Global Savings Glut Concept versus Excess Financial Elasticity - Literature review Example

Global Savings Glut Vs. Excess Financial Elasti Introduction The ‘global savings glut’ concept has been widely cited as a fundamental reason for the global economic crisis since it was introduced in 2005 by Ben Bernanke. This concept contends that the global economic crisis was caused by current-account imbalances, which resulted in sub-prime lending and the global financial crisis. According to Bernanke (2005: p1), a significant increase in external claims by Asian economies on western economies resulted in large, persistent current-account imbalances that, in turn, caused financial instability. However, there is growing debate as to whether the global imbalances and the economic crisis are actually attributable to a global savings glut. Specifically, the concept of excess financial elasticity has been proposed as being more culpable for the global imbalances and the economic crisis. Chinn et al (2014: p476) argue that the macroeconomic origin of the economic crisis was excess elasticity in a financial system that did not possess the tools to check excessive risk-taking, which led to asset price and credit booms. The purpose of this essay is to investigate whether Bernanke’s (2005) global savings glut thesis explains global imbalances and the economic crisis. The Global Savings Glut Generally, discourse on the economic crisis of 2007/2008 has mainly focused on global imbalances and sub-prime mortgages with several macroeconomic models seeking to directly link both themes. Bernanke (2005: p1) proposes the global savings glut model, arguing that excessive saving from oil exporting countries and Asian countries, especially China, resulted in large trade accounts deficits and persistently low interest rates. The current account balance in the balance of payments accounts is derived by subtracting a country’s domestic investment from its domestic savings. Asian economies and oil producing states generated large surpluses in their current accounts, which were matched elsewhere in western economies by current account deficits, as the former became excessive savers. Bernanke (2005: p1) speculates that excessive savings from these countries was due to their desire to avoid a replay of the 1998 Asian crisis by ensuring they had sufficient reserves in foreign currency. Because the US dollar and its treasury securities are international reserve currency and benchmark asset respectively, lending from these countries was disproportionately directed to the US as an insurance against macroeconomic instabilities. The global savings glut, during its highest levels, resulted in deficits in the US current accounts to the tune of $927 billion or >6% of the US’ GDP with the inflow of net savings invested primarily by managers of foreign reserves and central banks, specifically in Treasury and Agency debt portfolio (Bertocco, 2014: p202). The resulting drop in interest rates led to new investments in areas of the US economy that were sensitive to interest rate levels, including the real estate sector. Accumulation in foreign exchange reserves, in this case, contributed directly to an increase in prices of property and housing, spurring increased construction and increasing the attractiveness of home ownership by enabling cash-out refinancing. This, in turn, contributed directly to the real estate bubble. Furthermore, expectations that property prices would continue to increase saw a decline in the risk perceived on riskier debts. Because mortgage loans are normally secured against housing and property, the appreciation in housing decreased the likelihood of defaults because borrowers would rather sell their property than allow foreclosure (Bertocco, 2014: p204). If these investments from abroad flowed continuously, there would be persistently high housing prices, while laxity in mortgage lending would also increase. The result of emerging Asian economies trying to protect their economies by amassing huge foreign asset portfolios by exporting capital across the world, specifically in the US, and causing a large trade deficit (Krugman, 2009: p1). For majority of the recipients of these large inflows of capital, including the US, Ireland, Iceland, and Estonia, the financial systems at this time were increasingly deregulated, allowing bankers to hide risks from investors. Initially, this increased inflow of foreign capital led to illusions of wealth for such countries, especially in Europe, since the capital inflows were larger than their economies, leading to unusually strong currencies and rising asset prices. Krugman (2009: p1) calls this effect a bubble that soon burst, wiping out these countries’ assets, while their debts still remained with the effect being magnified by the fact that these debts were denominated in the currencies of the emerging Asian economies and oil exporting countries. This damage was then amplified to include other sectors other than the original creditors or borrowers, particularly as demand for manufactured products also collapsed due to reduced exports. Although this model of a global savings glut is logical at first glance, it is questionable in two main ways. To begin with, it would be expected that the housing bubble would have collapsed as a result capital inflow reversal and