To be more specific, I will argue that over the past decade a combination of diverse forces has created a significant increase in the global supply of saving--a global saving glut--which helps to explain both the increase in the U.S. current account deficit and the relatively low level of long-term real interest rates in the world today.
Bernanke's definition of the current account deficit:
When U.S. receipts from its sales of exports and other current payments are insufficient to cover the cost of U.S. imports and other payments to foreigners, U.S. households, firms, and governments on net must borrow the difference on international capital markets.3 Thus, essentially by definition, in each period U.S. net foreign borrowing equals the U.S. current account deficit, which in turn is closely linked to the imbalance in U.S. international trade.
Since America's savings is less than the amount required for domestic investment, we need to make up this shortfall by borrowing abroad (basically China and the Middle East):
Because saving can cross international borders, a country's domestic investment in new capital and its domestic saving need not be equal in each period. If a country's saving exceeds its investment during a particular year, the difference represents excess saving that can be lent on international capital markets. By the same token, if a country's saving is less than the amount required to finance domestic investment, the country can close the gap by borrowing from abroad. In the United States, national saving is currently quite low and falls considerably short of U.S. capital investment. Of necessity, this shortfall is made up by net foreign borrowing--essentially, by making use of foreigners' saving to finance part of domestic investment.
Do not blame the US federal budget deficit:
Here I simply note that the so-called twin-deficits hypothesis, that government budget deficits cause current account deficits, does not account for the fact that the U.S. external deficit expanded by about $300 billion between 1996 and 2000, a period during which the federal budget was in surplus and projected to remain so. Nor, for that matter, does the twin-deficits hypothesis shed any light on why a number of major countries, including Germany and Japan, continue to run large current account surpluses despite government budget deficits that are similar in size (as a share of GDP) to that of the United States. It seems unlikely, therefore, that changes in the U.S. government budget position can entirely explain the behavior of the U.S. current account over the past decade.
The financial crises in Mexico (1994), Asian Tiger (1997/1998), Russia (1998), Brazil (1999), and Argentina (2002) changed the domestic current account positions of these countries:
In my view, a key reason for the change in the current account positions of developing countries is the series of financial crises those countries experienced in the past decade or so. In the mid-1990s, most developing countries were net importers of capital; as table 1 shows, in 1996 emerging Asia and Latin America borrowed about $80 billion on net on world capital markets. These capital inflows were not always productively used. In some cases, for example, developing-country governments borrowed to avoid necessary fiscal consolidation; in other cases, opaque and poorly governed banking systems failed to allocate those funds to the projects promising the highest returns. Loss of lender confidence, together with other factors such as overvalued fixed exchange rates and debt that was both short-term and denominated in foreign currencies, ultimately culminated in painful financial crises, including those in Mexico in 1994, in a number of East Asian countries in 1997-98, in Russia in 1998, in Brazil in 1999, and in Argentina in 2002. The effects of these crises included rapid capital outflows, currency depreciation, sharp declines in domestic asset prices, weakened banking systems, and recession.
After 1997/1998, the countries in East Asia & Russia shifted their domestically policies and began accumulating large foreign exchange reserves, rather than borrowing from broad. These reserve would be used when then next "crisis" occurred (they could prop up their local currency using their reserves)
In response to these crises, emerging-market nations either chose or were forced into new strategies for managing international capital flows. In general, these strategies involved shifting from being net importers of financial capital to being net exporters, in some cases very large net exporters. For example, in response to instability of capital flows and the exchange rate, some East Asian countries, such as Korea and Thailand, began to build up large quantities of foreign-exchange reserves and continued to do so even after the constraints imposed by the halt to capital inflows from global financial markets were relaxed. Increases in foreign-exchange reserves necessarily involve a shift toward surplus in the country's current account, increases in gross capital inflows, reductions in gross private capital outflows, or some combination of these elements. As table 1 shows, current account surpluses have been an important source of reserve accumulation in East Asia.
