Fareed Zakaria usually writes very interesting pieces on international policy issues, but it seems to me that there is so much mystery about how the global balance of payments works that he, like so many others, makes simplifying assumptions that don’t take the balance into account, and for that reason just don’t make sense. In his latest piece for the current issue of Newsweek, for example, he says the following:
There is a consensus forming that Washington needs to spend its way out of this recession, to ensure that it doesn’t turn into a depression. Economists of both the left and right agree that a massive fiscal stimulus is needed and that for now, we shouldn’t be worrying about deficits. But in order to run up these deficits-which could total somewhere between $1 trillion and $1.5 trillion, or between 7 and 11 percent of GDP-someone has to buy American debt. And the only country that has the cash to do so is China.
In September, Beijing became America’s largest foreign creditor, surpassing Japan, which no longer buys large amounts of American Treasury notes. In fact, though the Treasury Department does not keep records of American bondholders, it is virtually certain that, holding 10 percent of all U.S. public debt, the government of the People’s Republic of China has become Washington’s largest creditor, foreign or domestic. It is America’s banker.
But will the Chinese continue to play this role? They certainly have the means to do so. China’s foreign-exchange reserves stand at about $2 trillion (compared with America’s at a relatively puny $73 billion). But the Chinese government is worried that its own economy is slowing down sharply, as Americans and Europeans stop buying Chinese exports. They hope to revive growth in China (to levels around 6 or 7 percent rather than last year’s 12 percent) with a massive stimulus program of their own.
The spending initiatives that Beijing announced a few weeks ago would total almost $600 billion (some of which include existing projects), a staggering 15 percent of China’s GDP. Given their focus on keeping people employed and minimizing strikes and protests, Beijing will not hesitate to add tens of billions more to that package if need be.
At the same time, Washington desperately needs Beijing to keep buying American bonds, so that the U.S. government can run up a deficit and launch its own fiscal stimulus. In effect, we’re asking China to finance simultaneously the two largest fiscal expansions in human history-theirs and ours. They will probably try to accommodate us, because it’s in their interest to jump-start the American economy. But naturally their priority is likely to be their own growth.
While I agree strongly with the thrust of Zakaria’s piece (cooperation between China and the US is extremely important to both countries), I disagree with his claim that “someone has to buy American debt, and the only country that has the cash to do so is China.” I was hoping that Brad Setser had already killed this argument, but apparently not.
Zakaria argues that the US needs a plan of massive deficit-financed fiscal expenditure in order to pull the US out of recession. This may or may not be true, but if it is true, the reason for the recession is that US households and businesses have found themselves overleveraged after years of excessive consumption, and must now cut back sharply on their spending as they increase savings. US fiscal expansion, in other words, will occur to offset the economic impact of a rise in US savings.
But if there is a rise in US household savings, don’t these increased savings need to be invested? Where will Americans put their savings? In fact almost all of it is likely to be invested in the US, and therefore the increase in savings is going to offset the need to finance a higher deficit (by the way, even if Americans decide to invest their incremental savings abroad instead of in the US, the net impact is the same). This is just another way of saying that the money that used to go towards financing private US consumption will now go to finance public US consumption, and we all hope (I think) and expect that overall US consumption declines from its clearly excessive levels of recent years, so the total financing will be smaller.
The net impact is that the US doesn’t need foreign savings to finance the fiscal expansion unless the expansion is so great that the US economy surges and Americans (private and public) spend more than ever, in which case the problem is not a recession but a boom.
There is more to it. The $2 trillion in reserves that China has is already invested, so it cannot be used for additional investment. If the US really needs larges amounts of Chinese financing in the future, this is simply another way of saying that China must run significant trade surpluses with the US in order to accumulate the dollars necessary to lend to the US government (remember, China doesn’t finance the fiscal deficit, it finances the trade deficit).
Basically what Zakaria is implicitly saying is that in order to boost the US economy – which means boosting US production of goods and surpluses – the US must run very large trade deficits with China so that fiscal deficits can be financed by the Chinese. But a trade deficit, by definition, is consumption supplied by foreign production, not domestic production, so insisting on a large trade deficit with China cannot be the way to boost US production. And of course if the US does not run a large trade deficit with China, then China simply cannot fund the US fiscal deficit.
