By Michael Pettis

This post was originally published at China Financial Markets at the Carnegie Endowment for International Peace website

According to a May 2020 CNN article, one consequence of the coronavirus pandemic is that “Americans are slashing their spending, hoarding cash and shrinking their credit card debt as they fear their jobs could disappear.” The article goes on to say that U.S. credit card debt has fallen by the largest percentage in thirty years while household savings rates have climbed to levels unseen since the 1980s.

While part of this increase in savings may be a temporary reaction to the lockdown, and consumer spending could very well pick up again quickly once conditions return to normal, there are many reasons to believe and some evidence to suggest that American households will cut back permanently on at least some future discretionary spending to have a higher savings buffer in case of future crises.

The idea that Americans want to consume less and save more might seem at first like a good thing, but it could put a severe damper on the consumer-driven U.S. economy as a whole: after all, one person’s spending is another person’s income. So even if individual Americans strive to save more money, that may not be enough to drive up the collective American savings rate, which can only rise under very specific—and improbable—conditions. Put differently, if some American households decide to save more, the country’s overall savings rate will not rise unless some other (unlikely) adjustments or tradeoffs elsewhere in the economy allow that to happen.

What’s more, higher household savings isn’t always a good thing for the broader economy. It could be positive or negative for the United States depending on what the country’s pandemic-era economic adjustment looks like. Because total U.S. investment is by definition equal to total American savings (that is, the savings of households, businesses and the government) plus net foreign savings (that is, the current account deficit), at the macro level there are only three ways the adjustment can play out. A higher household savings rate could be accommodated by a decline in the American current account deficit, or it could result in an increase in U.S. investment, or it could be matched by negative saving elsewhere, so that the total savings rate would not rise. There is no other way the economy can absorb a rise in the savings rate of American households.

It is important to understand the limited ways the economy can adapt to higher U.S. savings rates when grappling with the policy options.

Will Higher U.S. Household Savings Trim the U.S. Current Account Deficit?

In most other countries, a boost in household savings would almost certainly cut the current account deficit, but the United States is different. Countries that run current account surpluses must save more than they invest, and countries that run current account deficits must save less than they invest. The fact that the United States runs a current account deficit, in other words, means that U.S. savings is less than U.S. investment. Many mainstream economists would therefore conclude that any increase in U.S. household savings, by reducing the gap between investment and savings, would reduce the U.S. current account deficit.

But they are forgetting something. As the world’s borrower of last resort—the automatic recipient of the world’s excess savings—the United States operates differently than most countries. Because its deep, well-governed financial markets and its highly credible currency work automatically to absorb excess global savings from abroad, the United States is one of the few countries in the world that has no control over its domestic savings rate. The United States runs a current account deficit not because it saves too little, in other words, but rather it saves too little because it runs a current account deficit, the automatic corollary to its capital account surplus.

This dynamic has very important consequences during the coronavirus pandemic because the problem of excess savings by other countries is poised to get even worse. It is not just U.S. households who will likely respond to the economic downturn by saving more. Foreign households will also save more, and because much of this excess savings will be exported to the United States, the U.S. current account deficit is likely to rise, not fall. This means that no matter how frugal U.S. households become, higher U.S. household savings will not reduce the U.S. current account deficit: on the contrary, the country might be forced to accommodate an even higher deficit.

Will Higher American Household Savings Boost Investment?

It may seem as though higher U.S. household savings could be a shortcut to greater U.S. investment and a boon to economic growth, but that isn’t necessarily true either. If the United States were a developing economy with high investment needs constrained by scarce and expensive capital, an increase in domestic household savings rates could certainly result in higher investment. But in developed economies like that of the United States, the main constraint on business investment is expected demand, not capital scarcity. So, if anything, belt tightening among U.S. consumers could be a drag on investment, not a boost. That is why if American households decide to save more and consume less, the most likely consequence—as occurred, for example, in Germany after the 2003–2005 labor reforms that reduced wage growth and increased German savings—would be reduced business investment.

If U.S. households do reduce consumption and businesses do reduce investment—the latter condition exacerbated perhaps by a higher current account deficit—the combined effect would create a drop in total domestic demand, which would force businesses to close and lay off workers. The only way to counter this would be for Washington or local governments to engage in public sector investment in infrastructure (or incentivize the private sector to do it). Higher American household savings can only cause investment—and with it total savings—to rise, in other words, if the government responds by spending substantially more on public sector infrastructure. The private sector by itself cannot do the job.

