March 8, 2006

My colleague Genaro Gutierrez is the director of our Executive MBA program in Mexico City.  Genaro has a wonderful, charming personality.  When Genaro requests something from you it is difficult to say no, he is that disarming and charming.  Recently Genaro asked me to give a write “a little something” and give a speech in Mexico City on “the global economy…you know Michael, the things you study.”  I said “sure Genaro, whatever I can do to help….”

After he walked away, I starting thinking to myself…what on earth did I just agree to?  I have to talk about the entire world economy…where does one start?

After several bouts of anxiety (and about a case of Diet Coke) I decided to talk and write about the “global imbalances” that exist in today’s global economy.   Here is what I came up with.  It’s a bit longer than the “usual” Macro Update, but I hope you find it useful.  Genaro plans to have this translated and published in a Mexican business journal.  Next time, I am going to have think long and hard before I agree to Genaro’s next suggestion…

All the best,

MBrandl

March 2006

Global Imbalances by Michael Brandl, PhD.

The issue of “global economic imbalances” seems to be on the minds and lips of policymakers and business leaders around the global.  Financial newspaper editorials, academic research papers and think-tank white papers are written on the subject.  Yet there seems to be very little discussion of the issue of global imbalances and its impact on managerial decision making.  This paper is an attempt to correct that problem.

What are the “Global Imbalances?”

In many discussions with economists terminology is thrown around and it is assumed that the audience is in complete agreement as to what these obscure terms mean.  Such is the case with the term “global imbalances.”  Most often the term refers to the large current account deficit in the United States.  In 2005 the United States imported more goods and services than it exported to the tune of $666 billion dollars.  This current account deficit represents about 6% of the United States Gross Domestic Product.

The size of the U.S. current account deficit is large to be sure.  But it is not the only economic imbalance that exits.  Some of these other imbalances are related to the current account including: the low U.S. savings rate, slow economic growth in many regions of the world, and the aging populations in the west.

The Low U.S. Savings Rate

Over the past several years the household savings rate in the United States has continued to fall.  According to the U.S. Bureau of Economic Analysis, American household savings as a percentage of disposable income averaged 7.9% between the years 1959 and 2001.  However over the last decade this savings rate has continually fallen each year.  In 2004 the American household savings rate was actually negative for the entire year.  The last time this happened was in 1933, during the midst of the Great Depression.

While U.S. households are savings less the United States Federal Government continues to borrow huge amounts.  In 2004 the U.S. Federal government budget deficit was $412 billion or 3.6% of the U.S. GDP.  Thanks in part to a growing U.S. economy and thus increased tax revenues, the U.S. Federal government deficit for fiscal year 2005 looks to be around $320 billion or about 2.6% of U.S. GDP.  The post World War II record for the United States deficit as percentage of GDP occurred in 1983 when the deficit was at 6% of GDP.

While the reduction in the size of the government budget deficit is good news, the lack of U.S. savings means that the United States must draw in savings from the rest of the world to fund its spending habits.  Thus, the United States is drawing much needed savings from the rest of world, including places like Latin America.

This inflow of savings into the United States is shown in the U.S. capital account surplus.  Except for measurement errors the current account and capital account offset on another.  The U.S. runs a current account deficit and thus a capital account surplus.  That is, since the U.S. imports more goods and services than it imports it sells to the world more financial claims than it buys.

One thing to keep straight in all of this is that there is not a direct causation effects between the current and capital account.  That is it might be that the capital account surplus drives, to a certain extent, the current account deficit.  That is, the saving flowing into the U.S. may be a major contributor to the current account trade deficit.

This then raises the question:  why is so much of the world’s savings flowing into the United States.  As mentioned above there is the demand for those savings coming from U.S. households and the U.S. Federal government.  However, there may also be important supply drivers at work as well.  These forces that are resulting in capital flowing into the U.S. include the weak global economic growth and aging populations in the west.

