries.

Wow!  That is an incredible amount of money…But its not money that China has…no,actually… its mostly money that is owed to China.   Money being lent from China to the United States.  In this upside-down world of international finance, we actually see money flowing from places like China on a massive scale to countries like the USA… (note that only in recent history is money borrowed by rich countries from developing ones!).

But, having a massive amount of “reserves” (on paper) makes China rich, no?

On paper, yes…But, remember…these reserves (in the form of US treasuries) are like I.O.U.’s from the US to China.   In other words, the US takes the money now, and issues I.O.U’s for future payments, which fill up the Chinese reserves… As a result, this massive “wealth” of foreign reserves is a bit illusionary…because it exists on paper, and not in physical wealth.  (the real wealth of China* lies in its stock of productive capacity and innovative people…. and not in its paper wealth of international reserves)….

There are three main problems with a “wealth” of reserves…

  • Much of it is paper wealth…. its like Bill Gates having been the richest man, but having had all of his wealth tied up in MS stock…if he had tried to cash out quickly, it would have driven the stock price down…eliminating much of his paper wealth. China is in a similar situation; having the wealth of reserves tied up in I.O.U’s (debt issued by the US)…if China were to suddenly try to sell their position in US treasuries, it would drive down the price and reduce their value.  So, much like Bill Gates, China would need to sell off its position gradually (or just slow down their pace of acquisition).
  • If the US dollar were to depreciate, the amount of “wealth” would simply disappear.
  • China cant spend that money internally without risking (a) inflation, and (b) currency appreciation. While inflation isn’t that big of a risk (now), the currency appreciation is. Remember…the only way china can run HUGE current account deficits is if they also simultaneously run capital account surpluses (the Balance of payments must balance). So, that surplus capital must exit the country, or else…if they spend it internally, the current account must shrink (What would be the mechanism by which this would happen?… currency appreciation to eliminate exports).

Can China spend this “wealth” on Fiscal Stimulus?

No, I dont think so.

Its not that they dont want to (I believe the Chinese would love to spend that money to stimulate internal demand and boost production / jobs).  It’s that they can’t (at least not easily, and not all at once).

But, you might wonder…didnt I just read about a massive fiscal stimulus package coming from China?  Yes, you probably did (we highlight this in our wiki).  But, much of $600 billion in fiscal stimulus that China announced in (late) 2008 was already-planned spending (see Heritage Foundation analysis here).

Foreign analysts that encourage China to spend that stockpile of “money” to stimulate the internal demand (and boost the world economy) are likely to be disappointed.

*The Chinese wealth ultimately lies not with stockpiles of foreign reserves but in developing and expanding their internal market.  Stimulating demand internally and becoming less reliant on export growth is the key to China’s bright future.

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by Brian Butler

Fiscal stimulus too small…

2009/01/27 in credit crisis, macro trends

The proposed fiscal stimulus package of $825 billion is probably  (a) too small, and (b) not directed at the right part of our economy (the financial sector).  Let me share with you a recent quote that I read from the IMF:

“If there’s not a restructuring of the banking system, then all the money that you can put into [monetary and fiscal] stimulus will just go into a black hole,” Strauss-Kahn, director IMF

On the surface of it all, a massive spending binge of $800bn USD sounds impressive ….but is it?  If you think in personal terms, then hundreds of billions sounds like alot of money. And, maybe it is when compared to the budgets of most countries on the planet.   But not when its compared to the size of the international finance market, in which there are approximately $140 trillion in financial assets, and hundreds of trillions of dollars traded every year in the currency markets.

Why look at the financial markets size?

When looking at a fix to the financial problem, it is important to compare the size of the proposed fix to the size of the financial system.  You need to compare “apples to apples”, if you will.  And, since the root of the problem lies in the financial sector, it makes sense to compare the size of the stimulus to the size of the problem.   It doesn’t make sense to compare the bailout to the size of a countries GDP (or reserve), when the root of the problem lies not in the real economy (although that is clearly suffering right now), but with the heart of the financial system.

The size of the financial market

Lets look at the numbers…and take a look at how big the fiscal stimulus plan really is  in comparison to the estimated size of the global financial system…

see data below…or, here in our GloboTrends wiki

The overall size of the world financial assets (promises outstanding) was approx $140 trillion in 2005.  That incredible number was the total quantity of financial assets, or seen another way…there were $140,000 billion promises outstanding for future payments.   That unbelievable quantity of promises was only possible because people believed that the underlying assets upon which those promises were made were actually worth what people said they were.

