The Wrong Debate: Helicopter Drops vs.

Quantative Easing

A central theme of this blog is that the economy is still starved of the monetary
assets needed to restore full employment. That is, the ongoing shortfall of
aggregate demand is at its core caused by a shortage of MONEY and money-like
assets relative to the demand for them. The question, then, is what can be done
about this problem.

I have long argued, along with other Market Monetarists, that the Fed could solve
this problem by adopting a NGDPlevel target. Why would this help? The key
reason is that it would create an expectation that some portion of the
monetary BASE growth from the asset purchases would be permanent (and nonsterilized by IOER). That, in turn, would mean a permanently higher price level
and nominal income in the future. Such knowledge would cause current investors
to rebalance their portfolios away from highly liquid, low-yielding assets towards
less liquid, higher yielding assets. The portfolio rebalancing, in turn, would raise
asset prices, lower risk premiums, increase financial intermediation, spur
more INVESTMENT spending, and ultimately catalyze a robust recovery in
aggregate demand. (One could also tell a New Keynesian story where the higher
future price level implies a temporary bout of higher-than-normal inflation that
would lower real interest rates down to their market clearing level.)

The key to the above story is that some portion of the monetary base expansion
is expected to be permanent. If the public believes the Fed's asset purchases are
not going to be permanent and therefore the price level and nominal income will
not be permanently higher, the rebalancing will not take place. I bring this up
because this same point applies to helicopter drops or any other kind of
fiscal policy stimulus. Yet many of my fiscalist friends miss it. They seem to think
that helicopter drop will solve the excess money demand problem, period. That is
not the case if the Fed continues to hit its inflation target.

Imagine, for example, that Congress approved a $10,000 check be sent to every
household. Even in a non-Ricardian world where households are liquidity- and
credit-constrained, the increased private sector spending created by the checks
would be offset by monetary policy if it STARTED to push inflation above its
target.

This is why helicopter drops by themselves are not a fix. Nor or large scale asset
purchases. As noted by Christina Romer, there has to be a regime change in how
monetary policy is conducted, one that signals a commitment to a permanent
expansion of the monetary base (via a commitment to a higher price level and
nominal income). From this perspective, it does not matter whether one does
helicopter drops or large scale asset purchases. They would have the same effect
if tied to the same target, such as a NGDP level target.

Michael Woodford has made this point before:

It is possible for exactly the same equilibrium to be supported by a policy of
either sort. On the one hand (traditional quantitative easing), one might increase
the monetary base through a purchase of government bonds by the central bank,
and commit to maintain the monetary base permanently at the higher level. On
the other (helicopter money), one might print new base money to finance a
transfer to the public, and commit never to retire the newly issued money.
Suppose that in either case, the path of government purchases is the same, and
taxes are raised to the extent necessary to finance those purchases and
toSERVICE the outstanding government debt, after transfers of the central
banks seignorage income to the Treasury. Assuming the same size of permanent
increase in the monetary base, the perfect foresight equilibrium is the same in
both cases...
However, he notes the two approaches would have different effects if the public
thought the permanency of the monetary BASE injections differed:
The effects could be different if, in practice, the consequences for future policy
were not perceived the same way by the public. Under quantitative easing,
people might not expect the increase in the monetary BASE to be permanent

 after all, it was not in the case of Japans quantitative easing policy in the period
2001-2006, and US and UK policymakers insist that the expansions of those
central banks balance sheets wont be permanent, either and in that case,
there is no reason for demand to increase.
In other words, we should not be surprised that the Fed's QE programs have not
packed more of a punch. U.S. monetary authorities have clearly indicated the
programs are temporary. (QE3, though, has added some permanency with its
data-dependent nature and appears to have offset much of the 2013 fiscal drag.)
We should also, then, not be surprised that Abenomics--which has signaled a
permanent expansion of the monetary base--is doing so much betterthan the
original Bank of Japan QE program of 2001-2006. Finally, we should also not be
surprised as to why FDR's 1933 decision to go off the gold packed such a punch.
It permanently raised the monetary base. All of these experiences paint a picture
of the relationship between the expected permanency of monetary base
injections and aggregate demand growth. This relationship is sketched in the
figure above.
So stop worrying about whether large scale asset purchases or helicopter drops
are more effective. This is the wrong debate. Instead, START worrying about how
we can change the Fed's target to something like a NGDP level target.

P.S. Paul Krugman's 1988 article also implies that the temporary versus
permanent distinction is important in determining the efficacy of monetary policy,
particularly at the ZLB.

P.P.S. The above discussion is why I have previously argued for helicopter drops
to be tied to NGDP level targets.
Update: Compare this picture of Japan's monetary base to those of the
U.S. monetary base in 1933.

Posted by David Beckworth at 12:53 AM

What George Bailey Can Teach Us About QE
Quantitative easing (QE) is a lot like George Bailey in the classic FILM It's a
Wonderful Life. George was a man who began questioning his value to society. A
number of cascading events--unfulfilled life dreams, a run on his bank, lost bank
deposits, bank fraud charges--made it appear to hm that he was on balance a
drag on his community. George decided it would be better for all if he 'tapered' or
ended his life. Fortunately, an angel appeared at the last minute and revealed
that despite his immediate problems, George's overall contributions to society
were immense. Many lives wereSAVED and changed because of his efforts. All
that was needed to see this fact was a broader, longer perspective. George
Bailey, in other words, was not doing the right counterfactual.

The same is true for skeptics of QE. Many point to the apparent flaws of the Fed's
large scale asset purchases (LSAPs), but fail to step back and consider the
counterfactual of what would have happened in their absence. This point is
particularly poignant to those observers who claim the Fed's LSAPs of treasuries
are particularly bad because they drain the financial system of safe assets. These
critics note that these safe assets serve as collateral in the shadow banking
system and thus facilitate transactions. Therefore, when the Fed increases its
balance sheet it is actually restricting the funding capabilities of the shadow
banking system and creating a drag on the economy. A growing number of smart
people are making this point, including Izabella Kaminski, Tyler Cowen, Peter
Stella, Arvind Krishnamurthy and Annette Vissing-Jorgensen, and Michael
Woodford. I contend that while correct on the immediate effect of LSAPs, these
critics like George Bailey are doing the wrong counterfactual. The right

counterfactual is what would have happened had there been no QE2 and QE3 at
all.

Before delving deeper into this counterfactual, I want to mention two other points
about this critique. First, most of the safe asset shortage was created by factors
other than the Fed's LSAPs. On the supply side, there was the destruction and
subsequent anemic recovery of private-label safe assets as seen in this figure. On
the demand side, the financial crisis and then a spate of subsequent bad
economic news--Eurozone crisis, China slowdown concerns, debt limit talks, fiscal
cliff talks--has kept the demand for safe asset elevated. Also, new regulatory
requirements requiring banks to hold more safe assets is keeping safe asset
demand elevated.

Consequently, forces other than QE2 and QE3 have been driving much of the safe
asset shortage. This can be seen in the figure below which shows the treasury
general collateral repo rate and the Fed's share of marketable treasury securities.
Note that the largest drop in the repo rate (reflecting the reduced supply and
increased demand for treasuries collateral) occurred between late 2007 and early
2009, the very time the Fed was releasing treasury securities back into the
market.

Second, even though the LSAPs do cause an immediate drain of safe assets, they
potentially lead to more private safe asset creation. As I noted before:
The LSAPs, if done right, should raise expected economic growth going forward
and cause asset prices to soar. This, in turn, would increase the current demand

for and supply of financial intermediation. For example, AAA-rated corporations

may issue more bonds to build up productive capacity in expectation of higher
future sales growth. Financial firms, likewise, may START providing more loans
as the improved economic outlook makes households and firms appear as better
credit risks.
There is some evidence this is happening with QE2 and QE3. Even if these private
safe assets are not used as collateral in the repo markets they will be used
elsewhere to satiate liquidity demand. That, in turn, should FREE up more
treasuries for use in the repo market. Both of these points are often overlooked
by QE critics.

Now back to the counterfactual point. Are QE critics really making the same
mistake as George Bailey? To answer that question, let's think through the
counterfactual of no QE2 and QE3. First, assume the Fed's share of marketable
treasuries was constant over this period. Also, assume that the shocks from the
Eurozone crisis, China slowdown, debt limit and fiscal cliff talks still buffeted the
U.S. economy during this time. What would have happened to the U.S. economy?
Could the U.S. economy have been as resilient to these shocks had the Fed not
been supporting it? If not, then imagine the mess in the financial system and
what that would have done to the demand for safe assets. Repo markets, for
example, would probably be facing an even larger collateral shortage. A
reasonable counterfactual, then, is that the safe asset problem would be greater
were it not for the Fed's QE programs.

I took this idea to the data. I estimated a vector autoregression (VAR) over the
2003:1 to 2013:8 period and used it to create a counterfactual path for the
2010:10 to 2013:8 period.1 This corresponds to the QE2 and Q3 periods. VARs are
great for this TYPE of exercise because one, they allow the variables in the
model to interact and two, you can do dynamic forecast with them. The only twist
here is that I did a conditional dynamic forecast. Specifically, I dynamically
forecasted what would happen to employment, THE STOCK MARKET , PCE core
inflation, and the repo rate conditional on (1) the Fed not increasing its share of
marketable treasuries and (2) allowing the Eurozone crisis, China slowdown, and
fiscal policy shocks to still affect the economy. For the latter, I used the actual,
realized values of theeconomic policy uncertainty index over the forecasted
period as a way to summarize and include these shocks in the VAR. The results
can be seen in the figures below.

The first figure shows counterfactual path for the Fed's share of marketable
treasuries used in the forecast.

The next figure shows what happens to the STOCK MARKET . It declines over
much of the period.

The following figure reports the counterfactual path for employment. Again, not a
pretty picture.

This next figure shows that core PCE inflation stays around 1% and never
recovers. So QE is inflationary, at least relative to where inflation would be in its
absence.

Finally, this figure shows that the repo rates would have gone negative. Now this
would not happen in practice because of the ZLB. But the VAR does not know the
ZLB and simply forecasts based on estimated relationships. The fact, though, that
it goes significantly negative is instructive. It indicates the repo markets would
have faced even greater collateral shortages had the Fed not done QE2 and QE3.

Now we do not want to read too much into these results. They come from a
forecasting model that is far from perfect. Still, they indicate that a proper
counterfactual of the QE programs requires more than just narrowly looking at
the immediate impact of LSAPs on the collateral asset supply. We do not want to
be like George Bailey and do the wrong counterfactual. Neither should the Fed.
Otherwise, it too may be tempted to pull the trigger and taper too soon.

