The piece I wrote for YaleGlobalOnline, which I mentioned in my last entry, was published today, and is called “US and China Must Tame Imbalances Together.” In the article I try to argue that the roots of the current financial imbalance – or, more accurately, of the latest and strongest stage of the current financial imbalance – are buried in the trade and capital relationship between, primarily, China and the US. It is very important, I argue here and elsewhere, that the US and Europe do everything possible to help what could otherwise be a very difficult adjustment for China. The editor’s summary of the piece is:
With surging liquidity and massive trade imbalances, no one should have been surprised by the global economic crisis, because as finance professor of Peking University Michael Pettis explains, this has been the historical pattern. Pettis details the history of the crisis, starting in 1980s, when US policy encouraged securitization of mortgages, converting illiquid assets into highly liquid investments; US households shifted money into homes rather than savings accounts, and housing prices climbed; China, enjoying a trade surplus, collected US dollars and invested in US assets. A self-reinforcing cycle led US consumers to buy more, Chinese factories to produce more, banks in both countries to lend more, and the bubbles burst in late 2008. US adjustment is more rapid than China’s, which could lead to a new set of problems. Pettis warns that replacing US household consumption with US government consumption will only perpetuate the imbalances, and he urges the two nations to act responsibly, coordinating fiscal and monetary policies to ease US overconsumption and Chinese overproduction.
The argument I am making here is also part of a spirited discussion among a group of China scholars who communicate regularly on China-related themes. At the heart of the discussion is an argument over the monetary and policy mistakes made by the major players in permitting or even encouraging the credit bubble of the past decade. Although at its worst these kinds of discussions can quickly degenerate into a fruitless who-to-blame invective (“It is all the fault of Chinese polices” versus “It is all the fault of the US failures”), at its best – and the discussion has generally been quite good – it is a real attempt to understand the roots of the current crisis and the still-unclear ways in which it may continue to unfold.
I am not allowed to publish or publicize any of the comments among this group since the moderator wants to encourage completely open discussion, but I can say that one of the participants wondered about the sequence of events and questioned my claim that crises are always caused as a result of periods of excess liquidity, and that it is difficult for regulators to prevent excessive risk-taking when the financial system is forced to accommodate excess liquidity. I think that this is an interesting enough discussion, and very relevant to China, to repeat the argument and my response.
My friend argues that although he agrees excess liquidity is a necessary condition for credit bubbles, it is not at all clear to him that it is a sufficient condition. Besides excess liquidity, he argues, we need misguided regulatory policies to create a bubble and a subsequent financial collapse. In his view, the Fed was primarily responsible for the crisis because of its failure to regulate the financial system with sufficient rigor, and given the expansion of liquidity, it was only a question of time before that failure would lead to crisis.
In my response I argued that it is hard to say if excess liquidity growth is both necessary and sufficient condition for crisis since we would need an objective way to measure excess liquidity growth, and that is extremely difficult, at best. The late Frank Fernandez, while chief economist of the Securities Industry Association, spent years trying to do so, but always complained that the financial system was too good at developing new and unexpected ways to expand money.
I am convinced however – perhaps a little monomaniacally – that excess liquidity is sufficient and I doubt the ability of regulators to prevent bubbles. Part of my skepticism about whether or not a robust regulatory framework can truly prevent credit bubbles is theoretical, and part of it is empirical, with the latter resting on two personal experiences. First, in my reading on financial history and current events there has clearly been tremendous improvement over the past 300 years and more in our understanding of financial risks, the functioning of the financial system, the sophistication of our regulatory institutions, and monetary policy, but absolutely no concomitant reduction in the incidence of credit bubbles.
Quite the contrary, and if good regulation prevented crises, why wouldn’t we have seen evidence of gradual improvement in the number and viciousness of crises? Second, as a former smart-ass banker/trader I am too respectful of the enormous ability of the market to game any system that can be put into place. Regulators simply cannot outplay the market, and when too much liquidity leads to an increase in risk appetite, the financial system will find a way to take on more risk that might be healthy. As I argue in my piece, “When any part of the financial system is constrained from taking on risk, the market simply evades these constraints in one of three ways: It innovates around them, it generates or develops new and unregulated parts of the financial system, or it conceals regulatory violations.”
That leaves me a hard-core Minskyite on financial instability, and it is Minsky who creates the theoretical basis for my skepticism. According to Minsky it is not possible even in theory to eliminate financial instability because the very mechanisms used to control one form of instability will cause changes in the financial system (all those smart-ass bankers/traders) that will create new forms of instability. The whole purpose of a financial system is to intermediate risk, and when risk appetites change, the financial system will find a way to accommodate that change, whether or not regulators are comfortable with the change.
That doesn’t mean regulations are a waste of time. On the contrary, they are extremely important in the proper functioning of the financial system, but we need to be clear where they matter and where they don’t. As I see it, the purpose of the regulatory framework is:
1) To create a financial system that in “normal” times optimizes the ability of the system to allocate capital cheaply and efficiently. This is where issues of transparency, corporate governance, agency problems and information asymmetry matter.