Weak Global Economic Growth

Over the past few years the United States economy has been growing rather rapidly at real average annual rates of 3.5 to 4.5%.  At the same time the other major industrial economies of Japan, Germany, France and Italy have been growing at around real rate of a meager 1%.  While economic growth in Latin America has been strong over the past few years, its real growth rate is still below what it should be for emerging nations.

Thus, the investors in these other nations look at the U.S. economy, with its high rate of economic growth, as a safe place for their funds.    The lack of desirable investment opportunities outside of the U.S. has led Ben Bernanke, current Chairman of the Federal Reserve, to have labeled this situation as a “global savings glut.” 

Bernanke argues that savings is occurring in the other nations of the world, however due to their weak economic growth, rigid labor and capital markets, and fear of domestic inflation, investors in these nations are looking for investment opportunities outside of their own markets.  This is not to say that there are not profitable investment opportunities in Japan, Germany, France, Italy and Latin America, however in a desire to diversify their investment portfolios and given the weak risk/return trade-off in their own markets, these global institutional investors bring their savings to the American markets.

Aging Populations

Not only do Japan, Germany, France and Italy suffer from weak economic growth, they are also facing the issue of aging populations.  In all of these countries birth rates have falling significantly since the late 1960’s.  Thus as those who were born after the Second World War begin to retire there are fewer workers to fill their spots.  This is particularly troubling for government provided pensions that depend on current workers to pay taxes to support the growing number of retirees. 

This demographic imbalance thus forces pension planners to seek higher returns on their current investment portfolios.  This means looking beyond the “home country bias” that has consistently plagued asset managers.  In order to generate the needed returns on pension funds these asset managers are searching the world for higher rates of return.

Global Imbalances and Managerial Decision Making

How will these global imbalances impact managerial decision making?  The lack of U.S. savings and current account deficit will, in all likelihood, be corrected by a combination of higher U.S. interest rates and a depreciating U.S. dollar.  Will this mean a collapse of the U.S. economy and a free fall of the dollar in the foreign exchange market, the so-called “hard landing?”

A hard landing for the U.S. economy is unlikely for a variety of reasons.  One reason is that as the dollar falls in value the market value of dollar-denominated assets held by foreigners increases in value.  Thus, there will be an increase in demand for dollars to purchase more of these newly increased in value dollar-denominated assets.  Therefore, one can reasonably predict the dollar may fall some what in value against other currencies, but a free fall of the dollar is unlikely. 

Also one can reasonably assume U.S. interest rates will continue to increase, although at a very moderate pace, over the near term.  The Federal Reserve will probably continue to raise interest rates especially if it continues to see inflationary pressures building in the U.S.  However, these higher interest rates are unlikely to result in a major slowdown of the U.S. economy.  These higher U.S. interest rates however might mean that interest rates in places like Latin America may be able to fall without triggering massive capital outflows or fear of domestic inflation.

In terms of the overall U.S. economy it looks as though increases in U.S. total factor productivity will continue for the foreseeable future.  The total impact of increases in productivity due to Information Technology has yet to be felt by the entire U.S. economy.  Thus, look for U.S. companies to continue to look for other places to produce labor intensive commodity-type goods and services.

The aging of the American and European populations will bring about significant market opportunities.  Firms around the world who are able to adapt their product lines to meet the needs of the aging populations in the U.S. and Europe are sure to be rewarded with high margins.  Look for medical care, medical devices, entertainment and leisure activities aimed at aging Americans and Europeans to be successful growth industries in the future.

Conclusion

Many of the global imbalances such as the aging populations in Japan, Europe and the United States as well as the low U.S. savings rate will likely continue well into the future.  Other global imbalance such as the U.S. current account deficit, large federal government budget deficit and large capital account surplus will “correct themselves” as the global financial markets adjust to new equilibriums.  The adjust processes to these global imbalances offer important opportunities for global managers and their firms who are quick to identify opportunities and offer competitively priced solutions.  It is my hope that your firm is one of these.

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Dr. Michael Brandl is an economist at the McCombs School of Business at The University of Texas at Austin.  He team teaches the Money & Capital Markets course in the Texas Executive MBA Program at Mexico City.