Transcript excess demand for tradables

US Current Account and
Macroeconomic Policy
Puzzle in the world economy
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Relatively high growth rates in the
world economy
Budget deficit in many of the advanced
economies
Huge US current account deficit
Yet, real interest rates (both short and
long term) are low.
%Change in world output
Real long term interest rates
US
Japan
8 country
average
UK
IMF WEO April 2007
IMF WEO April 2007
Similarly in the US,
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The CA has been in deficit every year
since 1992.
Until 1997, the deficit was modest but
it grew thereafter.
In 2006 deficit was 5.2% of GDP.
US indicators in 2005
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Long-term (nominal) interest rates had
been falling and were now below 4%.
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Residential and business investment
had been been rising and was now at
16.5% of GDP, (well above the
average for the 1990s).
Two views regarding the
situation:
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1. Optimistic
2. Pessimistic
Optimistic view:
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What really matters for interest rates is
the global economy, and
The problem may be too much
savings, rather than too little.
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This is called the “savings glut” view.
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This was adopted by the Fed.
Sources of savings glut:
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Companies (US,German, Japanese,
Cinese) make profits but they do not
invest.
Oil exporters are reluctant to invest in
oil exploration.
Reserves in China accumulating in the
hands of the government.
Examples of savings glut:
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Rising in oil prices giving oil-producing
countries such as Russia and Saudi
Arabia far more money than they can
use right away.
The aging workers of Europe are
saving for the future
US undistributed profits
Possible positive outcome
Around the world,
 Increased productivity,
 Improved living standards
 Cheap money makes it easier to
provide for the equipment and
infrastructure.
 Increased supply reduces inflationary
pressures.
Outcome in the US
U.S. private and public sectors managed
to acquire big increases in
 housing construction
 health-care
 military spending
Without inflation
Risks (pesimistic view)
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To finance the CA deficit, US sucks in
savings from abroad that could not be
relied on for ever.
US needs to borrow from abroad or to
sell assets—shares, bonds, property.
Risks of savings glut
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Instead of going into productive
investments, cheap money
overheats spending and
inreases asset prices
ingredients for a bust.
Case for unsustainability: US
side
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A CA deficit results in an increase in
foreign liabilities and a high
net
foreign liabilities/GDP ratio.
CA deficit feeds itself since the interest
payments increase as liabilities
increase. Hence trade deficit needs to
shrink.
Depreciation of the $ may be required.
Case for sustainability:
US side
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US is a high growth economy and
offers a good home for investment: not
enough profitable investment
opportunities in the rest of the world.
“sophisticated US finance view”:
dynamic, high saving developing
countries suffer from inadequate
financial markets and their domestic
market is a poor venue for their liquid
Criticism of the case for
sustainability:
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A high growth country does not need
to run a deficit in CA (eg UK in the 19th
century had a surplus)
A rising deficit means that demand
growth exceeds output growth
Foreign claims are not invested in high
yield assets such as stocks but are in
the form of debt with low returns
Case for unsustainability:
creditors’ side
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You cannot be a borrower for ever, but
you can be a creditor as long as you
wish to be.
The creditors may change their minds
given that risk exposure is rising and
the return to their investments is very
low.
In China, reserves make up half of
GDP.
Case for unsustainability:
creditors’ side
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When reserves accumulate as a result
of intervention in the foreign exchange
market it has monetary consequences.
Reserve increases lead to monetary
expansion without sterilization.
Sterilization measures may not be
applied indefinitely.
Case for sustainability:
creditors’ side
Creditors have reasons to continue to
finance the US:
1. Some are rich countries with
structurally high savings: Germany,
Japan, Singapore, and Switzerland
2. Some rely on export-led growth: East
Asian countries
Case for sustainability:
creditors’ side
Creditors have reasons to continue to
finance the US:
3. Some fear currency crises and want
to avoid CA deficits and external
borrowing (Brazil and Malaysia)
4.
Oil exporters want to be prepared for
adverse circumstances
Case for sustainability:
creditors’ side
China is a host to all of those motives:
 Huge structural saving surplus
 Export-led growth
 Fears financial instability
 High growth performance has created
a resouce that may not be maintained
in the future
US macroeconomic policy
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“Savings glut” view: the root of the
problem is excess savings arounf the
world
“Money glut” view: Us monetary policy
(low interest rates) is the root of the
problem.
Explanation of low interest
rates:
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Saving glut view: the fact that interest
rates are low shows that there are
ample savings.
Money glut view: interest rates are low
because inflation is low and because
of accomodating monetary policy.
Fed policy
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US monetary policy aims at attaining
the natural rate of output
Yn: highest possible level of output
consistent with low inflation
But at this output level, the exchange
rate creates a current account deficit
(excess demand for tradables)
US macroeconomic policy
According to the savings glut hypothesis
 The dollar appreciates against the
intervening currencies.
 It is not easy for US to play against
this.
 An overvalued US dollar creates
excess demand for imports
US CA deficit
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Given income and the exchange rate
there is bound to be a CA deficit
The internal counterpart of this deficit
is an excess of spending over income
or a shortage of savings.
US spending grew faster than US
income.
US monetary and fiscal policy
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US monetary policy was expansionary
Fiscal policy usually supported this
US has no external constraint: it can
borrow internationally in terms of its
own currency
Lax monetary and lax fiscal
policy in US
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If not, a recession in US and around
the world would be likely
Emerging economies would have to
boost up domestic demand
Savings would have to decrease
Indicators of lax monetary
policy
Indicators of lax monetary
policy
Results of lax monetary policy
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Increase in credit volume
Increased demand for housing
Increased demand for assets
Bubble in housing market
Asset bubble
Indicators of lax monetary
policy
Direction of investments
High availability of loanable
funds
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Low nominal and low real interest
rates
Real cost of borrowing low
Borrowing increasing
A lot of loans extended by banks (with
a lot of money coming from ‘shadow
banks’)
A shift into risky assets
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For example stocks, because the rate
on risk-free assets (T-bills) is quite low.
Demand increases for hedge funds
and equity funds
Equity funds: stocks
Hedge funds: combination of stocks
and derivatives and options to
minimize risk exposure
As demand for these rise
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Stock prices and prices of stock funds
rise
This blunts the expected and actual
return
Return: (price paid-price sold)/price
paid
As price paid inreases, % return
decreases on a given price
Risk spread
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Difference between the return on
equity and risk free asset
Spread is compressed for a given risk
free rate