Zakaria continues:
“People often say that China and America are equally dependent on each other,” says Joseph Stiglitz, winner of the 2001 Nobel Prize in Economics. “But that’s no longer true. China has two ways to keep its economy growing. One way is to finance the American consumer. But another way is to finance its own citizens, who are increasingly able to consume in large enough quantities to stimulate economic growth in China. They have options, we don’t. There isn’t really any other country that could finance the American deficit.”
I have a huge amount of respect for Stiglitz but I also wonder about the logic of this claim. He says that China can either finance its own consumption or American consumption, and we should somehow hope they are kind enough to finance American consumption. As I have tried to argue in several previous posts, we should actually hope for the opposite. If China boosts domestic demand sufficiently, that will go a long way towards adjusting the global imbalance between excess US consumption and excess Chinese production. The main purposes of US fiscal expansion, I think, would be a)to slow down the US adjustment process so that it does not fall into a downward spiral, and b)to give the Chinese fiscal boost more traction – program of coordinated fiscal expansion by the world’s major economies would be better, I think, than leaving any one country to try to bear the brunt alone.
By the way the view that the Chinese authorities will have an easier time in this crisis than the US because “They have options, we don’t” is not, fortunately in my opinion, universally held among Chinese authorities. It is increasingly obvious that policy-makers here are very worried. Yesterday’s Bloomberg pointed out that the RMB is depreciating:
The yuan headed for the biggest weekly decline in almost two months on speculation China is seeking to protect exporters and prevent a recession in the world’s fourth-largest economy. Bonds fell. …”There is some pressure for depreciation as the dollar is strong and other Asian currencies are softening,” said Patrick Bennett, a foreign-exchange strategist with Societe Generale SA in Hong Kong. “Still, record trade surpluses and strong investment flows suggest appreciation pressure is intact.”
The currency declined 0.17 percent this week to 6.8356 a dollar as of 11:44 a.m. in Shanghai, according to the China Foreign Exchange Trade System. The yuan is allowed to trade by up to 0.5 percent against the dollar either side of the so- called central parity rate, which was set at 6.8317 today.
Michael,
Thanks for another insightful post. Would you mind telling me where I can find the investment portfolio of China’s $2T forex reserve? Thanks.
Regular reader of your columns. Many thanks! Goldman estimates Treasury will issue 2T in debt next year, of which 1.3T or so will be net new and the rest replacement. Who will buy this massive new debt? At what point will USA debt draw much higher interest rates?
Your description makes complete sense to me. What I do not understand is why it is a minority view. I am troubled by the focus on a US fiscal stimulus by such well known and influential people like Krugman, Stiglitz, and Summers. I see very little focus on the global imbalances. I have not seen a single Obama address on the trade imbalance. Have you or Setser been consulted by any people from the next administration? I certainly hope you are.
OT: I can only access your blog on Firefox, it does not work on Explorer at all. Hope you can get the glitch fixed. This is what I get on Explorer:
Why is the balance of payments constraint such a mystery?
November 23rd, 2008 by Michael | No Comments | Filed in Balance of payments, Reserves, Trade protection
A simple way of looking at the question of financing the fiscal deficit: Imagine nodes H, G, F, and W (households, government, firms, and rest-of-world respectively) as players in a giant poker game. In every period, some nodes are running surpluses and others are running deficits. But aggregate surplus (savings!) is always equal to zero.
In other words, the government, by running deficits is by definition pushing other nodes toward surplus. Whether the domestic private sector or rest-of-world capture that surplus depends, among other things, on the exchange rate. As things stand, forex policy in China and elsewhere more-or-less guarantees that rest-of-world will capture that surplus. So China, etc, will in fact finance the US government deficit because they have to to support their trade surplus.
So many aspects of the current situation strike me as lunacy. Let’s hope the world finds a path back toward balanced trade before the whole system blows apart.
