Excess German Savings, Not Thrift, Caused the European Crisis

One of the reasons that it is been so hard for a lot of analysts, even trained economists, to understand the imbalances that were at the root of the current crisis is that we too easily confuse national savings with household savings. By coincidence there was recently a very interesting debate on the subject involving several economists, and it is pretty clear from the debate that even accounting identities can lead to confusion.

The difference between household and national savings matters because of the impact of national savings on a country’s current account, as I discuss in a recent piece in Foreign Policy. In it I argue that we often and mistakenly think of nations as if they were simply very large households. Because we know that the more a household saves out of current income, the better prepared it is for the future and the more likely to get rich, we assume the same must be true for a country. Or as Mr. Micawber famously insisted:

Annual income twenty pounds, annual expenditure nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pound ought and six, result misery. 

But countries are not households. What a country needs to get wealthier is not more savings but rather more productive investment. Domestic savings matter, of course, but only because they are one of the ways, and probably the safest, to fund domestic investment (although perhaps because they are the safest, investment funded by domestic savings can also be misallocated for much longer periods of time than investment funded by external financing).

Saving in itself, however, does not create wealth. It is productive investment that creates wealth. Domestic savings simply represent a postponement of consumption.

In a closed economy, total savings is equal to total investment or, to put it differently, whatever we don’t consume we invest (if we produce something that we neither consume nor invest, we effectively write its value down to zero, so the balance remains). In an open economy, if a country saves more than it invests it must export the excess savings. It must also export the excess production.

Notice that by definition if a country saves more than it invests, total consumption plus total savings must be greater than total consumption plus total investment. The former is the sum of the goods and services it creates, whereas the latter is the sum of goods and services it absorbs. That country, in other words, supplies more goods and services than it absorbs, and so it must export the excess.

What is more, by exporting excess savings, the country is providing the funding to foreigners to purchase its excess production. This is why the current account and the capital account for any country must always add up to zero.

In the late 19th Century, as I discuss in my most recent book, economists like John Hobson in the UK and Charles Arthur Conant in the US noticed that the rich countries of the west were exporting large amounts of savings abroad – mostly to what were later called by the dependencia theorists of the 1960s the peripheral nations. Hobson and Conant argued that the reason for this excess savings had to do with income inequality. As more and more wealth is concentrated into the hands of fewer people, consumption rises more slowly than production, largely because the wealthier a person gets, the smaller the share he consumes out of his income. Notice that because savings is simply total production of goods and services minus total consumption, this forces up the national savings rate.

This was a very important insight. Excess savings, they pointed out, was not a result of old-fashioned thrift but rather a consequence of structural distortions in the economy. The consequence of this “thrift”, furthermore, was not greater wealth but rather structural imbalances in the global economy.

In a closed economy there are four ways of resolving the imbalances caused by an increase in the savings rate. First, and most obviously, investment can rise by the same amount.

The private sector, however, may be reluctant to increase investment if it believes the consumption share is declining over the long term, in which case the government can sponsor the increase in investment, for example in infrastructure, so that savings and investment balance at a higher rate. This is sustainable only as long as there are productive investments that can be made, but as consumption declines, the reason for investing should decline too. The purpose of investment today after all is to create consumption tomorrow.

The second way to resolve the imbalance is if the government or the labor unions take steps to redistribute income downwards. As middle class and poor households retain a greater share of total GDP, consumption will automatically rise relative to production (the savings rate declines), even if middle class and poor households save a greater share of their higher income. The savings rate declines to the point at which savings and investment are once again balanced domestically and everything a country makes it consumes or invests.

The third way to resolve this in a closed economy – albeit only temporarily – is to fund a consumption boom among the not-so-rich. How would this work? One way might be, as Conant discusses extensively, that as savings grow faster than opportunities for productive investment in infrastructure and production capacity, more and more of the savings of the wealthy go into speculative investments that drive up asset prices – homes, stocks and bonds. As asset prices rise, households feel richer and they begin to take advantage of the abundance of savings to borrow for consumption, and borrowing is just negative savings.

As home prices or the value of investment portfolios rise there is likely to be not just an increase in consumption but also an increase in investment in new housing. As both of these happen, the reduction in consumption caused by rising income inequality is matched by the increase in consumption caused by credit-fueled purchasing and an increase in housing investment, and once again savings and investment can balance domestically. We saw this happen in the US and in the peripheral countries of Europe in the run-up to the 2007-09 crisis.

