The inequality-made imbalances 1: Reformulating the global saving glut hypothesis

This inequality series reformulates Bernanke’s global saving glut hypothesis for a better explanation of economic and financial imbalances.

Ben Bernanke’s ‘’global saving glut hypothesis’’ has been a progress towards explaining low interest rates and financial crises.

Bernanke's narrative, ‘’an excess of desired saving over desired capital investment’’ narrative should be revised as ''an excess of desired gross saving over desired asset supply''.

The inequality series

Ben Bernanke’s ‘’global saving glut hypothesis’’ has been a progress towards explaining low interest rates and financial crises. This inequality series reformulates Bernanke’s hypothesis for a better explanation of economic and financial imbalances, chronic deflation, low growth, financial crises and asset price bubbles which have been dominating the economic agenda since 1980s.

Ben Bernanke's global saving glut hypothesis

Bernanke defines the global saving glut in one of his Brookings posts:

''… a global excess of desired saving over desired investment, emanating in large part from China and other Asian emerging market economies and oil producers like Saudi Arabia, was a major reason for low global interest rates. I argued that the flow of global saving into the United States helped to explain the “conundrum” (to use Alan Greenspan’s term) of persistently low longer-term interest rates in the mid-2000’s while the Fed was raising short-term rates.’’

In conventional monetary policy, central banks manage short-term interest rates. If long-term interest rates do not adjust to short-term ones, an exogenous factor, the saving glut, should be influencing long-term interest rates. Per Bernanke, falling long-term rates help to erode the excess saving desire.

The unit of the savings analysis

Savings might come about in various levels. Individuals, sectors or countries can save. Does Bernanke analyze savings at the personal, sectoral, national or global level?

Before articulating Bernanke's approach, it might be better to assess savings at different levels. To save, one needs to not consume their income. The smallest unit, persons can save via two ways, being a net lender or investing. When they lend, they buy others' liability. Thus, they financially save.

Financial Savings = Financial Liabilities

When they buy investment goods, they really save.

Real Savings = Investment

Thus, personal savings comprise real personal savings and financial personal savings.

Personal Savings = Real Personal Savings + Financial Personal Savings

Do individuals not really save if they buy debt? At the personal level, both financial and real savings equally count as savings.

Net financial savings

Net financial savings depends on the unit of analysis. Financial savings are netted by the unit's liability while real savings are not. For example, the private sector’s net savings are composed of its real investment and its net lending to the public sector. All private entities’ financial liabilities and financial savings are netted at this level. Likewise, public and private financial savings cancel out each other in national savings which is composed of capital investment and net lending to other countries.

At the global level, the only way to save is through capital investment as all liabilities and financial savings net each other.

World Savings = Aggregate Real Savings = Aggregate Capital Investment

If only persons’ savings constituted a country’s savings, this is how it would be formulated:

Savings = Aggregate Investment + Aggregate Financial Personal Savings - Aggregate Personal Liabilities

Savings = Aggregate Investment + Net Aggregate Financial Personal Savings

Aggregate real personal savings are not netted whereas aggregate financial personal savings are netted by aggregate personal liabilities. If personal savings exceed personal liabilities, the country is a net lender to other countries. If personal liabilities exceed personal savings, the country is a net borrower from other countries.

Including firms and governments into the formula, a country's savings is derived:

Savings = Investment + Net Financial Savings (Net Exports)

As the country exchanges foreign financial assets with its exports, net financial savings is also called net exports.

At the country level, positive value of net exports or net financial savings would increase savings whereas negative value of net exports or net financial savings would decrease savings.

Excess saving desire from Bernanke's perspective

Which unit does Bernanke base his analysis on? Per him, ‘’an excess of desired saving over desired capital investment’’ emanates from other countries’ trade surpluses. Thus, we notice that Bernanke’s unit of analysis is country. As already mentioned, individuals save both financially and really. Their real savings are already in national accounts. Thus, a nation’s gross real savings equal its net real savings.

Gross Real Savings = Net Real Savings

Not all personal financial savings, however, count as national savings, as all domestic debt and financial savings are netted in national accounts. The difference of the two is net exports or net financial savings. If financial domestic savings surpasses domestic debt, the country is a net lender to other countries, vice versa.

Net Financial Domestic Savings (NX) = Gross Financial Domestic Savings - Gross Domestic Financial Liabilities = Domestic Holdings of Foreign Debt - Foreign Holdings of Domestic Financial Liabilities

In the output equation, net financial domestic savings is NX, net exports. As most economists, Bernanke relies on the output equation in which all domestic debt and domestic financial savings are already netted.