2) To eliminate balance sheet feedback mechanisms that are automatically pro-cyclical and, to the extent possible, create fiscal and balance sheet stabilizers. These don’t eliminate bubbles and crises, but they do reduce the impact and weaken the transmission mechanism into the real economy.
To bring this back to China, it is for these reasons that I am more skeptical than most about the recent financial reforms in China. As I see it, the financial system here is replete with balance sheet pro-cyclicality, which the government has not directly addressed (in fact many of their interventions increase the risk) and so China runs the risk of a big, “unexpected” jump in volatility when things turn bad.
The strongest element of counter-cyclicality in China is probably government ownership and control of the banks, but even this is counter-cyclical only up to a point, beyond which it becomes massively pro-cyclical –for example if problems in the banking system ever threaten government credit, which is why I have always advised anyone who will listen that the government should be very sparing in its willingness implicitly or explicitly to guarantee credit risk. Government control of the banks can prevent banks from behaving in ways that exacerbate a downturn, and usually this is a good thing, but in a very severe downturn – like that which Japan experienced after 1990 – the attempt to control banking activity can actually backfire if it leads to a surge in government debt that threatens government credibility. This loss of government credibility hasn’t happened in Japan (yet) but it has happened in a number of other cases.
This is basically why I think the liquidity creation generated by the Chinese recycling of the US trade deficit would have led to crisis anyway, even if there had been stronger regulation within the US financial markets. And, by the way, although I share in the general horror about the huge breaches in our regulatory framework, I also remember that during the enormous petrodollar recycling in the 1970s, the US regulatory framework was much more robust, regulated, rigid and constrained then it is now, but that didn’t prevent excess risk-taking. The only impact of regulatory constraints was that extremely foolish behavior – massive loans to countries that had no chance in hell ever to repay – still occurred among American banks (to such an extent that by the time I joined the market in 1987 only one – JP Morgan – of the top ten US banks was not insolvent) but they occurred outside the regulatory constraint. For all the regulatory prudence the risky behavior simply migrated to London, where international banks were not as strictly regulated by their home countries.
The real fault of the Fed in the current crisis, in my opinion, was not to foresee that this unsustainable system would eventually come to a breathtaking close, and to prepare the stabilizers that would have prevented the decimation of the US financial system and its brutal transmission into the real economy. In fact every time they intervened to prevent the system from clearing, they increased the accumulation of balance sheet mismatches. The regulators did have a role, but it was not to prevent the crisis but rather to mitigate its impact. In my opinion the Fed could not have prevented the crisis except by engineering a recession in the US to counteract strong mercantilist policies in Asia, and that is perhaps a lot to ask.
One last thing about the joy of assigning blame, I have read and re-read several times Charles McKay’s Extraordinary Popular delusions and the Madness of Crowds and thought I should post the following selection from his chapter on the South Sea Bubble – after the bubble collapsed bringing ruin in its wake:
The state of matters all over the country was so alarming, that George I shortened his intended stay in Hanover, and returned in all haste to England. He arrived on the 11th of November, and parliament was summoned to meet on the 8th of December. In the mean time, public meetings were held in every considerable town of the empire, at which petitions were adopted, praying the vengeance of the Legislature upon the South-Sea directors, who, by their fraudulent practices, had brought the nation to the brink of ruin. Nobody seemed to imagine that the nation itself was as culpable as the South-Sea company. Nobody blamed the credulity and avarice of the people,—the degrading lust of gain, which had swallowed up every nobler quality in the national character, or the infatuation which had made the multitude run their heads with such frantic eagerness into the net held out for them by scheming projectors. These things were never mentioned. The people were a simple, honest, hard-working people, ruined by a gang of robbers, who were to be hanged, drawn, and quartered without mercy.
This was the almost unanimous feeling of the country. The two Houses of Parliament were not more reasonable. Before the guilt of the South-Sea directors was known, punishment was the only cry. The king, in his speech from the throne, expressed his hope that they would remember that all their prudence, temper, and resolution were necessary to find out and apply the proper remedy for their misfortunes. In the debate on the answer to the address, several speakers indulged in the most violent invectives against the directors of the South-Sea project. The Lord Molesworth was particularly vehement. “It had been said by some, that there was no law to punish the directors of the South-Sea company, who were justly looked upon as the authors of the present misfortunes of the state. In his opinion they ought upon this occasion to follow the example of the ancient Romans, who, having no law against parricide, because their legislators supposed no son could be so unnaturally wicked as to embrue his hands in his father’s blood, made a law to punish this heinous crime as soon as it was committed. They adjudged the guilty wretch to be sown in a sack, and thrown alive into the Tiber. He looked upon the contrivers and executors of the villanous South-Sea scheme as the parricides of their country, and should be satisfied to see them tied in like manner in sacks, and thrown into the Thames.” Other members spoke with as much want of temper and discretion.