Pettis: At the same time, Washington desperately needs Beijing to keep buying American bonds, so that the U.S. government can run up a deficit and launch its own fiscal stimulus.
No they don’t. Right now short term Treasuries are near zero interest. The flight to liquidity and from risk means that there is no shortage of buyers for US debt. Everyone in the world wants Treasuries, so there is no need to focus on China as the main buyer of US debt, and one reason that a massive stimulus package is essential is to “push out” the massive purchases of US Treasuries. Without a fiscal stimulus the end state will be everyone having non-productive US Treasuries in their mattresses and no investment in anything that isn’t a US Treasury.
Also, to clarify the main source of disagreement between you and Setser on the one hand, and me and the other:
1) I don’t think that China is or was overproducing
2) I don’t think that the United States is or was overconsuming
The basic problem with the US economy was that the productivity gains of technology and globalization ended up in low interest rates rather than in increasing wages, and that there was massive misinvestment in non-productive goods rather than in productive ones. Less money for houses, more money for universities.
Had the US government spent more on public goods such as infrastructure, health and education this would have provided in increase in wages and interest rates, and would have reduced the amount of leveraging that took place.
The other missing piece here is productivity. If you take out a loan and spend it on inner city education or better subways, you end up boosting productivity which is going to help you pay back those loans.
Pettis: By the way the view that the Chinese authorities will have an easier time in this crisis than the US because “They have options, we don’t” is not, fortunately in my opinion, universally held among Chinese authorities.
Chinese authorities to have an easier time in one respect and that is the issue of “time” and “administrative bandwidth.” In politics, time is critical, and it helps a lot if you have time to argue and think about what is going on. If you aren’t faced with a crisis that has to be resolved in the next few hours, then this gives you time to think and debate about what happens next, and to rollback changes if they turn out to be wrong. If all you are doing to trying to deal with the next explosion, then you don’t have the time or energy to think and argue about long term consequences.
One piece of evidence which I’d use to argue that US foreign debt was not particularly high is that the US has a rather low public debt/GDP ratio. So does China, but as we’ve discussed here China has a huge amount of contingent liabilities, so the high degree of savings was in fact a very good thing.
The other piece of evidence is the fact that people are running *to* short term Treasuries rather than away from them. This is inconsistent with the notion that the US public debt is too high.
Ultimately the mean driver for what happens next has to be in the United States, because the US can do two things that China can’t. It can issue US Treasuries, and it can print US dollars.
The reason that concern over global imbalances tends to be a minority view is that people don’t directly care about the trade deficit or aggregate consumption or investment patterns. The thing that people directly care about are employment and incomes.
Something that improves the economy in ten years isn’t of concern to politicians or the people that elect them, since they want something done *now*, and fiscal stimulus is something that you can go and to immediately and have that put into effect in a few months.
The other problem is that the connection between global imbalances and the things that people really do care about (incomes and employment) is complex and disputed. Prof. Pettis and Brad Sester think that they are important. I don’t, and my opinions on this aren’t too unusual (and neither are theirs). However, the result of this is that if a politician ask his economic advisers about the impact of interest rates and the trade deficit, and his economic advisers start arguing with each other, then this makes that politician less likely to do anything about those issues.
By contrast, there is something of a consensus that fiscal stimulus is a good thing, and so the politician is likely to push for that. This is also important because a lot of politics involves getting people to agree to something, and if your own advisers don’t agree, the likelihood that you will get people at the other end of the aisle to agree to it goes way down.
Dear Professor
As a non economist I probably get most of the underlying math wrong. But I wonder if the issue is only payment balances. If that were true, your logic appears to me correct. But I think beyond the balances of payment (of paper money) an important question is the “intrinsic” value of the underlying assets in terms of providing employment, feeding people, ensuring health care etc. that have to do more with actual productivity than financial valuations. When this value diminishes a reduction in consumption cannot lead to increased savings but might remain unpaired. The result will be a devaluation of currency, i.e. the confession that this intrinsic value of assets is less than previously believed. This is obviously true for assets that derive their value from useless consumption that can simply be stopped from one day to another. The US is world champion in terms of that.