My assessment is that QE2 and QE3 has done more to shore up the U.S. economy
than many observers realize. We do not know how much worse the economy
would be in their absence, but the analysis above suggests it could have been
ugly. With that said, the QE programs have been flawed because of their ad-hoc,
make-it-up-as-we-go-along approach that until recently was not tied to any
explicit target. Tying the LSAP more firmly to conditional outcomes would do
much to improve them. The more rule-like and predictable the better. I think
George Bailey would agree.
Update: Michael Darda provides some follow-up comments here.
1

The VAR was estimated with the Fed share of market treasuries, the log of
SP500, the log of employment, the core PCE inflation rate, the repo rate, and the
economic policy uncertainty index. Six lags were used on the monthly data. The
results were generally robust to longer lag lengths, but due to limited data six
lags were chosen. The conditional forecast was created by imposing fixed values
for the Fed share and the uncertainty index as noted above.
Is the Fed Squeezing the Shadow Banking System?
Some observers believe the Fed's large scale asset purchases (LSAPs) are
actually a drag on the economy. They note that the Fed's purchases of treasuries
is reducing the supply of safe assets, the assets that effectively function as
money for the shadow banking system. They do this by serving as the collateral
that facilitates exchange among INSTITUTIONAL INVESTORS . Critics, therefore,

contend that LSAPs are more likely to be deflationary than inflationary. A

recent piece by Andy Kessler in the WSJ typifies this view:
So what's the problem? Well, it turns out, there's a huge collateral shortage.
Global bank-reserve requirements have changed, meaning more safe, highly
liquid securities like Treasurys are demanded instead of, say, Greek or Cypriot
debt. And lately, Treasurys have been getting harder to find. Why? Because of the
very quantitative easing that was supposedly stimulating the economy. The $1.8
trillion of Treasury bonds sitting out of reach on the books of the Fed is starving
the repo market of safe collateral. With rehypothecation multipliers, this means
that the economy may be shy some $5 trillion in credit...
[T]the Federal Reserve's policyto stimulate lending and the economy by buying
Treasurys, and to keep stimulating until inflation reaches 2% or unemployment is
lower than 6.5%is creating a shortage of safe collateral, the very thing needed
to create credit in the shadow banking system for the private economy. The
quantitative easing policy appears self-defeating, perversely keeping economic
growth slower and jobs scarce.
So is the Fed really "squeezing" the shadow banking system as Kessler claims?
Are the LSAPs actually stalling the recovery rather than supporting it? In a
word, no, as this view misses the forest for the trees at two levels. First, by
focusing on the Fed's LSAPs of safe assets, this understanding overlooks the more
important contributors to the safe asset shortage. Second, this view takes a static
view. It doesn't consider the dynamic effect of LSAPs on the supply of private safe
assets. Let's consider each point in turn.

First, the main reasons for the safe asset shortage are (1) the destruction and
slow recovery of private label safe assets since the crisis and (2) the elevated
demand for safe assets that has arisen during this time. The importance of the
first develpment can be seen in the figure below. It shows the Gorton et. al.
(2012) measure of safe assets broken into government and privately-created safe
assets. The figure shows an almost $4 trillion dollar fall in private label safe
assets during the crisis. The Fed's purchases of treasuries has no direct bearing
on this private supply shortage (though I will argue below it has a positive
indirect effect on it).

This reduction in the supply of safe assets occurred, of course, just as the
demand for safe assets were rising in 2008. Since then, a spate of bad news-Eurozone crisis, China slowdown concerns, debt limit talks, fiscal cliff talks--has
kept the demand for safe asset elevated as well as new regulatory
requirements requiring banks to hold more safe assets. It is these developments
that are the real stranglehold on the shadow banking system. 1

Still, Kessler and other critics are correct to note that the immediate effect of the
Fed's LSAPs, even if relatively minor, is to reduce collateral in the shadow
banking system. However, this narrow focus misses the potential for the LSAPs to
catalyze the private production of safe assets. The LSAPs, if done right, should
raise expected economic growth going forward and cause asset prices to soar.
This, in turn, would increase the current demand for and supply of financial
intermediation. For example, AAA-rated corporations may issue more bonds to
build up productive capacity in expectation of higher future sales growth.
Financial firms, likewise, may START providing more loans as the improved
economic outlook makes households and firms appear as better credit risks.
Critics like Kessler miss this dynamic effect of LSAPs.

The potential for LSAPs to spur private safe asset creation is not just theoretical.
It appears to be happening alreadywith Abenomics in Japan. And to a lesser
extent, it has been happening in the United States with QE2 and QE3. Now, these
two LSAPs programs are far from perfect, but even they appear to have
supported some private safe asset creation. This can be seen in the figure below
which shows the year-on-year growth rate of the Gorton et. al. (2012) measure of
private safe assets. It also reports the year-on-year growth rate for the "M4
minus" Divisia measure from theCenter for Financial Stability. This metric

provides an estimate of the broad money supply, including shadow banking

money assets but excluding treasuries (the "minus" part). This measure, then, is
also capturing the supply of private safe assets. The figure indicates that under
both QE2 and QE3, the growth rate of private safe assets increased. Unlike QE1
which was designed to SAVE the financial system, the latter two QE programs
were explicitly geared toward shoring up the economy. In so doing, they also
appear to have ramped up the production of private safe assets.

QE3 is still ongoing and continues to support more private safe asset creation.
The recent rise in treasury yields is another sign of this process as it indicates a
rebalancing of portfolios toward, among other things, private safe assets. Now
there is a long ways to go before there will be enough private safe assets to
restore full employment NGDP growth. But we are on the way--the only way since
there is a limit to the amount of safe assets the government can provide without
jeopardizing its risk-free status--and this should not be ignored by critics like
Kessler.

The appropriate critique, then, of the Fed is not that it is squeezing the shadow
banking system, but that it has failed to do enough to undo the stranglehold on it
coming from the shortfall of private safe asset creation and the elevated demand
for safe assets.

P.S. John Cochrane reads Andy Kessler's piece too. He wonders if the
monetary BASE is losing its special standing as high-powered money since
treasuries have become high-powered money for the shadow banking system.
The answer is no because the monetary base is still the medium of account, a
huge advantage. Also, though the monetary base and treasuries may be near
perfect substitutes today, they won't be in the future. And investors make their

decisions based largely on what they think will happen in the future. Thus, a
monetary base injection today that is expected to be permanent and greater than
the demand for the monetary base in the future is likely to affect spending today,
even though treasuries and the monetary base are now close substitutes. The
key is creating the belief that monetary base injection will be permanent, a
point repeatedly made by Michael Woodford.

1The figure shows that government safe assets have partially offset the private label shortfall. I estimate there is still a U.S. safe asset
shortfall of about $4 trillion. This shortfall can be seen in this figure which shows the amount of safe assets needed to hit full employment
NGDP. The amount of safe assets needed to hit the pre-crisis trend NGDP path and CBO full-employment NGDP is calculated as follow. I solve
for the OPTIMAL

amount of money in the equation of exchange given an optimal amount of Nominal GDP (the pre-crisis trend and CBO

values) and actual trend money (safe asset) velocity as estimated by the Hodrick-Prescott filter. That is, I am solving for M* in M* =
t
NGDP* /V* .
t
t

Posted by David Beckworth at 12:18 PM

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hy is There Still a Shortage of Safe Assets?
JP Koning wants to know why many of us continue to talk about a safe asset
shortage five years after the financial crisis STARTED . Shouldn't this problem
corrected itself many years ago? He has asked this questions many times and
most recently framed it this way:
Why do we *need* more safe assets? Why don't we just let the existing ones rise
in value, thereby providing safety? If we wanted to express our desire for safety
by buying fire extinguishers, then I'd agree that we need to produce more safe
assets. After all, only some sort of increase in the supply of extinguishers will be
able to meet that demand.
But things are different if we express our demand for safety by turning to
financial markets. The great thing about t-bonds is that unlike fire extinguishers,
we don't need to fabricate more of them to meet our demands for safety... we
just need a higher real value on the stock of existing t-bonds. This can be entirely
met by shifts in prices. Where is the problem that needs to be rectified?
This is a great question. Why haven't financial markets--the nimblest, most
flexible markets of all--pushed treasury values to levels that would cause the
market for safe assets to clear? Shouldn't arbitrage in these markets fixed this
problem long ago?

Let me BEGIN my answer by recalling why the ongoing shortage of safe assets
is such a big deal. Safe assets facilitate transactions for INSTITUTIONAL
INVESTORS and therefore effectively acts as their money. During the crisis,
many of these transaction assets disappeared just as the demand for them was

picking up. Since these institutional money assets often backstop retail financial
intermediation, the sudden shortage of them also meant a shortage of retail
money assets. In other words, the shortage of safe assets matters because it
means there is an excess demand for both institutional and retail money assets.
This excess money demand, in turn, is keeping aggregate nominal expenditure
growth below where it should be.

It is also important to note that although the crisis began in 2007 there has been
a series of subsequent shocks that have kept the demand for safe assets
elevated: the Euro crisis of 2010-2012, the debt-ceiling talks of 2011, the fiscal
cliff of 2012, and concerns about a China slowdown. So there hasn't been for
sometime a period of prolonged calm to ease the heightened demand for safe
assets. Still, Koning's argument should still hold despite this spate of bad
economic news. Safe asset prices should be able to adjust to reflect these
developments.

The problem is that safe assets, treasury securities in particular, cannot make
this adjustment when they are up against the zero lower bound (ZLB) on nominal
interest rates. Given the large shortfall of safe assets, interest rates need to go
below 0% for treasury prices to rise enough to satiate the excess demand for
them. Investors, however, can earn 0% holding money at the ZLB. Consequently,
investors will not purchase enough treasury securities to sufficiently raise
treasury prices (i.e. lower interest rates) and clear the market. 1
In addition, the heightened economic uncertainty and the ZLB means the
demand for these transaction assets (i.e. money and treasuries) becomes almost
insatiable. Investors, therefore, shy away from other higher yielding, riskier
assets that normally would lure them. Portfolios get overly weighted toward liquid
assets.
Note what is happening here: treasuries and money become increasingly close
substitutes as they approach the ZLB, while the overall transaction asset market
becomes increasingly segmented from other asset markets. In other words, as
arbitrage becomes more powerful among transaction assets like money and
treasuries, it becomes less powerful between the market for transaction assets
and other asset markets. The short answer to Koning's question, then, is that the
ZLB has segmented the transaction asset market and this is preventing the safe
asset market from clearing.
Below is my initial attempt to show this graphically. It shows that while treasury
and money assets substitutability is always responsive to interest rate changes,
market segmentation is not and only kicks in after some threshold close to the
zero bound is reached. In other words, at some point when treasuries and money
become close enough substitutes, the market for transaction assets BEGINS to

segment from other markets. Where this actually occurs is unknown and the way
I have drawn it is arbitrary. But hopefully you see the point.

