After such a long entry last week I thought I would spare my readers and do something much briefer. A few days ago I read a good article (“Stuck on Neutral”) about Japan in the August 18 issue of the Economist. You can find the article on the Economist website if you are a premium subscriber, but if not, it has been partly reprinted elsewhere.
It may seem strange to be reading an August article in March, but in fact I often find myself a year or more behind in my reading. This may seem a little perverse, but it does let me see what the smartest people were thinking at the time while knowing what subsequently happened. Among other things this makes it clear how often informed consensus gets bogged down in the minutiae of everyday events while trying to understand the bigger picture.
In the case of this particular article, however, what triggered my interest is that it was about Japan’s post-1989 rebalancing, and among other things discusses why, in spite of every attempt, Japan has not been able supposedly to rebalance the economy and achieve any real growth during the two lost decades after 1990. Private consumption never took off to drive economic growth.
Many of these reasons for low consumption we have heard before, and no doubt will hear again, but I am not sure how meaningful they are. According to the article, the Japanese don’t take enough holidays, they are aging, exporters squirrel away profits to replace households as a source of savings, small companies are too inefficient, government supports big business, the Japanese don’t like to borrow, house prices are too high, and so on. Maybe these really are the causes of the failure for the surge in consumption, but many sound like variations on accounting identities, and as such they are as likely to be consequences as causes of low growth.
But what interested me is that in spite of the fact that Japan’s economy didn’t grow, and contrary to the article’s claim, some serious rebalancing actually did take place, at least as I understand it. Japanese gross national savings declined from around 35% of GDP in 1990 to around 23% last year. The household savings rate dropped too, from around 10% in the 1990s to around 2%. Neither declined in a straight line, but decline they undoubtedly did.
Household consumption, according to the article, nonetheless failed to grow meaningfully – in the past two decades it only grew by 1-2% annually – and this is much lower, presumably, than consumption growth in the 1980s.
But it was nonetheless higher than GDP growth, and that is exactly the point: consumption growth may have been low, but it exceeded GDP growth. Rebalancing in the context of Japan (and China) does not mean that consumption growth must surge. It just means that consumption must grow faster than the economy so as to become a bigger share of GDP and a bigger driver of total growth. Put another way, it means that the savings rate must decline. If this is what actually happened, then in fact Japan did partly rebalance.
But, mysteriously, in spite of the fact that Japan may have experienced real rebalancing and a real growth in the relative share of household consumption, the Japanese economy stagnated during the past two decades. If you had predicted in 1990 that Japanese household and national savings would have declined so sharply as a share of GDP, and that consumption would have risen, you probably also would have predicted that Japan, after a couple of tough years, would resume rapid growth (or at least growth more in line with other rich economies) as surging private consumption pulled Japanese growth forward and away from its over-reliance on net exports.
But you would have been wrong on two counts. First, Japan did not grow very quickly at all. It stagnated as consumption growth actually declined. Second, its reliance on net exports did not decline. The current account surplus remained high as a share of GDP.
Why didn’t Japan grow more quickly? One reason may be obvious from the very fact that the current account surplus did not decline. Although Japan certainly rebalanced by some measures, its current account surplus dropped from its peak of 4.2% of GDP in 1986 to 1.5% at its trough in 1996, only to turn around and surge, eventually to reach 4.8% in 2007, dropping to 3.1% in 2008 on the back of the collapse in international trade (and albeit on a much smaller economy as a share of global GDP than in 1990).
Since the current account surplus is another name for the excess of savings over investment, obviously this means that national investment declined as sharply as did national savings. The article helpfully provides us with the numbers for both in an accompanying graph, and this confirms that investment indeed dropped, from a peak of around 32-3% in 1990 to around 22% last year.
With investment such an important part of Japanese growth prior to the bursting of the bubble, the fact that it declined so dramatically seems to have had a huge impact on Japan’s subsequent lack of growth. So although in some important ways Japan “rebalanced”, for two decades it was nonetheless unable to grow even with a still-very-high and rising trade surplus, largely because investment declined sharply.
I am not an expert on Japan by any means, even though in the past two years I have been giving myself a crash course on recent Japanese economic history, but my Asian-development-model story suggests at least one explanation of what happened. After many years of excess investment driving growth, Japan’s rebalancing process, which occurred after corporate, bank and government debt levels prevented the investment party from continuing, locked the country into many years of slow growth because it had to grind through years of debt-fueled overinvestment.