[...] to prop up the U.S. by buying T-bills" argument that has been challenged quite well recently. Michael Pettis’ post on the topic is highly recommended (he also criticizes Zakaria’s position). Other than that, [...]
Not sure if too much comfort can be taken in currently low treasury rates. This reflects a panic flight to security by global investors terrified about spiraling toxic assets in banks. Demand for treasuries has temporarily spiked until the global financial system has stabilized and higher yielding investments elsewhere are perceived to be low risk again.
Assume this stabilization takes X years (maybe 2?)– then what for treasuries and the next trillions of issuance? US Debt to GDP will have grown substantially, and treasuries will have to pay substantially higher rates, will they not? Will there not be competition for those investments to drive up rates?
Further, it’s hard to see resumed USA private sector “savings” going into treasuries any time soon. Will not any reduction in spending go into debt reduction, either forced or voluntary? Does the USA not have too much debt to equity, and is the entire private economy not deleveraging to get to sustainable levels?
It seems to me that several massive USA imbalances will drive debt and treasury rates much higher once the current panic and flight to quality subsides, and until these imbalances are addressed over a number of years: excessive leverage, fiscal deficits, trade deficits, entitlement deficits, and unfunded public/private retirement commitments.
“someone has to buy American debt, and the only country that has the cash to do so is China.”
This line is getting pushed hard on MSNBC right now, just following Obama’s latest press conference.
The accounting identity surrounding current account balances should be obvious, but obviously isn’t. Maybe the issue should be framed in a different and simpler way.
The point of fiscal stimulus is to create increased demand, and the current account impact will depend on whether and where capacity exists to satisfy the increased demand.
Michael,
Its true that higher U.S. savings should help finance a rising U.S. deficit. As you say, this will help offset the declining flow of funds from the Chinese government.
The question is, at what price? The PBOC has a certain demand curve for Treasuries, and its likely very different (i.e., much more inelastic) than that of private U.S. savers. Combining the two yields a distinct “kink” in the total demand curve. That is, at higher quantities, the price (yield) required rises in a step function.
Put in simple terms, individuals and corporations are much less likely to supply the quantity of savings required at ultra-low real interest rates. I’m speaking of course of Treasury bonds and not bills, as bills are currently a safe-haven cash substitute.
The question is not whether the U.S. can finance its deficit, but at what price? The danger for the U.S. is a “sovereign premium” dynamic, where economic bad news results in HIGHER, rather than lower, Treasury yields. Every other country in the world has experienced this dynamic at one point or another.
It is said that Obama only read Zakaria’s book on international relationship this year. This makes you wonder what Obama can learn from that book.
Also off topic. I do not know if anyone experience this. But I cannot browse your blog using IE, Michael. I have to use firefox.
The USA needs very large fiscal stimulus starting now because starting early next year there will be waves of mass layoffs. Next year will be difficult.
TM: Not sure if too much comfort can be taken in currently low treasury rates. This reflects a panic flight to security by global investors terrified about spiraling toxic assets in banks. Demand for treasuries has temporarily spiked until the global financial system has stabilized and higher yielding investments elsewhere are perceived to be low risk again.
Part of what makes this interesting is that we are all making this up as we go along.
My sense is that Treasury rates won’t go up unless until it’s clear that the economy is recovering at which point you can pay for the deficits by raising taxes. That’s easy to say now, but it’s likely going to be extremely hard to do if we get the economy moving again. The difficulty with fiscal stimulus is that it is hard to turn off once it has outlived its usefulness, which means that you can very easily get into another bubble. However, getting into another bubble is I think a far less dangerous outcome than the alternative which is Japanese style stagnation.
There is supposedly a conversation between Keynes and the Austrians in which Keynes asked the Austrians while they were intent on keeping the economy in constant state of quasi-bust rather than a state of constant state of quasi-bubble.
To all, sorry for the problems in accessing this site. There were problems with using Internet explorer but I think we have fixed them
RBG, like most central banks the PBoC keeps its investment portfolio highly secret.