Now market segmentation is a controversial idea. Many observers don't accept it.
But it seems like a compelling story for the transaction asset market at the ZLB.
Empirically, it provides an easy explanation for why BAA-AAA corporate yield
spread, junk bond spread, and other non-transaction asset spreads are getting
closer to historical norms, while theBAA yields-10 treasury yield spread and
the S&P500 earnings yield-20 year treasury yield spread remain inordinately
high.Welcome to the strange new world of transaction asset market
segmentation.

P.S. Market Monetarists, including myself, typically downplay the importance of

the ZLB for monetary policy. We argue the ZLB is really just an artifact of doing
monetary policy with an interest rate; it should have no actual bearing on the
efficacy of monetary policy. Here, in the case of the safe asset shortage, it does
seem to be a non-trivial phenomenon that needs to be taking seriously.

Given a sticky price level, the increased holdings of MONEY

continue since the price level does not adjust quickly either.
Macro and Other Market Musings
Monday, January 14, 2013

at the ZLB will also

Resolving the Safe Asset Shortage Problem

One of the biggest challenges facing the global economy is the shortage of safe
assets, those assets that are highly liquid and expected to maintain their value.
This shortage matters because safe assets facilitate exchange and effectively
function as money. AAA-rated CDOs, for example, served as collateral for
repurchase agreements which were the equivalent of a deposit account
for INSTITUTIONAL INVESTORS in the shadow banking system. Therefore, when
many of these CDOs disappeared during the financial crisis, a large part of the
shadow banking system's money disappeared too. This precipitous decline in
institutional money assets declined occurred, of course, just as the demand for
them were increasing because of the panic. This problem bled over into retail
banking, since it was funded by the shadow banking system, and forced many
retail financial firms and households to deleverage. This deleveraging, in turn,
meant fewer retail money assets just as panic was kicking in at the retail level. In
short, the shortage of safe assets is a big deal because it means there is an
excess demand for both institutional and retail money assets. This
broad excess money demand is why aggregate nominal expenditures in many
countries remain depressed. A full recovery, then, will not happen until there is a
sufficient stock of safe assets.1

So what can be done about this problem? Matthew C. Klein of The

Economist believes the solution is for the government to create more safe assets
until this excess demand is satiated. He argues that governments who control
their own currency are the only producers of safe assets since there is
no CHANCE they will default. They can always create money to pay off their
creditors. He sees privately created safe assets, on the other hand, as only
having transitory "safeness"as evidenced by the history of AAA-CDOs and other
private-label assets that went bust during the financial crisis. Private debt
instruments, therefore, cannot solve the safe asset shortage problem according
to Klein. Instead, the road to full recovery can only be paved with fiscal policy
creating more safe assets.

I take a different view: a robust recovery can only occur if there is an

increased confidence in the safety of private debtinstruments (i.e. a drop in the
risk premium) and, as a result, an increase in demand for them. A full
recovery, therefore,requires a restoration of the market for privately-produced
safe assets. Klein does not believe this is possible, I do. Here is why I hold this
view.

First, there are no truly safe assets, only ones with varying degrees of safeness.
This is true even for governments thatcontrol their own CURRENCY
. Yes, they will never explicitly default since they can create money to
redeem their liabilities, but they can still implicitly default by creating higher-

than-expected inflation. In other words, investors worry about inflation risks too
when looking for safe assets. The U.S. learned this lesson the hard way in
the 1970s as seen in the figure below. It shows foreigners reduced their holdings
of treasuries when inflation soared:

We are a long way from the 1970s as evidenced by

the ongoing demand for U.S. treasuries and the resulting low yields(and no, the
Fed is not behind this development). Still, the U.S. government faces a tension. It
can run larger budget deficits to meet the global demand for safe assets, but
doing so may eventually jeopardize its risk-free STATUS , the very thing driving
the demand for its securities. This is the modern version of the Triffin
dilemma and it reminds us thatthere is a limit to how much safe asset creation
can be done by the government.

This point is underscored by the fact that the supply of U.S. private safe
assets has been significantly larger than the stock of U.S. government safe
assets, according to the Gorton et al. (2012) measure of safe assets:

Consequently, it would be unlikely that the U.S. Treasury could create enough
securities to fill the gap created by the shortage of private safe assets without
undermining the safe asset STATUS of treasuries. To be concrete, if we follow
Michael Belongia and Peter Ireland's recent paper, where they solve for
the OPTIMAL amount of money (or safe assets) by plugging in potential Nominal
GDP (as estimated by the CBO) and actual trend money velocity (as estimated by
the Hodrick-Prescott filter) into the equation of exchange (i.e. M *t= NGDP*t/V*t ),
the safe asset shortfall for the U.S. economy at the end of 2011 was just over $4
trillion. Can the U.S. government really run up 4 more trillion dollars in debt, on
top of the existing debt run up since 2008, without raising concerns about its
safe asset status? And that is before we even consider the non-U.S. demand for
U.S. safe assets.

It seems unlikely, therefore, that the U.S. government can produce enough safe
assets without harming its risk-free status. But then it does not have to do so. As
I noted above, the public's perception about the safety of private assets can
change given the right impetus and lead to an increase demand for privatelycreated safe assets. Another way of saying this, is the relatively high risk
premium on private debt is probably not the result of long-run economic
fundamentals. It is more likely the result of self-fulfilling excess pessimism that
has put the economy in a suboptimal equilibria (as shown in Roger
Farmer's work).

If this is this case, then what is needed is a major slap to the market's face. I
believe an ambitious NGDP level target that significantly raised expected nominal
income growth would do just that. If credible, it would both reduce the excess
demand for safe assets (because of greater nominal income certainty going

forward) while at the same time catalyze financial firms into making more safe
assets (because of the improved economic outlook and the related increased
demand for financial intermediation). For example, imagine how the public would
respond if the Fed suddenly announced Scott Sumner's proposal of raising their
asset purchase amounts by 20% per month until some NGDP level target was
hit.2 That would be the monetary policy equivalent of shock and awe and should
catalyze the market for privately produced safe assets.
But don't take my word for it. The figures found here show the estimated dynamic
relationships between positive shocks to expected NGDP growth rate and a
number of economic variables, including the Gorton et al. (2012) supply of
private and public safe assets for the period of 1968:Q4 - 2011:Q4. 3 It shows for
this period, that a sudden and permanent rise in the expected growth of NGDP
leads to a rise in the supply of private safe assets and a decline of public safe
assets. The former response makes sense for the reason laid out above, while the
latter response follows from the fact that a large part of the budget balance
is cyclical. The results also show that the risk premium (10 year treasury yield
minus Moody's corporate AAA yield) and unemployment rates decline after the
shock. The second figure at the LINK shows the same system now estimated
with the private and public safe assets combined into one series. It reveals that
overall safe assets increase.
The resolution to the safe asset shortage problem, then, is monetary policy
catalyzing the private sector into recovery. Fiscal policy can help, but is limited by
the size of the problem.
Update: Using the same estimated system above, here are the responses to a
positive unemployment rate shock (i.e. an unexpected increase in the
unemployment rate). Now public safe assets increase, private safe assets fall,
and the risk premium rises. These results and the ones above are consistent with
studies such as Bansal et al. (2011) that show public and private safe assets
serve as complements in providing liquidity SERVICES .

What I am describing here a recovery from a cyclically-induced shortage of safe

assets. This is different than the longer-term, structural safe asset problem that
existed prior to the crisis. This longer-term problem is the result of global
economic growth over the past few decades that has outpaced the capacity of
the world economy to produce sufficient safe assets. See this earlier post for
more on this point.
2

The key here is to do (or at least threaten to do) OPEN market operations
(OMOs) that permanently raise the expected level of the monetary BASE . When
this happens, expected nominal incomes will be higher too and lead to the
responses outline above. Thus, even though OMOs at the zero lower bound might
be TRADING near substitutes--monetary base for treasuries earning 0%--the
belief that they won't stay near substitute because of the permanence of the
monetary base injection will trigger a portfolio rebalancing effect that will lead to

higher nominal spending.

3

This is estimated using a vector autoregression (VAR). The data are quarterly, in
log levels unless already in growth rates, and estimated using 5 lags. The
generalized impulse response function is used here so that ordering of the
variables in the VAR does not change the outcome. The sample BEGINS in
1968:Q4 because that is the earliest data point for the expected NGDP growth
series. This series comes from the Survey of Professional Forecasters.
Safe Assets, Money, and the Output Gap
In the past, I made the case that the shortage of safe assets is really just an
excess MONEY demand problem. That is, the sharp decline in the stock of safe
assets that began in 2008 matters because it means there are fewer assets that
can facilitate exchange relative to the demand for them. This relative shortage of
transaction assets or money implies a deficiency of aggregate nominal
expenditures and can explain the ongoing slump. This notion of excess money
demand is not novel, but what is new and makes this view a compelling narrative
of the crisis is our expanded understanding of what constitutes money.

Prior to the crisis, most observers thought of some measure of retail money
assets like M2 as an appropriate measure of money. Thanks to efforts of Gary
Gorton (2008), Wilmot et al. (2009), Sing and Stella (2012), and others we now
know that a more accurate measure of money should also include institutional
money assets that facilitate exchange forINSTITUTIONAL INVESTORS . One
attempt to measure this broader notion of money comes from the Center for
Financial Stability (CFS). Using their data, one can show that the supply of money
has fallen sharply since 2008 and has yet to recover. By itself, this decline in the
stock of money assets implies an unsatisfied demand for money. Throw into this
mix the heightened demand for safe assets arising from economic fears and you
have a pronounced excess money demand problem. One would never know this,
though, by looking at traditional measures of money.

The nice thing about this excess money demand view is that it helps shed light
on the ongoing debate as to whether there is a large negative output gap. Since
money assets are on every market, excess money demand implies a general glut
that in turn should create a negative output gap. Thus, relative money shortages
should be correlated with the output gap. So is there any evidence for this view?

Michael Belongia and Peter Ireland provide a clever technique in a

recent paper that can answer this question. They solve for the OPTIMAL amount
of money assets by plugging in potential Nominal GDP (as estimated by the CBO)
and actual trend money velocity (as estimated by the Hodrick-Prescott filter) into

the equation of exchange (i.e. M*t= NGDP*t/V*t ). I reproduce their procedure here
using the CFS's M4 divisia money supply1 and come up with the following figure:

The figure shows that the quantity of money assets is currently about 7% below
what is needed to generate full potential NGDP growth. Now if one takes the
percent difference between the actual and needed M4 divisia in the figure
above--the M4 divisa gap--and plots it against the the output gap you get the
following figure:

I find this figure striking. With a R2 of about 60%, it shows that the output gap
typically tracks the M4 gap. For the recent crisis in particular, it shows the acute
shortage of money assets (or excess money demand) is MATCHED by the large
output gap. This figure, then, indicates the excess money demand explanation
for the recent crisis is a compelling one.

