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Jun 26

Paul Krugman on the GFC

Whilst the following statement from Paul Krugman is taken from a debate on how to deal with the global financial crisis and is quite a few weeks old. It still applies and is an excellent description of the current state of the Global Financial Crisis and why interest rates should stay relatively low despite massive budget deficitis from governments around the world…

Let’s think about what is actually happening to the global economy right now. On the one side there has been an abrupt realization by many people that they have too much debt, that they are not as rich as they thought. US households have seen their net worth decline abruptly by $13 trillion, and there are similar blows occurring around the world. So the people, individual households, want to save again. The United States has gone from approximately a zero savings rate two years ago up to about 4 percent right now, which is still below historical norms; but suddenly saving is occurring.

That saving ought to be translated into investment, but the investment demand is not there. Housing is flat on its back because it was overbuilt; housing bubbles collapsed not only in the United States, but across much of Europe. Many businesses cannot get access to capital because of the breakdown of the financial system. But even those that do have access to capital don’t want to invest because consumer demand is not there. Between the housing bust and the sudden decision of consumers to save, after all, we have a world with lots of excess capacity. The GDP report that just came out says that business-fixed investment, non-residential fixed investment, essentially business investment, is falling at a 40 percent annual rate.

This causes a problem. There are lots of people who want to save, creating a vast increase in savings, not only in the US but around the world, combined with a sharp decline in the amount that the private sector is willing to invest, even at a zero interest rate, or rather even at a zero interest rate for US government debt, which is what the Federal Reserve has the most direct impact on.

One way to think about the global crisis is a vast excess of desired savings over willing investment. We have a global savings glut. Another way to say it is we have a global shortage of demand. Those are equivalent ways of saying the same thing. So we have this global savings glut, which is why there is, in fact, no upward pressure on interest rates. There are more savings than we know what to do with. If we ask the question “Where will the savings come from to finance the large US government deficits?,” the answer is “From ourselves.” The Chinese are not contributing at all.

Those extra savings are, in effect, the savings that America has wanted to make anyway, but that US business is not willing to invest under current conditions. That is the way Keynesian policy works in the short run. It takes excess desired savings and translates them into some kind of spending. If the private sector won’t do it, the government will. There is actually no contradiction between the Federal Reserve’s actions and the actions of the US government with a fiscal stimulus. It’s very much necessary to do both. By buying a lot of private securities, the Federal Reserve is essentially going out there and playing the role that the private banking system is no longer playing properly; by engaging in investment, the federal government is playing the role that businesses are not now willing to play. All that debt-financed spending on infrastructure by the Obama administration is basically filling the hole left by the collapse in business investment in the United States. There is not an excess demand for savings that is going to drive up interest rates. The only thing that might drive up interest rates—and this is a real concern—is that people may grow dubious about the financial solvency of governments.

Now, the great concern I have is that although we understand these things fairly well, there are thirty-eight Republican senators who say that the answer for the crisis is another round of Bush-style tax cuts that will reduce revenues by $3 trillion over the next decade.

This crisis has been so large and the political process has been so sluggish that the difficulties have been greater than expected. And yes, there are some green shoots. Things are getting worse more slowly, but we have not managed to head off a crisis that could turn out to be self-reinforcing, and leave us in this trap for many, many years.

We are a little isolated in Australia and there’s little doubt we are positioned better than other countries around the world, but at the end of the day we are part of the global economy still in crisis so we should not be complacent and think all is well. For what its worth, in my opinion we have a long way to go yet. Markets have been responding sharply to the slightest bit of good news but whilst the crisis was created over many years, it will not be over in just a few months. Hang on for a rollercoaster ride.

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