In fact Japanese investment jumped in the last two years of the 1980s, after the 1987 stock market crash in the US should have spelled the end of rapid Japanese export-led growth, from an already-high 28% to nearly 33% three years later. In other words Tokyo seems to have responded to the collapse in the US by increasing its already-high level of investment to counteract the impact on the trade surplus. This is what happened in China too, after the 2007-08 banking crisis in the US. This jump in investment seems to have kept Japanese growth going solidly for another two years after the current account surplus began its steep nine-year decline.
But growth in investment wasn’t maintained. After 1990, when investment growth could no longer keep up, perhaps because Japanese corporate, banking and government debt levels were becoming a serious constraint, the Japanese economy began a long, slow, painful decline.
The government tried to continue subsidizing growth over the subsequent decades by keeping both wage growth and interest rates low, not to mention maintaining the undervalued currency, as we know. This unfortunately may have slowed the growth of both household income and household consumption, while maintaining the high trade surplus. This also may explain why the drop in household savings was partly matched by the rise in corporate savings – households continued seeing transfers of income to the corporate sector.
But ultimately in spite of maintaining some of the old trade-related policies that kept manufacturing growth so strong for so long, there was nothing Tokyo could do to combat the effects of the decline in investment. Had they allowed a more rapid rebalancing via higher wages, interest rates and the currency in the first two or three years, perhaps they would have had a tougher time early in the 1990s, and a lot more liquidations, but ultimately they might have pulled out of the slump a lot sooner because they would have transferred income to households more rapidly (although of course had they done this too aggressively, unemployment would have soared and consumption collapsed).
So where am I going with all this? I am not completely sure, and no doubt I am oversimplifying the Japanese story. Certainly I am not smart enough to figure out all the inner workings of Japan’s economy. Just trying to keep the accounting identities in line and, making sure that everything that is supposed to balance actually does balance, is tough enough.
But this macro approach might have some benefit in that it shows how the overall system can constrain the micro-developments that we all hope for. At the macro level, in other words, it doesn’t matter what individual policies we take to boost consumption if these polices don’t in the aggregate represent a real transfer of income to the household sector, as they did not in Japan. Rebalancing must occur, but as an accounting-identify matter it can occur both through good ways (a surge in consumption) and bad ways (a drop in growth).
In Japan it occurred the latter way. Without a serious attempt to redistribute income more rapidly back to households, Japan rebalanced, but not via a surge in consumption. Since it could not maintain investment levels, on which the economy was too dependent, and in fact increasingly dependent after 1987, it rebalanced via a sharp slowdown in growth. Either way achieves rebalancing – which only means that consumption has to grow as a share of GDP – but of course the former is much better than the latter.
Japan’s experience suggests one of the risks China faces. It is easy to talk about rebalancing as a solution to the underlying problem China faces, but as the Economist article points out, rebalancing can be “tricky,” and it does not lead automatically to growth – that depends to a significant extent on how quickly consumption grows, and can take many years before that happens.
Will China rebalance? Of course it will. It is not a question of if but rather of how. The same was true of Japan. No economy the size of China’s can be so heavily dependent on exports to absorb its excess production, especially once unemployment in the rich countries reaches significant levels. And no large economy can keep investment rates so high – and the allocation process so constrained by governance issues – for very long without running into the problem of capital misallocation. But there are many ways rebalancing can occur.
Chinese household consumption will undoubtedly rise as a share of Chinese GDP over the next decade or two, but the process nonetheless can be disappointing for growth. It depends on lots of other moving parts, most importantly perhaps the change in investment and the speed with which income is transferred to households. And the change in investment might depend on debt capacity constraints and the extent of earlier overinvestment.
Mr Pettis
Sir, if you may handicap the chances of a successful rebalancing act by China.
Japan’s lost decade(s) came at a time of unprecedented global growth elsewhere.
In your opinion did this hurt the Japanese economy or help it over the last twenty years?
- never having taken off to drive;
- as likely to be consequences as causes;
- Japan/ China.
It just occurred to me that I don’t think the word stagnant accurately describes Japan. Any trip there will confirm immediately that it isn’t frozen in time and thus feels more like it’s slow compared to the excessive days. I realise the figures might not say that but Japan isn’t creaking at the edges for me.
Just a thought and probably not a very good one either.
Michael,
I urge you to read Ralph Gomory’s piece in the Huffington Post. After your dismantling of Thomas Friedman’s article, Ralph picks up and destroys another myth perpetuated by Thomas.
