Finance ministers in search of a saving grace

There is no direct link between the malaise of the markets yesterday and the little local difficulties at the International Monetary Fund. The London markets had enough to worry about without bothering themselves over a row between the world's main finance ministers and the head of the IMF.

But the relationship does hold the other way round. The markets may not be worried by the antics of the finance ministers, but the finance ministers are certainly worried by the antics of the markets. And so they should be, for the world's finance ministries, as the main borrowers on the bond markets, have been the frontline victims of the rise in long-term interest rates this year.

Their concern has shown up in the commissioning of a study on the imbalance between savings and investment. The immediate issue is whether there has been a deterioration in recent months - that savings have declined relative to the demand for investment funds - or whether the rise in long-term interest rates is due to something else.

That something else might be fears of inflation, the withdrawal of Japanese investors from the US bond market, the surge of investment projects in East Asia. But it is difficult to know at this stage whether to focus principally on the supply side or the demand side of the equation.

It is hard to exaggerate the importance of this issue, not just for the markets now but for the whole development of the world economy over the next couple of decades. If the world is short of savings now, and accordingly needs high real interest rates to attract the cash, wait a bit and the problem will be vastly worse.

And, of course, if governments now have to pay real rates of 5- 6 per cent to cover their budget deficits the burden on the next generation of taxpayers will be enormous. Not only will they have to service these loans, but a smaller proportion of people of working age will finance a large increase in the numbers of the retired.

By rights, at this stage of the demographic cycle governments ought to be running large budget surpluses to set aside funds for this purpose, rather in the way the occupational pensions business builds up surpluses. In fact governments are doing the reverse.

Nor is this just a problem of the developed world. By coincidence the World Bank yesterday published Averting the Old Age Crisis, which looks at it from the developing world's perspective.

One of its conclusions, along with the need to relate contributions to pensions, was that long- term savings should be increased. True, many developing countries, particularly the newly- industrialised ones of East Asia, do have very high savings levels. But set against their age structure these look a little less impressive.

Add their need to fund future pensions and to devote savings to infrastructural projects - which have frequently been neglected as the rest of their economies have expanded - and there is not much spare cash, even in the high-saving countries. Besides, there is something unsatisfactory about relying on countries at a relatively early stage of economic development to be the world's main savers.

What usually happens when there is a great global imbalance of funds is that everything gives a little. That is what happened during the 1970s when the world was suddenly hit by the opposite problem - an excess of savings in the hands of the oil producers following the rise in the oil price.

They could not, it was argued, spend all their money and the world had to organise a giant recycling exercise if it was not to plunge into deep recession. What actually happened was that some of the money was indeed recycled. A lot more was spent by the Opec members than anyone had thought possible. The real value of many Opec investments was cut by inflation and there was the first really serious recession since the Second World War.

In this case one can see how such a 'little bit of everything' solution might evolve. Long-term interest rates would indeed remain rather high, perhaps for 15 years, with real rates close to their present 5-6 per cent range rather than the 3-3.5 per cent they averaged during the last century.

This may not seem dramatically higher, but all financial influences act at the margin. Such rates would undoubtedly boost savings, just as the low or even negative interest rates of the 1970s discouraged the saving habit. Such rates would also choke off some private sector investment, which must to some extent slow world growth.

Governments, under this model, would cut their deficits. People would pay a bit more tax and the services they would receive in return, including their pensions, would be smaller than they otherwise would be.

The early stages of such a shift are already taking place, with Italy and (soon) Sweden introducing large-scale financial reforms. This will have the effect of boosting savings, for as people find they are less able to rely on the state they have to save more for themselves.

The test, of course, is for countries to apply such reform in a humane and balanced way. They must do this, for they are in a way changing the rules of the game halfway through people's lives.

The option that is not really open is to erode the real value of public debt by inflating. Any sign of that immediately puts the markets into a tizz and increases the real rate of interest even more.

If all this appears rather dispiriting, it is worth pointing out that there have been long periods before when there have been great imbalances between savings and investment needs. For Britain the most difficult period for public finances was in the early part of the last century, when the country had to pay off the debts of the Napoleonic wars - and we managed not only to do so, but also to finance the industrial revolution.