2008-08-26

US bubbles and the global savings glut

I am now of a fairly firm conviction that the U.S. asset bubbles of the recent decade have been caused by the global savings glut.

What's happening is, ever more people around the world have been saving money, putting it into banks. But the banks can't just pull the money needed to pay interest rates out of thin air; it's not supposed to be a Ponzi scheme per se. So banks around the world need to invest their clients' money somewhere where it will generate decent return, so that they can pay the clients some interest, pay for their expenses, and collect some profits in turn.

The problem is, banks in most countries have found it unattractive to invest domestically. A few likely reasons:
  • Taxes and bureaucracy: Most countries in the world don't make it as easy to start and run a business as the United States or, say, Ireland do. Even most developed countries in continental Europe are in this category - e.g. France, Italy, Germany, Spain.
  • Incompetent educational systems: most ex-socialist countries have legacy "universities" with all kinds of wrong incentives in place which cause the education process to suck and the resulting talent to be sub-par when compared to those educated in developed countries. This reduces the ability of companies to find good enough employees.
  • Language barriers: Many countries speak a language that no other country speaks, so companies founded there are at an inherent disadvantage: they have a limited talent pool at home, and at the same time they find it difficult to attract talent from abroad.
  • No market: Even if a country is large, there are few things you can sell to poor people.
  • Corruption: In countries such as Russia, you have to keep bribing officials, or they will obstruct you and shut you down. A company can expect to pay some 10% of its revenue in bribes.
  • Political risk: In several other countries, you never know when the authorities are going to commandeer your company and just take it away.
  • Currency risk: Invest in Argentina just to see the peso collapse overnight.
  • Favoritism: In many countries, success in business is determined not so much by how well a company does its job, but in how well its owners are connected to those in economic power. Government contracts are awarded to large companies owned by favorites, and those companies contract out to their own favorites. Investing in such environments is much more difficult because you have to look not so much at the business you're considering, as to whether you have powerful enough friends.
  • No rule of law: Connected to favoritism, what good is law against anti-competitive behavior, if it takes 5 years to get anything done in court? And even then the outcome is unpredictable.
All of these reasons contribute to making most countries, seemingly or actually, unattractive investment opportunities when compared to the United States.

The United States have few of the above problems. First and foremost, there's rule of law. But also, while taxes are high, starting and running a business is relatively straightforward. If you want to change a lightbulb, you don't need to apply for a bureaucrat's blessing on a triplicate form. The educational system, for now, still produces some of the most competent people in the world. There's an affluent population of 300 million people, most of whom speak a single language. To the extent that there's corruption, it's by far not as endemic as it is in, say, Russia. Political risk is small; a shareholder's rights are well protected. And while the US dollar has had cycles, it has never collapsed overnight like the Argentinian peso.

Sounds like an ideal investment destination, right?

It does, and it would be - if it wasn't for the fact that, because of its appeal, all the world's money has been pouring into the place!

Suppose the world has, say, 1.5 billion affluent people at this point. This includes everyone in the developed world, as well as tens, or even hundreds of millions of people in developing countries who have already reached a level of affluence.

Now, instead of each country benefitting from the savings of its own people, the above factors produce a situation where the savings of 1.5 billion are all invested into an (already developed, and way affluent!) country of 300 million!

What is the natural consequence?

All that money is sitting there in the U.S., wanting to be chosen for investment, competing with all that money that is there after the same thing. But there's only so much investment that can be done. So what happens then? The interest rates for borrowing money fall dead low. What happens then? With money being so cheap, people start borrowing it for all sorts of purposes that make increasingly little sense. All that money is there, waiting to be invested, making people itchy. There are rules which require managers of certain large funds to have at most 5-10% of their holdings in cash. Which means that, because of these rules, and because, in the end, savers in foreign countries are looking for at least some kind of return on their deposits, there's an awful lot of money and there's pressure to invest it somewhere, somehow, in some way.