Perhaps even more disturbing than the lack of truthfulness is the fact that we are not addressing the consequences of not competing. There are some inescapable truths about any economic good, be it a manufactured good or a service: (1) you either produce it in your own country, (2) you trade something you do produce for it, (3) you do without it, or (4) you import it and promise to pay later.
We are moving steadily away from producing what we need in this country. We are also moving away from producing on a scale that enables us to trade for what we do need. Rather than do without, we are increasingly importing things with a promise to pay later. This cannot go on. When our trading partners, especially China, no longer want to loan us hundreds of billions of dollars a year to be paid later, we will have little productive capacity left and we will be a poor nation.
Friedman is only the latest to assume that we can avoid this fate by emphasizing designs, ideas, and R&D and trading them for the items we need. This is an attractive idea; we often hear about innovation parks and university research centers and often their work is both exciting and good.
But the chasm-sized flaw in this otherwise alluring proposition is scale. Balancing trade on ideas and R&D simply cannot be done. The most elementary analysis shows that the scale is entirely wrong. As one who spent many years as the head of research of a large corporation, I know how much R&D matters; I also know how small it is. Eight percent is a very large percent of revenue to spend on R&D. Even in manufacturing, which is relatively R&D intensive, 4 to 5 percent is typical. It is really wrong to think that you can scale up R&D to be big enough so we can trade it for the huge quantity of things we need but don’t make in this country.
…snip
http://www.huffingtonpost.com/ralph-gomory/the-innovation-delusion_b_480794.html
Nice description of Japan, but missing the main driving factor. By the late 1980s, Japan’s economy (at least the sectors not bound by heavy protection) had reached world-class standards of capital and technology. From this point on, rapid growth was much harder to sustain, as new capital investment yielded an ever-diminishing return. The decline in return to capital is what burst the bubble, caused the investment rate to fall, and put Japan on a similar productivity growth rate to other advanced economies. The much slower labor growth meant that Japan’s overall potential growth was lower than that of the US and even Europe. China will gradually go through these phases as well, but it will take decades to complete the process.
Michael,
Your explanation of what happened in Japan seems both clear and convincing. Essentially, it seems to boil down to a willingness to accept much slower growth for a much shorter time.
But doesn’t that mean a willingness to endure negative or flat growth? But when speaking of China, the assumption is that 9-10% growth is “normal” and 5% constitutes a relative recession.
How is it that China’s painful period will support growth like Japan’s in the 1980s? Put another way, why is China immune to the cycles every other nation, advanced and developing, has gone through repeatedly?
One other point, in your FT piece you pointed to the extreme views among both China bulls and China bears. Frankly, I can’t see much extremism among the bears. The most prominent right now is Chanos and it seems to me he makes a pretty measured and nuanced argument: the massive investment in China is what’s supporting a lot commodity/infrastructure businesses and that level of investment is unsustainable and likely to fall.
The whole China situation seems incredibly similar to the housing story here in the U.S. in 2005. The doubters than, like Robert Shiller, were out-numbered 5-1 by bulls offering all sorts of arguments. And the middle-of-the-roaders were predicting several years of flat home prices as incomes caught up.
But not even the biggest housing bear in 2005 would have predicted that the collapse would lead to the failure of ALL Fannie, Freddie, AIG, GM, Muni insurers, three investment banks, etc.
I have no idea what will happen in China, but if the cautious, middle-of-the-road observers see 5% growth as the worst case scenario, recent history makes me skeptical.
[...] reading — A global perspective from China: “Stuck in neutral – what Japan’s rebalancing can teach us“, Michael Pettis (Prof at Peking U’s School of Management), 3 March [...]
These “debt constraints” made me think of Victor Shih’s recent work – which was reported on again, this time by Bloomberg, earlier today.
http://www.bloomberg.com/apps/news?pid=20601089&sid=aN94MF7BDx_A
Having lived in Japan from 89 to 92, and again for 3 years on and off in the mid nineties, I think it’s also worth noting the whipsaw exchange rates Japan experienced through this period. The post Plaza Accord averages of around 135 – 150 yen per dollar in a given year in the early part of the 90s suddenly changed to 80 – 90 yen per dollar in the mid nineties. I remember doing those foolish mental calculations and conversions in my head and thinking “Wow, I just paid 5 dollars for a Coke” etc. The Economist’s famous purchasing power parity measurement of McDonalds hamburgers priced around the world was going crazy during that time.
