Savings, Production and Net Exports: Part III

Low interest rates due to low saving rates have produced large negative net exports (-6% of GDP in 2006) and large debt accumulation.  Large debt accumulation is the result of a high consumption rate (currently around 70% of GDP) produced in part by readily available credit.  Unemployment, both structural and temporary, is a lot like a residual effect.

The increase in net imports leads to the erosion of manufacturing jobs.  Debt accumulation leads to the erosion of construction and retail jobs.  Both cheap imports and (cheap) readily available credit allow the consumption rate to rise higher.

Exporting countries benefit from US credit availability by acquiring US paper currency for its exports at the benefit of low unemployment.  As long as the exporters produce more than they can consume and as long as the US can consume more than it produces, unemployment and savings should balance.

In the wake of the financial crisis, the US cannot expand its credit availability, and instead is at all levels - from households to government - cutting back on debt accumulation.  Because the US cannot indebt itself to buy cheap imports, exporting countries must deal with rising unemployment as an effect of a stagnation in the US consumption rate.

So who benefits more: China or the US?

Savings, Production and Net Exports: Part II

When household budgets are reduced, households will have extra spending money as long as household income has not declined.  So even with a stagnant income, low-cost imports can reduce household budgets, thereby freeing up extra spending money.

Such a reduction in household budgets is like a wealth effect in which households can withdraw savings at a rate proportional to the reduction in their budget.  Like any other wealth effect, it can be argued that as households acquire extra spending money, they become more cavalier with savings.

In the US since the early-1980s, the personal saving rate and the interest paid on savings have declined in the long-term.  It should reason that the personal saving rate should be higher as the interest earned on savings declines - whatever cannot be paid through interest must be saved, or at least should be saved.  However, as interest rates on savings declines so does the cost of borrowing.

As the saving rate (green) declines, the cost of borrowing (black) goes down.

Savings, Production and Net Exports: Part I

S - I = 0; saving is the supply of investment.  Nations with surplus savings tend have low consumption rates and are therefore net exporters; nations with deficient savings tend to have high-consumption rates and are therefore net importers.  Those relationships must make sense if we are to believe there is a balance between supply (saving) and demand (consumption).

China's GDP is primarily built around investment (~50% of GDP) while the US's GDP is primarily built around consumption (~70% of GDP).

China, because of its low consumption rate relative to its production, has surplus savings which it exports.  The US, because of its high consumption rate relative to its production, has deficient savings and relies on imports to meet demand.

In places like the US, low cost imports reduce household budgets, thereby freeing up some extra spending money.  Otherwise, much like a wealth effect, the US struggles against deflation in a balance against Chinese labor unemployment.

Household Balance Sheet - Equity

Something I have written about in the past: the household balance sheet.  We know that Equity = Assets - Liabilities.

Household equity - derived from the household balance sheet

I look at equity as a measure of expectations - the implied income less debt.  The adage of buying a house for investment means you must sell your house.  If you happen to live in the house it means you must seek another domicile.  I'm sometimes not sure if that makes any investment sense, though I could see the case that a house may be a store of value.

I focus on households because we all belong to a household - whether that means you have a warm, loving family at home or you are a single, poor and miserable individual living on the street.  Not everyone belongs to a business - some of us are retired, unemployed or in some way or another not part of a business.  Of course, we all live within a nation, governed on our behalf by non-elected or elected rulers, but we are not the government.

Household equity divided by disposable personal income (blue); household equity divided by gross domestic product (red).

The Great Re-Rotation

There is an investor rotation underway (preference-pivoting) - from bonds to equities - so I have read.  The story goes that investors are questioning bonds and would rather risk money in equities for yield.  The US federal deficit contracted in real terms in the fourth quarter of 2012.  Equity risk over cash (no yield) is a liquidity trap with no escape for NPL ridden China.

Federal spending (blue); federal taxes (red); federal deficit (green).

Are the bond markets speaking to us?  Are they telling us that they are tired of making risk free money at the expense of reflated balance sheets (on the asset side); that the federal government must reduce its deficit to appease their yield desires?

Didn't this happen in the 1990s?

Michael Pettis' New Book

I have just finished the first two chapters of Michael Pettis' most recent book, The Great Rebalancing.  A fan of his blog, I am expecting great things from his book.  Of course, to no surprise, the book does not stray far from his blog.
 

