Subscribe Feed (RSS)Is Governor Zhou a closet Bernanke-ite?
April 8th, 2009 by Michael Pettis | Filed under Balance of payments, Currency regime, Money growth, Savings glut.I have recently finished reading Martin Wolf’s latest book, Fixing Global Finance, and I strongly recommend it for its very clear laying out of the global balance of payments issues behind the global crisis. I should warn my readers that Wolf and I have come to very similar conclusions about the underlying root causes of the crisis – we are both in agreement, for example, about the distorting effect of Asian policies to constrain consumption and boost investment in manufacturing output – but I am mostly impressed by the fact that we come to the same conclusion from such different angles.
Wolf begins with a model based on analyzing the financial architecture of the past forty years and brings to his analysis a very US-centric view of the world, whereas my conceptual model is based on my obsessive reading in the history of financial flows between rich and poor countries and starts with a China-centric view. Somehow we end up in almost exactly the same place, which suggests to me that we may be right or, at the very least, onto something important.
I won’t try to summarize the book but I do want to set out two paragraphs in which Wolf explains, far more clearly than I have ever been able to, how it is that reserve accumulation in Asia “forced” US households into overconsumption. One of the most common fallacies in popular economic analysis is to assume that countries are somehow analogous to households, and the factors that lead a household to consume “beyond its means” are similar to those that cause a country to do so. In that case if the US over-consumed, it is no different than if a stereotypical welfare family maxed out on its credit cards, and while we can fret at the stupidity of the bankers who gave them their credit cards, ultimately the blame for the mess must rest with the innate profligacy of mom and dad.
But this is not true at all when we are talking about overconsumption at a country level. As I have tried to argue many times, the global balance of payments must balance, and significant change in any component of the balance necessarily requires adjustments elsewhere. If Country A enacts trade policies that result in a surging current account surplus, for example, Country B must see its current account deficit surge by the same amount, and the way that happens will reflect a number of factors including the structure of its financial system. Country B could try to resist the growing deficit by engineering a recession and so causing total demand to drop, but this can be very painful for both countries.
Let us assume, then, that a group of countries, perhaps in response to the 1997 crisis, decide that in order to protect themselves from a repeat of that disaster decide to engineer polices aimed at accumulating reserves and limiting external debt. The most obvious way would be to put into place policies that constrain consumption and boost savings (keep wages and interest rates low, limit credit availability to consumers, limit credit availability to small and medium enterprises and especially to the service sector, maintain an undervalued currency, etc.) and direct credit to the investment and manufacturing sector. As a consequence growth in production would exceed growth in consumption and the balance would represent the trade surplus. Trade surpluses, of course, have to be recycled as investment flows (or reserve accumulation) back to the country against which they are running these surpluses. This is not a choice, or even a real lending decision. It is the automatic and necessary consequence of running a trade surplus.
Since the US is the largest and most flexible economy in the world, and since the primary world reserve currency is the dollar (more on this later), in practical terms only the US can be the deficit country for any period of time, and so the surplus countries must accumulate US dollar assets as the obverse of their trade surplus. Martin Wolf explains what happens next:
The rest of the world’s capital outflow supports the dollar. At the resulting elevated real exchange rate for the United States, the output of the sectors in the US economy that produce tradable goods and services shrinks, other things being equal. The Federal Reserve cuts interest rates to expand the economy, thereby preventing excessive unemployment. As it does so, a large excess demand for tradable goods and services emerges in the United States. This finally, appears in the trade and current account deficits.
One consequence of all this is that US domestic demand has had to grow faster than real GDP, to ensure that the latter grows in line with potential. The difference between the two is, of course, the increase in the current account deficit, in real terms. With trend growth in GDP between 3 and 3.5 percent a year, domestic demand has to grow even faster. That is precisely what has happened. US real demand (or gross domestic purchases) grew faster than real GDP in 1993 and 1994 and then again every year from 1996 to 2004 inclusive. Cumulatively, between 1993 and 2004 US real GDP grew by 46 percent, while gross domestic purchases rose by 53 percent. That is how the current account deficit emerged. It is also how the United States absorbed the supply of excess capital from abroad.
In the face of a sharp contraction in those sectors of the US economy that compete with Asian manufacturers, in other words, the Federal Reserve must either permit a rise in US unemployment, in which case US consumption will decline and with it imports from Asia will decline too, or it must prevent the rise in unemployment by putting into place monetary policies that are consistent with rapid GDP growth. This argument, by the way, is not at all affected by the very common (and incorrect) argument that the main cause of the US trade deficit with China is the fact that China produces things that the US doesn’t want to produce, which I have tried to address in a March 9 blog entry.
Global savings glut
In either case US consumption must grow faster than US GDP, and the choice for the Fed is whether to target a “normal” growth in consumption, and permit rising unemployment, or a “normal” growth in GDP, and so permit rising indebtedness. The Fed must use US unemployment, in other words, as a tool to prevent Asian trade policies from leading to excess US indebtedness.
All this would have been bad enough if it hadn’t been for the need for the US to finance a very unpopular war, the Iraq invasion, in the way that unpopular wars have traditionally been financed – irresponsibly, through borrowing and money creation rather than taxes (remember that the Vietnam War was also associated with a credit bubble in the US). Asian policies, according to this view, definitely helped create the monetary distortions, but we must remember that there were plenty of bad domestic policies compounding the problem.
At any rate for the Fed to use US unemployment as a tool to prevent Asian trade policies from leading to excess US indebtedness is obviously politically very difficult, and it is also obvious that for the past ten year the Fed chose excess indebtedness. Since the 1997 crisis we have seen both household savings and the US trade deficit break out of their normal ranges and either collapse (household savings) or surge (trade deficit). This is a necessary consequence of the process that Wolf describes.
In that light, as U.S. fiscal spending surges in response to the crisis, increased attention will be placed on the way that U.S. fiscal spending leaks out through the current account to boost employment in China and elsewhere. And just as the Chinese complain bitterly, and rightly, that the West outsources polluting activity to China via the trade account, the U.S. will complain, as Martin Wolf pointed out in a March 31 editorial in the Financial Times, that China is outsourcing fiscal indebtedness to the U.S., also via the trade account. Surplus countries, he argues, “relied on the private sectors of deficit countries to do their irresponsible borrowing for them.” In response to the contraction in the borrowing among US households, the U.S. government, in other words, is currently choosing to borrow and spend the proceeds in order to generate job growth in the U.S. as well as in China. This can’t go on forever.
All of this is, of course, a variation on Ben Bernanke’s “global savings glut” hypothesis, and as everybody knows, Beijing wholly rejects this hypothesis as an explanation for the current global imbalances. For Chinese policymakers, the cause of the crisis lays firmly and totally within US monetary and financial policies (or lack thereof), and absolutely no blame can be apportioned to Asian trade policies.
Or is this really Beijing’s view? The extraordinary thing to me is that while Beijing has insisted almost desperately that any attempt to apportion blame to China is completely dishonest, they have nonetheless more or less welcomed Bernanke’s hypothesis, perhaps without realizing it, through the back door. I say this because the widely-discussed essay by PBoC Governor Zhou last week, in which he assailed the reserve status of the US dollar as being the main cause of global imbalances, is as far as I can tell nothing more than Ben Bernanke’s hypothesis viewed from a slightly different angle.
