Through the Looking Glass: Saving Glut or Demand Shortage

The old saying is that “If you only have a hammer everything looks like a nail”. For economists, the hammer is “saving” and a host of problems are reduced to questions of saving. Nowhere is this clearer than discussions of the U.S. trade deficit and global financial imbalances, which are often explained as a saving problem. Unfortunately, this focus on saving distorts understanding and distracts from the real challenge of creating mass consumption markets in developing countries.

Within national income accounts trade deficits represent the excess of country consumption over production. From an accountant’s perspective that makes it logical to label trade deficits as negative saving.

Most economists go a step further, asserting the U.S. deficit is caused by a saving shortage. However, one country’s trade deficit is another’s surplus, which has prompted Federal Reserve Chairman, Ben Bernanke, to argue for turning the conventional logic on its head. Thus, rather than resulting from a saving shortage, the U.S. trade deficit is the result of a global saving glut – especially in China.

Both stories are flawed. How does a saving glut translate into exports since households do not export? Likewise, the saving shortage story also lacks logic. If the U.S. is consuming too much, why has it been closing manufacturing capacity and why is there so much continuing labor market softness?

Both the saving shortage and saving glut hypotheses confuse accounting outcomes with causes. Trade deficits reflect transactions between producers and buyers, and those transactions are the product of incentives and price signals. U.S. consumers buy imports rather than American-made goods because imports are cheaper. This price advantage is often due to under-valued exchange rates in places like China and Japan, which often swamps U.S. manufacturing efficiency advantages.

Under-valued exchange rates are only one of the policies countries use to boost exports and restrain imports, so that they run trade surpluses while their trading partners (including the U.S.) run deficits. Other policies for export-led growth include export subsidies and barriers to imports.

In the modern era of globalization export-led growth is supplemented by policies to attract foreign direct investment (FDI), a pairing that has been particularly successful in China. Such FDI policies include investment subsidies, tax abatements, and exemptions from domestic regulation and laws.

These policies encourage corporations to shift production to developing countries, which gain modern production capacity. This increases developing country exports and reduces their import demand. Meanwhile, corporations reduce home country manufacturing capacity and investment, which reduces home country exports while increasing imports. Once again, China provides clear evidence of these patterns, with almost sixty percent of Chinese exports being produced by foreign corporations.

This is a fundamentally different story from both the saving shortage and saving glut hypotheses, and it leads to dramatically different policies. Developing countries need to grow, but in today’s globalization it is easier to acquire capacity and grow through FDI than it is to develop domestic mass consumption markets. Consequently, rather than facing a saving glut problem, the global economy faces a problem of market demand failure in developing countries.

The challenge is getting corporations to invest in developing countries, but for purposes of producing for local consumers. That requires expanding markets in developing countries, which means tackling income inequities and getting income into the right hands. That is an enormous organizational challenge that is off the radar because economists focus exclusively on saving and supply-side issues.

Labor standards, minimum wages, and unions are part of the solution. That is the unambiguous history of successful developers. Unions have historically been especially important since they engage in decentralized wage bargaining that tie wages to firm productivity. Consequently, wages are market sustainable.

Government spending can also help, but its role is limited. Countries that substitute government spending for market spending either generate excessive inflationary budget deficits, or end up with excessively high tax rates that destroy incentives.

Both the saving shortage and saving glut hypotheses fail to connect today’s global financial imbalances with global production patterns and inadequate market demand in developing countries. Tortuous claims that saving is merely the flip side of consumption and investment spending are the equivalent of Humpty Dumpty’s argument in Through the Looking Glass: When I use a word it means just what I choose it to mean”.

Copyright Thomas I. Palley

6 Responses to “Through the Looking Glass: Saving Glut or Demand Shortage”

  1. Jeff H. Says:

    Very interesting take on a tragically convoluted subject.

    I’m not an economist, but this is first logically sensible thing I’ve read on this subject in a year.

    The accounting consequence can’t be denied – although even that gets muddled. From this perspective, there obviously can’t be a global savings glut as a consequence of deficient US saving that is offset by non-US excess saving.

    Yet Bernanke persists with the global savings glut paradigm.

    This is not only false from an accounting outcome perspective, but inadequate from a causal perspective, as suggested in your article.

  2. Dr. James M. Cypher Says:

    The idea that the low rate of domestic savings somehow facilitates an explanation of the US trade deficit has been employed widely due to essentially Keynesian national income categories and equations.

    In a review of Krugman’s (otherwise well presented) introductory text on trade theory, I attempted to convince Krugman that there was something essentially bizarre about this well-circulated hypothesis.