Mr. Walpole was more moderate. He recommended that their first care should be to restore public credit. “If the city of London were on fire, all wise men would aid in extinguishing the flames, and preventing the spread of the conflagration before they inquired after the incendiaries. Public credit had received a dangerous wound, and lay bleeding, and they ought to apply a speedy remedy to it. It was time enough to punish the assassin afterwards.” On the 9th of December an address, in answer to his majesty’s speech, was agreed upon, after an amendment, which was carried without a division, that words should be added expressive of the determination of the house not only to seek a remedy for the national distresses, but to punish the authors of them.
Robert Walpole, for those who don’t remember, was the brilliant (if not always scrupulous) statesman – effectively Britain’s first Prime Minister, although the title hadn’t yet been invented – who had been more or less pushed out of favor for speaking strongly and often against the South Sea scheme and warning of its consequences. After the collapse, he was called back to London to clean up the mess – predictable, right? Perhaps because he had been so widely reviled for speaking against the South Sea scheme, he was not fully sympathetic to the claims that the whole thing had been a scam foisted on innocent people by evildoers. He was perfectly happy to avoid the whole orgy of blame and deal with the actual consequences, but needless to say blaming the schemers was always likely to be a lot more satisfying than acknowledging that an awful lot of people participated a little too willingly in the whole thing. Walpole was famously a realist – when there were sufficient incentives for foolishness and fraud, he didn’t doubt that even the nicest people would act stupidly or dishonestly.
Michael,
Previously, I thought that you believe we can get out of the current mess (de-leveraging and recession) only after the trade imbalance problem is solved.
Now it sounds like while correcting trade imbalance is necessary in the long term to prevent another crisis, it is not necessary now to get out of current mess. Am I understanding you correctly?
I am saying this based on Yale’s excerpt:
“Pettis warns that replacing US household consumption with US government consumption will only perpetuate the imbalances”
Understand Profit and Share
uprofish.blogspot.com
Always good to see people make reference to McKay’s book, it is either oddly reassuring (because the world did indeed survive) or absolutely terrifying (because the busts are getting worse without much evolution in the root cause) to read amidst the current backdrop.
Secondarily, I agree with your general skepticism when it comes to regulatory institutions actual ability to stop boom and bust cycles. You make a very good argument as to why it is difficult based on the very nature of the financial system. I would also point out that there has absolutely been a great deal of slippage attributable to the fact that many of the top members of regulatory bodies (since the late 70′s at least) eventually move to the private sector firms that they regulate. Given the compensation involved it would be perfectly rational for those regulators to be a little more cooperative with organizations looking to avoid or stretch any regulation’s intent.
Keep up the always engaging posting.
“The fun part – assigning blame”
Michael, nothing like the “good ol’ days”
“1125 A.D. In this year before Christmas King Henry sent from Normandy to England and gave instructions that all moneyers … be deprived of their members … Bishop Roger of Salisbury commanded them all to assemble at Winchester by Christmas. When they came hither they were then taken one by one, and each deprived of the right hand and the testicles below. All this was done in twelve days between Christmas and Epiphany, and was entirely justified because they had ruined the whole country by the magnitude of their fraud which they paid for in full.” – The Laud Chronicle (E)
IMO, the root cause of the current mess lies in China’s mercantilist practices. Cheap money was the fuel for the current mess. Securitization was just another means to create a vehicle in which to place the excess liquidity. If it wasn’t that it would have been another.
Money was cheap because China, largely, strived to keep a lid on its currency value to aid its export based economy. So while Zhang Yuyan and Tan Yaling et al may blame Greenspan’s interest rate policy, they fail to acknowledge that the fed had lost control of long term rates. Furthermore if the rates are/were considered to low why is/was there such a large appetite for UST?
With tongue in cheek Barry L. Ritholtz posted this in July 2005..
“The Peoples Bank of China (PBOC) announced to day that they are effectively taking over the interest rate responsibilities from the US Federal Reserve.
The Chinese Central Bankers announced that, effective immediately, they are beginning a series of incremental rate hikes in the United States. The first rate hike was for 10 basis points on the 30 year.
The Fed’s inability to significantly impact long rates anymore is what led to the outsourcing.
Unlike the United States Federal Reserve, who hold interest rate meetings monthly, the Chinese Bankers will now meet daily. Look for rate announcements each day at noon.”
—————–
Until China stops exporting its unemployment, its customers will no longer be able to fuel its growth. It appears that Smoot/Hawley 1.0 was better suited for Depression 2.0.
Mr. Fernandez was a wise man, but even he made the mistake that has clouded economic thinking since sovereign governments abandoned their commitments to exchange legal tender for specie. When he said that “financial systems were too good at developing new and expected ways to expand”, he was discussing Credit, not Money. In response to an earlier post about President Grant, you suggested that his returning the U.S. dollar to full convertibility worsened the economic consequences of the Panic of 1873. That is the conventional view, but the facts were that the country quickly adapted to the collapse in the existing credit structures and, as Mr. Fernandez would have predicted, its financial system developed new ways to expand credit. It was able to do so because people and businesses had the confidence that their Money was not subject to forfeiture or debasement. As you have pointed out, credit structures are Minsky castles; they are built through inventiveness, ambition and trust, and they are brought down by complacency, greed and arrogance. There is no way government regulation can produce a financial system that only has the better aspects of our human nature. What a Money secured by the barbarous relic assures is that the thrifty will be rewarded as equally as the profligate when a Panic strikes and the governments “have to do something”.