Will Higher American Household Savings Cut Into Savings Elsewhere?

If U.S. investment doesn’t rise and if the U.S. current account deficit does not contract, total U.S. savings cannot rise. What’s more, if the current account deficit expands and business investment declines—both scenarios that are possible and even likely—total American savings actually must decline to balance lower investment and a higher current account deficit.

This reality may seem very counterintuitive, so it is worth asking: how is it possible for total U.S. savings to remain unchanged or even decline if American households react to the pandemic by increasing their savings rate? There are basically four ways this can happen:

• The drained savings of laid-off workers: Falling household consumption—perhaps exacerbated by a decline in business investment and a wider current account deficit—might cause American businesses to lay off workers. Unemployed workers produce nothing but must continue to consume, so they are forced to deplete their savings or the savings of others. This is why total U.S. household savings would be flat or even down, even though some American households will be saving a larger share of their income. The negative savings of unemployed Americans would cancel out the increased savings of Americans who were able to retain their jobs.

• Ballooning consumer debt: The Federal Reserve and U.S. banks—the former concerned about rising unemployment and the latter forced to absorb higher savings—might respond by implementing policies to encourage some American households, usually those previously unable to borrow, to take on new credit card debt. The net result would be that their higher debt (debt is negative savings) would cancel out the higher savings of other American households. As in the above case, total U.S. household savings would again be flat or perhaps even decline, even though some American households would be saving a larger share of their income.

• Boosting government spending: Washington and local governments could implement policies that create consumption on behalf of households by, for example, increasing healthcare benefits, paying for education, and otherwise strengthening the social safety net. By consuming (on behalf of households) government spending could balance out the lower household consumption caused by the pandemic. But even if that happens, higher household savings would be matched by lower government savings.

• Redistributing income: Washington could implement policies that redistribute income from wealthier Americans, who save a higher portion of their income, to poorer Americans, who save a lower portion. If such policies are enacted, U.S. household savings wouldn’t rise because higher savings among poorer households would be matched by lower savings among wealthier households.

How Will the U.S. Economy Adjust?

Total U.S. investment is by definition equal to total American savings plus net foreign savings (that is, the current account deficit), which means that there are a very limited number of ways that the U.S. economy can respond to a rise in the household savings rate. These are listed below. Some scenarios are not entirely outside the realm of possibility but seem highly unlikely.

• One possible scenario is that the U.S. current account deficit could contract, but that is very unlikely, and if the rest of the world also responds to the pandemic by saving more, it is more likely that an incoming deluge of excess foreign savings will force the U.S. current account deficit to expand even more.

• Another possibility is that U.S. businesses could increase investment, but that seems like a longshot too. Because a higher household savings rate and a constant or bigger current account surplus would reduce aggregate demand, business investment is more likely to contract.

• The Federal Reserve and American banks could try to reverse the higher household savings rate by encouraging consumer debt—usually among the poorest households—in which case rising consumer debt by some households would balance out the increase in savings by others. This approach would merely postpone, not resolve, the problem of weak demand, and it would increase the financial fragility of the U.S. economy.

• Washington and local governments could strengthen the social safety net and increase consumption on behalf of U.S. households.

• Washington could redistribute wealth downward to boost net consumption.

• Washington and local governments could also implement policies that significantly increase much-needed infrastructure investment.

• Finally, if business investment doesn’t rise, the current account deficit doesn’t decline, and government spending on infrastructure or the country’s social safety net doesn’t markedly increase, any increase in savings among some American households must result in a reduction in savings in other American households. If this balancing out isn’t caused by increasing consumer debt, it must be driven by rising unemployment.

A few other technically possible but very unlikely responses can safely be ruled out. The U.S. government is highly unlikely, for example, to allocate massive amounts of foreign aid to developing countries (thus lowering the U.S. current account deficit) in the current economic and political climate. Americans could use their savings to go on a house-buying spree, but that doesn’t seem likely either. Otherwise, the aforementioned options are the only ways the United States can adjust to higher household savings rates.

Economically speaking, the best options would be for the government to pursue efforts to build and repair American infrastructure, redistribute wealth downward, and/or strengthen the country’s social safety net. Next best would be to reduce the current account deficit by intervening to keep foreigners from dumping their excess savings in the United States. The worst options would be to reverse higher household savings by encouraging consumers to embark on a credit-fueled spending spree, and, of course, to allow unemployment to rise. Unfortunately, the country has no other practical options.