Economics focus

A working model

Aug 11th 2005
From The Economist print edition

Is the world experiencing excess saving or excess liquidity?

WHEN The Economist's economics editor studied macroeconomics in the 1970s, the basic model for understanding swings in demand was the so-called IS-LM framework, invented by Sir John Hicks in 1937 as an interpretation of Keynes's “General Theory”. In recent years it has gone out of fashion, dismissed as too simplistic. That is a pity, for not only does the model seem more relevant than ever today, but it also casts useful light on why bond yields are so low.

America's Federal Reserve raised short-term interest rates again this week, to 3.5%, its tenth increase since June 2004. Yet over that period, long-term bond yields have fallen to historically low levels. Indeed, virtually everywhere around the globe real bond yields are unusually low. The most popular explanation is that there is a global glut of savings, which has driven yields down. However, while some parts of the world, notably Asia, may save more than they need to, it is not obvious that the world as a whole is doing so. Over the past couple of years, global saving has risen as a share of GDP, but so too has investment. By definition, global saving must equal global investment; what really matter are ex ante, desired rates of saving and investment which may have caused bond yields to decline. An alternative explanation, preferred by some economists, is that bond prices, like other asset prices, have simply been pushed up by excess liquidity (ie, yields have been pushed down).

The IS-LM model helps us to understand these two opposing theories. Originally devised for a single closed economy, it can today be more realistically applied to the global economy. Its main virtue is that it brings together both the real and the financial parts of the economy. The IS (investment/saving) curve represents equilibrium in product markets, showing combinations of output and interest rates at which investment equals saving and hence the demand for goods and services equals supply. The IS curve slopes downwards, because a higher interest rate reduces spending and so lowers the level of output at which demand equals supply.

The LM (liquidity/money) curve represents equilibrium in the money market, showing combinations of output and interest rates where the demand for holding money, rather than interest-bearing assets, such as bonds, equals the supply of money. This curve slopes upwards, because a rise in income increases the demand for money and so raises the interest rate at which the supply of and demand for money are equal to one another. (A rise in rates reduces the demand for money because it raises the opportunity cost of holding non-interest-bearing assets.)

The point at which the two curves intersect is the only combination of output and interest rates (ie, bond yields) where both the goods and financial markets are in balance. Too much economic commentary seems to assume that the IS curve alone (ie, the balance between saving and investment) determines bond yields. But yields also depend on the LM curve, which represents, in effect, the choice between holding money or bonds.

Reading between the lines

The left-hand chart shows the economy in equilibrium at interest rate r1 and output Y1. If desired saving increases relative to investment (ie, there is excess saving), the IS curve shifts to the left to IS2. Interest rates fall (to r2), and so also will output (to Y2). This does not fit the current facts: last year the world economy grew at its fastest pace for almost three decades, and this year remains well above its long-term average growth rate.

The right-hand chart illustrates the alternative theory. A loose global monetary policy shifts the LM curve to the right, to LM2. Bond yields again fall, to r3, but this time output increases. In contrast to a shift in the IS curve, the economy has instead moved along the IS curve: lower interest rates stimulate global output and hence investment. This seems to fit the facts much more comfortably.

Bond yields are low largely because central banks have created too much liquidity. Despite rising short-term interest rates in America, monetary policy is still unusually expansionary. Average short-term rates in America, Europe and Japan have remained below nominal GDP growth for the longest period since the 1970s. In addition, America's loose policy has been amplified by the build-up in foreign-exchange reserves and domestic liquidity in countries that have tied their currencies to the dollar, notably China and the rest of Asia. As a result, over the past couple of years, global liquidity has expanded at its fastest pace for three decades. If you flood the world with money, it has to go somewhere, and some of it has gone into bonds, resulting in lower yields. Or, more strictly, bond prices have been bid up until yields are so low that people are happy to hold the increased supply of money. In its latest annual report, the Bank for International Settlements suggests that the fact that the prices of all non-monetary assets (including bonds) have risen could indeed reflect an effort by investors to get rid of excess liquidity.

In fact, the two theories are not mutually exclusive. Too much saving relative to investment may well have gone hand in hand with excess liquidity, ie, both the IS and LM curves have shifted downwards. Central banks' monetary easing was, after all, partly in response to a fall in investment after share prices slumped. However, the current rapid pace of global growth suggests that excess liquidity is the prime cause of low bond yields. The snag is that central banks will eventually have to mop up the overhang of liquidity and bond yields will then rise.

Why isn't excess liquidity generating inflation? The basic IS-LM model assumed that the price level was fixed, and thus its inability to explain high inflation rates in the 1970s and 1980s hastened its fall from grace. If an economy is at full employment, an increase in money leads to higher prices, not lower bond yields. Today, however, the model may be more relevant because the entry into the world economy of cheap labour in China and other emerging economies is helping to hold down inflation. In a world of low inflation, IS-LM rides again.