Phelps On Global Imbalances: I Find Much To Be Thankful For

Edmund Phelps responds to a recent column by Martin Wolf discussing the relative strengths of the "money glut" and "savings glut" hypotheses as explanations for global imbalances. While he agrees with Martin Wolf and favors the savings glut explanation, he disagrees with the contention that it was necessary for the U.S. to run a current account deficit to absorb the surplus and keep it from sending the world into a recession:

Edmund Phelps: Martin´s lively piece this week is timely, since the US Congress looks poised to try to legislate the end of the "saving glut" - in China, at any rate, if not the one in the Middle East, and not to mention the "investment drought" in Germany, Italy and France, which also leads to current account surpluses.

I have written before about what is now known as the "saving glut" hypothesis, drawing on ... "structuralist models"... [A] version of one of the open economy models ... suggests the following analysis: As incomes in China, the rest of developing Asia and the Middle East keep on increasing by leaps and bounds, a gap opens up between consumer demand and consumer good supply. (Amar Bhide and I have a 2005 paper on why fast growth tends to create such a gap in an LDC setting.) The excess supply of consumer goods seeks foreign buyers...

If the global market for consumer goods is to clear, meaning that global consumer demand matches global supply, short-term world interest rates must drop, lifting global household wealth, to push up global consumption demand... The prospect of these low interest rates for a long time means that the whole real yield curve is shifted down.

In the west, notably the US, the UK and the others to some extent, the valuations ... of ... business assets - the employee, the customer, office space per square foot - are sharply increased. So is the value placed by households on residential structures. That leads in turn to an increase in investment demand and thus to the creation of new jobs. There is a drop in the path of the natural unemployment rate. Moreover, the drop of real interest rates boosts household consuming of all kinds, which also fits with what we observe.

In this view, there is much in agreement with what Martin has written. There are, however, two points of disagreement.

First, the analysis does not support Martin's contention that the opening up of a current account deficit in the US can be credited with saving the world from a slump. If US consumers possessed less responsiveness to each one point drop of the interest rate, there would have had to be a larger drop; and Chinese consumers would have been emboldened to step up a little their consumption, about which they have been so cautious.

Second, and more important, although this episode of "imbalance" is seen badly by Martin and some others..., I find much ... to be thankful for. Without the Chinese shock, the US economy would not come out of the slump of 2001-2002 nearly as well as it did.

Yes, the low interest rates are not sustainable - what is? But so what? If countries spurned every opportunity that looked to be unsustainable business life would be much the poorer.