I bring this up only to note that exchange rate “controls” are no panacea, either maintaining low or high rates vs. your “market” (the US) isn’t the only answer. Japan certainly saw it’s share of currency swings year by year, and never really seemed to benefit no matter what the yen did vs. the dollar.
Two questions.
First, per the Japan story, what role has the increased export competition from China, Taiwan, and Korea played in Japan’s flatlining? Japan seems to have done an ok job actually in dealing with the post-bubble problems except in 2002 and 1997–but that effort might be undone by the current problems in the US and Western Europe. Perhaps Japan could have worked out its government debt issues over time if the global market held together. Now it seems like some debt must be monetized.
Second, per the previous post re reserves, can China use its reserves to purchase American imports? This would serve as a stimulus to the American economy and also serve the end of maintaining the peg? Indeed–is this being done?
Maybe you forgot one point: the corruption of or by the successful. The way Japan took during its prolonged agony was probably hit into stone during the boom years. Who — over night — dumps something that has been so useful and successful for many, many years? Look at Greenspan, Bernanke etc. Congress men even today have a VERY hard time arguing against them because of “their” past successes and their assumed superiority, although Greenspan admitted in hindsight that he just followed his personal ideology.
Success also seems to make people regard the poor as worthless. And according to some documentary, social responsibility has a *VERY* low priority for the Chinese people — if you can’t make it, it is always your own fault or worse. For me, that seems pretty damn close to the eugenics movement that IMHO was part or of or even reason for the Great Depression — at least regarding the economic implications for the low men. Therefore I’m highly confident that the Chinese will face enormous problems down the road. A rebalancing towards the consumer in that context is highly questionable IMHO.
It’s a terrific idea to read seemingly “outdated” articles!
hi professor,
Do you really believe a rebalanced economy (consumption rise) will help Japan walk out of recession?! I genuinely do not believe so.
I personally believe the growth comes from supply side (in line with peng-wensheng’s view, economist in China and director & head of China research at Barclays Capital), mainly Research and Development.
it can be argued that consumption is one of the key driver/motive (probably the most important driver in majority of existing economies) for supply side to invest. However for a command economic system like China,the big players i.e. State Owned Enterprise, which would be key investors in the market and their asset allocation are policy driving. In this scenario, the growth direction would be decided between government policy and market consumption, other than free market system, which is almost entirely driven by market consumption.
any thoughts?
It is the Chinese citizens that will suffer the most. They will continue to work hard to subsidize consumption in the West.
You might enjoy Bronte Capital’s Feb 10 piece, “The final failure of the Meiji right wing ideology…” it sheds a lot of light
on the subject you cover in the preceding piece.
I have one question. You wrote “after the 1987 stock market crash in the US should have spelled the end of rapid Japanese export-led growth”. Why a stock market crash could lead to the end of rapid Japanese export-led growth? Since the maket recovered very quickly after that and it also didn’t lead to a severe economic recession.
I had been living in Japan for six years. From a micro view, I think Japanese corporate governance and culture are really out-of-date and have destroyed huge shareholder value. They could have done better.
Talking about China, I am also extremely concerned about this investment bubble and see quite a lot of similarities between China and Japan. I had a lecture yesterday and the lecturer asked students to raise hands if they believe China will still grow rapidly in the next few years. It’s really a variety of nationalites, although some are from China, and nearly all the students raised their hands. Only one or two said they don’t believe. It’s really an interesting result.
could you please comment in a future post on the amount of Japanese dollar based investment in China, Taiwan and Korea over this period? As a possible source of underinvestment in Japan?
Professor Pettis, I agree with most of your analyses on Japan’s failure to balance in the “better way”, but I think there are deep reasons why investment could not keep up when Japan’s lost decades began. Huge debt accumulated within Japanese government balance sheet might constrain its ability for further investment, but the balance sheet of Japanese household have remained relatively healthy (they seldom borrow). So why didn’t they make investment if interest rate was artificially low? I think it’s due to a declining aggregate demand, which is a function of household income but also subject to the rule of “marginal profit degression”. On the other hand, if one day Chinese government are forced to reduce their investment spending, I assume the Chinese individuals are more likely than Japanese household in 1990s to help fuel the investment engine, as long as they would be given more market access to compete with SOEs.
