Global imbalances and the paradox of thrift

Max Corden

People critical of global imbalances often blame the surplus countries and their currency manipulation. This column introduces a Policy Insight that argues that the basic problem has been the inefficiency of the world’s financial sector, which led to unfruitful investment in the US rather than productive investment in emerging economies.

The global imbalances are widely seen as a problem, especially by the US government and US economists. Sometimes they are even seen as a cause of the financial crisis (Suominen 2010). Yet such imbalances – i.e. current-account surpluses and deficits – reflect international intertemporal trade, and there should be gains from such trade as from “ordinary” trade, on the basis of standard arguments for free trade (see Obstfeld and Rogoff 1996, Chapter 1). Furthermore, an advantage of the present system is that an international general equilibrium is established which yields a set of current-account imbalances that do not require international central planning or coordination, but which respond to particular circumstances in different countries. The system depends, of course, on a relatively free international capital market.

In this column I analyse the current global imbalances debate – for more detail, see my CEPR Policy Insight (Corden 2011). This approach might be called a neoclassical way of looking at the international system and has to be subject to qualifications. These qualifications provide possible rationales for the common concern with global imbalances.

A key issue is that funds from countries that are net savers called the savings-glut countries (where savings exceed domestic investment) have been lent to borrowers (notably the US) who have used these funds unwisely, namely for current consumption and for investment that is not “fruitful.” The main form of “unfruitful” investment has been in excess housing construction. The funds coming from the savings-glut countries should have financed fruitful investment in the US and elsewhere. Instead they have also been lent to the US government, financing a war and tax cuts. All this is well known.

The result is that the borrowing countries, notably the US, have failed to build up resources out of which interest, dividends, and necessary repayments can be made. Yet such debt service or returns from purchases of equity are an essential feature of intertemporal trade.

Above all, we have to explain why more funds did not go to finance fruitful investment, whether in the US or elsewhere, notably in developing countries. When we look at the build-up to the 2008 financial crisis, we can see what an important question this is. In developing countries there is often an aversion to incur current-account deficits for two reasons – namely the instability of capital inflows and the dislike of real appreciations. These are understandable motives, but have created a problem when there was a worldwide search for sound investments to place the funds coming from the savings-glut countries.

A useful concept, originating with Keynes, is the “paradox of thrift”. This idea suggests that an increase in savings motivated by the admirable Victorian virtue of prudence – which involves foregoing consumption today for the sake of more consumption tomorrow – does not necessarily lead to greater capacity to consume tomorrow. It may just lead to a current decline in aggregate demand. Extended to the world economy it helps to explain the common criticisms of those countries, notably China, that have had large current-account surpluses. But the increase in net savings by the savings-glut countries did not actually lead to a decline in worldwide aggregate demand, as the simple Keynesian approach would imply. Rather it led to borrowing for consumption and for unfruitful investment. Hence the effect was indeed adverse. The recognition of this adverse effect, as well as various well-known inefficiencies in the world’s financial sector, led to the world financial crisis.

The basic neoclassical model really requires increased net savings to lead – induced by the decline in the real interest rate – to borrowing for more fruitful investment. There was a failure of the world’s financial sector in turning increased savings into fruitful investment, and that meant -- to repeat-- that the savings glut led to a debt crisis. The crisis was thus caused by an interaction of the particular global imbalances that led to low interest rates and high credit availability with the failure of the financial sector.

Here we should just mention that if there had been an increase in US savings rather than in other countries, there would also have been a decline in world interest rates, but this would have actually reduced the US current-account deficit and thus reduced (and not increased) the global imbalances. The basic problem has been not the global imbalances as such, but rather the sharp and prolonged decline in real interest rates, when combined with the inadequacies of the financial sector.

Going back to what actually happened in the period that ended in 2008, we might then ask: “were net savings of the savings-glut countries too high or were sound, fruitful investments in the rest of the world too low?” The particular global imbalances caused by the increase in savings (plus declines in investment in some cases) in the savings-glut countries led to the decline in the world real interest rates and high credit availability. This provided an investment opportunity for the rest of the world. But the inefficiency of the world’s financial sector and other factors led to an inadequate response in fruitful investment in the rest of the world, notably the US. As noted above, one of the other factors was the reluctance of some developing countries with good investment opportunities to run current-account deficits. There could also have been more fruitful investment – notably in infrastructure – by governments, especially in the US.

I would also add here that the reluctance to run current-account deficits by various smaller economies – whether Latin American, Asian or European – is thoroughly understandable when we take note of the instability of capital inflows that have caused so many crises, notably the Asian crisis of 1997-98 but also the current European ones. And this instability is yet another manifestation of a weakness in the world’s financial sector.

References

Corden, M (2011) Global imbalances and the paradox of thrift, CEPR Policy Insight No 54.

Obstfeld, M and K Rogoff (1996), Foundations of International Macroeconomics, MIT Press.

Suominen, Kati (2010), “Did global imbalances cause the crisis”, VoxEU.org, 14 June.