Now some observers like James Bullards and Stephen Williamsons believe that
the shortage of safe assets or MONEY is the consequence of real shocks to
financial intermediation that have permanently lowered the PRODUCTIVE
capacity of the U.S. economy. The relationship evident in the figure above,
however, suggests that there is in fact a large output gap given the significant
shortage of money assets. And even if the shortage were caused by a real shock,
there are still policy options that could close the M4 gap.

First, the government could create more safe assets in the form of treasuries.
This approach, however, is politically controversial as it requires more budget
deficits. It is also not clear to me that this approach would be able to create
enough safe assets to completely close the M4 gap. Second, the Fed could
create the incentive for the private sector to start producing more safe assets by
adopting a NGDP level target. Such a target would raise the expected level of
future NGDP and, in turn, raise the current demand for financial
intermediation SERVICES . That would lead to more privately-produced safe
assets and ultimately a recovery. There are ways out of this economic morass.
1

I specifically use the CFS' "M4 minus" money supply measure. It had a better fit
than the regular M4.
Posted by David Beckworth at 11:51 PM

Money Still Matters

Nick Rowe likes to remind us that MONEY is the only asset on every market. If
the supply of or demand for this one asset is disrupted then every market will be
affected. This reasoning implies that monetary disequilibrium is essential for the
emergence of general gluts. This crisis has reinforced this understanding, but also
has shed some new light on what it means. Specifically, this crisis has shown
that what is used as money is far broader than the standard measures of money.
The widely used M2, for example, is limited to retail money assets like cash and
deposits accounts that are used by households and small businesses.
INSTITUTIONAL INVESTORS also need assets that facilitate transactions, but the
assets in M2 are inadequate for them given the size and scope of their
transactions. Consequently, institutional investors have found ways to make
assets like treasuries, commercial paper, repos, GSEs and other safe assets serve
as their money. These institutional money assets, therefore, should also be
considered part of the money supply. When viewed from this broader perspective,
the money supply has been depressed during the crisis in both the United States
and the Eurozone. It should be no surprise then that both regions are in slumps.

Here are some attempts to measure these broader notions of money. First, from
the Center for Financial Stability is the M4 Divisia money supply measure for the
United States:

No monetary recovery yet in the United States. What about the Eurozone? Let
us first look at the Eurozone less Germany. For this region we use the ECB's M3
simple sum aggregate. This is not quite as broad as M4, but it does include some
institutional money assets:

Here too there is a wide gap between the trend and actual money stock. Finally,
here is the same M3 measure for Germany:

No surprise here. Germany's economy is doing relatively well and thus we would
expect to see better monetary conditions there. This relative stability of
the MONEY stock is another reason why Germany is no rush to OPEN the ECB
monetary spigot to save the Eurozone. Why disrupt stable monetary conditions
in Germany?

So what are the monetary policy implications? The most obvious one is that the
Fed and ECB should create an environment conducive to monetary asset creation
that would support the return of robust aggregate nominal spending. Since most
of the money assets are created by the credit, maturity, and liquidity
transformation SERVICES of financial firms, policymakers should aim to create
an environment conducive to increased financial intermediation. The easiest way
for monetary policy to do this is to raise the expected growth path of aggregate
nominal expenditures. This would raise expected nominal income growth and the
demand for money assets. This, in turn, would catalyze financial intermediation
and lead to the creation of more money assets. And of course, the way to raise
the expected growth path of aggregate nominal expenditures is to adopt a
nominal GDP level target. It is time for monetary regime change!
P.S. Peter Ireland and Michael Belognia have an interesting new paper that
shows money still matters for monetary policy. This is bound to get some New
Keynesians worked up! From their abstract:
Over the last twenty-five years, a set of influential studies has placed interest
rates at the heart of analyses that interpret and evaluate monetary policies. In
light of this work, the Federal Reserves recent policy of quantitative easing,
with its goal of affecting the supply of liquid assets, appears as a radical break

from standard practice. Superlative (Divisia) measures of money, however, often

help in forecasting movements in key macroeconomic variables, and the
statistical fit of a structural vector autoregression deteriorates significantly if such
measures of money are excluded when identifying monetary policy shocks.
These results cast doubt on the adequacy of conventional models that focus on
interest rates alone. They also highlight that all monetary disturbances have an
important quantitative component, which is captured by movements in a
properly measured monetary aggregate.
Why the Global Shortage of Safe Assets Matters
One of the key problems facing the world economy right now is a shortage of
assets that investors would feel comfortable using as a store of value. There is
both a structural and cyclical dimension to this shortage of safe asset problem,
with the latter being particularly important now given the recent spate of
negative economic shocks to the global economy. These shocks have elevated
the demand for safe assets and, as David Andolfatto argues, is probably the key
reason why we see such low yields on U.S. treasuries. Of course, these same
shocks have also destroyed many of the once-safe assets (e.g. European
sovereign bonds) adding further strain to this asset-shortage problem. This
shrinking stock of safe assets can seen in the figure below created by Credit
Suisse (ht FT Alphaville):

This figure shows that if one does not count French bonds as safe assets
(a reasonable assumption), then about half of the safe assets disappeared by
2011. That is a tremendous drop and, as I see it, matters for two reasons. Before
getting into them, though, it is worth briefly reviewing the structural and cyclical
dimensions to the asset-shortage problem.

The structural dimension is that global economic growth over the past few
decades has outpaced the capacity of the world economy to produce truly safe
assets. Ricardo Caballero, the author of this view, argues that it

probably STARTED with the collapse of Japaneses assets in the early 1990s, was
exacerbated by emerging market crises throughout the 1990s, and got
heightened by the rapid economic growth of the Asia in the early-to-mid 2000s.
These developments along with the fact that most of the fast growing countries
have lacked the capability to produce safe assets made the assets shortage a
structural problem.

The cyclical dimension is that the demand for and disappearance of safe assets
was intensified by the failures of the Fed and the ECB over the recent business
cycle. In the early-to-mid 2000s, the Fed exacerbated the asset-shortage
problem as its loose monetary policy got exported via fixed exchange rates to
much of the emerging MARKET WORLD which in turn recycled it back to the U.S.
economy via the "global saving glut" demand for safe assets. (For more on this
point see this post and my paper with Chris Crowe.) Since late 2008, both the
Fed and the ECB have worsened the asset-shortage problem by failing to first
prevent and then restore nominal income in each region to its expected path. In
other words, since 2008 both the Fed and the ECB have passively
tightened monetary policy and this has caused some of the AAA-rated securities
to disappear. (Yes, some of the AAA-rated MBS and sovereign debt would have
defaulted on their own, but some of them like French sovereigns would have
maintained their safe asset STATUS were it not for insufficient aggregate
demand caused by passively tight monetary policy.)

Okay, so why does this safe asset shortage ultimately matter? The first reason is
that many of these safe assets serve as transaction assets and thus either back
or act as a medium of exchange. AAA-rated MBS or sovereigns have served as
collateral for repurchase agreements, which Gary Gorton has shown were the
equivalent of a deposit account for the shadow banking system.
The disappearance of safe assets therefore means the disappearance of money
for the shadow banking system. This creates an excess money demand problem
for INSTITUTIONAL INVESTORS and thus adversely affects nominal spending.
The shortage of safe assets can also indirectly cause an excess money demand
problem at the retail level if the problems in the shadow banking system spill
over into the economy and cause deleveraging by commercial banks and
households. All else equal, such retail level deleveraging causes bank assets like
checking and money market deposits to fall relative to the demand for them. In
other words, the broad money supply falls relative to the demand for it. The
scarcity of safe assets matters, then, to the extent it creates an excess money
demand problem that adversely affects nominal spending.

The second reason the assets shortage matters is that it creates a Triffin dilemma
for the producers of safe assets. The original Triffin dilemma says that a country
with the reserve CURRENCY OF THE WORLD has to produce more money than is

needed domestically to meet the global demand for it. This, however, requires
running current account deficits that over time may jeopardize the very reserve
currency status driving this dynamic. Francis Warnocksummarizes this paradox
nicely:
To supply the worlds risk-free asset, the country at the heart of the international
monetary system has to run a current account deficit. In doing so, it becomes
more indebted to foreigners until the risk-free asset ceases to be risk-free.
Now apply this reasoning to the U.S. government that currently seems to be the
preferred producer of safe assets for the world. If it is to meet the excess demand
for safe assets it must run a larger budget deficit, a point made recently by David
Andolfatto:
[G]iven the huge worldwide appetite for U.S. treasury debt (as reflected by
absurdly low yields), this is the time to START accommodating this demand.
Failure to do so at this time will only drive real rates lower.
But running larger budget deficits over time may jeopardize the safeasset STATUS of U.S. treasury debt, the very thing currently driving the
insatiable demand for it. The global economy thus faces a Triffin dilemma for the
U.S. treasury, its go to safe asset.

There is way out of these problems. Both the Fed and the ECB need to return
aggregate nominal incomes in their regions to their pre-crisis trends and do so
using a nominal GDP level target. Being a level target it would keep long-run
inflation expectations anchored while still allowing for an aggressive monetary
stimulus in the short-run (i.e. until the pre-crisis trends were reached). It would
also stabilize nominal spending expectations and add more certainty to long-run
forecasts. More importantly, it would spur a sharp recovery that would that
would lower the demand for safe assets and increase the stock of safe assets.
Both of these developments would in turn reduce the excess MONEY demand
problem and minimize the problems with the Triffin dilemma for U.S. treasury
debt. Unfortunately, we are a long way from either central bank adopting
nominal GDP level targets.
The Cyclical Dimension of the Safe Asset Problem
An important problem facing the global economy is the shortage of safe assets,
assets that facilitate transactions at both the retail and institutional level. There
is both a long-term, structural dimension to this problem as well as a short-term,
cyclical one. The structural dimension is that global economic growth over the
past few decades has outpaced the capacity of the world economy to produce
truly safe assets, a point first noted by Ricardo Cabellero. The cyclical dimension
is that the shortage of safe assets was intensified by the Great Recession, a
point stressed by Gary Gorton. I previously made the case that both the Fed and
the ECB were an important part of the cyclical story by failing to restore
nominal incomes to their expected, pre-crisis paths. In other words, since 2008

the Fed and the ECB passively tightened monetary policy which caused some of
the safe assets to disappear while at the same time increasing the demand for
them.