Y = C + I + NX (net exports)

Y - C = I + NX

S = I + NX

We already know that savings is steady in the United States as new acquisitions of investment goods have not substantially risen for decades. So, in Bernanke’s view, the only source of an excess saving desire can be growing net imports. As the US has been a net borrower for a long time, Bernanke can confidently base his argument on the large US trade deficit.

The global savings analysis

Including all capital flows besides exports, net lending is analyzed through a more comprehensive term, current account balance. A country with a current account deficit finances net imports via net foreign lending:

Current Account Deficit = - NX

Savings + Current Account Deficit = Investment

A negative and growing current account balance implies that foreigners increasingly buy US debt. As Bernanke argues, foreigners' rising desire to buy US debt might be one explanation why interest rates keep falling in the US since 1980s.

Nevertheless, foreign desire for US debt does not necessarily imply a ''global'' saving glut. Foreigners may be transferring their saving desire from other countries to the US. In this case, the excess desire to invest in the US debt would be US-centric. A global saving glut would imply a global excess saving desire over global asset supply which can be analyzed at the global level.

As already noted, the global saving equation is simple:

Savings = Investment

At the global level, NX or net financial savings is always zero as financial savings and liabilities, exports and imports are identical at the global scale. Could Bernanke's narrative, ‘’an excess of desired saving over desired capital investment’’ explain falling interest rates? Is investment the sole means to store savings? Alternatively, could gross financial savings and liabilities also matter for a savings analysis?

Consumption debt as a means to store savings

A simulation with gross financial variables may be helpful to figure out whether gross or net financial savings determines interest rates. All variables are flow in the equations.

Output = Consumption + Investment

Savings = Investment + Net Financial Savings (Net Exports)

Savings = Investment + Financial Savings - Financial Liabilities

The world economy comprises A and B's activities. A can produce houses or hamburgers while B produces nothing tradable. For simplicity, A and B's production for their own needs is neglected. A always wants to save all his income.

In year 1, A produces a house for B on account. The house is $100 worth. A's income and B's spending rises for $100.

A's Assets: Financial Savings +$100

A's Liabilities: Labour Income (Equity) +$100

B's Assets: Investment +$100

B's Liabilities: Debt +$100

World output and savings equations:

$100 (Output) = $0 (Consumption) + $100 (Investment)

$100 (Savings) = $100 (Investment) + $100 (Financial Savings) - $100 (Financial Liabilities)

Thus, savings and investment are $100. Financial savings and Financial liabilities are also $100.

In year 2, B demands neither hamburgers not houses. To be able to save further, A builds a new house for herself:

$100 (Output) = $0 (Consumption) + $100 (Investment)

$100 (Savings) = $100 (Investment)

The difference between year 1 and year 2 is B. B functions as a middle man when he makes investment through borrowing. In year 1, she demanded an investment asset and supplied a financial asset for $100. That is, investor borrowers equally demand and supply assets. Hence, netting financial savings and liabilities makes sense if all liabilities finance investment.

In year 3, neither A nor B needs a house. So, the economy cannot produce new investment. Can A save despite the absence of investment opportunities?

At first, B has no desire to borrow despite A's saving desire. A's excess saving desire pulls the interest rate down until B gets convinced to borrow to eat hamburgers for $100.

A's income and B's spending rises for $100.

A's Assets: Financial Savings +100

A's Liabilities: Labour Income (Equity) +100

B's Liabilities: Consumption Expenditure (Equity) -100

B's Liabilities: Debt +100

World output and savings equations:

$100 (Output) = $100 (Consumption) + $0 (Investment)

$0 (Savings) = $0 (Investment) + $100 (Financial Savings) - $100 (Financial Liabilities)

Thus, savings and investment are 0$. Financial savings and liabilities are $100.

If B is eliminated in year 3's equations, A's saving desire is not satisfied anymore. Because there is no demand from B, A does not produce the hamburger. Output falls to $0 as A's saving desire is not satisfied.

Now, B has become a net asset provider. B produces savings for A although no investment is made in the economy. This scenario shows that an economy can produce assets through consumption-based borrowing. A's desire to save could be satisfied without supplying capital investment. Therefore, financial savings and liabilities should not be netted for a thorough savings analysis.

