Global demographics could land the world in a prolonged savings glut

The world is in the midst of very rapid demographic change. Not only are developed countries such as Japan and Germany ageing rapidly, but the process appears to be even more rapid in emerging markets. Large developing countries such as China and Russia have fertility rates well below the levels needed to maintain their populations. The impact on future labour supply is much debated - but few economists have focused on the likely impact on global imbalances.

The current account is the difference between a country's savings and investment rates. Both are influenced strongly by demographics. A rising share of working-age population tends to push up both savings and investment. However, as a society ages, the investment rate is likely to fall faster than the savings rate, thereby generating a current account surplus (or a smaller deficit). This is why Japan has run a surplus for the last 25 years despite a continuous loss of competitiveness (although this phase may be coming to an end).

This dynamic is now likely to play itself out in many countries. For instance, China currently saves and invests half its gross domestic product (GDP) but, as its workforce shrinks, its investment rate is likely to fall sharply. A rapidly ageing population, in contrast, will probably not lower its savings rate so quickly. This differential will generate ever larger external surpluses, which will transform China from being "the factory of the world" to being "the investor to the world".

It would have been convenient if global demographics were spread out in such a way that ageing countries could run surpluses when younger countries needed the capital. However, the world's demographics appear to be bunched up in such a way that many major economies will attempt to save for old age at the same time. Moreover, the younger countries are often emerging markets that have neither the scale nor the capacity to efficiently absorb the world's excess savings.

Thus, we live in a world where everyone wants to run a current account surplus. China has long run a large surplus. Now the euro zone, as a whole, runs a large surplus, with big swings in southern Europe adding to Germany's perennial surpluses. Similarly, America's deficit is now much smaller than it was in the pre-crisis era, and many economists argue that it should never revert to the earlier path. Till recently, the world's deficits were being run by countries like Brazil and India - but financial markets have made it clear that, beyond a point, they are not credible recipients of ever larger capital flows. Since the world is a closed system, this raises the question: who will run the world's deficits?

Mainstream economists are of the view that the global economy should function as a balanced mechanical system: temporary external surpluses/deficits may appear, but they should smooth over time. However, economic history shows that periods of global expansion are virtually always underpinned by symbiotic imbalances, rather than by balanced arrangements that satisfy theoretical ideals. Thus, one part of the world runs large deficits for long periods and creates demand, while another part of the world runs surpluses and finances the other. This was true of Roman-Indian trade in the first and second centuries as well as the age of European exploration in the sixteenth century. It was also true of Bretton Woods I till 1971 and of Bretton Woods II till 2007 - in both instances, the United States ran the necessary deficits.

Admittedly, every imbalanced system caused distortions. The Romans had to debase their coins due to the continuous loss of gold to India. The Spanish empire flooded the world with silver coins as it tried to pay for its wars. Bretton Woods I ended when the dollar's peg to gold became untenable, while Bretton Woods II suffered from the misallocation of capital. However, the existence of distortions does not mean that these systems did not last for long periods of time.

Moreover, there is almost no episode of sustained global expansion that was characterised by balance. The exception is the early nineteenth century, when the East India Company deliberately imposed a triangular trade system where Britain sold manufactured goods to India in order to buy Indian opium, which, in turn, was sold in China to finance the purchase of tea and other products. Thus, global "balance" required war, colonisation and drug trafficking.

This brings us to the present problem: what symbiotic imbalance will underpin the next round of economic growth?

It appears that, once again, it will fall to the US to run the world's deficits in what could be dubbed Bretton Woods III. It has not just the scale that's required, but also the youngest demographics of any major developed country. Many readers may be appalled that a country that is perceived to be so indebted should be expected to run more deficits. However, the circumstances are such that the world is willing to finance the US at negative real interest rates. Notice how the world is complaining about America's unwillingness to run up ever more debt by raising the debt ceiling!

Thus, we are faced with what is called Triffin's dilemma. On the one hand, it is possible that the US is unable or unwilling to take on this role. Then we should expect the world economy to flounder in a savings-glut environment of low demand and cheap capital till some other alternative emerges. On the other hand, the US may eventually be enticed by the cheap cost of international capital to absorb some of the excess savings. This would trigger the Bretton Woods III period of global expansion, which, in turn, would generate its own distortions. The likelihood of its eventual demise, however, does not mean that we should wait for some theoretical ideal of balance. Indeed, the arrangement could last a long time if the US uses the capital to fund sensible investments rather than consumption.