Shrinking the financial market

But when houses started losing value, the mountain of assets stacked on top of them needed to shrink.   The underlying assets suddenly couldn’t support this incredible (massive) amount of promises stacked on top of them.  And the mountain of finance began to fall…not all the way down, but to a new, lower level of promises.  This is what analysts often called “deleveraging“, which meant that we were shifting from an economy with lots of credit…to one with less credit.  Less lending, less leveraging, less total financial assets for you and me.    Note that this $140 trillion of financial assets was equal to about 3.16 time total world GDP in 2005….up from 2.18 times in 1995,  and from 1.09x in 1980.  This means that we were living on nearly 3 times as much financial credit in 2005 as we were back in 1980, just 25 years before.  This massive boom in finance just happened to correspond to the longest and most prosperous boom in US history…a coincidence?  I think not.

Complexity of modern finance…

So, what is happening now is we are moving back to a world with less financial leveraging.  It wasnt our choice, but a requirement once investors lost confidence in the underlying value of the property upon which the mountain of promises was heaped.

But because of the complexity of modern finance, once uncertainty entered into the picture, it because extremely difficult to know which assets were worth what. With mountains of derivatives stacked on top of other derivatives, spliced, diced and repackaged every which way…it became extremely difficult for counter-parties to judge the risk of lending to each other.

The result?  Banks stopped lending to each other for fear that the assets may not be worth as much as they thought.  With bad assets mixed in with good assets, a confusion set in.   As a result, all banks sought to shore up their balance sheets and reduced lending.   Uncertainty led to a forced deleveraging of the entire financial system…

The pain we feel in the real economy (with job losses, companies losing money, etc) is a direct result of the deleveraging process.   We start at one level of activity, and are forced down to a lower one.

The stimulus package is too small

We cant seem to spend enough money.  But thats because we are fighting the problems that result from the original problem rather than dealing with the original problem itself.  Trying to stop the water from a broken dam is much more difficult than plugging the holes in the dam!

If you add up all the money we have already spend, its clear that throwing money at the problem will not work.   Around the globe, country after country is spending money like crazy (cutting interest rates, proposing fiscal stimulus).  This latest round of $825 billion is just the latest round.  Remember, we previously spent a hundred billion plus in February of 2007,

“After the economy slowed in late 2007, Congress passed a $168 billion stimulus package in February 2008 consisting primarily of tax rebates. The package was later judged by many economists to have been ineffective, since surveys showed that much of the extra money was saved or used to pay debts, neither of which generates direct economic activity.”

And then there was the $700 billion of money in the TARP plan (Paulson Plan) that also wasnt enough to stop this deleveraging monster…

“$700 billion to use to buy up mortgage-backed securities whose value had dropped sharply or had become impossible to sell. While Congress eventually gave him most of the authority he sought, Mr. Paulson ended up switching gears and using the money to make direct investments in troubled financial institutions instead.  source NYTimes

I previously wrote an article arguing that the fall in oil prices was a big fiscal stimulus  (see link here).  But, all of this stimulus has done very little to fix the problem…because none of it went to the root of the financial deleveraging…the trouble is that the financial system is just too MASSIVE in comparison to all of these efforts..

In comparison…the financial Market is MUCH bigger!

  • $140 trillion in financial assets…compared to $0.8 trillion in fiscal stimulus.
  • On any given day, approximately $1 trillion US dollars worth of currency is traded in just the UK alone….with another $600 bn in the US (each day).  Add them up, and you have hundreds and hundreds of trillions of dollars traded each year in the international money markets.
  • in the face of such a MASSIVE market…one has to ask….

Will a stimulus of just $0.8 trillion make a difference?

If you accept that the root of the problem is in the financial markets, and not in the real economy…then you need to compare the size of the proposed fiscal stimulus plan not to the size of the real economy, but instead to the size of the financial one. Once you do this, you begin to see why economists such as Martin Wolf are saying that this stimulus package is too small to be effective.  (his argument was slightly different than mine, but with the same conclusion that the stimulus package is too small).

My thought is that spending $0.8 trillion in the face of $140 trillion in assets … is like spending half of one percent of the total assets in the hopes of propping up the market.  Not only is it way too small, but it goes after the real economy, and not the financial one.

So, what is the solution?

Do we all just need to accept financial system deleveraging?  Do we just need to learn to live with less (credit, goods, finance)?  No.  But we need to accept that this problem is not going to be solved by throwing $825 billion at the real economy.  Instead, what we need to do is to find a way to get all of the bad assets out of the larger pool of assets in the financial system.   Separate them, write them down, and isolate them from the majority of good -quality assets still in the financial system.

Here are my thoughts for a practical solution.