withdrawal. However, Chinn et al (2014: p477) note that China continued to accumulate huge foreign currency reserves way after the global economic crisis, while housing prices dipped during the time when current account deficits were highest. Moreover, this increased focus on the net flows of capital takes away from gross flows of capital. Bracke and Fidora (2012: p194) note that European countries were the main source of foreign capital inflows into the US with the UK contributing 25% of all fund inflows into the US in the year 2007 and that while net capital inflows fell to $33 billion in 2008, the fall in gross inflows simultaneously fell by ~$1.7 trillion. Thus, even as capital outflows from the US dropped by ~$1.7 trillion, leading to the deficits in their current accounts remaining generally unaffected over this period, gross capital flows were dramatically different over the same period. Excess Financial Elasticity The financial crisis in the EU, according to Shin (2012: p157), is the best place to start in introducing the excess financial elasticity model, as well as to distinguish it from the global savings glut by comparing the role played by imbalances in the current accounts in the US and the EU. Several parallels, however superficial, can be gleaned between the US and the EU prior to the economic crisis. In Spain and Ireland, for example, account imbalances dramatically increased prior to the financial crisis, in spite of both countries having much lower debt ratios and higher budget surpluses than the average of the Eurozone. Assuming the Eurozone to be a miniature financial system model, excess savings from Germany would flow to Ireland and Spain, causing inflated property and housing prices. In time, the bubble would burst and lead to bank bailouts as private debt is socialized, resulting in a sovereign debt crisis. Yet, according to the global savings glut theory, excess savers mainly favour treasuries in established, deep financial markets, which, in this case, would be played by Irish and Spanish Treasuries (Shin, 2012: p158). The only way to sustain the global savings glut is to assume that German savers believe Ireland and Spain to have safer treasuries, which discredits the savings glut model. The global savings glut as proposed by Ben Bernanke attributes blame for account imbalances and the economic crisis on China and other emerging Asian economies, which caused western economies to embark on a property and housing debt spree. However, the average rate of global savings has stood at 23% for the past twenty five years and only increased to 24.9% in 2004 before dropping to 23% again in 2005 (Shin, 2012: p169). As such, calling this one-year increase a global savings glut, it can be argued, is a stretch. Moreover, it is difficult to reconcile the global savings levels and the levels of securities issuance globally in 2006, which points to dynamics in the securities market, rather than savings levels per se, as an explanation for account imbalances. Furthermore, this global savings glut model fails to explain why banks created hybrid and synthetic collaterized debt obligations, which Justiniano et al (2014: p60) argue was the reason for supposedly dispersed risks ending up in financial firms with high leverage. Thus, the global savings glut should be dispatched in exchange for a model that focuses on the financial economy because it is increasingly evident that account imbalances must have resulted from an inability by financial markets to accommodate bubbles, which is where the excess financial elasticity model comes in. Excess financial elasticity, which Borio and Disyatat (2011: p13) also call the global banking glut, was mainly related to dramatic increases in transnational lending in the EU with cross-border domestic currency assets in Eurozone banks increasing dramatically between 1999 and 2007, before declining sharply between 2007 and 2011. A similar trend is also evident in cross-border domestic currency liabilities in Eurozone banks, both of which corresponded with the launching of the Euro currency. This may be explained by previously foreign-currency borrowing and lending being reclassified in Euros, which was now the domestic currency. However, there was an explosive increase in cross-border lending after 2002 fuelled property booms in Spain and Ireland, as well as expansion of the European banks into Eastern and Central Europe. Expansion of the European banks can be explained by the fact that the Euro allowed these banks to draw surplus deposits from these countries, specifically by eliminating mismatches on the balance sheets of these European banks (Borio & Disyatat, 2011: p14). Meanwhile, the Basel II conference resulted in increasingly permissive rules on bank capital, which eliminated regulatory constraints that may have slowed down the banks’ rapid expansion into Central and Eastern Europe. Indeed, cross-border mergers between European banks far outpaced other dimensions of integration in Europe, becoming the exception instead of the rule. Shin (2012: p158) identifies this as one of the biggest paradoxes facing the integration of the Eurozone with the Euro launch resulting in free flow of bank liabilities across borders, while assets remained immobile and local. Immediately these banks began to deleverage, the banks became increasingly vulnerable to massive