Thank you for this article and insight into the Japanese economic cycles. There is much to learn from what Japan has experienced. We do need to be able to transfer income into US households, which is not happening. We do need real investment into making things that can be used domestically by workers, as well as having the capacity to export. The US is failing in all these areas.
What is happening is the lack of investment into real production and the ability of small to medium, and even larger sized manufacturing to actually get enough credit to keep operations flowing. Currently, there are too many obstacles in the way. Unfortunately, we have US businesses on the verge of shutting down because of the lack of credit availability and investment.
Not enough lessons are being learned by DC bureaucrats, which Japan has already experienced.
http://eye-on-washington.blogspot.com
thank you for this excellent article Mr. Pettis,
i´m usually a quiet (German) reader because i don´t feel qualified enough to enter deeper discussions (trader, not a student).
but please allow me to ask you a question.
in many of your articles the following issue seems to be the core of your concerns on the future:
“…it doesn’t matter what individual policies we take to boost consumption if these polices don’t in the aggregate represent a real transfer of income to the household sector…”
->can this ever work?
isn´t capitalism all about maximizing profits?
we live in a very competitive, globalized world with high unemployment. politicians either sell themselves or have to cave to the “this policy kills jobs” argument.
doesn´t the coporate sector always have the most leverage and can prevent the transfer of income to households indefinetely?
and isn´t the credit bubble the result of this mismatch in corporate and household power?
if household income and corporate investment don´t grow, then the only way to grow GDP is by taking on debt on households balance sheets?
for whatever reason the Japanes consumer refused to lever up as did the German (suffering from low domestic demand for decades), while the Brits, Americans, Australians gladly took on as much credit as they could.
so once corporate investment stalls and the chinese government is capable to initiate pro household policies and the chinese consumer(savers by culture?) refuses to lever up – this would result in the exact same outcome as in Japan, wouldn´t it?
could one go so far to say that the prospects of economic growth of a country largely depends on the willingness of it´s citizens to take on debt?
thank you (or other commenters) in advance!
and if possible: could one of your next articles please comment on this bloomerg story: http://www.bloomberg.com/apps/news?pid=20601089&sid=aN94MF7BDx_A
“…One focus of concern is lending to the investment companies set up by local governments to circumvent regulations that prevent them borrowing directly. Shih estimates that, already, borrowing by such entities may result in bad loans of up to 3 trillion yuan ($439 billion)…”
thank you very much for sharing your ideas via this blog, truely appreciate it!
Sobering stuff, especially given how very very broke local governments are. They’re not going to be driving investment 5 years from now. I’m not sure big foreign investors are, either. Which just leaves Chinese companies…
If Chinese households have invested heavily in real estate a collapse in prices may set consumption growth back for a long time.
China should have opted for a slower growth strategy by allowing their currency to appreciate naturally against its trading partners. Haven’t the artificially maintained imbalances led to potentially devastating capital missallocation? If money represents a store of future labor and that store is spent on non-productive assets like housing or over investment in industry then the store has been consumed. Don’t those stores have to be replenished before consumption can resume? I don’t see how any sort of rebalancing can occur without either acute short term pain or severe long term pain.
I’m probably way off base it’s just that I’m reading Wealth of Nations just now and it all seems pretty simple. I’m sure Adam Smith would probably not be shocked to see whats been happening. He’d be saying, “did you not believe me?”
A couple of thoughts
1. Why would we expect much “growth” in a country with a high standard of living, highly developed industrial base, stable population, and relatively low unemployment? I do not think that times have been all that bad in Japan for the past 20 years.
2. Japan had a lot of fiscal stimulus/increase in public debt during this period. I see a lot of statements about how this didn’t work, with the proof being that they suffered a “lost decade” or more with low growth. If instead the fiscal stimulus had stopped and the yen allowed to float freely the market would have forced the rebalancing. How could this have happened? Unless the government was successful in somehow causing a huge increase in private consumption the only obvious mechanism is a crushing of production until production and consumption come into balance (with resulting high unemployment and wipe out of less competitive industries). Then, once this washed out Japan could restart the desired period of high growth. Would the average Japanese have benefitted from this wrenching cycle?
I think example of Japan is actually not so bad. When the people/businesses of a country are unwilling (on an overall composite basis) to spend the money they accumulate (cash savings) the central government needs to step in to: a) change policies to increase spending relative to savings, and b) to the extent this is not successful to spend the excess savings for the benefit of the country. Said another way, the government takes the excess cash savings of the people and spends it for the benefit of the people. This is the only way I can see to preserve the benefits of free trade on a long term basis and avoid the cyclic disasters that result from continuing large trade imbalances.