  1. Create a “bad bank” which would purchase assets from financial institutions in exchange for cash and equity.
  2. Look to Sweden, not to Japan (for the answers).  My recommendation is to spend some time studying the Swedish model for recovery
  3. Give the TARP another go.  Although Paulson later switched course and tried the European model of direct bank recapitalizations, I think he was originally on to a good idea…buy up bad assets, and find a way to strip them out of the financial system

If those steps fail…then the only other alternative may be to reluctantly nationalize the banks.  But, this WILL NOT SOLVE the root problem of forced deleveraging due uncertainty of what assets are worth.  It will only lead to forced lending and bad debts, and a potentially huge bill for tax payers.

Final recommendation…go ahead with the stimulus package

Yes, thats right.   After arguing that it wont work, Im still arguing that it should be done.   The point of my article is that this particular plan will not solve the underlying problem that is causing the financial crisis, but that doesnt mean that the fiscal stimulus shouldn’t be done.

There is a feedback-loop that exists between the “real economy” and the financial markets.  While the trouble may have started in finance (and ultimately needs to be solved there), the real economy plays a vital role.  Anything that can be done to get people working, and the economy moving ….will give our policy makers time to fix the real problem in the financial sector.

But the risk is that politicians will pat themselves on the back for “solving the problem”, when they should be realizing that the stimulus package is just a (much needed) bandaid.  It will cover up the trouble for a little while, but hopefully we dont all forget that this is just a temporary fix, and that further action is needed.

Hopefully, whatever fix comes next will be directed at the financial markets themselves….hopefully we wont open the newspapers 6 month from now to read news reports like this:

” USA faces extended downturn Despite Stimulus“

The data:  our financial mountain of promises:

* here is a sample of the data we are collecting in our GloboTrends Wiki…

Size of the Financial sector:

What is amazing is that the financial sector ballooned to the size that it has…with a worldwide total of $140 trillion in promises outstanding in 2005 (surely more in 2008/9).  Of that total, the US was the prime holder of promises (assets).  The US household sector held about $39 trillion (28% of world total), and with the US as a whole holding nearly $52 trillion (37% of all world financial assets, or promises).

USA:

  • household & non profit:
    • total assets = $64.4 trillion assets owned  (5x USA GDP)
    • total debts =  $11.9 trillion
    • total balance:  $52.5 trillion
      • of this $52.5 trillion…the breakdown was as follows:
        • $25.6 trillion = tangible, mostly property
        • $38.7 trillion = financial assets
          • $6.1 trillion in deposits
          • $3.1 trillion in credit market instruments
          • $5.7 trillion in direct corporate equity
          • $8.9 trillion in indirect corporate equity, of which…
            • $1.1 trillion in life insurance
            • $3.0 trillion claims on pension funds
            • $1.9 trillion claims on gov’t retirement funds
            • $2.9 trillion mutual funds

So, total US financial assets in 2005 was as follows…

  • Household & non profit sector (data from above):
    • financial assets:  $38.7 trillion
  • Business sector -  Non-farm, non-financial corporate sector
    • financial assets:  $10.9 trillion
  • Business sector -  Non-farm, non-corporate sector
    • financial assets:  $2.3 trillion
  • TOTAL US private sector Financial Assets:
    • $52 trillion USD (approx. in 2005)….obviously it grew more till 2008 (especially housing bubble), before falling…

Financial assets globally…

Compare this with world (in 2005):  source : McKinsey report 2005, “Mapping the global capital market”

  • USA (private sector only):  $52 trillion  =  37%  (rounded)
  • Eurozone (all):  $30 trillion                  =  21%
  • Japan  (all):  $19.5 trillion                    =  14%
  • UK (all):  $8 trillion                             =   5.7%
  • Top 4 total $109.5 trillion / 140           =  almost 80% world total !!
  • World total (all, including private + govt + business):  $140 trillion….owned of financial assets

How this $140 trillion breaks down…

  • $44 trillion was equities      =  31.4%
  • $35 trillion was private debt securities   =  25%
  • $23 trillion was government debt securities   =  16.4%
  • $38 trillion was bank deposits                        =  27.2%…….down from 42% in 1980 (shift away from simple deposits to more indirect banking)
  • $140 total

How has it grown? As a % of GDP…

  • $140 trillion was = 3.16 x total world GDP in 2005….up from 2.18 times in 1995,  and from 1.09x in 1980
  • Regional trends from 1995 to 2005
    • UK: rose from 2.78x to 3.59x GDP
    • USA  from 3.03x to 4.05x GDP
    • Eurozone: from 1.80x to 3.03x GDP

Sources:

* data from McKinsey report 2005, “Mapping the global capital market“  and http://www.federalreserve.gov/releases/

Should we More money for banks?  