Dear Prof Pettis,
“In my opinion the Fed could not have prevented the crisis except by engineering a recession in the US to counteract strong mercantilist policies in Asia, and that is perhaps a lot to ask.”
Do you suspect that the Fed was aware of the crisis early on? what do you think it takes to end this “crisis” and what are the signs?
Thanks again.
I agree with you that financial booms and busts cannot be stopped by regulation – even in a socialist country these types of things can happen simply because of the logic of crowds (ruling crowd in the socialist case) combined with inappropriate expectations of the future.
Regarding the trade imbalances, which I agree are at the heart of this financial crisis, they too have an underlying cause. These imbalances are not just happenstance. The causal driver is the very model of industrial development itself. As you point out, China (and ASEAN post 1997) has been employing a mercantilist development model. This is a very conscious choice, and directly opposed to the previous African and Latin America development models that ended so badly, which were debt financed partly by petrodollar recycling. This choice of mercantilism actually is the only realistic model that East Asia had for development, given the road to disaster the debt financed models would result in (and had for ASEAN pre 1997).
In order to drill down to the root of the development model problem, we need to examine some basic concepts about development. First, what is ‘economic wealth’? To have economic wealth is to have a claim on someone else’s future production. For example, my wealth consists of stocks, bonds, and currency. All of these are legal claims on the future production of someone else. Therefore, wealth can only be created if there are at least two parties willing to enter an agreement where one party receives something (technology, currency, etc.) today, in exchange for giving up some future production to the other party. To make this even simpler, we can say that economic wealth creation is possible if and only if at least one party is willing to sacrifice her future production for receiving something today. In order for her to enter such a bargain, she would have to believe that the present and future gains from what she receives today are larger than what she is sacrificing in the future. This is the philosophical underpinnings of NPV analysis, however, in our case the tradeoff may not be quantifiable, though just as valid an analysis.
Now that we have an understanding of economic wealth, let’s examine industrial development via a thought experiment. Imagine a world with 5 nations. Nation 1, through its own internal devices becomes industrialized. Nation 2, which is pre-industrial like all the other nations, examines the quality of life in Nation 1, and rightly determines that the quality of life improvements which Nation 1 experienced are enormous. Nation 2 decides that they want to industrialize as well. To do so Nation 2 will need to have engineers, technology, and some basic natural resources. Let’s assume that Nation 2 has all the natural resources it needs, but is obviously lacking in engineers and technology. Therefore, Nation 2 will have to acquire these engineering skills and technological machines from Nation 1. Nation 1 doesn’t want to part with its technology and knowledge capital for free, so a bargain is made. Nation 2 is willing to sacrifice one whole generation’s worth of production in exchange for access to Nation 1′s technology and knowledge capital. Why a whole generation of production? It’s an assumption, but a reasonable one. Ask a citizen of pre-industrial nation if they would sacrifice their entire working lives so that their children could live in an industrial nation – most would wholeheartedly agree. This is an indication of the magnitude of what the expected gains are from the perspective of Nation 2, and the debt they are willing to incur. For this debt to be paid off, or rather for Nation 1′s claim on Nation 2′s production to be satisfied, Nation 2 will have to produce goods that Nation 1 wants, or at least produce goods that other nations wants, then use the proceeds to pay Nation 1. Sounds simple, well it is not. The problem is that the process of industrialization is one where great human resources and capital goods are needed, however, once industrialization has been more or less completed, there is no need for much of those human resources and capital goods. The project is complete. Well, can’t Nation 2 then retool its industry to produce trinkets and baubles that satiate wants rather than needs? Yes they can, but the problem is that the proceeds of the sale of such items will not be even remotely enough to repay Nation 1. This is simply because the wealth created by the transfer of a good or service is proportional to the amount of sacrifice of future production the recipient is willing to endure. There is no amount of ‘wants satiation’ via baubles and trinkets that can even compare to the magnitude of the satiation of moving from a pre-industrial to an industrial nation. Thus, the amount of wealth created from the bauble and trinket production is nowhere near enough to repay Nation 1. So Nation 2 has only one solution, they must encourage Nation 3 to industrialize via knowledge capital and technology transfer from Nation 2. However, Nation 1 would like to get in on the action as well, so the price competition between the two of them makes it slightly cheaper for Nation 3 to industrialize, and conversely the wealth extracted from Nation 3 by Nation 2 isn’t quite enough to pay back Nation 1. But then Nation 3 needs to repay its loans as well, and thus attempts to get Nation 4 to industrialize. Nation 4 thinks this sounds like a good idea, but then realizes that for Nation 4 to even begin to repay its debts, it will be necessary for Nation 5 to industrialize. However, if Nation 5 industrializes, then there is no way for Nation 5 to repay its debts as Nation 5 would be the last nation to industrialize, and thus it has no potential new markets to sell its knowledge capital and technology. Nation 4 realizes that not only will it have to compete with Nations 1-3 to sell to Nation 5, Nation 5 won’t even repay its debt, so Nation 4 determines that they themselves will not be able to repay their own debts, and thus do not embark on industrialization. This causes Nation 3 to default on its debt, which has a big impact on Nation 2, and a less sizable impact on Nation 1. Thus, there is some equilibrium to the number of nations that can be industrialized, at least using this type of technology transfer versus debt development model.