Hi Michael: Thanks for sharing these interesting insights. I’m a little curious about some causalities here:
If the undervalued exchange rate did effectively transfer household savings to corporate savings, wouldn’t the presumable rise in the latter show up in the gross savings rate (as % of GDP) or in investment rates? Still, both of these variables, as you’ve noted, have decreased. Leads me to wonder what Japanese companies have been up to since the early 90s.
There is an alternative explanation for Japan’s weak investment growth.
The government stepped in to prevent asset prices from clearing, and that support created uncertainty over real returns from investment projects.
The issue in economies like Japan’s is what happens if and when the government removes its support? If a long-term investor in real assets cannot answer that question to their satisfaction, investment suffers.
I think that question is now being asked by investors all over the world.
My apologies for having taken so long to approve the above comments, and for not responding, but we are in the midst of the National People’s Congress and, as usual, there has been significant tightening of the internet. It has been difficult for me to get onto the proxy that allows me to access the blog. Tomorrow I will be at a conference in Arizona and so I will be able to get things done more easily.
You say, ‘it does let me see what the smartest people were thinking’
But how does one know who are/were the smartest people?
Professor Pettis: Thanks for raising such fascinating issues. Comparisons of China with Japan in the 1980s are tricky because the levels of development differ so radically. Japan failed to rebalance a highly developed economy and stagnated — despite or because of crazy girations in the Yen. A big issue is whether financial liberalisation was the cause of Japan’s stagnation?
China is still a dual economy, hence reblancing it is a transitional problem — albeit a critical one. This might best be achieved by Chilean type capital controls, promoting intelligent FDI outflows and avoiding “excessive” swings in the real exchange rate.
In the long run, growth is supply driven — hence the big unknowns are whether China can maintain strong growth despite a demographic bust after 2015 and a probable decline in the national savings rate? Another mystery is how good TFP performance has been attained despite large scale capital wasteage and if this will continue.
What role the financial system, liberalisation and regulation should play to facilitate the evolution of a “dual economy” while maintaining strong growth remains a mystery to me — but I don’t think cloning a US/UK model is the answer. best regards James
In Japan’s case, perhaps the bubble years’ growth was unsustainably high — pulling demand from the future, which made the growth in post-bubble era appears much slower. Japan’s population was also aging rapidly. The risk now is that US may now be going through a period of “below-trend” growth after decades of leveraging up…and China’s rapid investment is borrowing heavily from future growth. My view is the world is entering a period of slower secular growth.
Something went wrong with my earlier attempt. This is what it should have been:
MIchael,
The developmental state model (not quite the same concept as your Asian development model) can under the right cisrcumstances, deliver up to one generation of 3-5% per annum gdp/capita EXCESS growth (resulting in peak rates of around 8%). Unfortunately, the model is not able to lift a country, once developed/industrialized permanently above countries with similar resource endowments (especially human capital) and a developmental state will fight for market share with lower income copycats, where the model goes back to consumer/worker unfriendly policies, sold by politicians as inevitable because of foreign competition, which will tend to reduce the aspirations of consumers and workers and depress GDP relative to a state/society that cares much less about the competitive position of its industries (if you want to compete with Korea in industries where they have access to adequate scale and technology, you have to hire workers at Korean wages or move work to other locations). Japan is suffering from a variety of things: OECD membership, demographics (a legacy of its development model), an endless stream of copycats abroad and “national champions with little innovative talent” that want to survive on the basis of low cost production abroad, rather than die heroically whilst supporting the Japanese worker in return for his lifelong loyalty. And there are also firms that deal with imports in a variety of ways, by using barriers etc but if that does not work, they adopt policies that work out as deflationary at the national level.
Nevertheless, it will take China at least two leadership succession cycles before it starts to hit the same ceilings that Japan has bumped into and along the way it will wreck so much of its foreign competition (if it stays intact) that we will not have much left to worry about…Or China will run into unexpected trade problems before it has become more balanced. That might be less than funny.
Great piece. My question is why stop the comparison at China. Why not extrapolate to other developed economies such as the USA or Europe? Why not bring some Marxist critique into the picture?
Capitalism leads to this dead end because capital becomes more and more important over time vis a vis labor. This is what we saw in Japan. This is exactly why consumptions was not encouraged vis a vis investment.
