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Tuesday, December 26, 2006 11:07 PM


Global Savings Glut Revisited


Ben Stein hopped on the "global savings glut" bandwagon today in a New York Times article entitled The Hedge Kings Are Rich, but Will They Be Noble? Let's take a look.

HEDGE fund managers and traders make an astounding amount of money. This is now part of the lore of the nation. Young millionaires, young billionaires, all hunched over trading screens and manufacturing money while the rest of us toil for peanuts.

How did it happen? Why do they make so much more money than other people in finance do, or than people in industry in general? Do they deserve it? What will they do with it? And who makes it all possible?

These questions would take an entire book to answer. But I’ll just try to give a few answers that occur to me, and I invite anyone who knows more about this subject than I do to chime in.

First, the money is basically being made by “positive carry.” (By coincidence, this is also the name of a yacht owned by a supersmart, supersuccessful friend in finance named John Devaney.) That means the hedge funds can borrow money, invest it safely and make enough to repay the loan with interest and still have a profit. They can do this because the cost of money is so low these days.

Why is it so low? Because the Chinese people save about 40 percent of what they earn and use a lot of it to buy United States Treasury securities, keeping overall interest rates low. The Japanese do the same, and so do the immensely wealthy petro-states. So when the hedge fund managers cash their huge checks and sail their yachts and fly in private jets, they should thank people living carefully elsewhere. Savings in Guangdong, China, mean mansions in Greenwich, Conn.
Stein goes on to talk more about hedge funds, Warren Buffett, Andrew Carnegie, Andrew Mellon, Henry Ford, John D. Rockefeller, and philanthropy. I am stopping the post where I did because once again we see the idea presented that there is a "global savings glut" and that is the idea I want to focus on as well as refute. Before we get there, let's look a few previous articles on the subject.

In March of 2005 Bernanke proposed the idea of a "savings glut" in his speech The Global Saving Glut and the U.S. Current Account Deficit.

In July of 2005 BusinessWeek reported A global savings glut is good for growth -- but risks are mounting.
Look around the world, and extra money is piling up in all sorts of places. Japanese corporations are recording record profits, but not doing much spending. Chinese companies are on an investment tear, but the country is getting so much money from exports that it has billions to spare, including $18.5 billion that China National Offshore Oil Corp. (CNOOC) bid for Unocal. The surge in oil prices -- now about $60 a barrel -- is giving oil-producing countries such as Russia and Saudi Arabia far more money than they can use right away. And the aging workers of Europe are building nest eggs for an uncertain future.

The International Monetary Fund predicts that in 2005 the worldwide savings rate should hit its highest level in at least two decades.

A Jan. 31, 2005, article in BusinessWeek noted that a "global glut of savings" could explain low interest rates. Then, in March, Fed Governor Ben S. Bernanke -- now head of President George W. Bush's Council of Economic Advisers -- unleashed the flood gates with a speech on the "global saving glut."
In July of 2006 MacroBlog reported The Chairman Speaks: The Savings Glut Persists.
More from Chairman Bernanke's exchange with Senator Bennett during yesterday's testimony:

BENNETT: Do you still believe there's a global savings glut and that we can expect people to continue to want to put their money here?

BERNANKE: I think there still is a global savings glut. It may have moderated somewhat because of increased growth in some of our trading partners. But on the other hand, there's also been, of course, these large revenues that the oil producers are accumulating because of the high price of oil. They are not able to absorb - - use those revenues at home very quickly. So they are taking that money and putting it back into the global financial system. And so that's contributing to this overall global savings glut...
If you do a Google search of "Savings Glut" you will find over 400,000 hits.

Even articles attempting to refute the idea such as Investment dearth, not savings glut on Mises.org do not adequately explain exactly what is happening.

The simplest (and best) refutation to date of the silly notion that there is some kind of "Global Savings Glut" came today from Professor John Succo on Minyanville. In Response to Ben Stein, Professor Succo had this to say.
Dear Mr. Stein,

I have been running a hedge fund for almost seven years now and prior ran derivative trading at several wall-street firms. My fund trades derivative instruments with our $1.5 billion in capital.

In addressing your first assertion, that hedge funds make their money on positive carry, I would say that you are partially right. There are most likely many hedge funds borrowing low and lending high in “safe” investments, but the key word is “safe”. There are many likely scenarios where these safe investments would turn toxic quickly. It is not only hedge funds that are speculating in this way; you can say the same thing of Goldman Sachs and JP Morgan.

I disagree for the most part on your thoughts of where this cheap money is coming from: It is not coming from a high savings rate from Asian investors but from the creation of credit by all central banks.

The Federal Reserve creates credit through its open market operations like REPOS and coupon passes. If the Fed wants to inject liquidity (credit) into the system, they simply call up large broker dealers and buy some of their bonds with credit they create out of thin air (this expands their balance sheet). The dealer then passes this credit on to “the market” by making loans to mortgage companies or margin accounts or whatever. Because each layer of lender is only required to keep marginal capital on hand, a $1 billion REPO done by the Fed eventually creates as much as $100 billion in new credit to the consumer.

That credit creates the liquidity for additional consumption in the U.S., but these days we are buying our stuff from China (other countries too but we will just say China to make it easy). When a Chinese company receives dollars in trade, this normally would drive up U.S. interest rates: the company goes to the central bank of China to exchange Yuan for dollars; the central bank of China would normally sell those dollars into the currency market for Yuan thus driving up U.S. interest rates. But in our world of today these dollars are being sterilized: the central bank of China prints the Yuan to give to the company and takes the dollars and buys U.S. securities.

It is not the excess savings of Chinese investors that are buying U.S. securities. It is central banks creating credit themselves to buy those securities. The tick data that measure foreign inflows of money does not distinguish between private investors and central banks going through brokers to buy U.S. securities. We believe that as much as 90% of foreign money buying U.S. securities (not just Treasury bonds, but corporate bonds, mortgages, and yes, stocks) is not private investment, but central banks.

In order for other central banks like China’s to print the Yuan necessary, they too must create credit. Public debt in Asian countries is expanding as a result and creating worries: this is why Thailand came out essentially raising margin requirements to reduce speculation that is occurring as a result. Notice how they were quickly slapped down by their trading partners who do not want to rock the boat at this time.

This situation is very unstable in the long run. The Federal Reserves’ balance sheet this year alone has expanded by $30 billion in this way and created $3.5 trillion of new credit in the U.S. Public debt around the world is growing exponentially and total debt in the U.S. now stands at nearly 3.6 times GDP (1929 was 2.8 times).

My hedge fund’s position is the opposite of the carry trade you mention. There is coming (timing is unclear where it may be tomorrow or may be years away) a massive correction in debt and derivatives whose magnitude is only growing with time.

I invite you to visit and spend a few hours with me to discuss in depth hedge funds, their role and growth, and specific positioning and risk control we employ.

Best Regards,
John Succo
Key Points
  • There is not really a savings glut in China.
  • What people mistake for a savings glut is in reality a process in which the Chinese Central Bank prints Renminbi in exchange for US dollars and then has to figure out what to do with those excess dollars.
  • In the long run the situation is very unstable.
  • There is nothing "safe" about the massive carry trades in play.
  • Public debt around the world is growing exponentially and total debt in the U.S. now stands at nearly 3.6 times GDP (1929 was 2.8 times).
  • A massive correction in debt and derivatives whose magnitude keeps on growing with time is coming. Timing the event is difficult to predict.
A tip of the hat and thanks to both Professor Succo and Minyanville for exposing the myth of the global savings glut in a simple, easy to understand manner.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/


Copyright 2009 Mike Shedlock. All Rights Reserved.
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