I still hold this view, but after reading some papers on safe assets and talking
with Josh Hendrickson I have come up with a more general view to the cyclical
dimension of the safe asset problem. It goes as follows.

Gorton, Lewellen, and Metrick (2012) show that safe assets have constituted a
relative stable share of all assets since the 1950s. They also show, as
does Bansal, Coleman, and Lundblad (2011), that public and private safe assets
tend to act as substitutes in providing liquidity SERVICES . Given these findings,
it stands to reason that when the central bank is doing its job and nominal GDP
(NGDP) is growing at its appropriate trend, then there will be enough safe assets
being privately provided. If, however, the central bank slips and NGDP falls
below its expected path, then some of the privately produced safe assets
disappear, creating a shortage of safe assets. The government steps in and
creates safe assets that, if produced sufficiently, would restore NGDP back to its
expected path. In other words, if monetary policy does not do its job then fiscal
policy could substitute for it, but in a way not normally imagined. It would do so
not by increasing aggregate demand via higher government spending, but by
making up for the shortage of safe assets that facilitate transactions. All this
requires is running a budget deficit which may or may not imply higher
government spending (i.e. it could also come from tax cuts). Debates about
Ricardian equivalence, crowding out, and other fiscal policy concerns become
moot. What matters is if there are enough safe assets, and if not, whether fiscal
policy can provide them in the absence of a NGDP-stabilizing monetary policy.

This understanding may serve as the basis for a paper, so I look forward to any
feedback you can provide.
Macro and Other Market Musings
Tuesday, March 27, 2012
The Bernanke-Student Conversation You Missed: Part I
Somewhere in the halls of George Washington University, after Bernanke's last
lecture, a conversation between the Fed Chairman and a student was overhead.
This is the first part of that conversation. 1
Student: Oh hi, Chairman Bernanke. I have enjoyed your lectures. Thanks so
much for making time for us.

Bernanke: You are more than welcome. You know, it has been a real treat for
me to get away from the Fed and back into the classroom. Sometimes the stress
of dealing with hard-money congressmen, rogue regional Fed presidents, and
bloggers who cite my Japanese work can be overwhelming. So it really is nice to
escape into the classroom. Now tell me, is there anything in particular we have
talked about that struck your fancy?
Student: Actually, yes. When you explained that China's CURRENCY peg to
the dollar means China effectively has it monetary policy set by the Fed I was
shocked--1.3 billion Chinese have their monetary conditions set by a few
Americans holed up in a secretive, old building on the other side of the world.
Wow, talk about fodder for conspiracy theories! Anyhow, this got me thinking:
are there other countries that have their monetary policy determined by the Fed
too? So I did some research and learned that almost half of the WORLD'S
CURRENCIES are tied in some way to the dollar. This translates into about a
third of world GDP. That means you guys at the Fed are like a monetary mafia,
right?
Bernanke: Well, uhm, I would not phrase it that way but...
Student: But you do influence monetary conditions for about a third of the
global economy, right?
Bernanke: Yes.
Student: Okay, let's say the Fed eased monetary policy for a third of the world
economy. That would imply that the CURRENCIES of these dollar-pegging
countries would depreciate relative to the rest of the world. And that, in turn,
would make the ECB and the Bank of Japan mindful of U.S. monetary policy lest
their currencies becomes too expensive, right?
Bernanke: Probably, but...
Student: So the Fed, then, is also shaping monetary policy to some extent
at the ECB and the Bank of Japan. That explains figures like this one and
this one that until now I did not understand. Wow, you guys really are the
monetary mafia. So does this mean the monetary mafia thinks about the
implication of the FOMC's actions for these other economies when doing
monetary policy?
Bernanke: Actually no, we have a domestic mandate so we don't really worry
too much about them unless they create problems for the U.S. economy. And
besides, they don't have to peg to our CURRENCY . No one is forcing them to do
so. We may exert a lot of influence on global monetary conditions, but we are not
a monetary mafia! Please quit using that name!
Student: Okay, no more monetary mafia references. But, if you do exert a lot of
influence on global monetary conditions, then can't it explain, at least in part,
why there was a global housing boom? The Fed lowered global interest rates and
sparked off a global housing boom, right?

Bernanke: You need to read my papers on the SAVING glut. They show that it
wasn't U.S. monetary policy, but excess SAVINGS from rest of the world that
created the demand for safe assets that in turn drove down global interest rates.
This development combined with the securitization of finance, poor internal
governance, misaligned creditor incentives, and other private sector failings is
what caused the global housing boom.
Student: Doesn't that sound a bit self-serving, blaming only foreigners and
private sector failings for the housing boom?
Bernanke: Look, as I said, read my papers on the saving glut. The answers are
all there.
Student: Well, I have read your saving glut papers, but I still have questions. It
seems to me that in those papers you are focusing on the structural component
driving the global demand for safe assets, but ignore the cyclical ones.
Bernanke: What do you mean?
Student: The structural component is that global economic growth over the past
few decades has outpaced the capacity of the world economy to produce truly
safe assets. The cyclical component, on the other hand, is that because of the
Fed's monetary superpower STATUS , U.S. monetary policy accentuated the
demand for safe assets during the housing boom.
Bernanke: Oh really?
Student: Really. Here is why. First, in the early-to-mid 2000s, those dollarpegging countries were forced to buy more dollars when the Fed loosened
monetary policy with its low interest rate policies. These economies then used
the dollars to buy up U.S. debt. This increased the demand for safe assets. To the
extent the ECB and the Bank of Japan also responded to U.S. monetary policy,
they too were acquiring foreign reserves and channeling credit back to the U.S.
economy. Thus, the easier U.S. monetary policy became the greater the demand
for safe assets and the greater the amount of recycled credit coming back to the
U.S. economy.
Second, when the Fed pushed interest rates low, held them there, and promised
to keep them there for a "considerable period" in 2003 it created new incentives
for the financial system. First, via the expectations hypothesis (which says longterm interest rates are simply an average of short-term interest rates over the
same period plus a term premium) these developments pushed down medium to
longer yields as well, as seen in this figure. This drop in yields caused big
problems for fixed income fund managers who were expected to deliver a certain
return. Consequently, there was a "search for yield" or as Barry Ritholtz says the
managers of pension funds, large trusts, and foundations had to "scramble for
yield." They needed a higher but relatively safe yield in order to meet their
expected return. The U.S. financial system meet this rise in demand by
transforming risky assets into safe, AAA-rated assets. The Fed's low interest rate
policies also increased the demand for safe assets for HEDGE fund managers.

For them the promise of low short-term interest rates for a "considerable period"
screamed opportunity. These investors saw a predictable spread between low
funding costs created by the Fed and the return on higher yielding but safe
assets. They too wanted more AAA-rated assets to invest in so that they could
take advantage of this spread that would be around for a "considerable period."
Here too, the U.S. financial system responded by transforming risky assets into
safe assets. So what do you think Mr. Chairman?
Bernanke: Well, what do you know, I am out of time. We will have to continue
this conversation next time after my next lecture on the financial crisis.
Student: Speaking of the financial crisis, I also think that since late 2008 the Fed
has erred the other way. By failing to first prevent and then restore aggregate
nominal income to its expected path, the Fed allowed the large scale destruction
of many privately-produced safe assets far beyond that needed to correct for the
housing boom.....
Bernanke: I am outta here!
1

Okay, this conversation did not really happen, but I wish it had.

Did Fed Policy Matter to Housing Prices?

Kenneth Kuttner has a new paper that reexamines the relationship between the
Fed's interest rates and house prices during the housing boom. The paper is
receiving some attention because it claims that the existing literature on this
topic collectively shows only a small role for interest rates on the housing prices.
Here is Kuttner:
All available evidence existing studies, plus the new findings presented above
points to a rather small effect of interest rates on housing prices. VAR-based
estimates of the effect of a 25 basis point expansionary monetary policy shock
range from 0.3% to 0.9%, both in the U.S. and in other industrialized
countries....they are too small to explain the previous decades tremendous real
estate boom in the U.S. and elsewhere.
Looking back it is clear that there were other developments that contributed to
the housing boom like financial innovation, global demand for safe assets, poor
governance, industry structure, housing policy, and misaligned creditor
incentives. Contrary to the Kuttner's claim, however, this does not mean that
the contribution of the Fed's low interest rates were trivial. Here are the reasons
why.

First, to really learn the full impact of the low interest rates one needs to also
consider their indirect effect on housing. One indirect effect of the Fed's low
interest rate policy is that it influenced financial innovation and the demand for
safe assets which further lowered yields. When the Fed pushed interest rates
low, held them there, and promised to keep them there for a "considerable

period" in 2003 it created new incentives for the financial system. First, via the
expectations hypothesis (which says long-term interest rates are simply an
average of short-term interest rates over the same period plus a term premium)
these developments pushed down medium to longer yields as well, as seen in the
figure below:

As Barry Ritholtz notes, this drop in yields caused big problems for fixed income
fund managers who were expected to deliver a certain return. Consequently,
there was a "search for yield" or as Ritholtz says these managers of pension
funds, large trusts, and foundations had to "scramble for yield." They needed a
higher but relatively safe yield in order to meet their expected return. The U.S.
financial system meet this rise in demand by transforming risky assets into safe,
AAA-rated assets. The Fed's low interest rate policies also increased the demand
for safe assets for HEDGE fund managers. For them the promise of low shortterm interest rates for a "considerable period" screamed opportunity. As Diego
Espinosa shows in a forthcoming paper, these investors saw a predictable spread
between low funding costs created by the Fed and the return on higher yielding
but safe assets. They too wanted more AAA-rated assets to invest in so that they
could take advantage of this spread that would be around for a "considerable
period." Here too, the U.S. financial system responds by transforming risky
assets into safe assets.
There is another way the Fed's low interest rate policy increased the demand for
safe assets during the housing boom. The Fed controls the world's main
reserve CURRENCY and many emerging markets are formally or informally
pegged to dollar. Thus, its monetary policy is exported across much of the globe-it is a monetary superpower. This means that the other two monetary powers,
the ECB and the Bank of Japan, are mindful of U.S. monetary policy lest
their CURRENCIES becomes too expensive relative to the dollar and all the other
currencies pegged to the dollar. As as result, the Fed's monetary policy gets
exported to some degree to Japan and the Euro area as well. In the early-to-mid
2000s, those dollar-pegged emerging economies pegged were forced to buy
more dollars when the Fed loosened monetary policy with its low interest rate
policies. These economies then used the dollars to buy up U.S. debt. This
increased the demand for safe assets. To the extent the ECB and the Bank of

Japan were also responding to U.S. monetary policy, they too were acquiring
foreign reserves and channeling credit back to the U.S. economy. Thus, the
easier U.S. monetary policy became the greater the demand for safe assets and
the greater the amount of recycled credit coming back to the U.S. economy. This
is an important but overlooked point in most discussion about how the Fed's low
interest rates contributed to the housing boom.

