In a previous article, we explained that under specific circumstances, where savings exceed investment and the economy running way below capacity (the economy is demand constrained, not supply constrained). It is as if the normal laws of full-employment economics are suspended and vice can become virtue.
Under these circumstances, it makes sense to expand public expenditures (preferably public investments):
- To keep economic growth going.
- To keep the economy closer to full capacity and prevent the corrosive hysteresis effects that happen when economies run below capacity for prolonged period of times, producing a slow decay of productive forces that compromise future growth.
- The excess savings produce low interest rates rendering monetary policy powerless and making it cheap to fund the additional public spending.
- In fact, by boosting growth and not exerting upward pressure on interest rates, the additional public spending could very well crowd in rather than crowd out public spending. After all, business investment is much more sensitive to growth outlook than it is to interest rates.
- It might even be that the boost to economic growth and the avoidance of hysteresis effects make the additional public spending self-financing (see Summers and DeLong).
- QE could actually make a considerable part of the additional spending free.
Of course, this is only achievable under specific circumstances. These circumstances are most likely in the aftermath of a financial crisis, when the private sector reduces spending and boosts savings in order to repair the damage to its balance sheets.
In the face of such private sector deleveraging, the public sector should releverage or risk exacerbating the economic downturn. Witness the difference in experience between 1929-33 and 2008-09, or see how forced austerity threw much of Southern Europe into depression-like economies in the aftermath of the financial crisis.
Using the global savings glut
Financial crises are dramatic events, but the example of Japan (see the previous article) has shown that it is possible for economies to embark on this route under more normal circumstances. Japan is able to live with 250% of GDP public debt without triggering an investment revolt and monetizing a substantial part of it without triggering a loss in confidence in the currency.
In fact, on a world scale, some of this should be possible as there is a world savings glut, which has expressed itself as a relentless fall in world interest rates for decades. The problem is which countries would be able to “do a Japan,” using some of those savings to basically fund additional spending nearly free?
One obvious candidate would be the countries that generate the most excess savings, that is countries where the private sector has a huge surplus, and savings exceed investment by a lot. Countries which have large trade surpluses are big net savers as national income accounting dictates that:
Trade balance = (S-I) – (G-T)
That is, the trade balance equals the savings surplus (deficit) minus the budget deficit. These are countries like Germany, the Netherlands, and Switzerland.
But, if you think that the countries with the biggest savers should be the ones that have the most room for near free expansion of public expenditures, you might be wrong, even if from a world economy point of view it would be most desirable (as the global savings glut would diminish if they spend more).
What’s actually more important is whether there is a lot of spare capacity in their economies. We have seen that not only in Japan, but also numerous other advanced economies like the US, the UK, Switzerland, and the eurozone have been able to finance public expenditures at record low interest (sometimes negative real) rates despite sometimes scary deficits and debt levels.
What’s more, the central banks of these countries have been able to engage in large-scale asset buying programs without triggering accelerating inflation. While the latter isn’t outright debt monetization, in essence, it isn’t much different in principle.
Switzerland is an odd case as its central bank didn’t buy government debt; it bought foreign currencies (mostly euros) to keep the Swiss franc from rising (a policy which it suddenly abandoned, causing great losses at some currency traders).
Real interest rates are still next to zero, and the ECB and the BoJ are still buying government debt, so there is still a good deal of free money being metered out to combat the deflationary vortex created by a global savings glut.
However, these policies are not entirely without risks, although these risks have to be weighed against doing nothing, which carries its own risk (lower growth, hysteresis, deflation, etc.). We see four main risks:
- Moral hazard problem of free money
- Asset bubbles
- Supply shock risks
- Economy approaching capacity constraints
Free money for the public sector is a conservative nightmare, and they will rightly point out that the risk of abuse is prominent. There is certainly a moral hazard problem here. There are a couple of ideas that could lessen this:
- Take the decisions on quantities from politicians. This is already the state of affairs as unelected central bankers decide how much assets the central banks are buying.
- Use most or all of the free money for public investments, which tend to improve the supply side and increase potential growth. Stuff like science and basic research (which tends to have a very large payoff), education, and infrastructure.
Low interest rates increase the chances of asset bubbles as they make borrowing cheaper, lower relative stock values, allow people to take out larger mortgages, etc. However, interest rates should be used for monetary policy purposes, not as a tool to prevent or steer asset bubbles.
A central bank doesn’t want to increase interest rates and risk throwing the economy into a recession just because Wall Street can’t contain itself. There are other tools (so called macro-prudential policies) to deal with the latter (down-payments on houses, maximum leverage, reduced margin lending on stocks, etc.).
Supply shocks pose a real problem, as we have seen in the 1970s. A supply shock (a leftward shift in the aggregate supply curve) produces both higher prices and reduced output, throwing a wrench in the free money mechanism as a result of excess savings.
Luckily, general supply shocks like the ones we experienced in the 1970s with the two oil shocks are quite rare, and more localized shocks can be largely absorbed by currency movements (if a country isn’t stuck into a currency union).
What if the savings glut disappears? Well, no problem really. The cheap public sector financing will also disappear, but with it the need to increase spending. However, this isn’t necessarily the end of the problem.
With less global savings available, interest rates will rise, and this makes financing the public sector much more expensive. This could have been dealt with in several ways:
- Prudent public finances throughout the economic cycle, that is running surpluses during boom times. This is not given to everybody.
- Where things have already escalated, like in Japan, the BoJ debt monetization turns out to be pretty useful.
In Japan, in a couple of years, the BoJ might very well own half the outstanding public debt. Yes, the BoJ will have a huge loss if the government doesn’t redeem the bonds on expiration, but this is basically a paper loss.
One might retort that the flip side of that is that there is a huge amount of money in circulation, but if this becomes a problem (like threatening to create accelerating inflation), the BoJ can sell some of its bonds to mop the excess liquidity up like we suggested here.
As long as there is a global savings glut, there are economies running well below capacity, which in principle enables them to tap into these savings to finance public expenditure, preferably public investments. They might even be able to finance part of this by monetary means, but this isn’t without risks.
However, these are not necessarily the economies that produce most of the excess savings, as these are not necessarily the ones with the most excess capacity. Even so, from a global perspective, it would indeed be desirable if these countries embarked on public (or private) investment in order to reduce the global savings glut.
It’s also noteworthy that investors seem to have been smarter about this than many policy makers and observers. Where the latter often overly worried about the risks of accelerating inflation or untenable public finances, investors piled on in the bond and equity markets and made a killing.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.