The fourth way to resolve the savings imbalance in a closed economy is to force up unemployment (this is what Karl Marx said would eventually happen). As income inequality grows, and so consumption grows more slowly than production, companies are forced to cut production and fire workers. Fired workers of course produce nothing, but they still consume, either out of savings, welfare payments, or handouts from friends and families. This causes total savings to drop so that once again it balances investment, but of course in an economy with rising unemployment, profits are likely to drop, and with lower profits comes reduced investment, so more workers need to be fired and the process can become self-reinforcing.

Open economies have another option

In a closed economy there really aren’t many other ways to balance savings and investment if structural factors force up the savings rate. But we do not live in closed economies. Most of us live in open economies (although the world itself is a closed economy), so there is actually a fifth way to resolve domestic savings imbalances, and this is what Hobson and Conant described as the root source of late 19th Century imperialism.

If domestic savings rates are so high that the country cannot invest it all profitably, it can export those savings, which means automatically that it imports foreign demand for its excess production. Its net export of savings (less net returns on earlier investment) is exactly equal to its net export of goods and services.

In an open economy, in other words, a country’s total savings matters because to the extent that it exceeds investment, it must be exported, and it must result in a current account surplus. Here is where the confusion so many analysts, including economists, have about the difference between national and household savings. Household savings represent the amount out of household income that a household chooses not to consume, and so can be affected by cultural or demographic factors, the existence and credibility of a social safety net, the sophistication of consumer finance, and so on.

The national savings rate, on the other hand, includes not just household savings but also the savings of governments and businesses. It is defined simply as a country’s GDP less its total consumption. While the household savings rate may be determined primarily by the cultural and demographic preferences of ordinary households, the national savings rate is not. Indeed in some cases the household share of all the goods and services a country produces, which is primarily a function of policies and economic institutions, is the main factor affecting the national savings rate.

National savings, in other words, may have very little to do with household preferences and a lot to do with policy distortions. In China, which has by far the highest savings rate in the world, part of the reason for the high national savings rate of course is that Chinese households save a relatively high proportion of their income.

But while China’s savings rate is extraordinarily high, the Chinese household savings rate is merely in line with those of similar countries in the region, and in fact lower than some. Chinese households are not nearly as thrifty as their national savings rate implies. Why, then, is China’s savings rate so extraordinarily high?

The main reason, as I have discussed many times and which now has pretty much become accepted as the consensus among China specialists, is not so much income inequality (although this is certainly a problem in China) but rather the very low household income share of GDP. At roughly 50% of GDP, Chinese households retain a lower share of all the goods and services the country produces than households in any other country in the world.

This is a consequence of policies Beijing put into place many years ago that goose GDP growth by constraining the growth in household income. As a result of these policies, the household share of China’s total production of goods and services has been falling for thirty years, and fell especially sharply in the past decade. It isn’t surprising, consequently, that as households earn a declining share of what China produces, they also consume a declining share. Because savings is simply GDP less total consumption, and most consumption is household consumption, the fall in the household income share of GDP is the obverse of the rise in China’s extraordinarily high savings rate.

Many factors explain this very low household income share in China, including most importantly financial repression, whose characteristics typically include artificially low deposit rates, which, by reducing the amount of money that a saver should earn on his bank deposit, transfers part of his income to borrowers, who are able to borrow very cheaply. In China, this implicit transfer is extremely high, perhaps 5 percent of China’s GDP or more.

Of course the more money that is transferred in this way, the less disposable income the household depositor has, and so he is forced to reduce both his nominal savings and his nominal consumption. We cannot easily predict how this reduced interest rate will affect the household savings rate, but it is pretty easy to figure out how it will affect the national savings rate. If the transfer is substantial, it will reduce the share of GDP retained by households. Unless households reduce their savings rate by more than the reduction in the household share of GDP, it must automatically force up the national savings rate.

Confusing thrift with inequality

China’s extraordinarily high national savings rate, in short, is a function primarily of the extraordinarily low household share of GDP. Even economists who really should know better manage to make some fairly impressive mistakes when they discuss Chinese and other savings imbalances, mostly because their understanding of savings can be hopelessly confused. For a typical example, consider a piece Raman Ahmed and Helen Mees, published last year called, “Why do Chinese households save so much?”