TM, I am not sure higher interest rates will be a problem. If they are, that is probably good news because it means that the UWSG is competing with businesses for funding. My fear is that businesses won’t be interested in raising money.
Tyrasun, I think this is still a minority view but I am glad to say that more and more people are discussing it. For example there is an excellent piece by George Wehrfritz in this week’s Newsweek that addresses it.
Twofish, you misquoted me by saying that I am arguing that “Washington desperately needs Beijing to keep buying American bonds, so that the U.S. government can run up a deficit and launch its own fiscal stimulus.’ It is Zakaria who said that and the whole purpose of my article was to argue that this is not true. To that extent, I agree with your comments, although to say further on that you don’t agree that China is overproducing and the US overconsuming is a little strange since both clearly are. That is what the trade account tells us.
Pigeon, I think much of what you say is correct, but I would add that the BoP model is not intended to be a complete explanation of economic growth. It is simply a constraint that must be addressed. Neither the US nor China, nor anyone else for that matter, can violate the BoP constraints.
Estragon, you are right. So how do we make this simple fact more widely understood?
David, it doesn’t really matter where the investment preference is. If people want to save they can buy Treasuries or, if they don’t like the yield, they can buy risky assets thereby driving down the spread until someone along the way does the buying of Treasury bonds. Right now I am not so worried about rising rates unless they are driven by a resurgence of inflation, in part for the reasons I discuss with TM.
Fatbrick, I worry about that too, but the good news is that Obama’s advisors are probably a lot more sophisticated. We will see.
The other thing that gets missed is that people often say that China should consume more and the US should save less without really looking at why Chinese and US savers behave in the way that they do. The explanations for savings behavior tend to be cultural ones, but unfortunately it’s very difficult to use cultural reasons to formulate policy, or even test them. What a cultural explanation basically says is that “Chinese save because they are Chinese” which is a non-explanation.
The drivers for household saving in China seem to be 1) sharply rising incomes 2) lack of social safety nets 3) lack of high yield financial instruments and 4) low inflation. In the case of the United States we have 1) stagnant incomes 2) adequate social safety nets 3) financial assets that seem to be safe and high yielding and 4) low inflation. In essence, the high savings rate in China is to make up for low expected yields, whereas the low savings rates in the United States is based on the assumption of high yields.
Also this fits nicely with what cultural explanations seem to exist. I think if you ask someone in the US born in the 1930′s what they think the yield for the stock market will be, you will get a very different answer than someone born in the 1980′s. The other thing is that because the Chinese stock market and real estate market has boom-bust cycles, everyone I know thinks of them as playing the lottery and no one I know in China expects stocks and real estate to be the core of their retirement savings or children’s education fund.
What happens next I think will largely on how expectation change, and it’s far too early to see what happens.
Twofish, I just plain disagree with the popular characterization (at least in Asia, in my experience) that the low and declining savings rate we saw in the US this decade had anything to do with “cultural reasons”. Firstly the fact that these declined over a relatively short time horizon, should moot this point. Is the fabric of American society so dramatically different than it was just 10 years ago? Secondly, I think any “cultural” anecdotal evidence (“Americans just love their shopping malls!”) get the direction of causality wrong. American consumers over-consumed this decade _because_ the set of incentives that were presented to them. The cause of these incentives are in part a consequence of China’s policy of currency undervaluation and the associated enormous reserve accumulation. We should remember that the US savings rate was only low when using the narrow definition of saving through bank deposits and the like, not when measuring by overall net wealth which includes all assets (assets which were one of the US’s strongest exports).
Thirdly, any “cultural” explanation for Americans’ low savings rates is being proven wrong at this very moment. Household savings rates are rising dramatically.
I agree, Sharpe. Cultural arguments have been great at predicting the past but much less useful at predicting the future. Confucian culture for example was called inimical to sustained economic development in the 1950s and briefly after 1997, and yet also has been seen as all but guaranteeing economic success in the 1980s and once again now. Basically when Asian are poor, we blame Confucian cultural characteristics, and when they get rich we claim those same cultural characteristics more or less predetermined the outcome. Not a very useful independent variable.
