Paul Krugman wrote yesterday in his blog that:
Right now we’re in a liquidity trap, which, as I explained in an earlier post, means that we have an incipient excess supply of savings even at a zero interest rate.
In this situation, America has too large a supply of desired savings. If the Chinese spend more and save less, that’s a good thing from our point of view. To put it another way, we’re facing a global paradox of thrift, and everyone wishes everyone else would save less.
The US has an excess supply of savings and has too large a supply of desired savings? Somehow that runs counter to intuition and is contrary to what one reads about Americans not saving but consuming, so a closer look is needed here.
Lets have a look at at the definition of some terms Paul is using in his two posts.
First, the GDP which is defined according to Wikipedia as
GDP = consumption + gross investment + government spending + (exports – imports), or,
GDP = C + I + G + (X – M)
- C (Consumption) is private consumption, i.e. food, rent, medical expenses, etc but excluding new housing.
- I (Investment) is investments by business or households in goods, such as construction of a new mine, purchase of software, or purchase of machinery and equipment for a factory. Spending by private households on new houses is also included here. However ‘Investment’ does not mean purchases of financial products, this is considered ‘savings’. That is money is not converted into goods or services, it is simply a swapping of deeds, and thus not part of real production or the GDP formula.
- G (Government spending) is the sum of government expenditures on final goods and services. It includes salaries of public servants, purchase of weapons for the military, and any investment expenditure by a government. It does not include any transfer payments, such as social security or unemployment benefits.
- X (gross Exports). GDP captures the amount a country produces, including goods and services produced for other nations’ consumption, therefore exports are added.
M (gross Imports). Imports are subtracted since imported goods will be included in the terms G, I, or C, and must be deducted to avoid counting foreign supply as domestic.
Paul talks about C, I and S (savings, which is not part of the GDP), but he only graphs I and S in his explanation, so I take it that he keeps C, G, X and M constant (ceteris paribus).
He then argues that as the GDP rises more money (or funds, as he calls it) will be going into savings and investment.
I am not so sure. I think in Paul’s model this will only happen if more money is made available in the form of currency, otherwise it will just increase the velocity of the available currency, i.e. the time it takes for money to change hands.
There is something else that doesn’t enter Paul’s model, and that is debt and the role of debt securities. The rise in GDP we have seen over the last two, three decades was mainly based on the availability of easy credit. People didn’t earn more and didn’t save, they didn’t put money in their savings accounts back then. And they are not saving now either, they just spend, i.e. consume, less on credit. But consumption, the C above, is around 70% of the GDP.
So, I can’t see which ‘savings’ Paul is talking about. It certainly isn’t money deposited in savings accounts, some of it maybe but mostly not. Maybe Paul has all the financial products in mind which in GDP terms count as savings, but are not included in the GDP. So his reasoning might be that if all those savings were to enter the GDP world in terms of Investments, all would be fine, or at least better than it is now.
I think he is wrong. Those ‘savings’ are not backed-up by money (currency) in savings accounts. They are backed-up by debt and debt-derivatives, which some claim to be ‘securities’ and say that they were as good as cash. Well, they are neither. They are only backed-up by the ability of the consumer to pay down that debt, but this is unlikely, because that ability has just been all but destroyed. People need a job, and they need one that pays enough to live on and to pay down their debt.
So as a result, I think there are not nearly enough ‘savings’ waiting on the sidelines to save the day. Some, maybe most of those ‘savings’ are probably just junk with less value than a roll of toilet paper.
Unless, of course, the government decided to exchange those debt-derivatives for US dollars and printed enough new ones to be able to do so. In that case the private banks have effectively gained the possibility to ‘print money’, i.e. they print cash now (that would be illegal, but never mind). In essence the PPIP is doing just that, it exchanges cash-for-trash, as Paul himself has called that program.
That may sound like a good idea at first, but this will just increase the money supply and lead to massive inflation. I think that the only debt the government, i.e. the Fed, should redeem is the one issued in the form of treasuries.
It may be that the classical, pre-derivative economic models which are and have been taught in Econ101 and on which most economic theories seem to be based, do not hold anymore, and haven’t really held since the late 1970s.
Usually, I agree with Paul, but not here. I think he is wrong here.