This takes us to China. If what I stated about the equilibrium of industrialization is correct, then China would have been a fool to use the industrialization model of Africa and Latin America. China cleverly used a different model, the export driven mercantilist model where exports are sent to the existing industrialized nations; all the while obtaining technology transfers via joint venture arrangements. But how could China use an export driven mercantilist model to send goods to the already developed OECD? Doesn’t the OECD already have those goods? Yes it did, and here in lies the root of this current conundrum. Why would the US import Chinese goods, of which itself was already producing? Well the Chinese goods were offered at much lower price points. But wouldn’t US leadership be opposed to the resultant destruction of its own manufacturing base and put up import tariffs? Well, they would have been opposed if they hadn’t believed that the US was about to embark on a complete retooling of its economy into a post-industrial nation; an information age economy. Let us not forget that US corporations certainly were not opposed to relocating their manufacturing to China for the very self centered short-term notion of increased profits, regardless of the disaster of the sum of the parts of every corporation doing so. Nevertheless, let us assume that the reason for the importation of Chinese goods was because US leadership believed that the loss of manufacturing was to be more than offset by gains from the information economy. For this to work, the US would have to sell its information technology services to other nations (including China) in order to pay for the manufactured goods from China. All of this sounds plausible, but let’s dig a little deeper and we will find that the answer rests on the definition of economic wealth. If we do a simple analysis of the benefits of the move from an industrial society to an information age society versus the move from a pre-industrial society to an industrial society, we find a stark contrast. We have already reasonably asserted that the move from pre-industrial to industrial is worth about one generation of sacrificed production. Now ask yourself how many years of your life (production) would you be willing to sacrifice to move from an industrial to an information age society. Cleary not a full lifetime’s worth. How about 5 years? Well, whatever the number, it is most certainly vastly smaller than the sacrifice of moving from pre-industrial to industrial. Herein lies the rub. The gains from an information age society do not create even a remote fraction of the wealth that is created from a move to an industrial society. This conclusion is easy for us to arrive at only because we know what an information age society looks like. However, imagine if this wager had presented to us and we really did not know what an information age society was. How many years of our life would be willing to sacrifice then? Might we overestimate the gains, and thus the wealth? Well, that is exactly what happened when the US transitioned to an information age society. The US entered into a bargain with its lenders for too many years of sacrificed production that it cannot repay from its information age production. And to complicate matters, other nations transitioned to information age so quickly that the US found itself facing numerous competitors and thus further lowering the gain from selling its information age production. If the US borrowed too much for its information age transition, then what happened to the borrowings? Well the lack of positive NPV projects meant that much of the borrowing was used for consumption; consumption of imported manufactured goods. Hence the large trade imbalances. In effect, the US has de-developed its production capacity enough so that it is unable to even maintain its own existing development level. Maintenance and replacement goods more or less are being imported, and it is borrowing to do so. This must be the definition of ‘tragedy’.
What can be done about the trade imbalances? It is simple to say that the imbalances must be reduced, however, how that is to happen is vastly complex. I have not seen any suggestions on how this can happen. Basically what is being asked is, “What products can the US sell to other nations by which it can use the proceeds to pay for the imported manufacturing goods from China?” And remember we are just talking about the current account deficit on an annual basis, we haven’t even considered the vast amount of debt that has already been accumulated. Clearly the sale of information age products is not sufficient. What else can the US sell? Military equipment perhaps, though that clearly is a bad idea and also insufficient in size. Financial services was once a potential option, though no more. Cultural and entertainment products perhaps, though again these are not sufficient. Green technology is an interesting suggestion, but it fails unless other nations legislate that their citizens import these products, as very few citizens will decide that the change from a conventional product to a green product warrants sacrificing a large number of years of their future production. All else being equal, the only way I can see that the imbalances are reduced is if other nations are willing to idle their production of products which the US can make, thereby inducing large scale recessions in many countries so that the US can earn its way out of its hole. By the way, this type of idling can be achieved through a currency revaluation. The trouble with this solution is that no nation is going to agree to do something like this without the threat of military action otherwise. And since the trade imbalance problem is basically a US-China problem, it is hard to see China idling its production for the benefit of the US, particularly when doing so would unleash enormous social instability. Then what other options are there for idling production for the benefit of the US? A currency revaluation will be useless as every nation will do likewise. Of course tariffs are very likely, but a tariff in one country will be offset by a tariff in another. Involuntary capacity reduction can be achieved with military action against a competitor. This seems like a pretty remote given that the military actions would have to be between US, China, Europe, ASEAN, and Japan. Military actions tend to get out of hand in the era of nuclear weapons.