The first chapter is a foreword outlining the points of interest, in regard to international monetary economics, that Pettis will address.  It is a good introduction to the type of thinking that is needed in discussion of exchange rate regimes - whether they be float, basket, peg, crawl or some other kind.

 

Pettis states that "foreign reserves by definition cannot be spent at home, and so the real value of foreign reserves is the value of things a country can do with the reserves abroad", alluding to why a nation would ever have the motivation to acquire fiat currency.  The American dollar therefore is not an asset for China anymore than what can be used to purchase certain goods and services with the dollar.

Even in the US, Chinese possession of dollars is viewed as a pretense toward nationalism while the simultaneous acquisition of Chinese goods is viewed as a pretense toward boasting of the fruits of globalization.  The idea that the Chinese will "dump the dollar" is preposterous in light of the huge trade surplus the Chinese have with America.

Saying that China will not use American dollars but in the mean time they will continue to acquire American dollars, is a nonsensical idea.  Instead, what makes sense is that the Chinese must buy assets denominated in dollars.  Therefore, the Chinese must have some kind of motivation toward acquiring dollars, even beyond purchasing key commodities - such as oil.

 

That is how Pettis' book reads.  With his straight forward explanations of currency regimes, one must then begin to ask how and why does China want to buy so many treasuries?

There must be a high rate of saving in China to explain their ability to buy dollars, and there is, especially at the household level.  Pettis argues correctly that the high saving rate amongst households is not an effect of cultural beliefs but one of household income erosion.  As Pettis states:

Twenty or thirty years ago, most Chinese belonged to a work unit, which took care of their employment, their educational expenses, their medical needs, and their retirement.  As part of China's liberalization, most of these benefits were lost.  This loss represented, effectively, a transfer of wealth from households to the state since what was once a government liability became a household liability.

When Chinese society functioned under communist influence, rural work communes dominated the economy, which provided education, healthcare and work as basic social services.  The Chinese citizenry under the influence of the rural commune had a greater social safety net than they presently have under capitalist influence, albeit one of dubious crony distinction.  Pettis continues:

It is this reduction in household wealth, relative to the country's overall production of goods and services, which forced up the savings rate.  Chinese households, in other words, consumed less than they otherwise might have because their wealth decreased in relative terms thanks to the erosion of their social safety net, and this automatically forced up the saving rate.

 The state, otherwise known as corporations (controlled by the wealthy elite), has skimmed wages from the overcapacity of the Chinese labor class.  Former rural peasants, in exchange for the industrialization of their society and their often migratory status, have placed a greater burden on themselves to protect their own diminishing wealth.  This transfer must be rebalanced in the form of higher household income; depending on how this is done, higher incomes need not lead toward higher cost exports.

Quite clearly, what this means, according to Pettis, is that "the implementation of a social safety net has to be paid for not by Chinese households but rather by the state sector".  Being an economist, Pettis alludes to the fact that as the state sector's income share grows relative to the household sector's share, any social safety net that raises consumption must come from the state sector as a transfer.

Not being a political scientist, Pettis does not say that the politburo must tax itself to pay for the peasants' social safety net - though I imagine this is what he is truly stating.  However, he goes on to say that an increase in worker wage relative to productivity growth can offset inequality.  I think Michael Pettis is hitting on the correct issues, social issues which pervade every and all societies.

All Roads Lead To Rome

Years ago, I read through a very old book about the Romans - an ancient trade-based society in the Mediterranean basin.  The first page I read, at random, contained a conversation between a senator and his friend on how they, the Romans, were sending their money to foreign lands - often hostile to Rome.
 

This was not good for the Romans, not because they did not have enough money to send abroad, but because the protection of their economic system lead to the debasement of their currency.  Rome operated on the principal of tribute, hidden as a command economy based on cross-border trade.  Taxes had to be paid to Rome for protection from hostile threats, and taxes had to be paid in Roman currency.

 

The Romans naturally had to send their money to foreign lands in exchange for goods, so protectorates could acquire currency to pay their taxes.  How else were these states to acquire currency?  And who else was there to keep these states safe from unwanted threats?

   Circo Massimo in Rome with the Domus Agusti (House of Augustus) in the

   background just behind the tree line.  Courtesy of the street level view at

   Google Maps.

Nearly two millennium later the Roman system has become an outdated, arcane and  absolutely abhorred artifact of economic history.  However, the cross-border trade, pioneered by Phoenician merchants, and  perfected by Roman legions, is a live in the Pacific base.