    I think Thomas Palley has caputred the core concept in arguing that the use of national income accounting concepts confuses mathematical categories with economic analysis. And further, there is a confusion between movements in the sphere of ciruclation and those occuring in the sphere of production. Conventional trade theory grasps only the circulationist arguments/concepts while failing to analyze the, normally, primary productionist processes.

    Which is to say, once again, that neoclassical economics has little to offer, particuarly at the macro level–and that conventional neoclassical trade theory, at best, simply clouds thinking on trade, production and absolute advantage.

  3. Ron Calitri Says:

    This is an excellent summary, but the paragraph about government spending seems off. Government spending need not be inflationary provided it satisfies ordinary demand more efficiently than a contrastingly rapacious business system. Also, it is primarily in developing countries that environmental damage is most in need of repair.

    One cannot look with disfavor upon businesses who have gone abroad to leech upon the funds of U.S. consumers. I think that over the last few weeks it has become clearer that this umbilical cord is drying up. Multinationals are stuck out there and having a fine old time of it.

    We should rather focus, when speaking of saving, that it results from having income greater than expenditure; a definition of poverty flowing from Gregory King through Ernst Engel. Yes, the poor have expenses greater than income in every social survey I have ever looked at. Presumably it is unremarkable. However, this week I had occasion to walk my students through calculating out of the Consumer Expenditure Survey, using of course the 2006. In 1996, expenses > income below 22,000 (hh inc). By 2006, astonishingly, the crossover was above 40,000! I’m afraid that this phenomenon, rather than the level of wages, is primarily responsible for the insufficiency of global demand you refer to, Solving this poor borrowing problem of parasitic lending, wholesale, here in the U.S. seems equally important to worldwide demand. As things stand, financial “services” are a much more of a pandemic than fair labor standards could ever become.

  4. Per Kurowski Says:

    There are many looking glasses and the usefulness of one does not preclude the usefulness of another… to get a different angle.

    I try to understand what “the real challenge of creating mass consumption markets in developing countries” means in policy terms.

    If it is about allowing for a little bit more of the Chinese surplus trickle down a bit more into Chinese consumption then I am all for it, though we must find a way for China to refrain from following the US path of buying so many cars. They consume more… they buy more cars… demand for oil goes up… up goes the price of oil… up goes the trade deficits… and up goes the carbon in our air. Also, if more consumption in developing countries is going to be generated the American way… by the consumer taking on more debts… instead of those funds going to projects, infrastructure and other growth generating areas that lead to decent jobs… well count me out.

    When Pailey writes “The challenge is getting corporations to invest in developing countries, but for purposes of producing for local consumers. That requires expanding markets in developing countries, which means tackling income inequities and getting income into the right hands.”, he has a point, but only if we feel that this is the role that corporations should play, and want to live with the long term consequences of such role allotment. Myself, having seen the big paychecks that are still paid out in a financial crisis, I harbor my serious doubts that the corporations are the optimum income inequality tacklers.

    “Labor standards, minimum wages, and unions are part of the solution” Absolutely! Though, let us be frank, that unions will “engage in decentralized wage bargaining that tie wages to firm productivity” might be stretching our argument a little too much.

    “Government spending can also help, but its role is limited” Not at all that sure, when it is primarily governments that are building up so much foreign reserves… instead of…

    Finally I would not denigrate Humpty Dumpty too much. We all, when we choose a word, choose what it means.

  5. j Says:

    I always thought of Bernanke’s “savings glut” as being a euphemism for “government policies that restrict consumption,” so all the hubbub about it seems curious to me. He doesn’t feel he can say the “M” word (mercantilism) out loud for political reasons.

    Thinking about this issue reminds me of your previous post about Jack Welch’s barge. An interesting exercise is to turn it around; instead of a barge carrying modern production equipment to underdeveloped nations, think of a barge bringing poor workers here. The net effect is the same–low wage labor mated with modern production equipment and expertise owned by US corporations–but it paints quite a different picture regarding US labor.

    Would the effect be the same if the plant and equipment were owned by foreigners? If the foreign owners spent their profits on imports perhaps there would be no net loss in wages and employment by US workers–only a shift into export industries. When you think of it this way it isn’t so hard to see why our “trade deficit globalization” redistributes income away from workers. Indeed, it seems to me it depresses wages here *and* in the surplus nations.

  6. Bruce Gossage Says:

    I think your analysis of the underlying problem is dead on.

    As for a solution (creating demand abroad) consider the Marshall Plan:

    - Post-War European countries effectively bankrupt/destroyed infrastructure and economy (akin to many 3rd world countires today)
    - credit extended for reconstruction effort
    - meant job creation, and reviving demand among consumers in Europe (i.e. creating buying power)
    - meant a stimulous for US companies who exported captial goods to Europe
    - meant much of the US supplied funds never went overseas, but instead extended as credit to US companies on behalf of Europeans. (thereby avoiding concerns of corruption