Americans have swung from periods of high to periods of low savings, and I think it has usually been easier to point to changes in economic conditions than to posit sudden cultural transformations. I am impressed by the fact that Americans suddenly stopped saving after 1998, but I don’t remember anything in the air that suddenly changed our cultural predispositions. I find it far simpler to point to the 1997 Asian crisis and posit that the Asian determination to increase reserves had to have a counterbalance, and that counterbalance was rising US consumption.
Culture matters in the sense that experiences matter: Americans who grew up in the Depression, like Chinese who grew up in the Cultural Revolution, seem far more predisposed to caution, including saving, than Americans born after WW2 or Chinese born in the late 1980s or thereafter.
Sorry for the misquote.
Michael: To that extent, I agree with your comments, although to say further on that you don’t agree that China is overproducing and the US overconsuming is a little strange since both clearly are. That is what the trade account tells us.
The fact is that the US is saving little, China is saving a lot, and we have a huge trade imbalance.
However to say that this is overconsumption and overproduction implies that the optimal situation is a net zero trade balance, and that isn’t obvious to me that this is the situation, and it’s hard for me to find someone state clearly why zero trade balance is the optimal situation, and I can think of some obvious reasons why it may not be.
Same goes true with the statement that China invests too much and consumes too little. It’s not self-evidentally obvious what the optimal rates of Chinese savings and investment are.
Also correlation is not causation. It’s true that US household savings rates went down when Chinese reserve accumulation went up, but there were also fifty other things that were going on at the same time.
Something that actually helps me figure separate out causation from correlation is to look at my own behavior and to true to figure out what the drivers of on my own behavior. In my own case, savings rates end up being where they are because incomes are stagnant and volatile and house prices were going crazy. Similarly, I don’t think you are going to understand why a Chinese household saves so much by looking at tables of numbers. You get better data by finding someone on the street, and just asking them how much they save and why.
sharpe_mind: We should remember that the US savings rate was only low when using the narrow definition of saving through bank deposits and the like, not when measuring by overall net wealth which includes all assets (assets which were one of the US’s strongest exports).
The problem is that those assets included house prices and stocks and those are tanking. This is why I think that the US wasn’t overconsuming, it was just that what savings there was being directed at the wrong assets. Fundamentally, the important driver of economic growth is productivity, and there were enough productivity gains between 2001 and 2007 to sustain US levels of consumption.
Just to add to the debate above regarding cultural differences:
I am an ethnic Chinese myself. Having lived for a long time with people from different regions, I can say that there is definitely differences in the cultures in terms of saving habits.
Given everything else being equal, there is a much higher tendency for the Chinese to save comparing to their Western counterparts. This is the case EVEN if both have the same income, same reserve, same prospects, and the same safety nets.
For example, if we look at a typical Chinese person from Hong Kong, even in the exuberant 80′s where extravagant spending habits were everywhere to be seen at the time, it is almost unheard of for anyone to spend beyond what they can afford.
This is certainly not the case in the West. There are no shortage of people in the US happy to spend on credit that he/she may or may not be able to repay. In fact, the drawing down of home loan mortgages to fund expensive lifestyles have become quite common in recent years.
But if there is a rise in US household savings, don’t these increased savings need to be invested? Where will Americans put their savings? In fact almost all of it is likely to be invested in the US, and therefore the increase in savings is going to offset the need to finance a higher deficit
But what about if the process of deleveraging continues? Doesn’t it mean that the increased saving rate of US households will diminish their indebtness but will not increase credits? Or maybe it will be used to buy US bonds by banks but they will further decrease lending to private companies (US government will crowd out them in the deleveraging process)? So the nett effect would be additional requirements of abroad funding?
All of this seems to ignore the fact that many other nations are going through this at the same time, all trying to borrow and spend their way to a better life. The flight to US treasuries is bad news for the UK, France and Germany just for starters. They felt some of this shock and they’re just about to feel a much larger one as their loans to developing nations all go bad.
I’m wondering if there will be a bidding war for that cash as everyone tries Keynesian stimulations all at once.