Why? Because Governor Zhou makes the claim that the reserve status of the US dollar gives the US an unfair advantage in that it can borrow nearly unlimited amounts simply as consequences of the need for foreign countries to accept dollars as reserves and for the purpose of international trade and investment. Of course he is almost certainly right, and he is just as certainly not the first person to make this claim. I think it was De Gaulle’s favorite economist, Jacques Rueff, who first discussed this “exorbitant privilege” as far back as the 1960s (NB: Martin Wolf corrects me — it was Valery Giscard D’Estaing who first said it — but I leave the mistake, and the correction, because it is one so commonly made).
But remember that if we make the very simple (and necessary) assumption that the ability of a country to run current account deficits is constrained mainly by a country’s ability to finance those deficits, then the ability to borrow unlimited amounts also means the ability to run unlimited trade deficits. It was the reserve status of the dollar that permitted the US to run the massive trade deficits it has during the past decade.
Had the US dollar not been the reserve currency of choice (in other words had Asian trade surplus countries not recycled their trade surpluses into purchases of US government bonds), the dollar would have had to decline against world currencies as a consequence of the rising deficit – Asian currencies too, and not just European – and the US trade deficit would have stabilized at much lower levels. This is also another way of saying, as Martin Wolf’s piece directly implies, that the Fed would not have had to choose between unemployment and indebtedness and that the binge borrowing that characterized US household behavior would have been much, much lower.
The world loves dollars because the US seems to love deficits
In fact I would go further. Because of the dollar’s reserve status, only the US could have possibly run the deficits necessary to absorb the huge surpluses that Asian trade policies were generating. Without the dollar’s status as a reserve currency, the Asian development model that stresses expanding production while constraining consumption – which among other things results in trade surpluses and net investment abroad (which of course is the same thing) – would have either required another reserve currency, or it would have failed.
Could there have been another reserve currency – and could it be that the dollar’s “exorbitant privilege” is something that Washington has enforced? Yes and no. The US economy comprises about one-quarter of the world’s economy and one-third of the rich-country economies. In principle it would have been very easy for any country to accumulate reserves of other rich countries – nearly all of whose currencies are easily convertible – so that there is no reason why the dollar portion of all developing-country central bank reserves might not have exceeded roughly one-third of the total, instead of the two-thirds or more that it currently occupies. Another third could be euros, and the rest a combination of the currencies of Japan, the UK, Switzerland, Canada, Australia, South Korea, and so on.
But it can’t just rest there. When a central bank chooses which currency to buy, unlike when you or I make our own portfolio decision, it is also determining the direction of net trade flows. Those other countries would have had to match the investment surplus (net inflows on the capital account) with an equally large current account deficit. If China had followed this balanced policy of reserve accumulation, in other words, the only thing that could possibly have stopped them, and a very big impediment it would have been, was the political or economic willingness and ability of those countries to run the corresponding trade deficits with China.
That, of course, is the problem. Given their much more limited economic flexibility and their less ebullient financial systems, those other countries probably would have never been able to sustain the necessary levels of trade deficit, and they would have almost certainly moved aggressively against China to limit the development of unfavorable trade balances. China, in other words, chose to hold US dollars not because the US government has somehow enforced reserve status on the US dollar and denied it to other currencies (Washington could never have prevented China from buying euros or yen or anything else), but simply because no other country is able to run deficits of the necessary magnitude.
The argument, then, that the dollar’s status as the reserve currency and brings an exorbitant privilege is simply the other side of Ben Bernanke’s savings-glut coin. Without the dollar’s reserve status, the global savings glut would have never occurred, or rather it would have never resolved itself in the way it did, and Asian development models aimed at engineering trade surpluses would have had to fail.
So is Governor Zhou a closet Bernanke-ite? He would probably be surprised at this question, and even more surprised at my answer, I think, but I cannot see how you can separate the two arguments – his on the perils of the dollar’s dominant reserve currency status and Bernanke’s on the impact of high Asian savings on the US balance of payments. He and Bernanke agree fundamentally on the roots of the imbalance.
By the way, the model I have been using to explain the imbalances also addresses another contentious question between the US and China which I did not really think about until I read a fascinating short piece by MIT’s Simon Johnson on his blog, more in reference to Europe but relevant nonetheless. China, as we know, is very worried that the US will resort to monetary policy rather than fiscal policy to address collapsing demand in the US. The former hurts China (supposedly because it might cause an erosion in the value of the dollars the PBoC holds), whereas the latter helps by slowing the contraction in US net demand and giving China more time to adjust its overcapacity problem.
It turns out that there may be another reason, even more powerful, and as soon as I read this paragraph by Johnson I had one of those “Aha!” moments that means I am going to have think much more seriously about the implications:
Remember this. If you run an expansionary fiscal policy (building bridges), I have an incentive to free ride (selling you BMWs) and not engage in a similar fiscal stimulus. But if you run an expansionary monetary policy, your exchange rate will tend to depreciate, putting pressure on my exporters and I’ll be pushed – by BMW-type producers – towards providing a parallel monetary stimulus.
This may be why monetary rather than fiscal stimulus makes sense for the US, and less sense for trade surplus countries. It prevents, or at least reduces, the leaking-out of employment generation effects of US borrowing and spending.
The other China
Talking about BMWs, my argument, of course, is not so much about China and the US as it is about trade surplus and trade deficit countries. In that light there was a very interesting article in Monday’s Financial Times about the difficulties Germany is facing in adjusting to the changes in the global balance. Many people assumed that Germany, which was in a very “strong” position (high savings, large trade surplus, low debt – which are all more or less the same thing, really), would weather the crisis easily, but of course it should have been self-evident that a crisis that affects the deficit sides of the global balance of payments must also affect, by the same amount, the surplus sides:
The risk is that – like Japan in the 1990s – Germany faces a “lost decade”, or a protracted period of economic malaise as it waits for the global economic tides to turn and struggles to find domestically generated sources of growth. “I am convinced it is going to be a slow recovery,” says Mr Staake. “Who is going to be buying anything?”
This downfall is all the more galling because, even a year ago, the country could have expected to weather the global economic storms. There was no danger of a housing crash; prices had been flat for a decade. Consumers had saved; companies had not increased leverage dramatically. “From a structural point of view, this recession should never have happened,” says Commerzbank’s Mr Krämer.
With hindsight, however, Germany was a sitting target after the collapse of Lehman Brothers investment bank in mid-September. Its exports were equivalent to more than 47 per cent of GDP last year – compared with less than 20 per cent in Japan and about 13 per cent in the US. Its industrial base is skewed towards producing machinery and equipment – “investment goods” account for more than 40 per cent of its exports – and towards emerging European and Asian economies.
While the crisis was focused on US housing and capital markets, Germany was unaffected. But after Lehman’s failure paralysed banks, and confidence nosedived globally, companies around the world shelved investment plans – leaving German factories turning out goods nobody wanted to buy. Industrial production in January was more than 20 per cent lower than a year before; overseas orders for investment goods had almost halved.
“Who is going to buy anything?” Good question, and one that must be answered by policymakers planning to export their way out of the crisis.
I especially love the statement “From a structural point of view, this recession should never have happened.” One of my standard complaints about most economists, especially those who focus on a single country or group of countries, is that they ignore balance-sheet and balance-of-payments effects. Of course it should have been obvious that a crisis in the deficit countries would affect the surplus countries – in fact it should have been obvious that the impact on the latter should have been worse.