While not advocating Marxism, I certainly advocate a more equitable balance between labor and captial before things get back to an even keel in the global economy. There is no other way out. Will we see the repeal of NAFTA and WTO on the way? Perhaps. Perhaps we will be able to do it by modifying NAFTA and WTO agreements that focus more on labor empoverment than the free movement of captial.
tyaresun
Great point. I think the easiest way to do this is to lower taxes on things like payroll and increase the taxes on capital gains and interest.
Automation and technology is probably the greatest single threat to the wage worker
The Japanese economy has been stuck in a recession for the past 2 decades. The Plaza Accord forced down Japan’s throat by the US Treasury sharply revaluated the yen overpricing exports across the globe and crashing their economy. Viewed as a strategic threat by the US Elites, Japan’s then booming economy was de facto decapitated.
Over 50 years after World War II, with 50 thousand US soldiers deployed on dozens of military bases, the Japanese government remains subservient to the Washington Think Tank Elites. As an military occupied nation, Japan still isn’t a normal sovereign nation by any means.
In contrast, despite being a relatively poor developing nation, at least China retains an independent military structure with some strategic nuclear forces. Unlike the Japanese, the Chinese have their sovereign independence and simply can say “No” to foreign political pressure to revalue the yuan.
Professor Pettis and Rien: ON TRADE AND GROWTH
Does what you are saying boil down to: “Globalisation” inevitably leads to the dilution of comparative advantage and hence the growing dominance of absolute cost advantage?
Is this the basis of the “new” “new” trade theory — and does it imply that China and other late-coming “free riders” have continuing scope to exploit our hybrid world trade system via the Developmental state?
I do not have the answers and would greatly appreciate your insights on the role of “absolute vs. comparative advantage”. regards James
I may be oversimplifying the issues, but by reading though this, it seems to me that it doesn’t really matter how a country achieves its growth – whether its consumption led or investment led – but what matters most is how the country balances itself out. I think this is what we must focus on when looking for any potential problems in an economy. And I think the key to this rebalancing is the transmission mechanism between investment and consumption and vice versa between households, businesses and the government. Growth will ultimately be unsustainable if it is done imbalanced and there is only so much it can grow before some shock will cause it to collapse.
In the lead up to the Lost Decade, Japan relied heavily on investment spending, mainly from businesses. This enabled it to grow for many years, but the economy was imbalanced because this investment spending didn’t translate into improved household consumption. I believe wealth was also transferred from households to businesses as well during this period (Professor Pettis/anyone else, can you confirm?).
There are parallels with China, but I believe China still has a far way to go. Yes, there are high rates of investment and capital misallocation, but what are the impediments to China rebalancing?
Unlike Japan’s case, I don’t believe China is experiencing diminishing marginal returns to investments yet, nor are their high debt levels. Indeed, it experienced a shock in the last 2 years and the economy has proven itself to be resilient, which says to me that the imbalances aren’t catastrophic as one would think – or that investment dependent growth is still sustainable in the short term.
If anything China has more levers to pull than Japan in rebalancing the economy (I’m thinking wealth redistribution effects of revaluing its currency, more headroom to improve affluence, a command economy, etc.)
I am in the camp that China should do well to invest while it can, because there are still gains in productivity from it. And if you hear people talking about the ageing population and labour force problems in Japan, times that by ten and add in a One Child Policy and then you’ve got demographics that should help iron out investment imbalances in the long term (…and cause issues on its own).
Michael, G. Stegen,
Have you read Richard Koo? He knows a lot about this, being a former Fed officer who is also fluent Japanese speaking. He helps explain why, among other things, Japan doesn’t FEEL poor or stagnant when you’re there. I have just ordered his book “The Holy Grail of Macroeconomics”.
hm, so many comments and still nobody has mentioned Richard Koo and his view of a balance sheet recession? I haven’t read his book, but I’ve read several articles from him and his arguments make sense to me. What do you think of the following argument? I would really be interested in your opinion.
Features of Balance Sheet Recession
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A balance sheet recession emerges after the bursting of a nationwide asset price bubble that leaves a large number of private-sector balance sheets with more liabilities than assets.
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In order to repair their balance sheets, private sector moves away from profit maximization to debt minimization.
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With the private sector de-leveraging, even at zero interest rates, newly generated savings and debt repayments enter the banking system but cannot leave the system due to the lack of borrowers.The sum of savings and debt repayments end up becoming the leakage to the income stream.
