When Paul Krugman some time ago criticized the new Nobel Prize winner Eugene Fama he did a great job in clarifying the role of accounting identities for economic analysis. He wrote in response to Fama’s claim that higher savings will lead to higher investment: “The immediate thing Fama should have asked himself, even if completely ignorant of the history of macroeconomics, is why the causation necessarily runs from savings to investment. Why not the other way around?” Alas, this is exactly the question Krugman should have asked himself when treating the other accounting identity, the one that says that foreign savings always equal the domestic current account deficit.
In the case of the domestic deficit, Krugman comes to a reasonable result by stressing the dynamics of overall income in a case where consumers decide to save more. If consumers cut spending in an attempt to save more, investors facing falling utilization of their capacities or involuntary inventories would cut rather than increase investment. Krugman concludes that in this case “consumers may find that they’re not saving as much as they intended to, because their incomes fall. Naturally, these unintended results will lead to further changes in behavior, with firms cutting production and consumers further reducing spending, until we eventually reach a sort of equilibrium in which desired saving and desired investment match up; this new equilibrium need not be one in which investment rises, and could well be one in which investment falls”.
And his more general conclusion is also right: “The point, in any case, is that accounting identities can only tell you so much. Anyone who claims that the identities tell you everything you know, without an actual model of how things work, is just doing bad economics.” However, when it comes to external savings and their accounting counterpart, that same truth seems to escape him.
In his response to the German critique of the Treasury attack on the German current account surplus he writes: “It is a basic accounting identity that
Current account = Savings – Investment
Any story about the determination of the current account balance must take this identity into account. … So while it’s impressive that Germany can run a surplus despite quite high labor costs, and that’s a testimony to the quality of its stuff, ultimately the surplus reflects high savings relative to investment.”
It is a bit sad to note that Paul Krugman, who is so much needed as a critical voice in this world, does not seem to fully grasp the most fundamental relationship in the external dynamics of our economies. But that is not new. A paper that I wrote with UNCTAD in 2010, had already noted (it is quoted here) that Krugman said back as early as 1992: “An external deficit must have as its counterpart an excess of domestic investment over domestic savings, which makes it natural to look for sources of a deficit in an autonomous change in the national savings rate” (Krugman 1992, p. 5).
However, and I can easily continue with the older text “… suggesting that the identity implies causality and giving “saving” a specific, namely a leading role in the process, is unjustified. The fact that – from an ex-post point of view – a gap has emerged between saving and investment in one country does not hint at an “autonomous” decision of any economic agent in any of the involved countries. The plans of one group of actors cannot be realised without taking into account a highly complex interaction of these plans with those of other actors, as well as price and quantity changes under conditions of objective uncertainty about the future. In order to give the savings-investment identity informational content, it is necessary to identify the variables that determine the movements of each, saving, consumption and investment, and in consequence the national income of the country, along with the national incomes of all its trading partners.
In a non-stationary environment, any increase in expenditure (increase in a net debt position of one sector) raises profits and any increase in saving (net creditor position) reduces profits. Whether saving or investment change here or there, whether the beneficiaries (or losers) of the adjustment process are located in the country where the shock originated or in other countries, does not change the course of events. The decision of a certain group of economic agents (private or public, domestic or foreign) to spend less out of their current income diminishes profits. So it’s just the other way round one would expect when following Krugman’s statement: A smaller current account deficit (that means less foreign savings coming into the country) can actually mean higher domestic profits and more investment instead of a drop in investment.”
A current-account deficit, or a growing “inflow of foreign saving”, very often emerges as the result of falling terms of trade or a lasting real currency appreciation. Rising oil prices, for example, induced by rising demand in a big new consumer country like China, increases the oil bill of the industrialized consumer countries, which means rising demand (in nominal terms) for oil as the demand elasticity is very low in the short run. A current account deficit in the consumer countries emerges when the higher oil bill is financed by the international banking system (which is made easy by the fact that the banks expect the oil exporting countries to recycle their additional revenues quickly into the consumer countries). But the origin of these “foreign savings” has clearly not been the decision of the private households in Saudi-Arabia to save more than before.
A real appreciation of the domestic currency normally induces consumers to buy more foreign products and reduce consumption of similar domestic products. If the trading partner’s banking system is willing and able to finance the resulting gap between imports and exports (which is just a consumer credit to foreign clients), domestic income will fall as the revenues and the profits (the savings) of domestic companies are falling (while profits rise in the depreciating country). In this case again, the accounting identity indicates an increase of foreign savings even without one single private household in other countries having taken the autonomous decision to save more than before.
If a member of a currency union, such as Germany, decides to exert political pressure on domestic wage negotiations in an attempt to improve competitiveness, the first thing to happen (as a result of this effect that amounts to a real depreciation) is falling relative prices and the crowding out of some home made products in the trading partners markets by German products. When the domestic firms of other members of the currency union experience a real appreciation and a loss of competitiveness, the domestic banks in the deficit countries are willing to finance the rising gap as long as they can count on refinancing through the ECB for any reasonable transaction inside the currency union.
But nothing has happened on the savings side proper in Germany. Neither private nor public households have changed their behaviour. German companies – favoured by political pressure on wages – are making more profit in foreign transactions than before and foreign companies less. Nevertheless, a current account surplus emerges in Germany, which, in the terms of the accounting identity, can be interpreted as “Germany” saving more than before. And again, Krugman is obviously right: “Anyone who claims that the identities tell you everything you know, without an actual model of how things work, is just doing bad economics.”
Consequently, the capital flow hypothesis that attempts to explain the euro crisis is flawed, namely the idea that Germany had a savings glut and that German savings were needed in Spain, Italy or France in the first place to build houses and hotels. Moreover, to explain the huge German current account surplus it is by no means sufficient to argue that low interest rates in Germany induced German savers to invest abroad. In fact, interest rates in the relevant nominal terms all over the Eurozone were exactly as high as in Germany and in real terms interest rates were lower in the rest of the Eurozone because prices and wages there were on a higher growth trajectory than in Germany.
On an ironic note: Following Krugman’s logic, funnily enough, German savers seem to never give up. Untiringly they are searching for new foreign investment. After many of the debtors in the Eurozone find themselves in a critical situation now, German savings are flooding emerging markets and the United States more than ever before. Even China, a country we thought to be the world’s most important and powerful saver, recently is becoming more reliant on German savings. Why is that? Why is France unable to convince its private households to save more and invest these savings abroad instead of fighting for higher competitiveness by cutting wages? At least, to end with a positive message, Italy made it recently into the club of the net savers. The country records a current account surplus. Do Italian households finally understand that their behaviour is key to success of the whole economy? Remains the question why it took Italy the worst recession since the Second World War and rapidly falling imports to get there while Germany could do it without such pain? So on balance, Krugman’s blind-spot notwithstanding, we do agree after all that we need a much better model than accounting identities to understand what is going on!