Meanwhile, and as a continuing part of how the crisis will evolve, there is an interesting article in today’s Bloomberg about one of the ways in which the Chinese fiscal response to the crisis risks making the imbalance, and China’s long-term adjustment, worse.
China’s shipbuilding industry may be about to get a bailout — from its customers. The government may force state-owned shipping groups to buy more vessels as foreign carriers scrap orders, according to Steve Man, an HSBC Holdings Plc analyst in Hong Kong. That risks increasing costs and overcapacity among shipping lines grappling with a collapse in global trade.
“They ‘encourage,’ but my thinking is it’s more of a directive,” said Man. “It hurts every player in the industry and creates excess capacity that will take longer to absorb after an upturn.”
As I have argued many times, the constraints of the Chinese development model and limitations in the financial system mean that it will be very hard for China to shift its behavior quickly enough to match the possible adjustment in the US and elsewhere. Bailing out the ship-building industry is one way in which Beijing’s fiscal reaction – while understandable from an employment point of view – may exacerbate the adjustment. Washington’s bailing-out of the automobile industry is the same sort of mistake, I think, but in the US case it is much easier to justify. The US must reduce its net consumption, and if boosting production is economically inefficient in the long term, at least it fits within the overall adjustment in the short term. This is not the case with China – it should be boosting consumption directly, and not indirectly by boosting capacity.
There is a lot more I wanted to discuss today, but this blog entry is getting to be way too long. But just one quick thing, yesterday I was having coffee with some visiting friends from Goldman when one of them received a notice that there were credible rumors on the March increase in new loans. We had all been expecting a very big March number – between RMB 1.3 and RMB 1.6 trillion.
It turns out that the true number may have been an astonishing RMB 1.9 trillion.
That means that for the first three months of the year we have had loan increases of RMB1.6 trillion, RMB 1.1 trillion, and RMB 1.9 trillion. This amounts to RMB 4.6 trillion for the first quarter of 2009, compared to RMB 4.5 trillion for all of 2008. Notice to my students: learn more about how to resolve and restructure bad loans. This will be a great career option for you over the next few years.
Regarding the 4.6 tr RMB loan increase:
Any idea how much that amounts to in percentage terms?
Regarding the Simon Johnson article:
He makes it sound like the US is conducting expansionary monetary policy, whereas Europe isn’t.
But in actual fact, yields on US treasuries and German Bunds are nearly the same at mid- to longer-term durations (5 y, 10 y). Short-term rates are lower in the US, but the difference is less than 1 percentage point (and will reduce further if/when the ECB eventually lowers the money market rate further).
So if the alleged pressure on the US$ is supposed to come from interest-rate differentials (he doesn’t explain his theoretical framework, but interest-rate differentials would be the usual suspects, I suppose), I don’t really see it based on prevailing market yields.
Wolf’s argument seems to rest on Asian demand for dollars causing a loss of US exchange rate competitiveness which kills US domestic production of exportable goods/services. When I read this I immediately pictured the DXY index declining about 30% from 2002-2007 and wondered about that premise. But if you compare the USD to a basket of the main Asian net exporters to the US over the same period (end of Asian crisis to the start of this one), the basket still managed to depreciate almost 10% vs the dollar and stay below it for all but about a year. Apologies if I’m stating the obvious but the extent of Asian currency depreciation notwithstanding the massive dollar depreciation surprised me.
Still not sure about blaming the decline of US domestic tradable goods/services production entirely on the exchange rate, though.
Michael, do you know how much of the US decline is US firms seeking higher margins by relocating their domestic production offshore (and the best source of this data)? How much of the productive capacity reflected in Chinese GDP is actually owned by US (or other foreign) firms? To the extent foreigners ever really own something in the emrging world, that is. I guess that kind of relocation is to some extent a function of the exchange rate but it seems to me the very high level of labor or environmental cost differentials, for example, would overwhelm the FX benefit. What do you think? Is the exchange rate really the primary cause?
The core argument of Martin Wolf is still the “easy money” policy of Fed(lower interest rate) cause the overcusumption and excess US indebtedness, although it points out that Fed is forced to do so because of the trade policy and currency policy of asian export countries.
Greenspan, however, give a slightly different explanation, which states the low long term interest rate as the key facor for rising asset buble.
http://online.wsj.com/article/SB123672965066989281.html
Instead of tring to use monetary policy tools(rising rate or dollar devaluation against asian currency) to effectivly condemn “easy money”, his policy advisory is to improve the ability of financial institutions to effectively direct “easy money” into the most productive capital investment.
China is blamed to give credit to the US consumers, who in turn buy the chinese export goods. But the ability of US consumer to buy such a big amount of goods, lies only partly on the low price(exchange rate contribute to it ), and to a large part on the artificially rising income. Rising asset price make the US consumers feel rich, which encourage their consumption. Thanks financial inovation, they have a big leverage to run debt.
The financial institution set wrong incentive to the US household. Getting debt and investing them in house is a better way to accieve wealth, than saving. Their economic activities are not productive, which make them not able to pay the comsuption bill. The problem is not US comsume too much, but rather they produce too less.
Michael,
I had meant to send you a link to the Bloomberg piece on China’s aid to shipbuilders when I found your new post. You comment that this plan “may exacerbate the adjustment.”
Won’t this policy particularly, and this type of policy generally, most definitely exacerbate the adjustment? There was another piece in Bloomberg about the mothballing of ships and how that was a new business opportunity. Because of ships already started, the glut would almost certainly grow for another year or two, even if no new keels were laid. But they are actually talking about subsidizing the laying of new keels.
Meanwhile, other parts of the Chinese government are buying huge quantities of cooper, oil, aluminum, etc. And encouraging investments in capacity elsewhere.
This really seems like madness to me. There is clearly too much industrial capacity world-wide. Steven Roach has noted that U.S. consumption needs to correct by 5% of GDP. We have only managed 1% so far and have a long way to go from here.
Aren’t the Chinese almost certainly trading medium-to-long term pain for a short-term gain? Or do they think the pain will all be felt by Taiwan, Japan, Korea, Germany, etc.?
I much appreciate your postings and really look forward to them.
I understand your argument in relation to Chimerica. But, I wonder how Spain and Ireland, without benefit of reserve status fit into this picture. I’d blame their plight on the Euro, but that leaves out Hungary.
What allowed/compelled them to run up such levels of debt?
Robert Acker, a professor at UC Berkeley, has suggested in a podcast course, that because US corporations often set up subsidiaries in foreign countries, that these subsidiary revenues, categorized currently as imports, are actually misrepresenting trade imbalances, due to the fact that the US corporation is the ultimate beneficiary of the generated revenues and profits. If you were to reduce the trade imbalances by accounting for these subsidiary revenues, the trade imbalances would look much different. What are your feelings regarding this argument?
Who is to be blamed for the financial crisis? Read what Obama has to say:
http://www.guardian.co.uk/world/2009/apr/03/g20-barack-obama-nick-robinson-question
Michael, you are the physiologist of economics, you look at the big picture! Thanks for the time you take in making your posts.
It should be noted that politics seems to be behind the decisions. As much as it is characterised that the US borrowed from China, or Japan before them, that is not the case. The distinction is not minor. They purchased treasuries for a purpose, and being a good investment was not one of them.
[...] (Hat tip to: Michael Pettis.) [...]