Second, the claim that "all available evidence" point to a small effect ignores
some studies that actually reach the opposite conclusion. For example, there
are two studies by Rudiger Ahrend et. al that show low interest rates, specifically
ones lower than those prescribed by the Taylor Rule, in conjunction with rapid
financial innovation were very important to the housing boom for most of the
OECD countries. Here is one graph from the papers that makes this point:

Another study that finds contrary evidence is Eickmeier and Hofmann (2010) who
use a factor-augmented VAR to show that monetary policy not only affected
house prices, but also credit spreads and debt levels.
Third, one problem with using VARs for this analysis, as is done in the Kuttner
paper, is that they show the effect of a monetary policy shock. Such shocks,
however, have become notoriously hard to identify over the past few decades in
VARS because Fed actions have become so much more transparent and
predictable, and also because monetary policy has become better at responding
to output shocks (at least prior to the Great Recession). As a result, shocks to the
federal funds rate show much milder effects on other variables (See Boivin and
Giannoni, 2006). Also, even if one is capable of properly identifying shocks, it
seems the real problem was more the sustained shift in monetary policy--the
2002-2004 easing cycle--that cannot really be called a shock per se. Maybe one
can call it a series of shocks or change in systematic monetary policy, but the
point is not to look at one impulse response function and draw conclusions, but
look at the cumulative effect of this easing cycle and its contribution to the
housing boom. The Eickmeier and Hofmann (2010) study does just that. Among

other things, it runs a counterfactual experiment that allows the authors to see
what part of the housing price boom can be attributed to the Fed's actions, both
shocks and systematic policy. Here is what they find:

The blue line is the combined effect of shocks and systematic policy on housing
prices. The OFHEO house price index shows a large amount of the surge in HOME
prices is because of monetary policy, while the Case-Shiller index shows
somewhat smaller but still meaningfully large role for the Fed. In both cases,
monetary policy only matters for the early-to-mid 2000 period. And that is what
most critics have been arguing: the Fed's policies in early-to-mid 200s
contributed to housing boom of that period.
Now Kuttner's view may one day be vindicated, but before that it happens the
above points need to be addressed.

That Savings Glut vs. Those Low Interest Rates

AUGUST 28, 2013David Howden

TAGS Free MarketsInterventionismMoney and Banking
Five years after the worst financial crisis since the Great Depression, economists
are still starkly divided as to its causes. Perhaps this is not too surprising as we

are now more than 80 years past the Great Depression with little end in sight to
the debate surrounding the causes of that downturn.
Most economists fall into one of two camps when explaining where the
imbalances originated that led up to the current crisis. Austrian School
economists are in the unique position of being able to reconcile these two camps,
even while favoring the first explanation to the second.
The first camp, which includes most Austrian School economists, looks at the
imbalances caused by central bank interest rate policy being set too low for too
long. In this view, artificially low interest rates allowed for erroneous capital
investments following the dot-com bust of 2001, and continuing to the present
time.
The Federal Reserves artificial reduction of interest rates (to use the U.S. as a
proxy for the Western world) put in motion two shifts in the economy. The first
was the decrease in savings by Americans, and a corresponding consumption-led
boom (what Mises called overconsumption). The second was the overall
decrease in INVESTMENT and production in the lower stages of the capital
structure, with a corresponding increase in investment and production in the
higher stages. This shift is what Mises termed malinvestment. Note that this
shift does not represent an overinvestment in capital, as is commonly and
erroneously claimed by non-Austrian economists, but rather a temporal shifting of
productive activity from stages closer to consumption to those further away.
Specifically, we see malinvestment in the large-scale shift of capital away from
manufacturing in favor of higher-order research and development.
Overconsumption, on the other hand, is illustrated by the rise of consumer
culture embodied by big box stores and a plethora of SHOPPING malls and
outlet stores.
In the opposite camp are the economists favoring the excess savings view or
the global savings glut hypothesis. These economists view the crisis as a result
of current account surpluses, primarily in Asian countries, that led to financial
imbalances in Western economies.
As consumers consumed more but the economy restructured itself away from
producing consumer goods, an increase in imports was inevitable. As luck would
have it, developing countries and especially Asian countries were in the
reverse position of the U.S., and years of financial underdevelopment left many of
them with immature financial markets. These Asian countries also proved to be
low-cost producers of many products. As Americans increased their imports from
these countries to feed their own unsustainable consumption-led boom, the net
proceeds in these countries had no developed domestic financial markets
to INVEST in.
In response, these funds were channeled back to U.S. financial markets, and in
the views of those who favor the saving glut theory, this is was set in motion the
unsustainable boom. As time went on, the TRADE surpluses in Asia resulted in
net capital outflows in search of a market to invest in. Western economies that

were the recipients of these capital flows witnessed remarkably low interest rates
and credit booms with a corresponding buildup of debt.
Thus, in the view of proponents of the savings glut theory, the Federal Reserve
was not the cause of lower interest rates, but rather it was a passive observer as
interest rates were lowered exogenously from these foreign sources.
Yet proponents of the global savings glut hypothesis must grapple with one
unanswered question: What caused citizens of Asian countries to increase their
savings rate and destabilize Western economies with their excess capital
outflows? One could take the view that savings rates are exogenously determined
e.g., by animal spirits yet this explanation only pushes the problem one
step back. What determines these animal spirits?
To find a satisfying answer we must look at the role of monetary policy in
determining SAVING rates.
There is no need to look to animal spirits or any ill-defined exogenous force to
explain why developing countries increased their SAVINGS so much during the
boom and funneled these SAVINGS into Western financial markets. The
unsustainable boom propagated by Western central banks set this process in
motion by creating a disconnect between the consumption demands with the
domestic PRODUCTIVE capacity of their economies.
Moreover, the current ire directed at the loss of manufacturing in the United
States is not the result of greedy outsourcers or even CURRENCY
manipulators in Asian countries. The loss of productive capacity in the U.S. is the
outcome of a too-low interest rate policy by the Federal Reserve incentivizing
entrepreneurs to move their investments to the higher stages of production
those furthest from final consumption while simultaneously incentivizing
consumers to increase their present consumption at the expense of savings.
Note: The views expressed on Mises.org are not necessarily those of the Mises
Institute.
Global savings glut or global banking glut?
Hyun Song Shin 20 DECEMBER

2011

It has become commonplace to assert that current-account imbalances were a

key factor in stoking subprime lending in the US. This column says the global
banking glut, i.e. the rise in cross-border lending, may have been more culpable
for the crisis than the global SAVINGS glut. As the European banking crisis
deepens, the deleveraging of the European global banks will have far-reaching
implications not only for the Eurozone, but also for credit supply conditions in the
US and capital flows to the emerging economies.
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A

A
Since Bernankes 2005 speech (Bernanke 2005), it has become commonplace to
assert that current-account imbalances were a key factor in stoking the
permissive financial conditions that led to subprime lending in the US. The
global SAVINGS glut is what Ben Bernanke called it. This phrase provided a
powerful linguistic focal point for thinking about the surge in net external claims
on the US on the part of emerging economies. The biggest worries concern the
financial stability implications of these large and persistent current-account
imbalances.
But maybe the finger is being pointed the wrong way. My recent research
suggests that the global banking glut may have been more culpable for the
crisis than the global savings glut (Shin 2011).
What is the global banking glut?
To introduce the distinction, it is instructive to START with the financial crisis in
Europe. What role did current-account imbalances play there? There are some
superficial parallels with the US in the run-up to the crisis.
The current-account deficits of Ireland and Spain widened dramatically before the
crisis (Figure 1). This despite the fact that Spain and Ireland were paragons of
fiscal rectitude with budget surpluses and low debt ratios (much lower than
Germanys and the Eurozone average in 2006, see Figure 2).
Figure 1. Current account of Ireland and Spain (% of GDP)

Source: IMF International Financial Statistics

Figure 2. Government budget balance and debt-to-GDP ratios of Ireland, Spain
and Germany

To push the analogy with the US further, imagine for a moment that the Eurozone
is a self-contained miniature model of the global financial system. In this
miniature model, Germany PLAYS the role of China, while Spain and Ireland play
the US.
According to the analogy, excess SAVINGS in Germany find their way to Spain
and Ireland where they inflate the property bubbles there. The bubbles
subsequently burst, resulting in the socialisation of private debt through bank
bailouts and precipitating the sovereign-debt crisis.
However, the further we push the analogy, the stranger it gets. According to the
global SAVINGS glut hypothesis, Chinese savers favour US Treasuries because
China lacks deep financial markets that could cater to demands for safe assets. In
the miniature model of the savings glut for the Eurozone, Spanish and Irish bank
deposits play the role of US Treasuries, since current-account imbalances in the
Eurozone were financed through capital flows in the banking sector. To sustain
the analogy, we would need to argue somehow that German savers shunned
bank deposits in Germany to favour bank deposits in Ireland and Spain. Why
would German savers believe that deposits in Spain and Ireland are safer than
those in Germany? At this point, the savings glut analogy strains credulity and
breaks down.

