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An Economic Theory of (Almost) Everything

Tuesday, October 15, 2019

Written by Nathan Polackwich, CFA

Categories: General Markets and Economy

Comments: 1

Why are interest rates so low in America and negative in Japan and much of Europe? Why does America run a large trade deficit with a still developing and fast-growing country like China? Why are southern European countries like Italy and Greece such economic basket-cases? Why, despite record low interest rates and corporate tax cuts, are U.S. (and other nations’) businesses still not investing? What inflated the U.S. housing bubble? Why have investors thrown tens of billions of dollars at ridiculously unprofitable businesses like Uber and WeWork and practically useless digital currencies like Bitcoin? Why is income inequality so pronounced across the developed world? Why has U.S. life expectancy started falling? What’s behind the rise of populist governments worldwide? What if I told you that a single, wildly misguided economic theory was the primary driver of all these trends?

Once upon a time America was a land that needed lots of money for prodigious investment spending on infrastructure like canals and railroads. But in those days (the 19th century), the U.S. lacked the developed financial system and savings to pay for those investments. Fortunately, European economies – particularly Great Britain and Holland – had the mature financial industry and extra savings (due to less attractive investment opportunities at home) to provide America with the necessary funding. Although a great deal was borrowed, the money was invested on essential infrastructure that more than paid for itself with the economic growth it helped create.

This scenario where a country with insufficient savings but compelling investment potential attracts capital from countries with savings to spare is how the world used to work – but not anymore. In the modern global economy, savings are no longer scarce anywhere in the developed world or even in most emerging market countries. To some extent this abundance reflects the maturing of developed nations’ economies and finance industries, as well as the aging of the population practically everywhere outside of Africa.

Problematically, though, certain fiscal and monetary policy choices by major governments –which were inspired by this single, misguided economic theory – have turned a global abundance of savings into an outright glut. And this savings glut (in addition to the side-effects of the policies that helped cause it), is behind practically everything – from trade distortions to investment bubbles to income inequality to negative (or very low) interest rates to even falling life expectancies in the U.S. – wrong with the global economy today.

What is this exceptionally destructive economic theory? – Supply-Side economics, which posits that tax cuts and other policies that favor businesses (or their owners) will stimulate investment and thus economic growth to the benefit of everyone. While reasonable in theory, the historical data shows zero correlation between tax rates and economic growth. In fact, the relationship has been slightly negative! For instance, America’s best GDP growth in the post WWII period occurred between 1951-1970 (3.72% average annual real GDP growth), a time when the average corporate tax rate was around 50% and the highest marginal tax rate began at an astonishing 91% (1951) and ended at a still astronomically high 71.75% (1970).

Why don’t Supply-Side policies boost economic growth? – Because they attempt to fix a problem that no longer exists. The theory centers around the notion that tax cuts or other subsidies for the wealthy and businesses will enable them to boost investment (by increasing their savings rates), expanding production and job formation. But Supply-Side policies only work if businesses lack the savings (or access to others’ savings through borrowing) to increase investment. And as discussed earlier, with the modern global financial system, mature economies, and aging populations, savings are already plentiful.

So what happens when governments impose Supply-Side policies on major economies with no shortage of savings? The experiences of Germany and China are instructive.

Germany instituted such policies from 2003-2005 when they introduced labor reforms that effectively increased taxes on workers while cutting corporate taxes. Wage growth declined and corporate profits soared. German companies found themselves flush with cash (excess savings).

Similarly, China has suppressed its interest rates for years, a policy that represents a huge subsidy to Chinese businesses and penalty to its households who struggle to obtain a return on their savings higher than the rate of inflation. The result is that Chinese companies also generate enormous excess profits (savings) that exceed their country's overall investment needs.

Now, under the Supply-Side model, German and Chinese businesses would use their excess savings to dramatically increase investment in their home countries. But they haven’t. Why? Because access to capital isn’t a roadblock to business investment in the modern global economy. Rather, German and Chinese companies’ rate of investment has lagged their growth in savings because they don’t see the consumer demand that justifies greater business expansion. Compounding the issue, Germany and China’s subsidizing of businesses at the expense of workers only served to further weaken consumer demand making higher business investment spending even less likely.

So where have all the German and Chinese excess savings gone?(1) It’s important to understand that for an individual country, savings and investment don’t have to equal (assuming they trade with other nations). But on a global basis, it’s a fundamental accounting identity that total savings must equal total investment. Thus, if Germany, China, and other nations pursue policies that cause them to save much more than they invest, then, by definition, the rest of the world must invest much more than it saves. But when excess savings from one country enter another that doesn’t need those savings for productive investment, there are only two possible outcomes:

  1. Investment rises – But the savings are wasted on unproductive/unprofitable investments.
  2. Domestic savings fall – Typically, this occurs thanks to higher household borrowing for consumption. But absent higher household (or sometimes government) borrowing, savings will fall due to rising unemployment and associated lower household income.