Even though China did not suffer significant capital outflows during the 1997/1998 crisis, it too decided to build up a "war chest" of large foreign exchange reserves. It uses this war chest to keep the RMB pegged to the US dollar, which in turn promotes its export-based economy:
These "war chests" of foreign reserves have been used as a buffer against potential capital outflows. Additionally, reserves were accumulated in the context of foreign exchange interventions intended to promote export-led growth by preventing exchange-rate appreciation. Countries typically pursue export-led growth because domestic demand is thought to be insufficient to employ fully domestic resources.
In 2009, this is known as Chinese "sterilization" of its currency:
In practice, these countries increased reserves through the expedient of issuing debt to their citizens, thereby mobilizing domestic saving, and then using the proceeds to buy U.S. Treasury securities and other assets. Effectively, governments have acted as financial intermediaries, channeling domestic saving away from local uses and into international capital markets.
The sharp rise in the price of oil over the past 15 years has turned the Middle East, Nigeria, Venezuela, and other oil-exporting nations into net-lenders:
The current account surpluses of oil exporters, notably in the Middle East but also in countries such as Russia, Nigeria, and Venezuela, have risen as oil revenues have surged.
Even though the US was saving less, the value of our portfolios (and real estate) was increasing due to a number of factors at the time, making us feel richer:
From about 1996 to early 2000, equity prices played a key equilibrating role in international financial markets. The development and adoption of new technologies and rising productivity in the United States--together with the country's long-standing advantages such as low political risk, strong property rights, and a good regulatory environment--made the U.S. economy exceptionally attractive to international investors during that period. Consequently, capital flowed rapidly into the United States, helping to fuel large appreciations in stock prices and in the value of the dollar. Stock indexes rose in other industrial countries as well, although stock-market capitalization per capita is significantly lower in those countries than in the United States.
Continued ...
From the trade perspective, higher stock-market wealth increased the willingness of U.S. consumers to spend on goods and services, including large quantities of imports, while the strong dollar made U.S. imports cheap (in terms of dollars) and exports expensive (in terms of foreign currencies), creating a rising trade imbalance. From the saving-investment perspective, the U.S. current account deficit rose as capital investment increased (spurred by perceived profit opportunities) at the same time that the rapid increase in household wealth and expectations of future income gains reduced U.S. residents' perceived need to save.
Even as the equity markets collapsed in 2001/2002, the low interested rates continued in the US. These low interested spurred and increase in real estate prices in refinance of mortgages:
The transmission mechanism changed, however, as low real interest rates rather than high stock prices became a principal cause of lower U.S. saving. In particular, during the past few years, the key asset-price effects of the global saving glut appear to have occurred in the market for residential investment, as low mortgage rates have supported record levels of home construction and strong gains in housing prices. Indeed, increases in home values, together with a stock-market recovery that began in 2003, have recently returned the wealth-to-income ratio of U.S. households to 5.4, not far from its peak value of 6.2 in 1999 and above its long-run (1960-2003) average of 4.8. The expansion of U.S. housing wealth, much of it easily accessible to households through cash-out refinancing and home equity lines of credit, has kept the U.S. national saving rate low.
Because the US has the world's reserve currency, surpluses in other countries tend to by "recycled" into US dollar-dominated assets such as US Treasuries. This was on of the main factors that kept US interest rates low for so long:
Another factor is the special international status of the U.S. dollar. Because the dollar is the leading international reserve currency, and because some emerging-market countries use the dollar as a reference point when managing the values of their own currencies, the saving flowing out of the developing world has been directed relatively more into dollar-denominated assets, such as U.S. Treasury securities. The effects of the saving outflow may thus have been felt disproportionately on U.S. interest rates and the dollar. For example, the dollar probably strengthened more in the latter 1990s than it would have if it had not been the principal reserve currency, enhancing the effect on the U.S. current account.