So, lacking sufficient opportunities, people start throwing money indiscriminately into things that turn out to be Ponzi schemes. Returns are good for the first few years, which attracts more investors and makes it really difficult for conservative fund managers to keep their jobs while everyone else is "making" a killing. Then the bubble collapses, but all the same pressures still exist, so all the "investment" is just redirected elsewhere. First there's: "Oh, we know what to do with all this money, we're gonna throw it into tech stocks, and we will make a killing while we revolutionize the world!" And then that blows up. People sober up, and there's a new tune: "Oh, we know what to do with all this money safely. We're gonna lend it to American mortgage borrowers! Mortgage lending is the safest investment historically. And it pays well." So now the savings of 1.5 billion people fly into the mortgages for a country of 300 million, and lookie look - that blows up, too.

If my assessment is correct, then the reason for these bubbles is not that US regulation failed. It is that the US economy is being overwhelmed with the desire of 1.5 billion people to invest in a "safe place with good returns". Because everyone has the same place in mind, that place becomes no longer safe; and it no longer provides good returns.

One way to fix this, surely, is to make the United States a more bureucratic country. Put up more roadblocks for investment, and the relative appeal of the US for foreign investors will decrease. Make the US shitty enough as an investment destination, and hey, people might consider investing in their own countries.

But that's a fool's solution.

The proper way to solve this problem is to open up the other countries in the world; to put them in a shape where they will themselves become attractive investment opportunities. Reduce taxes; reduce bureaucracy; improve education; teach foreign languages; weed out corruption and favoritism; provide strong ownership rights; have an effective legal system; run a solid monetary policy. Implement these steps, and other countries will become attractive investment opportunities.

The "crisis" of the financial system that we're seeing, however, is already part of the solution. What people seem to think is a "crisis" is merely much needed change. For a while at least, investors around the world seem to have come to their senses, and may just realize that they can't just shovel all their money into the United States and expect it to magically work out.

If the world becomes more balanced, money will never again be as easy to borrow in the US as it has been in recent decades. That would not be a crisis. That would be a regular, sensible course of things.

3 comments:

verbatim said...

I strongly agree with your observations.

If you want to change a lightbulb, don't need the country's blessing on a triplicate form.

I agree that elsewhere you first need papers to do things. Main advantage in U.S. is that you can obey to rules without first introducing tons of papers showing that you will be doing by the rules. But that doesn't mean there are no rules in place in U.S. Actually there are much more of them than in average western society. You can't even dig a hole on your own, rethorically speaking.

most ex-socialist countries have legacy "universities" with all kinds of wrong incentives in place which cause the education process to suck and the resulting talent to be sub-par when compared to those educated in developed countries.

I would agree with your statement if it would be for "average" student. Regarding natural sceiences, the problem with ex-socialist education system isn't that it is bad but that a 98% of people can't handle it because it is too tough for them. Result of ex-socialist educational system is that huge number of graduates on the most elite universites are from those countries, the best scientists also got their basic or full education there and usual winners on various knowledge competitions also came from those countries. So, they are not really sub-par.

For vast majority of people learning by recipe (as they are doing in the "west") is better solution than to base your education system on understanding the background of topics they are studying. Talent needs to understand background so he can improve solutions or make one on its own but a regular average worker doesn't. He just needs a way.

I am always checking various school textbooks in countries I visit. Differences are amazing. In west there are usually no proofs in mathematical textbooks and books have like 5 times less pages, but there they include only steps how to solve something. Textbooks, coming from east, are full of proofs without practical examples, which for sure isn't appropriate for majorty. But that shouldn't affect talents.

denis bider said...

Good and interesting points.

In my limited experience from Slovenia, while some technical faculties can be decent, there are huge numbers of students on faculties such as Law, languages, Social Studies, whose "education" is an abominable, counterproductive waste of time.

There's problems like faculties accepting way more students than their capacity allows, because the government pays them for each student. At the end of the year, regardless if they're good, most of those students don't pass.

Then there's arbitrary standards; professors who mark students based on how much they like them; professors who mark students at random; professors who mark students based on how well they can reproduce the exact sentences that the professor used; professors who just fail everyone to make a point; and so on.

This "quality of learning" persists because government control over higher education takes the market completely out of the picture, and replaces it entrenched interests and preposterous incentives.

denis bider said...

I forgot another important aspect that very much limits the investment appeal of many countries:

Economic favoritism.

I'll add that in the article.