The US accessed the global savings glut to sustain its domestic consumption. The dollar’s dual role as the world’s reserve currency and as the national currency of the US made this possible, says S. GURUMURTHY.

The three-trillion-dollar-plus financial steroid digitally administered to financial markets keep the stock indices alive today; off and on, even kicking. But the facts masked by stock indices are scary. The McKinsey Quarterly magazine [June 2009] estimates the un-booked credit losses of banks at $2.13 trillion for the year 2010; the loss so far booked is only $930 billions. The US/Western economies are still in the $3 trillion Intensive Care. The steroids-supported stock indices are holographic and nothing more.

Understandably, some think tanks are trying to figure out how and why did the US/West mess itself up and the world, to get at the remedy. These experts now point to the continuing global imbalances as the culprit.

The Council on Foreign Relations (CFR) an independent think tank in the US, in its recent report (March 2009), finds that “one of the root causes of today’s crisis is the imbalances between savings and investment in major countries”.

It says that this will have to be addressed if the crisis were not to repeat. The CFR report also faults the G20 summit of November 2008 for not explicitly mentioning the global imbalance as the root cause of the crisis.

Surpluses, deficits

For the uninitiated, here is what global imbalance between savings and investment means. A nation’s account is very like a household’s. A country earns by exports of goods and services and spends by importing them. When it earns more than it spends, it is in surplus. When it is the other way round, it is in deficit.

If the surplus countries are unable to invest all their savings within, their savings are in surplus. The deficit nations need loans or investments from surplus nations to pay for their deficit and also for investment. If this trend persists long, with surpluses in some hands and the deficit in some others’, it is imbalance.

Economic laws rule that such surpluses and deficits normally even out over a period. The deficit economies face high interest, dip in their currency values which helps them to export more and import less, and turn into surplus that offsets past deficits; and the surplus economies move in the opposite direction, land in deficits that eats away past surpluses.

But this law of economics failed to work for the US, which has been unfailingly in current account deficit from 1976; and between 1996 to 2008 alone, it had accumulated a deficit of $5.74 trillion.

In these very years, China and others had earned huge surpluses mainly by exporting to the US more than they had imported from it.

A small break here. The CFR report complains that the surplus economies like China did not allow their currencies to appreciate; thereby prevented the economic law of equalisation to work and perpetuated the imbalance. This charge is made redundant by the CFR admission that, as the supplier of the reserve currency, the deficit US chose to flood the world with dollars; thus did not allow its domestic interest rate to rise, its economy to contract and the dollar to depreciate and so did not even attempt to earn surplus to offset its deficit.

No other deficit nation has this privilege of printing dollars and forcing others to keep them, for, to transact global business they need to get dollar from the US and hold it as they cannot print them. The need to stock dollars accentuated by the absence of an alternative to the dollar. Now back to the sequence.

The savings glut

The surpluses of China and others, not absorbed by their investment needs within, added a huge stock of liquid money supply — the savings glut — to global financial market. This over supply of money pushed down global short term interest rates, which reduced the long term interest rates also.

This low interest global surplus, says the CFR, forced its way into the US. But, as The Economist magazine (May 30, 2009) says in ‘A special report on business in America’ [p14], no one forced the US to borrow, that is, let in the global savings glut. And yet the US did. Why?

The deficit US never wished to get into surplus; instead it chose to let the savings glut to flow in, to offset its burgeoning deficits. So its red-carpet invite for the global savings glut. The US was not playing marbles with dollars. The US mass-produced digital dollars, paid for trade its deficits and brought those very dollars back to US as investment.

It had strategically leveraged the dollar as world’s first reserve currency which all others need, but, only the US could supply. The story of imbalance masks the reality that the US was actually making credit purchases from others by substituting the dollars as reserve currency for IOUs. Read on.

After the dotcom collapse in 2000 and the 9/11 attack, the US economy had nose-dived. There was desperate need to generate mass economic activity to bring life back to the US economy. With a third of the Americans, who could not afford homes, not owning homes, a huge unexplored area of potential demand for homes invited the US government to exploit it.

Real estate bubble

Acting in tandem with the US financial system that had innovated multiple financial products to borrow and lend easily, the US Fed cut the interest rates to 1 per cent and triggered an artificial housing — read ‘real estate’ — boom which was bound to burst one day. With the cheap, abundant global money at their disposal, the US banks lured the Americans not owning homes with non-recourse, interest holiday, loans to buy houses.

Americans owning homes also were funded to buy additional houses, like they bought stocks, for speculative gains as the home values boomed. This generated artificial demand for homes, and led to the real estate bubble. For the next five years this bubble took the US economy on a high.

The new home prices soared by over 50 per cent in six years between 2001 and 2007. The home values to GDP rose from 123 per cent in 2001 to 156 per cent in 2006. Some two-thirds of the Americans had bought homes at less than $25,000 well before 1970. Their home values rose to over $2,90,000 by 2007 — almost 12 times. This unrealised asset value — celebrated as ‘home equity’ in the world of finance — became the collateral for the sudden ‘rich’ home owners to borrow money against. This virtually turned the homes into “ATM machines” for their owners to draw cash on and spend at will.

In just five years, says The Economist [May 30, 2009], Americans borrowed $2.3 trillion against the home equity and splurged it on consumption (20 per cent), on sprucing up their homes (19 per cent) and for buying stocks (44 per cent, most of which they lost once the stocks bust). More. It says that the US household debt leapt from 71 per cent of the GDP in 2001 to 97 per cent of the GDP in 2008.

The borrowing against home equity accounted for 77 per cent of America’s huge economic growth from 2002 to 2007, which sustained the US consumption that accounted for 70 per cent of its GDP.

Borrowing, spending

In this period, the average American increased his consumption by 44 per cent; their household savings turned negative in 2005 [07 per cent of the GDP]. A “Shop for America” movement was launched in 2001, in the wake of the 9/11 terror strike, to perceive buying, even needlessly, to save America’s economy as a patriotic duty.

With borrowing and spending becoming the fashion, savings became unfashionable. The former US Fed chief Alan Greenspan proudly wrote in his book The Age of Turbulence [2008], that only insecure people of developing nations that do not provide for social security, need to save. He added that in modern countries — read the US — where enlightened state provides social security, people could confidently borrow and spend beyond their current income [pp.385/86].

The Americans confidently borrowed from the world, and happily spent on themselves. The US accessed the global savings glut to sustain its domestic consumption. The dollar’s dual role as the world’s reserve currency and as the national currency of the US made this possible. Result, the US registered an unprecedented GDP growth of 3 per cent during the years 2003 to 2007.

But the fall, which was inevitable, started in 2008. The US never faulted the global imbalance till it was useful to it. QED: The imbalance that kills the US economy today was the nectar sustaining it till yesterday.

(To be concluded)

(The author is a corporate adviser. blfeedback@thehindu.co.in and comment@gurumurthy.net)

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(This article was published in the Business Line print edition dated June 23, 2009)
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