Consumption debt is another means to store savings. Investment is one driver behind interest rates whereas the other driver is consumption borrowing. When economic agents increasingly borrow to purchase consumer goods, interest rates adjust upwards to set the new equilibrium between gross savings and gross liabilities.

''Consumption debt'' is different than consumer debt. It shows where (consumption or investment) finance is allocated, rather than who receives finance. It describes all debt that directly or indirectly finances consumer goods. In this framework, household debt financing a new house is considered investment debt whereas business debt financing consumer goods is considered consumption debt.

Under liabilities, equity can rarely be a source of consumption funding. In principle, firms are not supposed to raise consumption through equity issuance. They invest equity either in real or financial assets. As illustrated for debt finance, financing real or financial assets through equity also does not change the equilibrium between supply and demand of assets.

Equity can be a source for consumption finance for particular firms and circumstances. The so-called zombie firms consume the funds acquired through debt and equity issuance. In economic downturns, losses push even solvent firms to consume their equities. Therefore, a small portion of equity also finances consumption.

There is no statistical way to figure out how much of debt and equity finance is allocated into consumption. In coming posts, total liabilities will be employed in the analyses of coming posts. Another handicap with data is the inability to detect when liability finances consumption. Equity is employed as a consumption finance usually not at the time of issuance but mostly in economic downturns. Total debt can hence serve as a better proxy for consumption finance.

Which one matters, gross or net financial savings?

In an economy with only financial savings and liabilities, there could still be excess saving desire driving interest rates down. If A desires to save $100, B desires to borrow $80 to raise consumption, the interest rate would fall to deter A from saving and to encourage B to borrow more. The demand and supply of savings would meet at a point between $100 and $80.

Bernanke's narrative, ‘’an excess of desired saving over desired capital investment’’ narrative should be revised as ''an excess of desired saving over desired asset supply''. All assets, both real and financial, should be taken into account while analyzing the excess saving desire.

In this framework, a global saving glut would imply that the desire to financially and really save exceeds the desire to supply liabilities and investment:

D = Desire

DSavings + DFinancial Savings > DInvestment + DFinancial Liabilities

Falling interest rates all over the world suggest that the global saving glut has been dominating interest rates since 1980s. Including financial savings and liabilities into the analysis will enable a better understanding of imbalances in economies. On the asset supply side, liabilities stand together with investment now. An excess saving desire might be the result of not only a lower need for capital investment but also constraints on consumption debt production.

10-year treasury rates

Determinants of US interest rates

What if the same interest rate analysis is conducted on a country's savings? With gross variables, a country's savings equations is as follows:

Savings = Investment + Financial Savings - Financial Liabilities

When demand and supply side of assets are grouped:

Savings + Financial Savings =? Investment + Financial Liabilities

The equation holds only if the country's net financial savings (net exports) is zero. Otherwise, one side is greater than the other side. Ex-post, supply and demand of assets in a country must be equal to each other. This indicates that a country's savings equation does not comprise all supply and demand factors. The US savings comprise US financial savings in abroad that influence economic and financial variables of other countries. For a sound analysis, the country's asset suppliers and holders of those assets should be present in the equation.

A new savings equation can be derived from the global equation. To be able to pick country variables, financial variables in the global saving equation needs to be split into four based on parties' residency. For instance, UOFS represents, US's financial savings in other countries and OUFL represents other countries' financial liabilities to the United States.

S is excluded in the new equation. Instead, RS, real savings represents the economy's real savings which is always equal to investment. As all capital investment made in a country is inherently domestic, all real savings are also domestic. Therefore, investment and real savings are not classified based on their owners' residency.

S = I + FS - FL

URS + ORS = UI + OI + UUFS + UOFS + OOFS +OUFS - UUFL - OUFL - OOFL - UOFL

In the equation, each variable has an identical twin:

RS (Real Savings) = I (Investment)

UUFS (US Financial Savings in the US) = UUFL (US Financial Liabilities to the US)

UOFS (US Financial Savings in Other Countries) = OUFL (Other Countries' Financial Liabilities to the US)

OOFS (Other Countries' Financial Savings in Other Countries) = OOFL (Other Countries Liabilities to Other Countries)

OUFS (Other Countries' Financial Savings in the US = UOFL (US Financial Liabilities to Other Countries)

The new country-level equation can be derived from the relevant variables in the global equation:

URS = UI + UUFS + OUFS - UUFL - UOFL

The new equation does not merely comprise the country's savings. Other countries' financial savings in the US is also in the equation whereas US financial savings in other countries is not. The owners of the US debt regardless their residency are in the equation because both residents' and foreigners' desires to acquire US debt influence US interest rates. US residents' financial savings in other countries should be in other countries' equation.