Michael, great post. I just edited it and posted the following on my blog at http://prof77.wordpress.com/2009/04/08/china-and-us-partners-in-the-global-financial-crisis/ What do you think? – Hepkat
China and US: Partners in the Global Financial Crisis
If Country A enacts export trade policies that result in a surging current account surplus, then Country B must see its current account deficit surge by the same amount.
Cumulatively, between 1993 and 2004 US real GDP grew by 46 percent, while gross domestic purchases rose by 53 percent. The difference is the US trade deficit–which is financed by promises of future payment known as debt. China sends goods and services to the US and accepts dollars and promises of US dollars (debt) in exchange. Because the amounts are so huge there is no way for the Chinese to “exchange” trillions of dollars into other currencies. They are stuck with dollars.
As of March 2009 China has accumulated $2000 B in excess dollar reserves. Seeking to gain a return on these dollars much of it is invested in US Treasury bonds (i.e., debt). Net effect? The goods and services come to the US but the dollars used to pay for them return to the US too (recycled into the US economy as US Treasury bond indebtedness). In other words, China sells us goods and services, then loans us our purchase monies back, trusting the US Treasury to invest it wisely in the US economy on their behalf.
Asia’s expanding export of goods and services to the US tends to displace corresponding sectors in the US economy and create unemployment in the US. As a result, over the last 10 years, the Federal Reserve has faced a difficult choice between rising unemployment and rising indebtedness, either:
- Attempt to limit US unemployment by permitting the US money supply to expand, thereby increasing consumer demand for goods and services, satisfied by both increasing domestic production and imports from China, increasing trade deficits, which are recycled back to the US as investments in US Treasury bonds, thus increasing indebtedness; or
- Attempt to limit US indebtedness by permitting a rise in US unemployment, which reduces money supply in the US economy, causing US consumption to decline, limiting domestic production and imports from China, leading to smaller trade deficits, thus resulting in less debt to China.
For the last several years the US Federal Reserve has chosen to cut interest rates, to expand the economy, and to mitigate unemployment. Allowing US unemployment to rise was seen as politically impossible. The Fed’s attempts to keep the US economy strong, led to excess demand for tradable goods and services, which partially appears as increasing trade and current account deficits, which are recycled back into US Treasury bonds, increasing US indebtedness. Neither China nor the US could have done it without the cooperation of the other–like it or not, China and the US are partners locked together in this global financial crisis.
(Hat tip to: Michael Pettis.)
Your argument that China’s savings caused the current problem is pretty weak. If you were in charge of US, would you run national debt and trade deficit to that high level? How about the following observation: both national debt and trade deficit shot up during the bush years. The economical structural problem pales in comparison with the problem of having a chimp for president.
johnson hit the nail on the head. monetary policy (~dollar depreciation) forces china’s hand. if the dollar falls, chinese exporters become less competitive AND their reserves are worth less. in turn, china either buys MORE dollars (to force down the yuan) OR decides to live with a more expensive currency. either way, its a road to pain. as a result, this is the day china has been trying to defer for many years.
I am sorry, but the thesis that China is much to blame for the current mess is just wrong. It is not true that reserve capital inflows imply a current account deficit, and even when they are allowed to generate a current account deficit, it is not true that this implies increased consumption or higher unemployment. Reserve capital inflows can be invested, either in financial investment overseas (in which case, no capital account surplus) or in domestic capital (in which case, no increase in consumption).
The US squandered its exorbitant privilege by refusing to manage it. And if the US was unhappy about the reserve status of the dollar, it should have resisted it.
If your bank manager uses your bank deposit to go on a spending spree, you have provided the means, but to what extent can you be considered responsible? It is about time this fallacy was put to rest.
A few points. While I agree that the Chinese development model clearly channeled cheap capital towards export while stifling consumption… it really takes two to tango.
IMO, the key quote from the Wolf passage:
“The Federal Reserve cuts interest rates to expand the economy, thereby preventing excessive unemployment. As it does so, a large excess demand for tradable goods and services emerges in the United States.”
I don’t see how this is fundamentally different from the analogy of a household growing dependent on welfare. It’s just not clear to me at all that “large excess demand for tradable goods and services” necessary follows the cutting of interest rates. Even less clear is the assertion that all of this was the only solution for “preventing excessive unemployment”. Considering US unemployment levels over the last decade (coinciding with the ramping up of the Chinese export machine), I’m not at all convinced the Fed was forced into action due to political necessity.
As usual an excellent and thought-provoking piece which you put together with utmost clarity. By the way I just saw your presentation today at Tsinghua on the panel with Ylmaz Akyuz, Prabhat Patniak and Yu Yingdong where you made your points about the adjustment process for trade surplus countries. I was surprised by how much Dr. Yu agreed with you because I was under the impression that Chinese policymakers strongly resisted your analysis. Is a change taking place?
Why should only China take the blame? China has done everything the foreign advisors have said and now it should not be blamed for the crisis.
You keep mentioning the 1997 crisis. Do you have evidence that the process started as a response to the 1997 crisis?
Prof Pettis,
The astonishing number in new loans,I’m afraid,cannot be achieved without some explicit guarantee by governments at all levels.So they will be less riskier than most business loans.
On the other side,interest rates in informal banking sector has been rising,which is not out of expectation but disconcerning as well.
The savings glut hypothesis,I’m afraid,neglects some long-term trend in western society since 1960s,basically huge public debt,demographic change,low savings rate,etc.It only gets more haunting after 9/11,when ppl suffered from some kind of doomsday-stimulated enjoy-life mentality,till the day of reckoning.
Aside from these,I still wonder why this hypothesis has received so many criticizitaion all over the world.Maybe during ciris,everyone becomes more belligerent than before.
Thomas, there is about RMB 33 trillion of outstanding loans, so in the first quarter the total book expanded by about 15%. Long-term rates in the US have been affected by a number of things including the portfolio decisions of central banks. The fed has actually been complaining for a while that they have had limited ability to influence long-term rates for that reason.
BCG, I would not place the full blame on exchange rate policies. The way I see it, there are a number of ways to intervene in trade – anything that affects the balance between domestic production and domestic consumption affects the trade balance. In that case lowering interest rates, constraining the ability of workers to organize for higher pay, weakening the social safety network, subsiding energy or other commodity prices, forcing and investment credit expansion to manufacturers, and so on will all tend to expand the trade surplus.
Litz, I wouldn’t have said that China is blamed for US overconsumption by its granting of credit. I do not see the PBoC acting as a banker making credit allocation decisions. The purchase of US Treasuries is just the automatic consequence of running a trade surplus with the US. You are right that rising asset prices might have encouraged US households to draw down savings, but some might argue that the recycling of the US trade deficit led to higher asset prices. Historically major recycling are associated with asset price booms (remember for example, the recycling of the large US-Japan trade deficit in the 1980s or the recycling of German reparations payments in the 1920s).
Bob, I think boosting capacity when the market wants less will clearly make the adjustment more difficult. I spoke today to one of China’s most prominent economists and director of one of the leading think tanks (I can’t mention his name because I did not get approval to do so) and he said he was incensed by such activity. He actually welcomes the crisis because he thinks after a year of foolish behavior the government will be forced into making the adjustments that he, according to him, has been pushing since 2002.