I just want to go on a tangent for a bit about military action regarding Iraq. The nearly 30 years that Iraq has been exposed to war has destroyed almost all of the capital goods of what once was a fairly advanced industrial society. If the US can rebuild Iraq, financed with loans to be paid back from oil production, then this might be a source of demand for US goods unencumbered by competitors since it is solidly under US control. The social unrest that has transpired since 2003, however, has resulted in much of the knowledge capital leaving Iraq, which makes for the rebuilding of the nation nearly impossible. Perhaps the Iraqi knowledge capital will return if the violence subsides. Nevertheless, perhaps the US can use this model of creating demands for goods through military action against other counties which are sufficiently advanced and have abundant natural resources to sell, though are not militarily capable of defending themselves.
I would really like to hear people’s thoughts on how the trade imbalances can be reduced. And I mean detailed thoughts. Simply stating that Germany, Japan, or China has to increase consumption is insufficient and may be ridiculous
Dear Dr. Pettis:
Upon reading your most recent article, I wonder if you have considered how you might define and even quantify “liquidity”.
Here’s my take. For convenience we divide the economy into “real” and “financial” economies. In the real economy payment imbalances naturally arise, which get channeled into the financial markets as savings and ultimately must be matched by primary financial flows. I would define “liquidity” as the amount of money flowing from saver to final borrower (including also equity flows) via primary financial transactions in a given period – perhaps expressed as a percentage of GDP. With this definition of liquidity, imbalances in the real economy are the main source of liquidity, not the money supply per se.
One example of a real economy imbalance in the USD zone would be the US trade deficit which you have discussed. Another and perhaps larger source would be income imbalances amongst US households. If the top 1% of households received 24% of household income (70% of GDP) and saved 50% of that, then that would add another 8.5% or so of GDP flowing through the financial markets annually. Thus, due to both the rising trade deficit and rising income polarization in the US, perhaps as much as 15% of GDP has been trying to find credible borrowers annually.
Some of this money was absorbed by government borrowing (3% to 4% pre-crisis). Some was actually borrowed by business for investment in new projects – offering some confirming evidence for the so-called identity Savings = Investment! But given high corporate profit margins, businesses were not net borrowers in recent years, even considering loans for dividend payouts.
The rest of the money had to find borrowers elsewhere – primarily amongst households and financial firms. Over time, lending standards eroded, leading to massive over-investment in housing and excessive leverage amongst banks, hedge funds, et al, with the risk papered over by innovations in credit insurance. The fall of the subprime market triggered the rapid deleveraging we witnessed last year. The rest, as they say, is history.
I think this is a clear and useful way of looking at liquidity. What do you think?
I have a follow-up question – if real economy imbalances fueled the liquidity which led to the current train wreck, can the current crisis really be solved without correcting the underlying imbalances? What will happen if the dust settles but the imbalances remain?
I’ll end with a perhaps humorous quote from somewhere on the blogosphere:
“Giving liquidity to bankers is like giving a barrel of beer to a drunk. You know exactly what is going to happen. You just don’t know which wall he is going to choose.”
- Nick Sibley, Jardine Fleming
Thank you for your blog and I eagerly await your thoughts.
Can’t we blame the Fed for keeping the interest rates at very low levels ofr too long? Can’t we blame the Fed, the SEC and the alphabet soup of US regulators for regulatory capture? Can’t we blame the existence of Fannie and Freddie with their extreme market share of mortgage loans driving the competition towards the remaining subprime crumbs? Can’t we blame the regulators for the unchecked behavior of hedge funds? Can’t we blame the Congress for the budget deficits and external debt ballooning to unsustainable levels? I think I agree with your friend at least partially that the USA could have done a lot more to reduce if not prevent the present bubble.
Sir – In the piece published in the YaleGlobalOnline, it seems that the U.S. dollar’s role as the global reserve currency is left out of the equation. Asian countries and China accumulated the reserve currency because that was the ‘sure thing’ capable of retaining its value when all other assets could devalue. While the effect may have been to reduce Asian consumption, this may not be the rationale for accumulating USD reserves. It seems that the Asian tigers and China were all following the path cut by Japan in its modernization from 1950 to 1970.
Also, liquidity as the direct link to consumption seems quite reductive. Why wasn’t the excess liquidity plowed back in the form of household or corporate investment? America’s current predicament seems to be partly a product of our unique consumerist culture.
Enjoy your commentary.