A more plausible narrative is a banking glut associated with the explosive growth
of cross-border lending in Europe, as illustrated by Figure 3 which plots the crossborder domestic CURRENCY lending and borrowing by EZ banks.
Figure 3. Cross-border domestic CURRENCY

assets and liabilities of EZ banks

Source: BIS Locational Banking Statistics, Table 5A

There is a mechanical jump in the two series at the start of 1999 with the launch
of the euro, as previously foreign-CURRENCY lending and borrowing are
reclassified as being in domestic currency (i.e. euros). But from 2002, crossborder bank lending saw explosive growth as the property booms in Ireland and
Spain took off and as European banks expanded their operations in central and
Eastern Europe.
What drove European banks to do this? By eliminating CURRENCY mismatch on
banks balance sheets, the introduction of the euro enabled banks to draw
deposits from surplus countries in their headlong expansion. Meanwhile, the
permissive bank-capital rules under Basel II removed any regulatory constraints
that stood in the way of the rapid expansion. To be fair, the permissive bank riskmanagement practices epitomised by Basel II were already widely practised

within Europe before the formal introduction, as banks became more adept at
circumventing the spirit of the initial 1988 Basel Capital Accord.
Compared to other dimensions of economic integration within the Eurozone,
cross-border mergers in the European banking sector remained the exception
rather than the rule. Herein lies one of the paradoxes of Eurozone integration.
The introduction of the euro meant that "money" (i.e. bank liabilities) was freeflowing across borders, but the asset side remained stubbornly local and
immobile. As bubbles were local but money was fluid, the European banking
system was vulnerable to massive runs once banks STARTED deleveraging.
Europes crisis: A banking crisis first, a sovereign-debt crisis second
The banking glut hypothesis is a better perspective on the current European
financial crisis than the savings glut hypothesis. The crisis in Europe is a banking
crisis first, and a sovereign-debt crisis second. It carries all the hallmarks of a
classic "twin crisis" that combines a banking crisis with an asset-market decline
that amplifies banking distress. In the emerging-market twin crises of the 1990s,
the banking crisis was intertwined with A CURRENCY crisis. In the European
crisis of 2011, the twin crisis combines a banking crisis with a sovereign-debt
crisis, where the mark-to-market amplification of financial distress worsens the
banking crisis.
The banking glut in Europe was part of a global phenomenon, as documented in a
recent paper delivered as this years Mundell-Fleming lecture at the IMF (Shin
2011). Effectively, European global banks sustained the shadow banking
system in the US by drawing on dollar funding in the WHOLESALE market to
lend to US residents through the purchase of securitised claims on US borrowers,
as depicted in Figure 4.
Figure 4. European banks in the US shadow banking system

Although European banks' presence in the domestic US commercial banking

sector is small, their impact on overall credit conditions looms much larger

through the shadow banking system. The role of European global banks in
determining US financial conditions highlights the importance of tracking gross
capital flows in influencing credit conditions, as emphasised recently by Borio and
Disyatat (2011). In Figure 4, the large gross flows driven by European banks net
out, and are not reflected in the current account that tracks only the net flows.
The netting of gross flows shows up in Figure 5, which plots US gross capital flows
by category. While official gross flows from current-account surplus countries are
large (grey bars), we see that private-sector gross flows are much larger.
Figure 5. Gross capital flows to/from the US

Source: US Bureau of Economic Analysis

The downward-pointing bars before 2008 indicate large outflows of capital from
the US through the banking sector, which then re-enter the US through the
purchases of non-Treasury securities. The schematic in Figure 4 is useful to make
sense of the gross flows. European banks' US branches and subsidiaries drove the
gross capital outflows through the banking sector by raising WHOLESALE
funding from US money-market funds and then shipping it to headquarters.
Remember that foreign banks' branches and subsidiaries in the US are treated as

US banks in the balance of payments, as the balance-of-payments accounts are

based on residence, not nationality.
European banks: Gross flows and US pre-crisis credit conditions
The gross capital flows into the US in the form of lending by European banks via
the shadow banking system will have PLAYED a pivotal role in influencing credit
conditions in the US in the run-up to the subprime crisis. However, since the
Eurozone has a roughly balanced current account while the UK is actually a deficit
country, their collective net capital flows vis--vis the US do not reflect the
influence of their banks in setting overall credit conditions in the US.
The distinction between net and gross flows is a classic theme in international
finance, but deserves renewed attention given the new patterns of international
capital flows (see, e.g., Borio and Disyatat 2011). Focusing on the current account
and the global SAVINGS glut obscures the role of gross capital flows and the
global banking glut.
Net capital flows are of concern to policymakers, and rightly so. Persistent
current-account imbalances hinder the rebalancing of global demand. Currentaccount imbalances also hold implications for the long-run sustainability of the
net external asset position. For the US, however, the current account may be of
limited use in gauging overall credit conditions. Rather than the global SAVINGS
glut, a more plausible culprit for subprime lending in the US is the global banking
glut.
As the European banking crisis deepens, the deleveraging of the European global
banks will have far-reaching implications not only for the Eurozone, but also for
credit supply conditions in the US and capital flows to the emerging economies.
Just as the expansion stage of the global banking glut relaxed credit conditions in
the US and elsewhere, its reversal will tighten US credit conditions. Its impact in
the emerging economies (especially in emerging Europe) could be devastating. In
this sense, there is a huge amount at stake in the successful resolution of the
European crisis, not only for Europe but for the rest of the world.
References
Bernanke, Ben S. (2005) "The Global Saving Glut and the U.S. Current Account
Deficit", Remarks at the Sandridge Lecture, Virginia Association of Economists,
Richmond, Virginia, March 10, 2005,
Borio, Claudio and Piti Disyatat (2011) "Global imbalances and the financial crisis:
Link or no link?" BIS Working Paper 346
Shin, Hyun Song (2011) Global Banking Glut and Loan Risk Premium 2011
Mundell-Fleming Lecture,
Why a savings glut does not increase savings
By Michael Pettis May 8, 2014 Consumption, Income inequality 48 Comments

Debate about the global savings glut hypothesis is mired in confusion, a

fundamental one of which is the seemingly obvious but false claim that a global
savings glut must lead to higher global savings. Here, for example, is a recent
piece by one of my favorite economists, Barry Eichengreen:
There is only one problem: the data show little evidence of a savings glut. Since
1980, global savings have fluctuated between 22% and 24% of world GDP, with
little tendency to trend up or down.
As surprising as it might sound, global savings gluts do not result in higher global
savings except under specific, often unlikely, conditions.
What is a savings glut?
There is no formal definition, but whenever market conditions or policy distortions
cause the savings rate in one part of the economy to rise excessively (itself an
ambiguous word), we can speak of a savings glut. There are at least two main
causes of a savings glut.
1. A rise in income inequality. We see this in Europe, the US, China, and
indeed in much of the world. As wealthy households increase their share of
total income, and because they tend to save a larger share of their income
than do ordinary households, rising income inequality forces up the
savings rate.
2. A decline in the household share of GDP. Weve seen this mainly in China
and Germany over the past fifteen years. When countries implement
policies that intentionally or unintentionally force down the household
share of GDP (usually to increase their international competitiveness) they
also automatically force down the consumption share of GDP. Because
savings is defined as GDP minus consumption, forcing down the
consumption share forces up the savings share. There are many policies
and conditions that do this, and I discuss these extensively in my book,
The Great Rebalancing, but the main ones are low wage growth relative to
productivity, financial repression, and an undervalued currency .
Notice that in both these cases, and completely contrary to the popular narrative
that praises high savings as a consequence of household thrift, and so as morally
virtuous, the rise in the savings rate does not occur because ordinary households
have become thriftier. In the former case household savings rise simply because
the rich increase their share of total income. In the latter case national savings
rise without households in the aggregate increasing their savings.
How does the economy balance?
An economys total production of goods and services (GDP) can be defined either
from the demand side (consumption plus investment ) or from the supply side
(consumption plus savings). By definition, in other words, savings is always
exactly equal to investment.

An economy experiencing a savings glut must maintain this balance. It is

consequently just a matter of logic that a savings glut must be accompanied by a
balancing adjustment either by an increase in investment or by a reduction in
savings in another part of the economy and this adjustment must occur
simultaneously. The necessary implication is that whatever causes the savings
glut must also cause one or both of these balancing adjustments.
There are only two ways investment can rise and two ways savings elsewhere
can drop. This means that a savings glut must result in one or more of the
following, enough fully to offset the savings glut:
1. If productive investment has been constrained by the lack of savings,
productive investment will rise.
2. Nonproductive investment can also rise. Excess savings can cause large
speculative flows into real estate or other assets, perhaps even setting off
asset bubbles. When this happens it can create additional investment
outlets for excess saving in the form of projects, including most often real
estate projects, whose economic value can only be justified by rising price
expectations.
3. Rising asset prices can unleash a consumption boom if it causes ordinary
households to feel wealthier and so increase their consumption (the
wealth effect). This increased consumption creates what I will call,
perhaps clumsily, a consumption glut.
4. If less consumption caused by the savings glut is not matched by higher
investment or by a consumption glut, total demand drops, resulting in
higher unemployment. Unemployed workers stop producing goods and
services but do not stop consuming. Because savings is simply the gap
between production and consumption, unemployment causes the savings
rate to drop.
Economists almost always miss this point. A global savings glut must be
accompanied by one or more of the four adjustments listed above. It can result in
higher global savings if the economy rebalances in the form of higher productive
or unproductive investment, or it can result in no change in the global savings
rate if the economy rebalances in the form of a consumption glut or a rise in
unemployment. Nothing else is possible.
The best outcome is if a savings glut is accompanied by higher productive
investment. This is often referred to as trickle down economics when both the
rich and the poor benefit from productive investment, with the rich benefitting
more.
If there is a savings glut, will productive investment automatically increase? If
productive investment has been constrained by low savings it will, but productive
investment tends to be constrained by insufficient savings mostly in undeveloped
countries. Most excess savings, however, have originated or flow into rich
countries.

In rich countries there are often many productive projects that desperately await
investment, but this failure to invest is driven by other factors, and usually not by
the lack of savings, so that a savings glut is unlikely to lead to higher productive
investment*. Former Fed Chairman (1934-48) Marriner Eccles even argued that a
savings glut could reduce productive investment. By taking purchasing power
out of the hands of mass consumers, he wrote, the savers denied to
themselves the kind of effective demand for their products that would justify a
reinvestment of their capital accumulations in new plants.
More commonly when excess savings are high they flow into real estate and
stock markets, perhaps even setting off bubbles, with overinvestment in real
estate an almost inevitable consequence of rapidly rising housing prices (we saw
this most obviously in peripheral Europe, the US and China). These speculative
flows have another impact that allows the economy to balance savings and
investment. The real estate bubble makes households feel wealthier, which
encourages a consumption glut, so that between the real estate boom and the
consumption glut, the savings glut is fully absorbed.
But this is temporary. When the asset bubbles burst, the resulting surge in
unemployment brings down the savings rate enough again to maintain the
balance between savings and investment.
Savings must balance
The point here is that a savings glut need not result in an overall rise in savings.
It can just as easily cause a consumption glut elsewhere whose positive impact
on total demand fully mitigates the negative impact of the savings glut. The idea
however that a savings glut can simultaneously create a consumption glut seems
to be one of the most difficult things for many economists to understand, perhaps
because it seems at first so counterintuitive.
Of course the other way a savings glut need not result in an overall rise in
savings is through higher unemployment. In fact because neither an asset bubble
nor a consumption glut is sustainable, unless productive investment has been
constrained by a lack of savings, the only long-term consequence of a savings
glut is a rise in unemployment and no rise in total savings.
In that case there might be only two sustainable ways to address the resulting
unemployment. Either the savings glut is reversed, or governments act to
eliminate whatever were the previous constraints on productive investment
(perhaps by liberalizing constraints to investment or even by initiating a kind of
new deal in infrastructure investment). The third way, although not sustainable,
is for another asset bubble to be inflated so as to encourage another
consumption glut, which seems currently to be the preferred way of US and
European governments.
Which way is the causality?
It is just a matter of logic that unless investment rises substantially, a savings
glut must combine with a consumption glut or with a surge in unemployment so

