If Americans Save, Who Will Borrow? (Part II)

Karl Smith -- Assistant Professor of Public Economics at UNC-CH and Blogger at Modeled Behavior

In my first installment I tried to make the point that the range of investment opportunities is limited. If the whole world tries to save at once we very quickly run into investments that have very low returns or alternatively are very risky.

Nonetheless, readers might understandably object that even a very low rate of return is better than becoming ever deeper in debt as America has of late.

That depends. The type of debt really matters.

Everyone is familiar with paper currency, the dollar bills you may carry in your pocket. They are useful for buying things, but they are also inconvenient. Carrying around a lot of cash is dangerous for starters. To solve this problem we have bank accounts. The bank holds on to our cash and in return we can write checks and use a debit cards.

Large international companies and financial institutions face a similar problem. Only for them even bank accounts will not due. Banks having to deal with such large accounts by institutions transacting around the world in all different currencies could not pay return for the equivalent of a savings account and would have huge fees for the equivalent of a checking account.

Instead, these institutions participant in the shadow banking system. They hold bonds or other financial assets which they can easily turn into cash in the repurchase or repo market. In the repo market one institution will agree to buy a bond from another institution and then sometime later, often 3 days, the original institution will buy the bond back.

This essentially serves as a loan from one institution to another. However, in a larger sense it can be thought of as making a cash withdrawal from the shadow banking system. In that way, the bonds held by these companies serve as their bank accounts. As long as the repo market is functioning they can always make withdrawals based on the bonds they have.

Where do these bonds come from?

Some are government bonds issued to fund national deficits. However, many of the bonds - at least before the crisis - were created from private loans taken out by individuals and businesses. Included in these are infamous mortgage backed securities.

As global finance and international trade grew larger and larger institutions needed ever larger shadow bank accounts. This requires ever larger quantities of bonds. Unfortunately, most of the world was saving not borrowing, and even the US had dramatically reduced its debt-to-GDP ratio.

This international demand for bonds not only drove interest rates way down but promised huge profits for anyone who could find a new source of safe bonds. In order to be useful as collateral bonds have to have little risk.

In response investment banks developed mathematical techniques to combine risky mortgage loans in such a way as to produce bonds that appeared safe. The extent to which this process involved fraud, hubris or simple error is still debated, but the outcome was not.

The issuance of these bonds fed a world-wide housing boom. That boom peaked around 2006 and as it faded the once safe bonds were no longer safe at all. The shadow banking system experienced a run. The repo market shut down. Major financial firms collapsed and the world economy hurtled into the Great Recession.

The issuance of that type of debt went badly.

The problem, however, is that the underlying thirst for debt has not be quenched. This implies that new credit bubbles are waiting to happen. Currently, that demand for debt is partially though not completely met by soaring US and UK budget deficits.

Yet, politicians in both nations are busying themselves attempting to drive down the respective deficits. As this happens the demand for new sources of debt will only increase and the propensity for bubbles will only grow larger.

This a part of a twin problem. The aging of the world population means that there are ever more savers and relative to young people to invest in. At the same time the global financial system depends on large quantities of safe assets.

Either the safe assets go to the financial system and the savers move into risky investments like the dot-com bubble or the savers stick with existing safe assets and the global financial system scrabbles to manufacture new safe assets out of risky loans.

We sometimes think that the large projected budget deficits and lack of savings on the part of middle aged Americans represent a failure to accumulate enough assets to pay for our own retirement and hence an increased burden for our children.

However, they are simply one manifestation of a much deeper issue: with slowing population growth the world is running short of things to own.