In the article the authors try to address the causes of China’s high savings rate, but they do so by thoroughly confusing national savings with household savings. For example they set out trying to prove that financial repression has no impact on China’s savings rate, but because they fail to understand that financial repression does this by reducing the household share of income, and not necessarily by reducing the household savings rate, they find:

China’s monumental savings rate is a popular topic of for policy discussion.  It has been blamed for the global financial crisis, currency wars, and the ensuing Great Recession. But what explains the high savings rate?

…Although the savings rate varies significantly per income group, with the lowest income group’s savings rate in urban areas in the single digits and the highest income group’s savings rate at almost 40% of disposable income, we do not find evidence that income inequality as such is a motive for households to save a larger portion of their income, as Jin et al. (2010) have suggested. It would have been the Chinese version of ‘keeping up with the Joneses’, albeit that ‘keeping up with the Wangs’ would not have involved conspicuous consumption but rather conspicuous saving. This would have instigated higher savings rates across the board of deciles of savings rates, with the strongest effect on low-income households. However, using urban data on household savings rates and income inequality from 1985-2009, we do not find this effect present.

There is no evidence that the household savings rate in China is high because of low deposit rates, as Michael Pettis (2012) has asserted time and again, which would indicate that the income effect of lower deposit rates trumps the substitution effect of lower deposit rates. The coefficient of the deposit rate has alternating signs, but is insignificant in every single estimate.

The article purports to discuss what they refer to as China’s “monumental savings rate”, which, according to the authors, has been blamed for the global financial crisis, currency wars, and the ensuing Great Recession, but it focuses on the wrong savings rate. Chinese household savings are not by any definition “monumental”, and they most certainly did not cause the global financial crisis, nor does anyone seriously claim that they did. Chinese household savings rates are high, but not exceptionally high, and because household income is such a low share of GDP, Chinese household savings as a share of GDP, which is what really matters, are even lower than the household savings rate would imply. Chinese household savings are not the problem.

It is China’s national savings rate which is “monumental” and which drives China’s current and capital account imbalances, and the national savings rate is monumentally high because the national consumption rate (which consists mostly of the household consumption rate) is extraordinarily low. The authors have either confused national and household savings rates or they have failed to see that what matters is not the household savings rate but rather total savings. Aside from the fact that there is indeed evidence that Chinese savings are negatively correlated with interest rates, for example a 2011 study done by the IMF, the relationship is one of pure logic.

The important lesson from this article, aside from suggesting just how confused many economists are when it comes to understanding the source of global imbalances, is that national savings represent a lot more than the thriftiness of local households, and as such it has a lot less to do with household or cultural preferences than we think. In fact many factors affect the savings rate of a country, including demographics, the extent of wealth inequality, and the sophistication of consumer credit networks, but when a country has an abnormally high savings rate it is usually because of policies or institutions that restrain the household share of GDP.

This has happened not just in China but also in Germany. In the 1990s Germany could be described as saving too little. It often ran current account deficits during the decade, which means that the country imported capital to fund domestic investment. A country’s current account deficit is simply the difference between how much it invests and how much it saves, and Germans in the 1990s did not always save enough to fund local investment.

But this changed in the first years of the last decade. An agreement among labor unions, businesses and the government to restrain wage growth in Germany (which dropped from 3.2 percent in the decade before 2000 to 1.1 percent in the decade after) caused the household income share of GDP to drop and, with it, the household consumption share. Because the relative decline in German household consumption powered a relative decline in overall German consumption, German saving rates automatically rose.

Notice that German savings rate did not rise because German households decided that they should prepare for a difficult future in the eurozone by saving more. German household preferences had almost nothing to do with it. The German savings rate rose because policies aimed at restraining wage growth and generating employment at home reduced household consumption as a share of GDP.

As national saving soared, the German economy shifted from not having enough savings to cover domestic investment needs to having, after 2001, such high savings that not only could it finance all of its domestic investment needs but it had to invest abroad by exporting large and growing amounts of savings. As it did so its current account surplus soared, to 7.5 percent of GDP in 2007. Martin Wolf, in an excellent Financial Times article on Wednesday on the subject, points out that

between 2000 and 2007, Germany’s current account balance moved from a deficit of 1.7 per cent of gross domestic product to a surplus of 7.5 per cent. Meanwhile, offsetting deficits emerged elsewhere in the eurozone. By 2007, the current account deficit was 15 per cent of GDP in Greece, 10 per cent in Portugal and Spain, and 5 per cent in Ireland.

About Michael Pettis 166 Articles

Affiliation: Peking University

Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business.

Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups.

Visit: China Financial Markets

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