Sunday, June 21, 2009

Miserly Gluttony

A recent Goldman Sachs report revisits the idea of the savings glut Ben Bernanke first propounded back in 2003. I'll admit that when I first heard this theory, I found it kinda laughable. It sounded like yet another justification for the huge US current accounts deficit in particular and for US exceptionalism in general -- if things look unbalanced, let's blame the Chinese; the American economy is unstoppable and infinite by divine right. Over the last year or so though, I have come to see that reaction as both right and wrong. There really was a savings glut and the Chinese really are partly to blame for this mess. Their choice to peg to the dollar and accumulate US Treasuries was a necessary, if not sufficient, part of this whole crisis.

The basic argument is pretty simple. Sure, we had a giant credit bubble, centered on housing, accompanied by all the scams and looting that come with every bubble. Part of the reason for this was a lack of financial regulation, a corrupt government, and a crazed compensation structure. But that only explains explains why the bomb went off just where it did. It does not explain why everyone sat down on a powder keg to begin with. For that you needed the availability of easy credit, and for that you needed low rates and low inflation expectations.

The Chinese peg to the dollar and their forced march to industrial prosperity goes a long way to explaining these last two items, and this is the case the paper makes in some detail. Essentially, it boils down to the fact that China over-saved and under-invested. The first bit is what kept interest rates and inflation so low for so long (though Easy Al Greenspan should probably get some blame for this as well). The second part is no less crucial however, and that's what makes the paper interesting. They show that in addition to saving too much and pushing down rates, the Chinese were unwilling to take any investment risk with the glut they had piled up. They didn't invest enough in their own factories, or anyone else's factories, despite the fact that returns on real capital were high, and they didn't invest in equities or any other productive asset class. They just wanted to pile it up in ultrasafe Treasuries, which completely skewed relative prices in the financial world. If they had distributed things more evenly between asset classes, the price of everything would have risen together, and we would have called it prosperity, and not a bubble. However, since the US government was the only group they would lend to, somebody else had to do the magic of putting this pile of scaredy-cat funds into use in the economy. And lo, the nearest thing to hand was housing, commodities, and bank debt for private equity. To compensate for a large player's risk aversion, everyone else was encourage to embrace more risk.

Naturally, I don't mean that we should bomb China or let they boys at Citibank off the hook, but we should try to really understand how we got here, and I think this is a fundamental part of it. On the other hand, if you want to play conspiracy theory, you might claim that this was China's attempt to sponsor a socialist coup in the United States through clever financial engineering. Induce a financial crisis that you know they will resolve via larger government involvement in the economy. Maybe Trotsky was right and socialism's permanent revolution worldwide is inevitable -- we just failed to understand the mechanism. Clever monkeys.

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