Saving should begin at home

In IMF/World Bank meetings last week, the Chancellor drew attention to a potential problem that has recently become an obsession in the financial markets - the alleged shortage of world savings. Mr Clarke asked for a special study of this topic from the Group of Ten largest industrial nations, and this will start forthwith.

Many analysts have attributed the recent rise in global bond yields to a combination of low savings in the industrial countries with rising demands for capital in the emerging economies of Asia, Eastern Europe and Latin America. The argument is that the marginal return on investment in the emerging economies is now much higher than that in the Organisation for Economic Co-operation and Development (industrial) economies, so increasing quantities of capital are flowing to the former from the latter.

The rise in capital investment in the emerging markets has, it is alleged, led to an increase in global real interest rates. This is squeezing out capital projects in the OECD countries to make room for the higher returns available on competing projects in the emerging markets.

While this process is optimal for the world economy, since it is reallocating scarce capital to the geographical regions that can generate the highest returns, it may cause uncomfortable adjustment problems in the OECD economies, including the UK. For example, new industries in the emerging economies will compete directly with older industries in the OECD, and this could lead to plant closures and unemployment, especially among unskilled workers who are in effect being displaced by cheaper labour overseas.

In the very long run, all economies should be better off from this process, but for many years, perhaps even decades, there will be large pools of losers in the developed economies, notably the rump of unemployed who never retrain, move regions and find a new job. Such may be the political fall-out from this dislocation that the OECD economies may start to think about protecting their industries against foreign competition, and may even reintroduce controls over the free movement of capital. The European Union seems particularly prone to think in these terms, which is why some international investors view Europe as a protected backwater to be avoided at all costs.

COMPELLING STORY

This story of globalisation certainly seems compelling, and appears to fit with some of the stylised facts in the world economy today - in particular, high real interest rates, rising unemployment among unskilled workers in Europe, and downward pressure on the real wages of the unskilled in the United States.

Furthermore, several of the key elements of this story appear to be uncannily similar to the revolution which hit the world economy from 1870 to 1914, the last time that capital was allowed to move freely throughout the globe. In that era, there were massive capital exports from the established industrial nations (mainly the UK) to the emerging countries of the time (mainly the US).

Real interest rates were very high, and although global economic growth was healthy, it occurred mainly in the new economies. The older nations struggled with repeated recessions, bouts of high and volatile unemployment, and low returns from their equity markets. While the low-paid workers in the older nations had a tough time, the capitalist classes did well on the back of high returns on their investments in the new economies.

The telling of this tale can seem so convincing that it seems almost churlish to point out that there are several holes in the argument, at least as it is applied today. First, and most important, there is as yet no massive capital drain from the OECD economies to the emerging markets. If net capital inflows were large, then we would by definition expect to see a large and rising current account surplus in the OECD. (This would automatically be the counterpart in their balance of payments statistics to the capital outflow.)

Do we in fact observe this? Only to a very limited extent. For example, the current account surplus (and therefore by implication the net capital exports) of the OECD this year will be only dollars 13bn, equivalent to a trivial 0.1 per cent of their combined GDP. In no year since the mid-1970s have the OECD economies either imported or exported capital in excess of 1 per cent of their GDP. In the 1870-1914 era, the UK frequently exported capital equivalent to 5-10 per cent of its GDP, a figure which is utterly non- comparable with the present situation.

If we look instead at the current account deficit of the developing countries, we find that the officially recorded figure is running at about dollars 115bn this year, so there should be a net capital inflow of the same amount. This seems like a large number, but there are several mitigating factors.

First, it is only 0.7 per cent of OECD GDP, about one-sixth as large as the capital demands of the governments of the OECD, and about one-thirtieth as large as private-sector capital demands in the developed economies. Second, much of this figure may anyway be a statistical artefact, reflecting the over-recording of the global current account deficit, with part of this (perhaps all) coming from the developing countries. Third, the deficit of the developing countries has not in fact grown in the past three years, so it can scarcely be blamed for the recent sell-off in the bond markets.

DEVELOPING CAPITAL

The truth is that the emerging economies are at present generating much of the capital they need for their development from their own savings. In some cases, such as the Asian tigers, they are generating more than enough domestic savings, and are actually exporting small quantities of capital to the rest of the world. In other cases, such as Latin America, there are recorded capital inflows of about dollars 40bn a year. But who knows how much illicit private capital - drug money and the like - is leaking each year from these countries into the West.

To the nearest ha'penny or two, it has been safe for many years to treat the OECD economies as a closed capital market in net terms, with any capital exports to the equity and bond markets of the emerging economies being almost exactly offset by capital inflows in other areas.

This may certainly change, but if it does we would expect to see the OECD suddenly reporting a much larger current account surplus than anything we have seen in the post-war period.

It follows from this that if there is any problem with a shortage of OECD savings at the moment, then it must stem from events within the developed economies themselves.

As the graphs show, Mr Clarke is quite right to be worried about this. In both Europe and the US, savings and investment have been dropping as a share of GDP ever since the early 1970s, and the main cause has been a sharp deterioration in government budgets. (Note, incidentally, the contrast with the good performance of Japan on all these counts.)

Instead of bemoaning the leakage of capital to the emerging markets, which so far is something of a mirage, OECD governments should start by examining their own navels. As global activity recovers, they urgently need to save more and spend less.

(Graphs omitted)