OGT, Spain and Ireland had a similar process for different reasons. For years analysts have been warning that one of the key problems of the euro is the inability to match monetary policy with each country’s needs. Whereas Spain and Ireland were experiencing asset booms and high growth, and so needed tighter monetary policy, the ECB was accommodating German and French needs for looser policy. I grew up in Spain and my family lives there, and for years until last year every trip home came replete with stories of real estate prices gone out of control.
DMG555, Acker is probably right, but the employment impact and most of the economic impact of manufacturing has little to do with the nationality of ownership. Total sales are a better proxy for the total value added of manufacturing than net profits. When Toyota opens a plant in Tennessee it hires mostly American workers and very few Japanese workers.
Dr. Loo, a very funny article.
Noname, the whole argument presupposes that no one is “in charge” of the US, which is a pretty accurate description of reality. The Fed has the responsibility both for monetary stability and employment, and so to that extent it was in charge of monetary policy but with conflicting objectives. You are right that the trade deficit shot up during Bush’s presidency, and certainly he can be criticized for a lot of things on that front (including waging an unpopular war and ducking responsibility for financing it correctly, with taxes), but they began climbing out of their historical ranges after the 1998, before Bush became president but after the 1997 crisis.
RebelEconomist, the discussion of global imbalances nearly always degenerates into a fairly fruitless “it’s all China’s fault” claim versus an “its all America’s fault” claim, but I don’t think either helps. The point is that mistaken money and trade policies among a number of countries, most importantly the US and China, led to the imbalances, and the chances of arriving at a reasonable and coordinated response are practically zero as long as either side insists that it had nothing to do with it. Of course you are right that the US adjustment that corresponded to changes in Asian trade policies could have happened in a number of different ways, many of them much better than the way the US actually adjusted, but that doesn’t change the argument. In the end, trade policy decisions in Asia forced an adjustment in the US, and that process for better or worse was at the heart of the imbalance. Any “solution” that does not recognize this and attempts to resolve it is probably a waste of time.
Reader, I think it follows because after the contraction in the tradeable goods sector consumption was growing faster than GDP, and in order for GDP to grow at potential the Fed had to engineer excessive growth in consumption.
KCF, thanks. I don’t want to speak for someone as prominent as Dr. Yu, but from my readings of his papers he has been very, very critical of China’s policy response over the past decade, and has argued that China is now reaping the fruits of its unwillingness to adjust trade policies early in the decade.
XZ, I guess I should never get tired of repeating this, but the two options are not 1)China is a wholly innocent victim, and 2)China is evil incarnate. There could be an option between those two.
LiXiao, US household savings collapsing below its normal 6-10% range, the US trade deficit surging above its normal 1% range, and the “paradox” of the reversal net flows from rich to poor countries, all occurred after 1998-99. One possible theory may be that in 1998 Americans experienced some sort of religious conversion that turned them all into overconsuming addicts, and another might be that the 1997 crisis affected policymaking.
MoneyIllusionist, of course you are right and I am being sloppy. The NPLs probably won’t represent losses for the banks, but they will accumulate as contingent liabilities of the government. China’s real debt will rise by the amount of uncollected NPLs. As for the informal sector, have interest rates in the informal sector been rising? I am hearing that they are declining.
I am not sure I agree that the past decade simply represents the continuation of long-term trends in Western society. For example, as I say above, most of the indicators were roughly stable over the past several decades but only start to change radically after 1998-99.
Michael,
Debating the allocation of blame may be fruitless but it does matter, and I would emphasise that China is much less to blame than the US. Why does it matter? Because there are some in the US who will justify inflationary repudiation of their debt on the grounds that “they made us borrow, they deserve it”.
RebelEconomist, of course you’re right that these arguments can be misused, and not just in this particular case. Some people have used my postings on trade imbalances to support claims for aggressive trade protection against China, even though I’ve always insisted that Chinese policies are not predatory but largely reflect the difficulty of changing the development model and, furthermore, that the US and the world should accommodate as much as possible China’s transition for our own as well as their benefit.
But we still need to get as complete an understanding as possible because people are going to make these arguments anyway, and this doesn’t preclude the need for policy to be informed. More importantly, if the only ones who are willing to make the case for China’s role in the imbalance are the ones who want to use it for repudiation reasons, the fact that their analysis might be correct, or at least plausible, strengthens their credibility, and our refusal to acknowledge it undermines our own.
Finally, the refusal of China even to consider their possible role in the imbalances has made negotiations very difficult. I have spoken to both US and European officials who have told me how frustrated they have been in discussions with their Chinese counterparts – one IMF friend called them completely “pigheaded” (which, disturbingly enough, sort of reminds me of some of Keynes’ comments about his discussions with US policymakers in the 1930s). If China begins from the position that they are merely innocent victims of a US plot (as Americans were the victims of evil and cynical British machinations in the 1930s), and you would be surprised how often this claim turns up, I really see little good coming out of this.
Michael, thank you for taking the time to respond. There are a lot of people predicting China and East Asia will recover this year, including Soros. But I just can’t get my head around how the over-capacity issue can be dealt with so quickly. Using shipbuilding as an example, there were people predicting a future glut even when the commodity bubble was in full swing last year. Steel is almost as bad… China is going to have to build a LOT of hospitals and clinics…
Anyways, thanks again for sharing your insight.
Over-capacity is a relative term IMO. Given time, it is not that difficult to deal with. Gradually we see the gov/market shift the resources from one sector to another.
“China is going to have to build a LOT of hospitals and clinics”
This is just an example that I see as the resources are shifted to a much under-capacity sector.
Michael: Yes, it is indeed a very funny article. Sometimes I am wondering if Obama can speak that well without the teleprompters. I am been observing his speeches since his campaign days. I remember not too long ago he visited a nut and bolt factory with only a handfull employees and when he was giving a speech there he had to use the teleprompters. If he is such a good orator why use the teleprompters in front of a couple of guys.
I believe you can do a better job (speaking) than him as I know you don’t need the teleprompter when speaking to your students at the University. Put him in front of Tiananmen Square I bet his knees will turn soft without the telepromters.
Bob in MA: “There are a lot of people predicting China and East Asia will recover this year, including Soros”.
Whether China will recover this year or not is a $4 trillions dollars question. However, looking at the stock markets in China as well as in the US the signal is quite positive. The stock markets always move ahead of the economy. If China do not recover this year would you agree the chances of a recovery in the US this year are extremely slim? Having said that the result announced by Well Fargo today appears to be positive but the result of Wal Mart is bad. I would rather take the result of Wal Mart as an indicator as the American economy is driven by consumption and not by the banking industry. Would you agree with me? Furthermore it is reported that banks toxic assets are as much as US$4 trillions dollars. I am just wondering how this issue can be resolved in the near future. They came up with “mark to market” accounting system and I am of the opinion they are just trying to distort true valuation per se.
I firmly believe the “second wave” is yet to come but China will surely get out of the mud first. The big question is “when”?
Setting aside the blame game for moment, I was thinking about the options the party, local and national government have in stimulating local consumption. They can go on a large fiscal spending frenzy (social security, almost free household appliances, cut taxes, state subsidised jobs etc.) but would this help in long run?
The last 30 years of reform through technology programs such as 863, 963 and the new 2006 – 2020 have created a young but fairly good innovation system, and for the first time in modern Chinese history there hasn’t been a lost generation within the innovation system in 25 years (1966-76 being the worst and 1989 – 93 being the last time). This means that are structures in place which could accommodate huge investments in the science community or in parts of the technology programs. I still think the 2020 2.5 % GDP spending goal on S&T might be pushed to 2015 or even closer. My point is that there are more options available to party now then 10 years ago. I am betting on a S&T boost, because the party holds the employment of the nations educated closer to heart then those less fortunate.
