Argument built on questionable logic

The authors’ claim that the source of global economic imbalance is a glut of Asian savings rather than insufficient American savings is well argued, but ultimately relies on a flawed assumption.

The Bill from the China Shop is important as it is one of the most coherent expressions of a new orthodoxy on the world economy. At its baldest, its argument is that the reason the global economy is unbalanced is because of excess Asian savings rather than insufficient American savings.

If the argument sounds familiar, it is probably because it was popularised by Ben Bernanke, now chairman of America’s Federal Reserve, in March 2005. In a keynote speech, the then governor of the Fed attributed America’s deficits to an “Asian savings glut” rather than to domestic US weakness. But Charles Dumas, head of the world service at Lombard Street Research and co-author of the book, had already propounded a similar argument in 2004.

As Dumas and Diana Choyleva, another director of Lombard, note, the argument owes a lot to the “zeitgeist in 2004”. Growing economic imbalances did not seem to be resolving themselves through an improvement in the American trade deficit. In addition, the growing importance of China in the world economy was becoming increasingly widely appreciated. From this situation, Dumas concluded that the imbalances needed to be looked at from a new angle. The primary responsibility for the imbalances, he came to argue, lay with Asia rather than America.

Although the facts had not changed, they were interpreted in a radically new way. Until then, the conventional view was that America was primarily to blame for the imbalances. Americans were saving too little and consuming too much, with outsiders financing excess US consumption. Asian capital flows into America were, in this view, a response to developments in the US.

Dumas and his colleagues argued instead that the problem was Asians were saving too much. These excess savings had to find a home and America was the obvious target. The massive inflow of savings into the US led to a reduction in American interest rates, which in turn encouraged a build-up of debt.

Dumas says: “The problem is not for the United States to find $2bn [1.1bn] a day to fund its deficit, as has so often been stated. Rather, the problem is for the Asian, together with some European, countries, to find a home for $1.5bn a day of capital generated by their surpluses.” (p9).

The reason there is so much emphasis on Asia is that imbalances within Europe tend to cancel each other out. Although some European countries have surpluses and others deficits, on balance, the overall picture is roughly neutral. Therefore, the American-Asian axis is the key one to consider.

At the root of the problem, according to Dumas and Cholyeva, is the crude mercantilism of many Asian nations. They pursue economic policies that encourage high exports and relatively low consumption at home.

As Dumas argues: “Increasingly, China’s policy looks like crude, muscle-bound mercantilism: a simple, zero-sum-game attempt to grab export market share by exchange rate manipulation.” (p62-3). Many other Asian nations have followed China’s example.

Although the Lombard/Bernanke argument is logically consistent, there are reasons to question it. For a start, for American policymakers, it is self-serving. It is expedient for them to blame Asians for imbalances in the world economy rather than take a large part of the responsibility themselves.

But just because an argument is self-serving does not necessarily make it wrong. It is possible that it both serves vested interests and is correct. In any case, the Lombard authors have no such vested interest. If there is a fundamental problem with the Lombard analysis, it is the importance it attaches to savings. Although savings might sound like a simple concept in principle, it is hard to identify in practice. In any case, it is not clear why it should be the logical starting point for an analysis of global imbalances.

Terms like savings and investment are often used as if they were straightforward, but they are far from it. How best to measure a national savings rate is not an easy thing for statisticians to work out. And investment, in the sense in which it is often used by economists – capital investment by companies – is far from investment in the stock or bond markets. Most investment in the financial markets is secondary – a seller selling to a buyer – rather than being used to finance companies directly.

In any case, a more fundamental measure for any market system is the rate of profit. Whether companies succeed or fail in a market system, and ultimately the health of the economy as a whole, depends on profitability. Yet while there are various measures of profitability, their use can be problematic. It is also striking that profitability as a concept is hardly used outside of the stockmarket nowadays.

This downgrading of the importance of profitability itself raises important questions about the one-sided way in which contemporary economics is understood. Ultimately this area needs further work, but it seems clear that the imbalances in the global economy should be seen as part of a secular trend.

From a long-term perspective, the American economy is declining relative to the rising powers of Asia. America is desperately in need of Asian help to shore up its economy and Asia, for the time being, has an interest in playing along.

As previously argued in Fund Strategy, this situation can continue for some time as a result of the end of the Cold War. The muting of domestic conflict gives countries more room for manoeuvre to cooperate internationally. This situation has added considerable resilience to the international system and allowed imbalances to be maintained at an unprecedented size.

Although The Bill from the China Shop is consistent, it is ultimately flawed. It assumes savings rates are a logical starting point for examining global imbalances, when such a contention is open to question. Today’s peculiar set of international economic relations need to be examined from a more fundamental perspective. Simply flipping over the previous orthodoxy, while requiring a leap of imagination, is not good enough.

To order a copy of The Bill from the China Shop call 01730 233870 or go to www.fundstrategy.co.uk/bookshop.

Charles Dumas and Diana Choyleva
The Bill from the China Shop:
How Asia’s Savings Glut Threatens the World Economy
London: Profile Books 2006.