The excess liquidity was caused by the policies of the U.S. government and Federal Reserve, not U.S.-China trade. Like all bust-boom cycles, income disparity creates over investment/over production on one hand, and under consumption (compared to the investment/production) on the other. Quite a lot of the over investment and production spilled over to China, because the products produced in China were still affordable by the poor and the middle class in the U.S. For the past quarter century, the Fed kept interest low and over supplied money, which fueled speculative bubbles and price inflations, and the government failed to raise income for the middle class by not bringing back progressive taxation. The Fed is the only one that can print money at will, not China, because the reserve money is in U.S. dollar, not RMB.
A 50+% decrease in sales leaves much new housing vacant. By the end of December, 2008, the number of salable houses and apartments under construction in Beijing reached 188,031, while finished but unsold houses and apartments totaled 174,290, leaving over 360,000 units on the market. If they are sold at 120,000 a year, the rate in 2007, it will take at least 3 years to sell them all, and that’s if no more are built.
(ChinaStakes, Jan 6)
Clearly, U.S. fiscal policy is NOT going to be aimed at improving China’s “traction’, that probably means that the correction in China will come about the old fashioned way; and once the political instability escalates, economists will have little to say until the dust settles.
Pettis: Quite the contrary, and if good regulation prevented crises, why wouldn’t we have seen evidence of gradual improvement in the number and viciousness of crises?
But we have. If you look at the 19th century, it was a series of one massive boom-bust cycle after another. In the 20th century, we only had one really, really bad episode in the 1930′s, and the business cycles in the late-20th century were far more benign than the in the early 20th.
This downturn feels particularly bad since in the last 20 years, there have only been two recessions and those were rather mild ones. This is quite historically unprecedented.
Pettis: Second, as a former smart-ass banker/trader I am too respectful of the enormous ability of the market to game any system that can be put into place.
So let the market game the system. Any regulatory system must take into account the fact that people will use the rules to their advantage to make as much money as possible. So let them. The role of the regulator is *not* to fight the market, but to act as an umpire or referee. If you see a situation in which most people see the regulators as an obstacle rather than a friendly neighborhood police officer, then you’ve already lost the game.
The reason I’m pro-regulation is that I’ve seen good regulation. If you look at the investment banks that had problems, they were independent IB’s that were very lightly regulated by the SEC. By contrast, the investment banks that were associated with mega-banks were regulated by the Fed, and you had far more effective regulation.
Part of the reason Fed regulation was effective was:
1) the mega-banks got something out of it. In exchange for Fed regulation, the mega-banks got an liquidity line from the Fed.
2) the regulation was “pro-business” which is why you never hear about it. One problem with “bad regulation” is that the regulators are less interested in getting something useful done than in looking good on television which means that you have lots of high profile public hearing to make someone look good and someone look bad.
Brian R. Murphy: Secondarily, I agree with your general skepticism when it comes to regulatory institutions actual ability to stop boom and bust cycles.
I don’t think that financial institutions can or should even try to *stop* boom and bust cycles. They should try to manage them in order to keep every bust from threatening total economic collapse. If you can minimize the fallout from a bust, they it makes it much easier to prevent a boom from getting out of hand. If everyone knows “it’s recession time” then people will see the bust as something like a bad snowstorm.
Brian R. Murphy: I would also point out that there has absolutely been a great deal of slippage attributable to the fact that many of the top members of regulatory bodies (since the late 70’s at least) eventually move to the private sector firms that they regulate.
And that’s because the compensation is skewed. If you want good regulators and good regulation, you have to pay for it. Talent doesn’t come cheap, and if you have a situation in which the regulated are making obscenely more money than the regulators, you are going to have problems.
One good idea that I’ve heard is to have the government pay the student loan debt of anyone that becomes a regulator. If you do that then you have talented people lining up, trying to get entry level positions with the SEC.
Part of the reason, that China has something of an advantage is that the private/public pay/prestige equation hasn’t gotten as far out of balance as it has in the US.
Brian R. Murphy: Given the compensation involved it would be perfectly rational for those regulators to be a little more cooperative with organizations looking to avoid or stretch any regulation’s intent.
So change the compensation structure. The compensation doesn’t have to totally be in pay. You can also compensate people with prestige. The trouble is that regulation often carries with it neither pay nor prestige, in which case you have a really big problem.
mpettis: The strongest element of counter-cyclicality in China is probably government ownership and control of the banks, but even this is counter-cyclical only up to a point, beyond which it becomes massively pro-cyclical –for example if problems in the banking system ever threaten government credit, which is why I have always advised anyone who will listen that the government should be very sparing in its willingness implicitly or explicitly to guarantee credit risk.
One problem is that it becomes very difficult to disclaim credit risk. Once people *think* that you will do a bailout then the only way you can credibly disclaim this risk is by letting something happen and walk away. You can do if you have small institutions which you can let fail without disruption (i.e. the failure of GITIC). However, this becomes impossible if the institution becomes large enough.
