Last month, Ben Bernanke took over as head of president George W Bush’s Council of Economic Advisers. Bernanke is also the front runner for the post of chairman of the Federal Reserve, when Alan Greenspan ends his long reign as the most influential economic player in the world in January.
So what Bernanke has to say about the world economy and the prospects for economic growth and financial assets must not be taken lightly. He has been developing an important thesis on this.
Greenspan has been bemused about why his steady edging up of short-term interest rates in the US has not led to a similar trend in long bond yields. Bernanke is convinced he has the answer. Rising Asian savings in excess of investment needs are the reason why long-term interest rates are so low.
Happily, as a result, he argues, the world economy has established a sort of sub-optimal equilibrium where the excess-savings economies of continental Europe, Japan and Asia are balanced by the excess-spending economies of the US, UK and Australasia. This equilibrium, Bernanke suggests, is sustainable and will continue to deliver good economic growth without financial crises.
The worry I have about this line of Keynesian reasoning is that it absolves central bankers of all responsibility for mispricing capital (it’s the bond market’s fault, stupid!) and thus of fuelling excesses and feeding bubbles.
Unfortunately for Bernanke, the statistical evidence does not justify his argument. I did a little analysis and found that it was disinflation and declining issuance of long-term US treasuries that explained 78% of the decline in US treasury yields over the past decade or so. Asian savings explained only 15% of the shift.
Deficit and surplus
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Corporate financial balances % of GDP |
Moreover, Asian savings rates have been falling, not rising. The real culprit in creating a “savings glut” has been falling corporate investment rates in the OECD. Indeed, the swing from the peak of the US corporate spending deficit in the third quarter of 2000 to the peak point of its savings surplus in the fourth quarter of 2003 was about $375 billion, compared with Asia’s swing from current account deficit in 1996 to the peak of surplus in 2003 of about $160 billion. So the impact on the US economy of domestic US corporate spending was at least double that of Asia’s “excess savings”.
When it comes to economic principles and reality, I am as cynical as a streetwalker. But if you look to macro theory for an explanation of the current low cost of capital, it seems monetarism might be given a shot at it, particularly because the Keynesian shoe fits so ill on the foot of economic reality.
A central bank that forces down interest rates to below equilibrium levels will produce inadequate levels of savings, excessive liquidity and consumption, an ex ante investment-savings gap (which must be plugged by capital inflows from abroad) and investments in excess of what the sustainable level of return justifies.
The linkage between abnormally low US and global long-term interest rates is attributable to the Fed and transmitted to other currencies through the dollar’s reserve currency role, rather than through the savings-glut economies of the world.
So if the Fed sets interest rates too low, the rest of the world’s central banks have Hobson’s choice. They can either do likewise or let their currencies appreciate against the US dollar. Given how weak their economies are, the latter strategy is not an option.
The heart of the matter for investors is whether the current very low real rates of interest are sustainable. If Bernanke is right, any global imbalances should be gradually corrected through a rise in corporate investment that may well be under way, a development that is also warranted by the closing output gaps in the OECD.
But if the monetarist model is the right one, the reversal could come sooner and more violently. In the monetarist model, a shift in the cost of capital depends upon either the policies of the one central bank that controls the world’s reserve currency or on a bunch of bond or currency market vigilantes. That’s a much smaller group than that needed to shift global savings and investment balances.
So the linchpin is the Fed. A reversal of monetary policy in the US would do the trick whether it was driven by the market (long-term rates, asset values or the exchange rate) or by policy.
But whether you opt for the Keynesian model or the monetarist one, the very limited upside and big downside risk in most asset values makes it the wrong time to chase long-term financial assets or the dollar. So I am not fazed by the dollar’s recent rally and Bernanke’s convictions. I’d stay short the dollar.