Other than these two outcomes, there are no other possibilities unless a country strictly limits excess foreign savings from entering its capital markets in the first place (not a bad idea).

Can you see where this is headed? German, Chinese and other countries’ excess savings poured into the U.S. inflating the housing bubble that popped in 2008. Meanwhile, German excess savings also submerged southern European countries like Portugal, Italy, Ireland, Greece, and Spain (collectively, the PIIGS), which drove housing bubbles (particularly Ireland and Spain) and government borrowing/spending (with Greece as the poster child). More recently, investment bubbles have even popped up in speculative novelties like comically unprofitable technology companies and effectively useless cryptocurrencies like Bitcoin.

You know what else happens when excess savings from one country overwhelm another? The country on the receiving end of the savings ends up running a trade deficit. This is inevitable because of another fundamental accounting identity.

Exports – Imports = Savings – Investment

When Chinese or German or Japanese savings flood the U.S. economy, they’re either going to be wasted on unproductive investment (like occurred during the U.S. housing bubble) and/or U.S. household consumption of goods and services, which necessarily causes the U.S. savings rate to decline. In the latter case, effectively, the excess foreign savings compel U.S. households to spend more than they make. And based on the accounting identity above, as U.S. savings fall (relative to U.S. investment), our trade deficit with excess savings countries like China, Germany, and Japan must widen.

Now, U.S. households spending more than they make doesn’t reflect some lack of moral fiber. It’s an inescapable consequence of the foreign savings inundating the U.S. economy. As Chinese savings, for instance, enter America they drive up the value of the U.S. dollar relative to China’s currency (the Yuan). This makes China’s currency weaker than it should be enabling Chinese businesses to outcompete those in America. All else constant, the result is higher U.S. unemployment and associated lower U.S. household income and savings.

For U.S. households, the only alternative to this income hit (absent higher government debt/spending) is to borrow money to maintain spending. Of course, while increased borrowing temporarily supports U.S. economic and job growth, debt levels can only rise so far – with the 2008/2009 Credit Crisis being a prime example of what happens when the dam breaks.

Doubling Down

So, the U.S. has been swamped by excess foreign savings from China, Germany, Japan, and a few others. This has led to a surging trade deficit as well as ballooning U.S. household (and increasingly U.S. government) debt. And note that, particularly in the case of U.S. households, debt-fueled consumption merely boosts growth today at the expense of tomorrow.(2)

How have major governments attempted to deal with these trade distortions, rising household debt levels (in the countries receiving all the excess savings), weak consumer demand, sluggish business investment, and global interest rates spiraling down into negative territory? – Why, by doubling down on the same misguided Supply-Side policies that exacerbated the problems in the first place! To the man with a hammer every problem looks like a nail.

  1. Businesses aren’t investing even though interest rates are approaching (and in some countries are already below) zero? Well, the solution must be to force interest rates even lower!
  2. Businesses aren’t investing despite record high profit margins? Well, just cut corporate taxes even more – That should do the trick!

Of course, these policies only make the global savings glut worse. They also aggravate income inequality. As China shows, suppressing interest rates makes businesses more profitable but hurts household income by reducing the interest they receive on their savings (particularly problematic for nations with aging populations).

Further, when tax cuts disproportionately benefit businesses and the wealthy, that extra income tends to be saved rather than spent. Then, when the economy doesn’t respond with faster growth, the tax cuts cause government budget deficits to balloon. Ironically, this usually leads governments to cut back on the benefits they provide to poor and middle-class families. And as households’ incomes get squeezed, consumer demand weakens (unless artificially propped up by rising debt), further disincentivizing business investment.

Minimal income growth and higher debt are not conducive to happy, healthy populations. There’s a sense of despondency among the masses – not just in the U.S. but globally – that’s behind higher suicide rates and opioid addiction as well as increased nationalism, xenophobia, and populist policies (like trade wars) as people and politicians seek a scapegoat. And these trends will continue until politicians realize that the global economy suffers not from a lack of supply but from weak demand.

1) Japan is also a major contributor to the global savings glut. Initially, this was caused by the same factor behind China’s excess savings – suppressed interest rates that helped businesses and hurt households. But these days Japan’s excess savings largely reflect its strong manufacturing base and export industries (generates lots of profits), extreme corporate financial conservativism (hoards profits), and declining population (weak consumer demand so no need to invest domestically).
2) In the Federal Government’s case, debt constraints are mainly political, so long as the government maintains control of the metaphorical “printing press.”

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