Once people believe that the US government will bailout Freddie/Fannie or a megabank or people also believe that the Chinese government will bailout a commercial bank, you are in trouble. People believe that you will do this because to do otherwise means risking the end of the world, and the only way to convince them otherwise means risking the end of the world. The trouble with risking the end of the world, is that you get into trouble if the world really starts ending. Once the dominoes start falling then with each domino, you get into a game of “regulatory chicken.” If enough dominos fall, and you are forced to do an emergency action by the mob that is forming outside of your office, you have lost both your credibility while destroying the world in the process.
I think that once an institution is seen as “too big to fail” and people believe that the government will bail it out, it becomes impossible to get rid of that belief, and the solution is to say “yes we the government will bail out this institution if it gets into trouble but since we are on the hook for money, we are going to make darn sure that the institution will be managed so that we won’t lose our money.”
The other problem with a bank is that if people think that you aren’t going to do a bailout if things get really bad, and it looks like things are going to get really bad, then the logical thing to do at that point is to take out all of their money which then kills the bank.
One problem is that a lot of models of risk assume that people will be willing to accept more risk for more return, when in some situations they won’t. If I thought that my bank had a 5% chance of going under tomorrow and I had no FDIC insurance, then I’m not going to be happy if the bank promises to pay me 15% interest since 15% of nothing is nothing.
Your explaination of the underlying monetary mechanisms are very interesting. I am wondering how you might contrast the recent past with the years that gave rise to the idea of the “great moderation”. The growth in liquidity/leverage was accompanied by a long decline in the level and volatility in interest rates in major economies. Then, boom, the coin flips, the tendency changes. Are the coming years going to be the antithesis of the “great moderation” – rising interest rates and more volatility over time?
One comment with respect to the private/public pay/prestige angle in China. Overall it probably works better to have outrageous pay packages that are publicly disclosed, otherwise bureacrats and officers compensate themselves in non-transparent ways that skim off or otherwise distort company asset structures. This does not mean that they take excessive risks in a financial sense (as in the US), rather they take what amount to large political risks to gain control of resources. Financial resources follow political capital.
The broader point referenced above with respect to China is the politicization of financial flows in China, which has produced distortions that, in concert with different excesses in the US produced such large bilateral imbalances.
Speaking of blame and regulators … there is one thing that might be laid at the feet of certain officials and that is the lifting of caps on dealer/broker leverage. The SEC lifted the limit in 2004 when it was argued they were not necessary. (The argument against the limits had apparently previously been put forward by a Mr. Hank Paulson in 2000, when he was then heading up GS – but, it knocked back on that occasion because it was considered “unsafe”.)
Great blog contribution to the current debate. I disagree strongly on the efficacy of regulation.
I think you are confusing bankers try to circumvent regulation with regulatory ineffectiveness.
This can be seen clearly with a driving analogy.
You could make the argument that since drivers will try to avoid speed limits, one shouldn’t have them.
I think most of us would prefer driving on roads with speed limits!
Nyet,
Extending your driving analogy, the problem with speed limits is they concentrate thinking on the wrong idea. Speed doesn’t hurt anyone much. It’s the sudden stopping that does all the damage.
I’m forced to agree that excess liquidity is a necessary but not sufficient condition in the formation of (damaging) bubbles. Of course, that agreement is subject to definition of “excess liquidity” and “bubbles”.
In a sense, an excess of liquidity has historically been present more often than not. Were that not the case, the prices of goods and services (both current and future) would drop moderately over time (roughly in line with productivity increases). Further, bubbles (being a condition in which demand moves positively with price, rather than the more normal inverse) are forming more often than not as the “excess” liquidity sloshes about between targets and durations.
Generally speaking, this sloshing about sets up economic ripples which are out of phase, and the sloshing is self-canceling. Every so often though, waves end up being in phase, which is what we’re seeing today. Correlations which are ordinarily negative suddenly become positive. Self-limiting cycles become self-reinforcing. What formerly appeared linear becomes non-linear.
Assigning blame to a particular wave is pointless, since it’s the interaction of the waves that causes the problem, not the waves themselves.
What we really need is a better understanding of why and how liquidity bubbles become the equivalent of in-phase waves.
Michael,
Wonderful piece! Almost forgot how much fun it was to sit in your classroom…
curt,
what you posted was interesting.
I think the trade imbalance will be resolved very soon by this US recession.
Nov China’s export was -2.2%. although import was -17.9%, it was mostly due to falling comdty prices. however, comdty prices have stablized since then. Dec or 1Q09 will mark the first time China sees a shrinkage in trade balance.
esp, now comdty seems to be the place to invest and given the size of all the infra projects in stimulus pkges worldwide. prices are likely to rise.
if by then US is running at a 9% unemployment. China’s export will still be in trouble, and china will see hot money, investment net outflow. b/c USA will be the ideal place for investors.
in addition, when US sees that 9% unemployment rate, what will China’s unemployment rate be? my wild guess would be >20% in urban area and much much bigger in rural.
according to many broker’s report on money flows in the recent months, outflow is in all developing and emerging countries. USA is the country sees the most inflow.
[...] 3.The fun part – assigning blame [...]