The first problem here is logic suggests the situation should be flipped 180 degrees:
We see that many of the major industrial countries--particularly Japan and some countries in Western Europe--have both strong reasons to save (to help support future retirees) and increasingly limited investment opportunities at home (because workforces are shrinking and capital-labor ratios are already high). In contrast, most developing countries have younger and more-rapidly growing workforces, as well as relatively low ratios of capital to labor, conditions that imply that the returns to capital in those countries may potentially be quite high.11 Basic economic logic thus suggests that, in the longer term, the industrial countries as a group should be running current account surpluses and lending on net to the developing world, not the other way around.
The second problem is investment is being directed into unproductive areas such as real estate in developing countries:
Because investment by businesses in equipment and structures has been relatively low in recent years (for cyclical and other reasons) and because the tax and financial systems in the United States and many other countries are designed to promote homeownership, much of the recent capital inflow into the developed world has shown up in higher rates of home construction and in higher home prices. Higher home prices in turn have encouraged households to increase their consumption. Of course, increased rates of homeownership and household consumption are both good things. However, in the long run, productivity gains are more likely to be driven by nonresidential investment, such as business purchases of new machines. The greater the extent to which capital inflows act to augment residential construction and especially current consumption spending, the greater the future economic burden of repaying the foreign debt is likely to be.
I bet Bernanke wishes he could take this statement back. Also, both Obama and Bush hardly followed anything we could call a conservative approach:
Fundamentally, I see no reason why the whole process should not proceed smoothly. However, the risk of a disorderly adjustment in financial markets always exists, and the appropriately conservative approach for policymakers is to be on guard for any such developments.
Finally, Ben give some suggestions on how to solve these problems he identified above:
Although I do not believe that plausible near-term changes in the federal budget would eliminate the current account deficit, I should stress that reducing the federal budget deficit is still a good idea. Although the effects on the current account of reining in the budget deficit would likely be relatively modest, at least the direction is right. Moreover, there are other good reasons to bring down the federal budget deficit, including the reduction of the debt obligations that will have to be serviced by taxpayers in the future. Similar observations apply to policy recommendations to increase household saving in the United States, for example by creating tax-favored saving vehicles. Although the effect of saving-friendly policies on the U.S. current account deficit might not be dramatic, again the direction would be right. Moreover, increasing U.S. national saving from its current low level would support productivity and wealth creation and help our society make better provision for the future.
However, as I have argued today, some of the key reasons for the large U.S. current account deficit are external to the United States, implying that purely inward-looking policies are unlikely to resolve this issue. Thus a more direct approach is to help and encourage developing countries to re-enter international capital markets in their more natural role as borrowers, rather than as lenders. For example, developing countries could improve their investment climates by continuing to increase macroeconomic stability, strengthen property rights, reduce corruption, and remove barriers to the free flow of financial capital. Providing assistance to developing countries in strengthening their financial institutions--for example, by improving bank regulation and supervision and by increasing financial transparency--could lessen the risk of financial crises and thus increase both the willingness of those countries to accept capital inflows and the willingness of foreigners to invest there. Financial liberalization is a particularly attractive option, as it would help both to permit capital inflows to find the highest-return uses and, by easing borrowing constraints, to spur domestic consumption. Other changes will occur naturally over time. For example, the pace at which emerging-market countries are accumulating international reserves should slow as they increasingly perceive their reserves to be adequate and as they move toward more flexible exchange rates. The factors underlying the U.S. current account deficit are likely to unwind only gradually, however. Thus, we probably have little choice except to be patient as we work to create the conditions in which a greater share of global saving can be redirected away from the United States and toward the rest of the world--particularly the developing nations.
Bernanke makes some very good points, and a lot of this speech and the problems he identified are still visible today. But with the FEDs balance sheet ballooning by trillions of dollars (and the corresponding increase in the federal deficit by billions of dollars) and the FED refusing to be transparent on where all of the largesse is going, Bernanke seems to be using the exact opposite of his suggested solutions to solve the crisis.
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