Americans send their money to foreign lands, at times up to 6% of GDP, and often times to hostile lands.  This is not because America demands tribute but because Americans are the most efficient users of capital, and foreign lands, especially poor developing nations, require investment to build their economies to developed-nation status.

Actual disposable income percent (blue); net exports as percent of GDP (black).

Before the Great Recession, American households had 30% more debt than they did disposable income.  Households' actual disposable income was gone and in its place, substituted, was debt.  Of course, Americans are creditworthy and have no problem obtaining credit.  Credit is the fuel of the modern economy but debt is the dead weight which kills fuel efficiency.

Actual disposable income.

Since the Open Door policies of Deng Xiaoping, Americans have been unfairly placed at the mercy of cheap Chinese imports.  It is obvious that economist have paid too much attention to the wealth effect of stock markets and house prices, those assets of concern for the wealthiest of Americans, and not enough to the budgetary wealth effects of cheap imports, one in which affects all Americans.  This third type of wealth effect has lead toward an increase in personal consumption as a percent of GDP, in which domestic manufacturing is sent abroad at the expense of increased indebtedness of the household.

 

 

Even with stagnant wages, Americans feel richer as the breadth of available cheap imports reduces their spending bill at large retailers, such as Walmart.  As Americans "save" through the purchase of cheap imports, they are then able to acquire previously unattainable assets, such as financial wealth through the acquisition of credit.

The poor developing nations, through which Americans "save", acquire trade once designated for more developed nations, which causes another type of wealth effect.  This cycle in many ways fuels credit consumption in the form of consumer credit in the US and industrial investment in China.

The greatest emphasis for China will be to balance its inflation and employment through sectoral shifts.  This has been given the guise of "domestic consumption" by mainstream media.  But, because all roads lead to Rome, China will create additional overcapacity separate from American consumption.  One which cannot be consumed by the American household - the military industrial complex.

That Was Unexpected

The personal saving rate shot up from 4.1% in November to 6.5% in December, and has nearly doubled from its September level of 3.3%.  What gives?  Stagnant unemployment; government spending cuts; fiscal cliff/debt ceiling?

Personal saving rate: 6.5%!

Why Are Federal Funds Better Than Discount Rates?

The interest paid on required reserves and excess reserves is the same.  The spreads between the discount rate and the fed funds rate is not the same.

Excess reserve rate-Discount Window Rate spread (blue); excess reserve rate-Fed funds rate spread (red); excess reserves (green).

For a bank, borrowing money from the lender-of-last-resort (the Federal Reserve) is less profitable than borrowing from a primary dealer.  So, if you are a primary dealer, holding excess reserves and lending amongst other primary dealers is a good option.  This makes it easier for banks to sell and forget (quantitative easing) than to enter into a bond with the Federal Reserve.

 

The Fed has taken on many mandates from congress and the president since its inception.  It is now the lender-of-last-resort, inflation/price-control warden, employment creator, money supply master, central banker to central banks, and of course (through open market operations) the interest rate trend-setter.

M2 money supply (blue), unemployment (red), fed funds (green), primary window rate (orange), and inflation (purple).

The Federal Reserve sure has a lot to keep itself busy.

Stagreflation and Unemployment

One benefit of rising asset prices is the wealth effect; also, businesses will begin hiring when their balance sheets are no longer underwater.  Household real estate assets increased year-over-year in 2012.  Residential investment increased some but not enough to justify the increase in assets which were propelled higher by low inventories.

Household real estate (blue); unemployment (red).  Household real estate values are growing - helping to bring household balance sheets into the positive.

Median sales price of houses (green); unemployment (red).  Rising real estate prices in a low-inventory housing market have helped raise household real estate values.

S&P 500 (black); unemployment (red).  Stock prices rise as cash flow and asset prices increase; business activity picks up and businesses begin hiring again.

Unemployment initially benefited from the reflation in asset prices, but during the last quarter of 2012 unemployment was stagnant while real GDP declined.  The initial reason for negative real GDP was placed on a decline in real government consumption and investment; however, real gross private domestic investment (not as large) declined in real terms but not by as much as real government consumption and investment.

Real gross private domestic investment (blue); real government consumption expenditures and investment (red).

To be fair, the next round of quantitative easing, by its true definition, has only recently begun and may have the expected impact on unemployment that the earlier rounds had.

QE 3.0 began in January.