In a way the State Council and the PBoC just did what most good Chinese business men do they stayed in cash. Being an economist you would properly tell me about the problem with a nation staying in cash is that it can’t use it in the same way a household or business flushed with cash can. Being a nation in cash you can buy goods, stocks, run trade deficits (not an option in Chinas case), US bonds etc. now none of the above helps China with its internal affairs as unemployment, aging demographics, low consumption etc. and I think the party understands this. The fact that they don’t admit going cash was a mistake to US or Euro diplomats means nothing. There is no reason to lose face over something that happened because of their passiveness (as the continuing peg to the dollar was), it is still the bad management of excess cash that stands out in this crisis (and of course the strange reluctance to let the market do its thing and let that fail which should fail)
1) I agree with Michael’s arithmetic-based observation that it obviously takes two sides to form an imbalance. This implies that Asian/Chinese savings are at least one side of the problem.
2) At the same time, we can certainly “blame” overall US economic policy. At any given time, an imbalance is not necessarily bad. Cheap financing of productive pursuits would have been great, especially if Asian economies were not structurally capable at the time of pursuing the same pursuits due to cultural or political limitations. Unfortunately, Americans had plowed much of the cheap financing into consumption activities, which includes housing in my own categorization (since housing much eventually be paid for by other productive earnings).
3) I am concerned as well about the gradualist nature of structural transformation of the Chinese economy. We have a chart showing the latest investment vs. consumption trends. ????…
http://cfail.blogspot.com/2009/04/martin-wolf-has-good-piece-in-ft-about.html
It looks like the party did understand that the RMB has to start flowing. Shanghai, Guangzhou, Shenzhen, Zhuhai, Dongwan are to be part of a cross boarder RMB settlement experiment. No banks have been selected yet, but it seems like they have been ready for this for a while. Cao Honghui from the Academy of Social Sciences finance department says this is the first step towards a full internationalization of the RMB. Could this be the end of a long and fruitful currency marriage that went bad in the end? And if the RMB really starts flowing will it not appreciate faster then the party wants? The article argues that the cross boarder RMB settlement is to help the exporting sector, but would this not be hurtful to them in the long run?
Source (In Chinese)
http://jb.sznews.com/html/2009-04/09/content_578711.htm
Thank you very much for yours and Martin Wolf’s clear explanation of the situation. It was very useful for me that you started using the household analogy and then showed how a central bank has to make a stark choice when faced with adopting suitable monetary policy in the face of unfavorable trade imbalances.
I also read the entry in Simon Johnson’s blog that sparked your interest. It did not give me an aha moment but I did understand it immediately. I have yet to read Martin Wolfs article but will with interest.
I guess that, since posting a comment here stating that “it would be a cold day …” before I would accept that the financial meltdown that started in the US was caused by glutinous Chinese peasants etc, I have had time to process the possibility that differences exist between households and countries
.
As you say it is very important to fully process and understand and have at hand suitable analogies and arguments that will deflate possible antagonistic behavior in relation to resolving this crisis.
In relation to the Zhou essay his proposal seems to make a lot of sense. And since you have shown that having the worlds reserve currency is such a double edged sword wouldn’t a dilution of that situation be and all round great idea?
Fatbrick, I agree that the shift will occur gradually, but I think it will be a slower and more difficult process than most realize. Building hospitals may boost domestic demand, but it doesn’t solve the problem for the factory that sells DVD players to the US. It will have to go bankrupt, and fire its workers. That will cause a temporary decline in wages and consumption until gradually the resource are redeployed. China will make the transition but slowly. Yu Yongding has gone on the record as saying that he welcomes the crisis, as brutal as it will be for China, because it is the only thing that will force policymakers to make the very difficult transition they should have started five years ago. I agree with Mr. Yu.
Dr. Loo, actually I think that is a bit unfair. Much as I liked Clinton I think Obama is one of the best orators in recent presidential history, and was certainly much better than most of his G20 counterparts. However even a good orator can have trouble with difficult questions.
Anders, I often hear that China has plenty of cash but I have no idea what that means. Nations don’t have cash. Individuals do mainly because they are too small to affect the total amount of goods and services, but the wealth of a nation is wholly the sum of the goods and services it produces and its ability to produce more. China has borrowing capacity, but that is not cash. It is largely the ability to divert current purchasing power from other domestic entities. It has large reserves, but this only means that its balance sheet is mismatched and that it can support a run on its currency and can continue buying foreign goods in a financing squeeze.
Randy, there is no question that the US could have better invested its capital surplus, but that is a debate too deep for me. I am not sure why a country chooses investment over consumption, and I suspect macroeconomic policies may determine that. If I understand the Austrian argument, it could be that the US kept interest rates too low, which caused companies to misjudge future demand, but I am not sure.
Simon, in the Monday edition of South China Morning Post I will have my regular biweekly op-ed piece. This week I try to explain why Zhou’s SDR proposal probably would have been good for the US and the world but would have entailed much slower Chinese growth. I will post it here when it comes out.
Prof Pettis, you seem to begin this post arguing that because China chose to run trade surplus, US consumption MUST increase more than GDP, but then you say (in response to RebelEconomist) that there are other ways in which US could adjust. Why does contraction in US producers who compete with Asian exporters mean US must increase consumption? Why not investment? Also, why does Chinese buying government bond with “recycled” dollars lead to increased CONSUMER debt in US?
Litz is right: “The problem is not US comsume too much, but rather they produce too less.”
To understand the global trade shifts and growing imbalances since the 60’s, add Michael Porter (www.isc.hbs.edu) to your reading list. The USA’s global competitiveness has eroded materially since the late 90’s. Cheap money and asset bubbles kept our standards of living up for a while, but now the party is over. The USA must get much better at creating real value. It’s simple: we will eat what we produce.
A little history: I got my degrees in the 70’s, times much like today. Much of USA industry was in the tank, Japan was killing us, oil has skyrocketed, stagflation was cancerous.
We were saved in the 80’s by enhanced competitiveness from massive corporate restructuring/delayering (think neutron Jack Welch), the new computer industry, an influx of educated baby boomers (like me), and emerging global trade greatly enhanced by the fall of communism.
In the 90’s all these factors bloomed, driving more USA and global growth, and facilitating the emergence of China et al. Finally a world doing business rather than war.
In the current decade, emerging markets become much bigger factors in the global pie. USA companies find it much easier to outsource/procure/produce in emerging markets, and jobs and income fall in relative terms for the bottom half of the USA population.
Trickle down doesn’t work fast enough, and the bottom half plus some enlightened members of the top half elect Obama. Now we have a lot of catching up to do. America is once again put to the test in transforming itself, and creating new value streams. The good news is the pie is much bigger and still not at war. The bad news is that we have dug ourselves a big hole, and we have more competition than ever before.
Dr. Loo, I know comparing this crisis to the 1930s is problematic, but as Michael and many others have pointed out, the over-producer then was the U.S., and we suffered disproportionately. Britain and France, net consumers, had a shallower drops and recovered more quickly. It seemed obvious to me there was going be a big overcapacity in production back in 2006, the growth in things like steel production was truly absurd. Then it went on for another couple years… Just like the dot-com bubble.