Via rewriting the conventional savings equation in the same way, two equations can be compared:

S = I + FS - FL

S = UI + UUFS + UOFS - UUFL - UOFL

On the left side, the difference between savings and real savings emanates from the replacement of other countries' financial savings in the US (OUFS) by US financial savings in other countries (UOFS) in the conventional savings equation. Which one drives US interest rates, OUFS or UOFS?

As already mentioned, US financial savings in other countries drive other countries' interest rates whereas other countries financial savings in the US drive US interest rates. Therefore, the US savings equation is not qualified to explain interest rate determinants.

As each variable has a twin in the new equation, the new savings equation can be rearranged based on the supply and demand of assets. Savers are on the left side, fund seekers are on the right side:

URS + UUFS + OUFS = UI + UUFL + UOFL

As the desire (D) to really or financially save through US assets rises, interest rates go down in the US:

DURS + DUUFS + DOUFS > DUI + DUUFL + DUOFL

As the desire (D) to supply investment goods or financial liabilities rises, interest rates go down in the US:

DUI + DUUFL + DUOFL > DURS + DUUFS + DOUFS

Statistical data's ex-post nature does not give any idea about desired or planned parameters. Surging debt in an economy also indicates surging financial savings. Interest rates are the one that signals the side with dominant desire. A downwards trend in interest rates suggests the dominance of planned savings over planned asset supply and vice versa.

The US saving glut

Involvement of the gross financial variables into the savings analysis purports that deficit producing countries can also contribute to the global saving glut. US savers can also be a saving glut source. Even though US saving figures suggest no domestic excess savings, US financial savings might be telling a different story. US savers’ excess saving desire might have been satisfied by the US consumption debt.

On the demand side of US financial assets, besides other countries' financial savings in the US (OUFS), US residents' financial savings in the US (UUFS) is another determinant of US interest rates. US savers' increasing desire to hold US financial assets drives interest rates down in the US.

URS + UUFS + OUFS = UI + UUFL + UOFL

URS (US Real Savings) = UI (US Investment)

UUFS (US Financial Savings in the US) = UUFL (US Financial Liabilities to the US)

OUFS (Other Countries' Financial Savings in the US = UOFL (US Financial Liabilities to Other Countries)

US financial savings can also be analyzed through net exports (NX) in the conventional savings equation:

S = I + NX

NX = Domestic Financial Savings - Domestic Financial Liabilities

If the US saving desire is satisfied by the US consumption debt, it cannot be observed through the net formula, S = I + NX. Could it be observed in the gross formula?

S = I + NX

Savings = Investment + Domestic Financial Savings - Domestic Financial Liabilities

The savings equation comes with handicaps. Domestic financial savings also include US savers' financial assets in other countries that drive other countries' interest rates. Only US financial savings in the US (UUFS) matter for US interest rates whereas US financial savings in other countries (UOFS) matter for other countries' interest rates.

Rising domestic financial savings in the US would suggest a growing desire to save from US residents. Besides foreigners, US residents' excess savings hence can be a determinant of low interest rates in the US. In the upcoming posts, US domestic financial savings will be analyzed in this respect.

Per Bernanke, negative net exports imply a greater desire to save from foreigners. Foreigners’ purchase of domestic liabilities with respect to residents’ purchase of foreign liabilities signals the side with higher excess savings. Nevertheless, a negative net export account does not mean that residents do not have excess financial savings. They can still be a source for excess savings. Vice versa, positive net exports do not suggest that the unique source for excess savings is domestic. It merely signals that domestic savers are more willing to save than foreign savers. Though, foreign demand for domestic debt might still be a factor driving interest rates down.

As a store of savings, consumption debt deserves special attention to shed light to the dynamics of economic and financial imbalances. Mian, Sufi and Straub's indebted demand theory explains low growth and low interest rates through the constraints on consumption debt. As consumers reach their borrowing limits, consumption debt production does not catch up with the saving desire. The unsatisfied saving desire induces low growth and low interest rates.

What is next?

Inequality is a major factor that amplifies savings and constrains borrowing through depleting borrowers' equity. This series will shed light on how inequality plays a major role in generating a permanent excess saving desire which has produced economic imbalances such as negative interest rates, persistent deflation, asset price bubbles and financial crises since 1980s.