The G-20 Meetings: Bernanke on Capital Flows

Introduction

At the recent G-20 meetings in Paris, Fed Chairman Ben Bernanke gave a talk that summarized research he has done on international capital flows over the last 20 years. His points are interesting and important. Capital flows are as important in determining the value of the dollar as the US trade deficit. Below, I summarize his points and provide data on a number of the key issues. On a related note, I show why the US savings rate has appeared to have been so low in recent years.

Capital Flows

 Bernanke said that in the late 1920s and early 1930s, the U.S. dollar and French franc were undervalued. That resulted in current account surpluses (large capital inflows) for both countries. If markets were working properly, these inflows should have caused both currencies to strengthen, thereby making imports cheaper and exports less competitive. And this, plus growing domestic aggregate demand resulting from the capital inflows, should have narrowed their international trade surpluses. But that did not happen. Both countries neutralized the effects of the capital inflows by reducing the money supply so their currencies remained undervalued. Bernanke concludes that the actions of France and the US helped to destabilize the global economic situation and bring on the Great Depression.

Bernanke then pointed out that the United States has recently been the recipient of the largest capital inflows ever. But unlike earlier times, this has been accompanied by massive current account deficits. Why are things different? He argued that the capital inflows are in part the result of what he calls the “global saving glut”.¹ The very high savings rates of certain emerging market countries meant they had large surpluses to invest. And emerging market investors were attracted to what they viewed as the safest and most liquid assets: US debt and equities. So the resulting large capital inflows helped to offset the US trade deficits and kept the dollar from losing more value.

Back to the “global savings glut”. Table 1 provides data on savings rates for the G-20 countries.

 China’s saving rate is quite exceptional, but the oil countries along with India and South Korea also have extremely high savings rates. And yes, the US has had a low savings rate. But there are reasons for the low US rate.

Why the US Savings Rate Was Low

There is a unique feature the composition of US income that explains why its savings rate has been so low. There is no country in the world that earns such a large fraction of its income via capital gains. Remember that the savings rate is roughly (I – C)/I, where C is consumption and I is income. And what is most important, capital gains income is not included in I when the savings rate is calculated. Now look at Table 2. The first savings rate (line 5) is calculated in the traditional manner without including capital gains. But note how important capital gains income (and losses) has been as a component of total income: between 2003 and 2006, it averaged 31% of total income. Americans got used to it and got in the habit of spending more because of it. And note that when capital gains are included as income, the US savings rate is much higher.

 But both the real estate and equity markets go up and down. And look at how dramatically income, including capital gains, was affected in 2008 when both the real estate and stock markets collapsed. Income, including capital gains, fell from $10.6 trillion in 2007 to only $1.7 trillion in 2008. That led to a massive reduction in US consumption and the consequent global recession.

Capital Flows

Table 3 shows what has happened to the US current account (the net trade in goods and services plus income) and capital account over time.

From a surplus of $14 billion in 1973, the current account went to a deficit of $711 billion in 2006. The global recession reduced it for a while, but it is growing again. But note how the capital account has compensated for these deficits: from a deficit of $33 billion in 1982 to a surplus of $779 in 2006. Part of this was fed by Bernanke’s savings glut and the world’s preferences for US securities. But there is more to it than that.

Table 4 gives a breakdown of the US Current Account. Note the large foreign government purchases of US government securities. This reflects the purchases by China and Japan to prop up the dollar relative to their currencies so as to keep their imports competitive. And note the growing propensity of US investors to buy foreign stocks and bonds.  

Looking Ahead – Investment Implications

But consider possible changes in the Current Account. In Table 5, data on the first three quarters for the last four years are presented.

Questions that need to be considered:

• Will private US investors increase their holding of foreign securities?
• Will foreign governments to continue to prop up the dollar by purchasing large amounts of US government securities?
• Will foreign private investors continue to purchase large amounts of US government and private securities?