Now, I think an early recovery in China, or elsewhere in East Asia, would have to be country specific. China can recover this year, but only if they gain huge export market share at Korea, Japan and Taiwan’s expense. But the Korean Won has depreciated significantly, so that would necessitate a currency depreciation war. That didn’t help the US much last time around…
Steven Roach has pointed out that if the US returns to a reasonable consumption rate of ca. 65% of GDP, from the 70+% we were at a year ago, consumption still needs to fall another +/-4% of GDP. It could be that the “low hanging fruit” for consumer cut-backs were cars and LCD TVs, so Japan and Korea took the brunt. But the next stage may involve more non-cyclicals, like the stuff China exports…
The stock markets seem to obviously be in a bear market rally. Wells Fargo’s numbers are highly suspicious and their charge-offs came in under everyone’s estimates. They have $100B in commercial real estate loans on their books and rents and values are dropping like stones. In their home town, San Francisco, rents fell 24% in 1Q2009 from a year ago. Corporate credit spreads are still at levels far beyond previous levels. And sentiment has turned much more positive, in just a few weeks (a contrary signal.) Stock markets may turn positive before the economy (though not in 2001-2002), but that doesn’t mean a particular positive move in stock markets indicates a bottom. Otherwise, we would be talking about how the economy bottomed last March, July or November.
If you want a REALLY negative view, check out:
WSJ: “Giving Corporate Credit Its Due”
http://online.wsj.com/article/SB123929216724105401.html
I don’t delude myself that I have notable predictive powers, but it seems to me the upside risk is negligible and the downside risk is almost hard to imagine.
Is it better to have loved and lost than never to have loved at all?
As a result of the export boom, you have lots of people with wealth that they didn’t have before. That wealth can now be used to fund whatever the next boom is.
The place that countries get themselves in trouble is that they assume that boom X will continue and then overborrow, at which point they have no capital funds to do adjustment once boom X disappears. That happened to Mexico, but it didn’t happen to China.
I get the same feeling reading your explanation and Wolf’s that I do sometimes do reading Yansheng Huang. I agree with a lot of it, but then think …. Well this is a bad thing because????
This mistake I think is to think that you need an economic model that works until the end up time rather than realizing that any economic system will blow up every decade or two, and the trick is that you put yourself in a position that when the system blows up, you can rapidly restructure yourself. If you have lots of cash in the bank, you can rapidly restructure. If you owe lots of money, you can’t.
Pettis: Building hospitals may boost domestic demand, but it doesn’t solve the problem for the factory that sells DVD players to the US. It will have to go bankrupt, and fire its workers.
No it doesn’t. If it has cash in the bank, then to takes its workers and goes into the construction business. If it is already doing fifty businesses when when the DVD business blows up, then it goes in to the construction or ice cream business.
Yes it’s going to cost a lot of money and be socially disruptive, but the question is will it be more or less socially disruptive then firing everyone.
Pettis: Anders, I often hear that China has plenty of cash but I have no idea what that means. Nations don’t have cash.
It means that Chinese corporations and households are not leveraged, and therefore if they are not getting cash inflows they do not have a liquidity crisis.
Pettis: The wealth of a nation is wholly the sum of the goods and services it produces and its ability to produce more.
No it’s not. If you are small island but you end up with lots of treasury bonds, you are quite wealthy. The cool thing about money is that people in one nation can actually own claims to production by other nation. So if you own lots of US treasuries, you wealth includes claims on the sum of goods and services produced in the United States.
Since the US happens to have one of the more productive economies in the world, that’s not a bad thing.
Pettis: Randy, there is no question that the US could have better invested its capital surplus, but that is a debate too deep for me.
But that affects everything else.
If the US had taken the capital surplus and invested it in something other than real estate, then there would not have been a crisis. Agree? Disagree?
Pettis: The most obvious way would be to put into place policies that constrain consumption and boost savings (keep wages and interest rates low, limit credit availability to consumers, limit credit availability to small and medium enterprises and especially to the service sector, maintain an undervalued currency, etc.) and direct credit to the investment and manufacturing sector.
Except that these weren’t Chinese policies. China was limiting credit to the investment and manufacturing sectors and trying to increase credit availability to consumers. The key thing that happened in China was that in the 1990’s, the state owned enterprises were devouring credit, and by the early 2000’s that wasn’t happening. Once you had a manufacturing sector that was actually manufacturing things, then productivity and savings shot up.
The need to boost savings was less from the Asian crisis than the fact that the Chinese economic system in the 1990’s would have collapsed if there wasn’t a pool of savings to keep SOE’s operating until they could be restructured.
The other thing place that this doesn’t work is that if you use this model you’d expect that the export goods would be produced by the large manufacturing enterprises getting state directed aid. This *is* the case in Korea and Japan. It isn’t in China. The factories in the export sector tend to be the SME’s that are starved for Chinese bank credit. Most export industries in China get their financing directly or indirectly overseas.
Michael:”However even a good orator can have trouble with difficult questions”.
I have been observing Lee Kwan Yew (speeches) for decades in fact since the day he became the Prime Minister of Singapore. He was very good and is still good despite his age now. It is not easy to corner him with difficult questions. I used to live in Singapore for many years and I enjoyed listening to his speeches and Q&A from the floor.One of his best speeches was given on the day he announced Singapore was breaking away from Malaysia. I was there listening to him. It was kind of Mark Antony’s style.
Pettis: Bailing out the ship-building industry is one way in which Beijing’s fiscal reaction – while understandable from an employment point of view – may exacerbate the adjustment.
Or not. Beijing can bail out the ship-building industry by placing huge orders for aircraft carriers and guided missile destroyers, for example.
This is why I don’t accept the argument that consumption is good and overproduction and investment is bad. Once you have plants that are producing ships or steel or anything else that you aren’t using, you can step back, and think of something useful to do with them. So no one wants DVD players, there must be something with DVD player assembly lines that you can produce.
Living in the US Midwest and seeing firsthand the effects of an undervalued currency on our employment levels I have long favored a tariff to offset the undervaluation of a “Pegged currency”. While in the past the cold war may have provided a foreign policy justification for this, I do not think the US can tolerate mercantilist trade policies any longer. Won’t the imposition of such a tariff be a means of avoiding the employment tradeoffs you discuss?
There is currently a proposal in the US congress to introduce a carbon tariff to prevent companies to from moving their carbon emission to a country where they are unregulated and then exporting back to the US. This seems a reasonable means to compensate our industries for the costs imposed by regulation or treaty, Kyoto. I was wonder what you thought of this.
Michael, the various explanations relating the Chinese surplus to the US financial expansion seem problematic to me. Of course, we can all agree that, ex post, a current account surplus in one country must be accompanied by an equal capital outflow and a current account deficit in the receiving country. If this were a macro model, Martin Wolf’s scenario would be one kind of closure. But there are others, and if the Fed had not engineered such an aggressive expansion after 2002, it is likely that housing would not have boomed so much and neither would have imports, leaving China with less of a surplus. But that did not happen.
So that leaves me with a further observation and that is that while the US financial system was intermediating the Asian saving it was not intermediating US saving because that was negative. Was the net volume of saving being intermediated in the US so much higher as a share of GDP relative to previous periods? I’m guessing the answer is no. In earlier posts you have suggested that there is something unique to foreign saving (or at least the distribution of saving) that needs to be considered. But I don’t quite understand that.