that there is no net increase in savings. But logic only tells us that the two must
occur simultaneously. It implies no obvious direction of causality. Does a savings
glut cause a consumption glut, or does the consumption glut cause the savings
glut? To put it in contemporary terms:
1. Did Chinese policies aimed at forcing up domestic savings (by forcing down
the household income share of GDP) set off a consumption glut in the US,
or did profligate US consumption require that Chinese savings rise to
accommodate it?
2. Did German policies aimed at restraining workers wages force up the
German savings rate, with excess savings pouring into peripheral Europe,
setting off real estate bubbles, which then set off consumption gluts, or did
over-enthusiasm about the euro cause overly confident citizens of
countries like Spain to embark on a consumption binge, which could only
be balanced by a rise in the German savings rate?
One way of resolving these questions might be to examine the cost of capital.
Pulling capital from low-savings to high savings parts of the economy might seem
to require high interest rates. Pushing capital from high-savings to low-savings
parts of the economy might seem to require low interest rates.
There is so much misunderstanding about the savings glut hypothesis that much
of the debate has verged on the nonsensical. Unless it unleashes a truly heroic
surge in investment productive or nonproductive, although the latter can only
be temporary a savings glut must always be accompanied either by a
consumption glut elsewhere or by a rise in unemployment. No other option is
possible. This is why savings gluts rarely result in higher overall savings.
This is also why any serious discussion of the savings glut must eschew
moralizing and must focus instead on the direction of causality. Did distortions
that created a savings glut force the creation of a consumption glut, or did
distortions that created a consumption glut force the creation of a savings glut?
Any analysis that does not recognize that both must occur simultaneously, and so
must be resolved simultaneously, cannot possibly be correct.

Academics, journalists, and government and NGO officials who want to subscribe
to my newsletter, which sometimes includes portions of this blog and sometimes
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write to me, also at that address.

* Perhaps in cases in which investment has been constrained by high interest

rates, higher savings can unleash more productive investment. It may also be,

although I cannot prove it, that when income inequality is low, higher savings
associated with further increases in inequality can lead to more productive
investment in part because interest rates might be high. In that case it would
seem that when income inequality is high, higher savings associated with further
increases in inequality will not lead to more productive investment.
Do we understand the math behind the PPP calculations?
Some things to consider if Spain leaves the euro
48 Comments
Add your comment

1.
Michael Pettis May 8, 2014 at 7:19 am
P.S. There may be many reasons to dispute the argument and the reasoning in
this essay, but in a fractious political climate in which groups are defined by the
positions they unalterably oppose, I suspect that this essay is likely to be disliked
for reasons that often have nothing to do with the actual logic of the argument:
Libertarians reject the implication the income inequality can lead to
unemployment.
Statists reject the implication that a disproportionate government share of GDP
can lead to unemployment (either at home or, although this is not fully explained
in this essay, abroad if the savings are exported).
One faction of Euro supporters rejects the implication that the European crisis
was caused by Germanys forcing down wages.
Conservatives reject the claim that trickle-down economics works only under
very specific, and often unrealistic, conditions, and they especially reject the
claim that a governmentled infrastructure investment push is one of the ways
trickle-down can work in developed countries.
Liberals reject the implication that income inequality can under certain
conditions sustainably increase growth, either in undeveloped countries or in
developed countries in which interest rates are high enough to constrain
productive investment.
Monetary doves reject the idea that monetary expansion might be reducing
unemployment in the US and Europe mainly by reigniting asset bubbles and
consumption gluts.
Many people reject as immoral any suggestion that more savings is not better
for an economy or that more consumption can be good.
Any discussion of the savings glut presses too many hot buttons for the
discussion to be useful.
Debunking The Global Savings Glut Theory

Is paper money created by the worlds central banks responsible for

the global imbalances that destabilized the economy?
By Richard Duncan, July 12, 2012

Purchase The New Depression on Amazon.com.

Takeaways

Instead of acknowledging its own complicit if not actively steering

role in the global money explosion, the Federal Reserve prefers to blame
others.

Savers should not be blamed for saving the money they have earned.
Central banks are to blame.

The paper money that the central banks have created has played a leading
role in bringing the world economy to the brink of catastrophe.

It is high time, Mr. Bernanke, instead of playing the innocent bystander, to

acknowledge the chaos you have wrought.

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The global savings glut theory, embraced by no one more prominent than Ben
Bernanke, the chairman of the U.S. Federal Reserve, attributes the global
imbalances not to a U.S. propensity to overconsume. Rather, the supposed root
cause of all evil is the flood of foreign capital into the United States, and hence
perplexingly the propensity of certain countries to save too much.
Traditionally, trade imbalances were understood to be caused by differences in
national levels of saving and investment. National savings are comprised of the

savings of three sources the household sector, the business sector and the
government sector. Investment is made up primarily of investments in factories
and equipment, as well as residential investment, the building of houses and
apartment buildings.
The rationale for attributing the trade imbalance to the difference in national
levels of savings and investment runs as follows. If a country invests more
than it saves, then that country can borrow from abroad to finance that gap.
In that case, that country would have a surplus on its financial account and (since
the balance of payments must balance) a deficit on its current account. In other
words, a country that invests more than it saves will have a current account
deficit.
Investment

> Savings = Current Account Deficit

Conversely, a country that saves more than it invests, can lend its surplus
savings to other countries. It then will have a financial account deficit (money
flows abroad) and (again, since the balance of payments must balance) a current
account surplus. Thus, a country that saves more than it invests will have a
current account surplus.
Savings > Investment = Current Account Surplus
Bernanke has often used this reasoning to explain the United States massive
current account deficit. Some countries like China, he argues, save more than
they invest, causing them to have a current account surplus and a glut of savings
that they need to lend abroad to savings deficient countries like the United
States.
This allows the United States to borrow from abroad and invest more than it
saves, which produces the U.S. current account deficit.
Bernanke often used this argument to explain away the U.S. current account
deficit, even as it grew to terrifying proportions. It peaked at $800 billion in 2006.
Bernanke liked to explain that countries like China, Japan, Korea and Taiwan had
such a high propensity to save that it simply wasnt possible for them to find
profitable investment opportunities for so much savings in their own countries.
This assertion is at least somewhat astounding, given the very high rates of
economic growth that most of those countries experienced. Either way, in this
view they were compelled to lend to the United States, thereby causing
Americas massive current account deficit. That line of reasoning became known
as Bernankes global savings glut theory.
That argument ignores one very important fact: Most of the money those
countries invest in the United States is not derived from savings. The money
those countries invest is newly created fiat money.

When the Peoples Bank of China (PBOC), Chinas central bank, created $460
billion worth of yuan in 2007 to manipulate it currency by buying dollars, that
$460 billion worth of yuan was not saved, it was created from thin air as part of
government policy designed to hold down the value of its currency so as to
perpetuate Chinas low wage trade advantage.
That is a very important difference. It introduces a third variable in addition to
saving and investment, fiat money creation. Therefore, the equations
expressing the determinants of the balance on the current account must be
rewritten as follows:
(Savings + Fiat Money Creation) > Investment = Current Account
Surplus
When a countrys savings when combined with the paper money created by its
central bank exceeds the amount of its investment, then that country will have a
current account surplus that will force other countries that do not create as much
paper money to have current account deficits. And,
Investment > (Savings + Fiat Money Creation) = Current Account Deficit
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up here.
Thus, it has not been a savings imbalance so much as an imbalance in the
amount of paper money being created by the worlds central banks that is
responsible for the global imbalances that destabilized the world.
Seen in this light, it is clear that the paper money creation by the PBOC and other
currency manipulating central banks, which amounted to nearly $5 trillion
between 1999 and 2007 alone, is responsible for destabilizing the world economy
but not differences in the rate of real savings as Bernanke contends.
Chinas economy has been growing at roughly 10% a year for two decades. It has
the highest level of investment relative to GDP any country has ever experienced
(46% in 2009). It is absurd to argue that there are not enough attractive
investment opportunities in China to absorb its savings and that China therefore
is compelled to lend its surplus savings to the United States.
The truth is that Chinas central bank prints yuan and uses it to buy dollars in
order to hold down the value of the yuan to support export-led growth. It is the
dollars that the PBOC accumulates in that manner that are lent to the United
States.
The money China pumps into the United States has had effects that most U.S.
policymakers consider very welcome and are keen to achieve. Chinese funds
drove up asset prices, drove down interest rates and made funds available for a
wide range of malinvestment, especially in housing.

In the years leading up to the crisis, it fuelled a credit bubble that pacified the
Americans who were losing their manufacturing jobs to low-wage Chinese
competitors.
Think of the Federal Reserves actions since 2008. In two rounds of Quantitative
Easing, the Fed created $2.3 trillion. That money is now on the Feds balance
sheet. It is considered to be part of the U.S. monetary authoritys assets.
Is it savings? Did the Fed save $2.3 trillion? Of course not. It printed that
money.
That is exactly what The Peoples Bank of China, The Bank of Japan, The Bank of
Korea, The Central Bank of the Republic of China (Taiwan) and a long list of other
central banks have been doing for many years.
But instead of acknowledging its own complicit if not actively steering role in
the global money explosion, the U.S. Fed prefers to blame others.
But either way one wants to cut it, there has been a glut. Of that there can be no
doubt. But it has been a paper money printing glut, not a savings glut.
Savers should not be blamed for saving the money they have earned. Central
banks are to blame and should be held accountable for printing money,
manipulating their currencies and destabilizing the global economy.
The paper money that the central banks have created has played a leading role
in bringing the world economy to the brink of catastrophe.
The extent to which the U.S. government has been complicit in this arrangement
is uncertain. There can be no question, however, that the government found it
easier to finance its massive budget deficits as a result of those inflows.
There can also be no doubt that this arrangement is responsible for the hollowing
out of the United States manufacturing base, the current high rates of U.S.
unemployment and the unprecedented duration of joblessness among those who
are unemployed.
In other words, its high time, Mr. Bernanke, instead of playing the innocent
bystander, to acknowledge the chaos you have wrought.
Editors note: This article is adapted from The New Depression: The
Breakdown of the Paper Money Economy (John Wiley & Sons) by Richard
Duncan. Published by arrangement with John Wiley & Sons. Copyright 2012 by
Richard Duncan