Yes, Virginia, Demand Curves for Bonds Slope Down
Bush Has a Difficult Job?

Glenn Hubbard on the Global Investment Deficiency

The core argument of Glenn Hubbard's recent Wall Street Journal op-ed is another of those extremely rare pieces in that space that is both coherent and insightful. Its core argument seems a definite possible factor at work: - A Paradox of Interest : [T]the large increase in the U.S. current account deficit in recent years has mirrored large increases in current account surpluses in the rest of the world, principally in Asia. Over the same period, world real interest rates have declined.... The rise in the global saving rate is more than accounted for by a higher saving rate in emerging economies, particularly in Asia. I say "more than accounted for" because the U.S.... reduced its national saving....

[M]aking the transition from a global savings glut to a policy prescription requires delicacy. Taken seriously, this argument can be used to justify fiscal "pump priming"... [i]ncreases in public spending or temporary tax cuts... absorbing excess saving while increasing aggregate demand.... [But a] weak financial system -- reflecting an underperforming banking system, poor investor protection and corporate governance, or fragile securities markets -- yields a high cost of financial intermediation.... In an open economy, the international capital market offers the possibility of investing domestically generated savings in countries with a low cost of financial intermediation and/or a safe nominal anchor in government bonds -- the U.S., for example....

The efficient financial system of the U.S., liquid bond markets, and a stable nominal anchor have attracted large international capital flows. These inflows have financed large U.S. current account deficits. And this arrangement has been particularly strong between emerging Asian economies and the U.S.

While the U.S. needs to raise domestic saving gradually to fund entitlement promises in Social Security and Medicare, getting America's fiscal house in order provides little short-term solution to global saving and investment imbalances. Increases in U.S. saving, with unchanged investment opportunities or financial system efficiency around the world, puts further downward pressure on the world real interest rate.

To address the global saving and investment imbalance meaningfully, domestic financial systems must be able to shift capital where it can be most profitably employed.... Mercantilist trade policies in emerging Asian economies have played a large role in sustaining high domestic saving.... Official sector acquisition of dollar assets... strategies to promote export growth combined with direct intervention in credit markets have limited the domestic economy's ability to absorb its own savings....

[S]uch policies sacrifice long-term growth. Essentially, relatively poor citizens of China and other emerging Asian economies are lending funds to the more affluent U.S., where lower interest rates can facilitate a property boom.... The U.S. financial system stands as a beacon for the possibility of a virtuous relationship between capital markets and sustainable economic growth.... [T]he bigger immediate challenge is to address the imbalance of saving and investment in international capital markets by encouraging the development of efficient banking and securities markets.... [S]ustainable improvements in living standards require a financial system as modern as one of the region's new airports.

Glenn Hubbard's argument is roughly this: Emerging Asia is now big enough that its savings are weighty, but who can its savers entrust their money to? "Underdeveloped financial systems"--a euphemism for "it's not obvious the people you entrust your money to will give it back"--make investments in dollar assets housed in the United States seem very attractive, even with the long-run expectation that the real value of the dollar vis-a-vis other countries will fall. The best way to fix this is to work on institution building in emerging Asia: securities regulation, accounting rules, honest courts, clear lines of corporate control. Don't worry so much about soaking up excess saving. Worry instead about how to create modern financial institutions to boost the financial system's ability to boost investment, and so fix deficient investment in the rapidly-growing emerging market economies.

This may well be an important piece of the puzzle.