So that takes us to the question, what really did cause the huge increase in financial leverage that occurred after 2004? Do we structurally need that to intermediate a capital inflow of 5-6 percent of GDP when domestic saving is falling? I doubt that. It seems that this runaway leverage explosion was something internal to the changing structure of asset financing and the crazy VaR driven demand for leverage. I guess i still do not see the strong connection between the capital inflow on the one hand and the sudden explosion of leverage on the other. And at the end of the day, isn’t the leverage and its financing, rather than capital inflow, that are the main cause of our current dilemma?
By the way, I have enjoyed your ideas ever since reading (and buying!) The Volatility Machine when it was first published. And I am glad to have stumbled on this blog about 18 months ago.
The big problem with Marcus Wolf’s analysis is that it doesn’t get you to the “then the world economy blows up” part of the story. Things blew up when Lehman defaulted, and there is no direct causal relationship between that and large trade deficits. You can make indirect causal relationships, but those can be speculative and disputed.
Or it may be that there is no relationship at all. The problem with economic theory is that usually there are about fifty things happening at the same time, and just because A happened at the same time as B doesn’t mean that A caused B.
If China were to own a dollar note printing press, it would be worthless. Either they do not use it, then it is worthless. Or they use it, then it becomes worthless.
A large country should not hold a currency reserve. Add to this a huge reserve, and the marginal utility of every additional reserve dollar is approximately ZERO.
China is giving away welfare to the US. That is it. That is all we are talking about. We may ask ourselves why, but that’s it.
Prof Pettis,
Maybe we should look at two different contents of informal banking sector business.
In the field of working capital financing(bill discounting?),interest rates is in line with formal banking sector,which is declining.
But in other areas,as corporates became less confident about future,they’re more hesitant to borrow money now.So whether interest rates are rising or declining,it doesn’t matter.As informal lenders are dying like flies during last year’s bull market,they may be more hesitant to lend now.
Interestingly,Governor Zhou is being more and more labeled as China’s Greenspan,in the Mr.Bubble’s sense.
Bob_in_MA: I agree with you that it is now a bear market rally and the pull back can be very nasty.
The most obvious way would be to put into place policies that constrain consumption and boost savings (keep wages and interest rates low(????), limit credit availability to consumers, limit credit availability to small and medium enterprises and especially to the service sector, maintain an undervalued currency, etc.
Should it not be interest rates HIGH?
Michael – PBOC announced Saturday China foreign reserve hit $1.95 trillion as at end of March.
http://news.xinhuanet.com/english/2009-04/11/content_11167852.htm
How do you (as well as others) how do you read this?
Anna and Twofish, an expansion in one country’s current account surplus requires a counterbalancing adjustment, in this case an increase in the US current account deficit. In principle it could have happened by a surge in US investment, but we have to avoid making the mistake about questioning the US decision to consume rather than invest. There was no such decision. The “US” doesn’t decide such things. What happens is millions of economic actors make tens of millions of decisions and the result is changes in consumption and investment. This can presumably be affected by policy, but only indirectly.
I am not aware of any model that would explain why a surge in the trade deficit, and consequently in recycled capital inflows, should cause am equivalent surge in investment, except for perhaps the “Austrian” argument that forcing interest rates lower should have resulted in mistaken signals that future demand was going to rise, thus encouraging more (misallocated) investment today. That seems not to have happened except in the real estate sector. One explanation for the surge in consumption, however, might be that the recycled investment, by boosting the value of stock and real estate portfolios, created a sense among American households of higher savings achieved through their portfolios, thus obviating the need to save out of income.
TM, as you point out the US tends to be pretty good at rapid adjustment. Just as the truly awful 1970s set the stage for a massive restructuring, I suspect that it will happen again.
Twofish, you are right that there may be positive impacts of bubbles and booms, but that doesn’t change the analysis of what happened and what will happen next. I personally am impressed by the fact that every major stage of the industrial revolution occurred in the midst of a financial bubble. Perhaps excessively high risk appetite is bad for investors and bad for stability but good for the spread of productivity-enhancing innovation.
As for your next point, Twofish, I applaud your many innovative views of recent history but I am afraid that these most certainly were China’s policies. Perhaps we should make the useful distinction between the publicly proclaimed aims of policy and the actual policies and their impacts. As for your next point, of course Beijing can bail out the ship-building industry by placing huge orders for aircraft carriers and guided missile destroyers, but since they didn’t do that, and instead did what the Bloomberg article said they did, I am not sure why that is a valid objection.
Richard, yes you are probably right, and I think that was one of Martin’s points. The Fed could have engineered tighter policies, but that might have come at the cost of rising unemployment. As for your second point, US household savings for most of the past 80 years has stayed within a range of 6-10% of GDP (one major exception was in the late 1970s when it rose, if I remember correctly, to around 12-13%, and the other was in the mid-1980s when it decline to around 4-5%). By the time the US trade deficit it 7-8% of US GDP, US household savings was around 0%. One could make a superficial argument that foreign savings wholly substituted for US savings. And thanks for the nice comments on my book. I guess it had to happen after a crisis of this magnitude but it seems I am finding ever more people who have read it.
Twofish, before you discuss the shortcomings of Martin’s book you might want to read more than my two paragraph excerpt. Actually he does discuss a “world blows up” scenario.
Reader, no, I meant keep interest rates low, which by the way is what has generally happened. In China, and in most Asian countries, lower interest rates tend to increase savings. This is probably because the high savings rate means that interest income is a significant portion of total household income, and since a reduction in interest rates has a notable effect in reducing income and savings, it therefore leads to a reduction in consumption.
Do economists know more than us?
http://www.independent.co.uk/news/business/analysis-and-features/do-economists-know-any-more-than-us-1667301.html
It appears that the political unrest in Thailand will not calm down until its prime minister steps down and this will further hurt its economy which is already bad. Looking back the last Asian financial crisis started from Thailand and in view of what is happening right now I am not surprised Thailand will trigger off another Asian financial crisis before the the global crisis is fixed. If it happened we will be back to a square one when many people are saying we will soon bottom out. Situation around the world is so unpredictable and delicate.
Thanks for answering; but i thought this rationale would only hold true in a high inflationary scenario, when the household can count in a diferential return of its interest income, big enough to become an real (or imaginery?!) income. Otherwise lower interest rates should encourage the abandon of savings and induce highers spending. Check it with your friend Arminio Fraga. Thanks for your time.
Michael, thank you for replying to my previous comment. Now how about these numbers: While it may be impossible to give the total cost of Iraq and Afghanistan, various “special budget items” have already added up to about 1 trillion. This cost has to be financed somehow. Again, using rough estimate, say China holds 2 trillion US debt. The “war on terror” along can account for 50% of that total debt. Using this simplified model, the chimp’s effect in last 8 years is at least equal to the cumulative effect of 20 years of trade imbalance. I am exaggerating as it is really a group of monkeys, but the “chimp” just sounds cooler.
Regardless of policy, what *forced* american people to borrow for consumption and not investment?
Johan – “what forced American people to borrow for consumption..?”
They believe tomorrow will not come!!
What? Chinese citizens complain that the US has outsourced its polluting industries to their country? Chinese firms could have built low-emission plants, but chose not to for cost reasons. This is a self inflicted problem.