I was recently asked by an Australian economics journal to write a review of a book I had already read, The Leaderless Economy, by Peter Temin and David Vines (published in 2013). Because the book is a great place from which to start a discussion on the links within the global economy, I decided to base this essay on the book. I had already read Peter Temin’s Lessons from the Great Depression (1991), The Roman Market Economy (2012), and Prometheus Shackled (2013), and I know his work fairly well.
There is substantial overlap between the way Temin and Vines view the global economy and the way I do. I am a regular reader of Diane Coyle’s blog, The Enlightened Economist, in which she reviews books, usually on economics-related topics but also on anything else that might catch her attention. Besides having said very nice things about my book, The Great Rebalancing, and including it in her shortlist of top books for 2013 (I am bragging a little) she has also reviewed The Leaderless Economy, and has noted the similarities in the way both books approach the balance of payments.
She is right. Both books analyze the global economy in pretty much the same way, as an economic system in which any country’s domestic economy is inextricably linked to other economies through the balance of payments mechanisms. The ability to place events within their global context is consequently crucially important in understanding any country’s economic performance, but actually doing so tends more to be the exception than the rule.
To take one example, I remember in the early 1990s I read a book about the Panic of 1873, in which during September and October of that year gold reserves in New York plummeted, banks folded, and the stock market crashed, with the New York Stock Exchange actually closing, on September 20, for ten days. It was in many ways an excellent book about the events leading up to the crisis and the various factors that “caused” it, but except for a brief mention of the impact of the crisis on the British banking system, you could have easily assumed, as I did then, that the 1873 crisis was purely an American affair, and that events in the rest of the world barely mattered.
It was only a few years later, while I was reading Charles Kindleberger’s A Financial History of Western Europe that I learned that the 1873 crisis actually “began” with a stock market crash in Vienna in May, four months before the New York markets fell, which spread to Germany, England and other countries, and the subsequent depression was perhaps the first “global” panic and depression in history. It was in Kindleberger’s book that I also first learned about the impact of the Franco-Prussian War of 1870-71 and the subsequent reparations payments on global financial markets (which I discuss extensively in a February blog entry) and in unleashing the final stage of a global liquidity bubble that ended with the various panics of 1873.
[drizzle]The Panic of 1873, in other words, was clearly not only, over even mostly, an American affair. It was global, and its causes could not have been limited to American causes, as the book seemed to imply. On the contrary, I would argue that it is impossible fully to understand the crisis, whether the focus is on the evolution of the crisis in the US, the UK, continental Europe, or Latin America, without understanding the full global context.
The Leaderless Economy makes the same point I try to make in The Great Rebalancing: the economic analysis of any country is largely useless if it ignores, or treats as a minor issue, links with the external sector – i.e. other countries – and this is even more true today than in the past. Even something as important, and as seemingly “domestic”, as the US savings rate (which for most people is assumed largely to reflect cultural preferences towards thrift among American households) is not determined primarily by American households but rather by its links with savings distortions abroad.
This might seem a profoundly counterintuitive statement, but in fact you only need to understand two or three accounting identities to be able to work logically through the explanation. I showed why one country’s savings rate is as likely to be determined by domestic distortions as it is by distortions abroad in a blog entry on whether a savings glut must cause global savings to rise. In another blog entry, I explained why a low savings rate in countries like Spain was a necessary outcome of policies in Germany that effectively restricted wage growth. And finally I showed how – because of the role of the dollar in reserve accumulation and, more generally, the unrestricted ability of foreigners to buy US assets – the US savings rate is determined largely as a residual needed to balance net capital flows, in a blog entry on the so-called exorbitant privilege, and in a follow-up blog entry.
Global balancing mechanisms
In their book Peter Temin and David Vines don’t discuss the US savings rate but they do a lot of the same thing by changing the focus slightly. In my book I argue that because global savings and global investment must balance, if any country’s savings exceeds its investment by some amount, investment in the rest of the world must exceed savings by exactly the same amount. Temin and Vines express the same relationship between conditions in one country with conditions abroad in a way that can be summarized in two sentences. First, the domestic imbalance in any economy – i.e. high levels of unemployment or demand, large gaps between savings and investment, and so on – must be consistent with and equal to that country’s external imbalance at all times. Second, that country’s external imbalance must be consistent with and equal to the external imbalance of the rest of the world at all times
These two ways of seeing countries within their global contexts are basically identical. Any country’s capital account of course is simply the gap between its domestic savings and its domestic investment, and because the capital account must balance the current account (the two always add to zero), to say that the gap between savings and investment in any country must be equal to an opposite gap between savings and investment abroad is simply to restate the far more intuitively familiar claim that every current account surplus in the world must be matched by a current account deficit. Until we begin trading with extra-terrestrials the total must add up to zero.
This should all be obvious, but if an imbalance in one country must be matched by an opposite and equal imbalance abroad, there are only two possible explanations. Either the imbalances in every country are set endogenously, and, by some miracle, at every point in time, they balance out perfectly, or an imbalance in one country can force imbalances onto other countries. The first explanation is obviously absurd, so the gap between the amount a country saves and the amount it invests is as likely to be determined by external conditions as by internal.