“Politically difficult”…but worth it…

Strauss-Kahn recognized that putting more public money into the banking sector to restructure it can be unpopular politically. “But the reality is that one dollar spent in restructuring the banking sector today is much more useful to achieve recovery than the same dollar spent on bridges, hospitals etc.”

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by Brian Butler

Local “fiscal stimulus” plans won’t stop this recession

2008/12/02 in Tumblr blog imports

Many economists are now calling for the US to embark in a massive “shock therapy” fiscal stimulus package to bring the US economy back to life (and save us from a severe recession).  While I see their reasoning, and I appreciate their optimism, I am doubtful that the US has enough firepower or ability to slow this one down (on their own).  Its only with a well coordinated global action that a fiscal stimulus would work.

The financial and economic crises are too big and too global for any one (national) local fiscal stimulus package to have much effect.  If the US moves forward with plans to spend up to $700 billion in fiscal stimulus (building roads, bridges, and green investments), we may end up with many new roads and bridges, but its unlikely that this action alone will pull the US out of recession.

The government of the US can not spend nearly enough money to make a significant change in the over-powering deleveraging process that is working its way through the world of global finance.  Perhaps even a coordinated attempt by many governments would not be enough to jolt this train (wreck) back on track.

Over the past few weeks, there has been alot of discussion about an upcoming fiscal stimulus package.  President elect Obama has put much attention to this topic…then, yesterday, there was a lineup of Governors from across the US that came to Washington to pitch President elect Obama on the need for $176B in fiscal spending to jump start the economy. In addition, there is along line of industry leaders lining up with their hands out looking for help.

Conclusion:  the US is clearly considering a fiscal stimulus package as the way out of this mess…but Im not so sure that this conclusion is correct.

Lack of Monetarist options:

I agree with the conclusion that traditional monetary policy remedies will not work.  Not this time.  In GloboTrends, I have previously stated that Monetary policy wont work during this particular crisis (to jump start the US economy) because of the malfunctioning credit markets.  In this posting, Im going to cover why I believe that fiscal stimulus won’t work either, and why the US should not borrow vast amounts of money to do this.

Existing Fiscal stimulus has done nothing

First of all, I ask that readers consider the massive fiscal stimulus package that has already hit the consumers since July (2008)….What fiscal stimulus package you ask?   The stunning recent fall in gasoline prices globally, of course!  (this has been a MASSIVE economic stimulus package that has been launched globally, putting cash into consumers hands, and has boosted confidence, making people feel richer).

Falling gas prices = same as fiscal stimulus

This fall in gas prices must be one of the largest (and most welcome) fiscal stimulus package imaginable for struggling governments around the globe.  They got the fiscal boost without having to raise taxes or pass any new laws.   But the lesson of the gas-price fiscal stimulus is that people will save their money rather than spend it, and that consumers are less willing to spend new money than they have in the past.

While the gas-price fiscal stimulus may be small in comparison to the proposed $700bn bandied about by the new administration, its doubtful that the entire sum could be put to productive use immediately.  Instead, what we are looking at is a mixture of road building, green projects and tax cuts.  The infrastructure projects might put people to work, but the fiscal impact would be spread over months or even years.  The tax cuts would be more immediate, but the new money would probably be saved rather than spent (as is shown in the gas-price stimulus example).  In the rest of this posting, I will examine the size and impact of this gas-price fiscal stimulus….

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by Brian Butler

Trends: Fiscal policy in, Monetary policy out

2008/11/11 in Tumblr blog imports

In a credit-crisis environment, the tools of monetary policy are rendered ineffective.  Fiscal policy is the only other choice (to stimulate the economy).

With central banks around the globe cutting rates, its clear that monetary policy alone will not be enough to steer our economies out of recession.

The reason that monetary policy has been so ineffective during this crisis, is that in order for monetary policy to work as an effective instrument of control, you first need the money markets to be working efficiently.   But, with the dysfunctional money markets not up to the task, the Central Banks around the globe are left with ineffective tools to influence the money supply, and hence control the markets.  For this reason, they are forced to look to fiscal stimulus to help.

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by Brian Butler

Fed vs. Treasury – how we treat them differently

2008/10/07 in Tumblr blog imports

Ask anyone in America for their opinion about the $700 billion “financial rescue plan”, and nearly everyone will have an opinion (most of them negative).  Everyone will no-doubt have heard the Presidents’ speeches, or the long drawn-out battles in Congress.   They will have heard both political candidates for President talk in great length about how “angry” they are about having to “bail out” Wall Street, or about how the bill was intended to protect “Main-street”.

But, ask those same people about the hundreds of billions of dollars (trillions?) being spent by the Federal Reserve, and hardly a person will have anything to say about it (if they have heard about it at all)….

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