bank runs as customers flock to reclaim their money from the banks, specifically because of the fluid nature of capital compared to the localization of bubbles. The massive bank runs were gradually realized as customer began to fear that the highly leveraged banks may collapse before the clients have the opportunity to get out their assets, leading banks to begin bleeding deposits (Shin, 2012: p159). There is mounting evidence that the global economic crisis was, first and foremost, a banking crisis and secondly a sovereign debt crisis. The excess financial elasticity model, therefore, presents a more comprehensive explanation for the account imbalances and economic crisis than the global savings glut model (Eichengreen, 2009: p17). The economic crisis possessed the characteristics of a twin crisis, which ties together a decline in asset markets and a banking crisis, amplifying distress in the banking sector. In twin crises observed in emerging markets during the late 90s, there was intertwining of a banking crisis and a currency crisis. During the global economic crisis, the combination involved a sovereign debt crisis and a banking crisis, in which the amplified distress in financial markets acted to exacerbate the banking crisis. Excess financial elasticity was a global phenomenon, where global banks in Europe sustained the American shadow banking system by using the wholesale market to draw on foreign currency (Eichengreen, 2009: p17). This dollar funding was then lent to US citizens through the purchase of securitized claims made on borrowers in the United States. While the presence of European banks in US domestic commercial banking is relatively small, the shadow banking system amplified their impact on the overall conditions of credit. As such, the role global banks from the Eurozone played in determining financial conditions in the US is supporting evidence for the aforementioned importance of tracking flows of gross capital in determining the cause of account imbalances (Eichengreen, 2009: p17). Solely relying on net flows, as advocated by the global savings glut model, fails to reflect large flows of gross capital fuelled by banks from the Eurozone outwards to the US. Thus, considering gross capital flows in the US by category, Borio and Disyatat (2011: p19) find that gross flows from the private sector were significantly larger than official flows of gross capital from economies with surpluses in their current accounts. In addition, large capital outflows from the United States via commercial banks re-entered the economy via non-treasury security purchases. As Eurozone banks operating in the US raised wholesale funding from money market funds in the US, driving up the outflow of gross capital through commercial banks, these funds were shipped back to the Eurozone. This trend was significant because the balance of payments accounts are not based on nationality but, rather on residence, meaning that Eurozone banks subsidiaries and branches were considered as American banks (Borio & Disyatat, 2011: p19). Conclusion Thus, it is increasingly evident that deficits were only a small part of the account imbalances and the economic crisis. Instead, the excess financial elasticity model, fuelled by gross flows of capital in form of lending to the US by Eurozone banks through shadow banking, played a more critical role in the behaviour of US credit conditions prior to the economic crisis. Persistent account imbalances acts as barriers to global demand rebalancing, while also influencing net external asset position sustainability over the long term. However, current accounts in the US have limited use in determining credit conditions. As a result, excess financial elasticity provides a more plausible explanation for account imbalances from sub-prime lending, as well as the subsequent economic crisis, compared to the global savings glut model. References Bernanke, B. S. (2005, March 10). The Global Saving Glut and the U.S. Current Account Deficit. Retrieved March 18, 2015, from The Federal Reserve Board: http://www.federalreserve.gov/boarddocs/speeches/2005/200503102/default.htm Bertocco, G. (2014). Global Saving Glut and housing bubble: a critical analysis. Economia politica, 31, 2, 195-218 Borio, C. & Disyatat, P. (2011). Global imbalances and the financial crisis: link or no link? BIS Working Papers no.346. Geneva: Bank for International Settlements Bracke, T., & Fidora, M. (2012). The macro-financial factors behind the crisis: Global liquidity glut or global savings glut? The North American Journal of Economics and Finance, 23, 2, 185-202 Chinn, M. D., Eichengreen, B., & Ito, H. (2014). A forensic analysis of global imbalances. Oxford Economic Papers, 66, 2, 465-490 Eichengreen, B. (2009). The financial crisis and global policy reforms. Federal Reserve Bank of San Francisco, Asia Economic Policy Conference (pp. 1-49). Berkley: University of California. Justiniano, A., Primiceri, G. E., & Tambalotti, A. (2014). The effects of the saving and banking glut on the US economy. Journal of International Economics, 92, 1, 52-67 Krugman, P. (2009, March 1). Revenge of the Glut. Retrieved March 18, 2015, from New York Times: http://www.nytimes.com/2009/03/02/opinion/02krugman.html?_r=0 Shin, H. S. (2012). Global banking glut and loan risk premium. IMF Economic Review, 60, 2, 155-192 Read More