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The deflationary gap created by the above leakage will continue to push the economy toward a contractionaryequilibrium until the private sector is too impoverished to save any money (=depression).
????
In this type of recession, the economy will not enter self-sustaining growth until private sector balance sheets are repaired.
(from page 7)
http://www.scribd.com/doc/13970982/Richard-Koo-Presentation
Actually Pettis has mentioned Richard Koo before, and favorably. I went out and got his book on Japan’s balance sheet recession on his recommendation, although I haven’t read it yet.
Professor, for several years you have been the only one to talk about weaknesses in the country’s balance sheet and to warn that at some point this was going to become big news and a big problem. It seems that this is what is happening. Now everyone is talking about dangerous debt levels and even predicting collapse. Since most of this seems to be based on your own work, I was wondering what you thought about the most recent comments, including Victor Shih’s work.
DJC can you ever say anything that isn’t silly and cliche ridden? When you talk about the US you spout the wildest lefty-loony things and when you talk about China you revert to a classic China fascist. Is there any ideological consistency to your discourse besides a sense of ethnic resentment?
By the way, and speaking of loony ideology, didn’t John Ross use to come to this blog regularly to lambast Pettis with nastiness. Even since the post three weeks ago where Pettis causually killed him, without even mentioning his name, he seesm to have disappeared. Coincidence?
DJC. Indeed, the Chinese military is very independent. It does not even report to the Chinese government. It reports to the Chinese Communist Party.
The price of a base model Honda Accord or a Buick LaCrosse in China is about 350,000 yuan, a whopping $54,000. Now you tell me what the right exchange rate should be. In reality the currency issue is entirely political nonsense. I propose this deal for the Washington Consensus Elites. China and Asian countries be allowed cash out the treasury bills first into Gold and hard assets before they become fiat money toilet paper. Then China will raise exchange rate to one yuan for two dollars. Once China reasserts its historic sphere of influence across Asia and US military forces depart from the region, the Chinese will settle for a permanent divorce from the United States. Americans can purchase their Walmart trinkets from Mexico and Haiti.
Thank you Daniel for the link.
Prof. Pettis,
Why bother with proxy servers at all? While you’re in the U.S., why not purchase Witopia (a popular VPN used by many of us here in China). It’s both cheap and easy to install.
Interesting parallels though direct comparison might be taking things a tad too far. The question is what the demographics and income distribution levels were in Japan as compared to China. The thing with Japan is its relative high level of development before the slump. Take a walk out of first and second line cities and China’s situation is completely different – it’s probably closer to some parts of Akita than Tokyo or Osaka. These differences make investment and overinvestment (at times) seem almost justifiable in China. Not that the consequences are negligible.
“… Japanese corporate, banking and government debt levels were becoming a serious constraint, the Japanese economy began a long, slow, painful decline.”
It will be interesting to see if a parallel situation develops in China, given the central government’s edict nullifying all guarantees local governments have provided for loans taken by their financing vehicles.
It appears obvious that efficiency of “central planning” will be tested as cities and counties struggle with repayments because of debt ratios exceeding 400 percent.
this is probably the most important news on China economically in the last 6 months at least. Seems like implicit admission that loan issues are coming perhaps soon.
“China to Nullify Loan Guarantees by Local Governments ”
http://www.bloomberg.com/apps/news?pid=20601087&sid=ay..a15ZCHJU&pos=2
DJC,
Not sure what your point is. The high cost of imported autos in China would be reduced to some extent if the RMB appreciated. How does that support your argument? It would be great for Chinese consumers if Hondas and other foreign cars were cheaper. (I think the LaCrosse might be made in China.)
“China and Asian countries be allowed cash out the treasury bills first into Gold and hard assets before they become fiat money toilet paper.” Huh? What do you mean “be allowed”? Of whom should they ask permission? What authority is stopping China from divesting of Treasuries?
James,
My short answers to your questions would be “no” to dilution of comparative advantage and “yes” to China’s prospects for continuing a sort of latter day developmentalism.
However, that does not mean that all of the rest of the world will become as poor as China (if it responds by other than low cost production strategies) or that China will be able to take the traditional DS approach as fas as, for instance Japan and Korea have (and even they have not become truly balanced). Because the world is a bit too small and -importantly- there are some competitors left with democratic regimes and the ability to block demand within their jurisdiction.
But China got away with displacing a fair bit of rich country manufacturing (but not yet with the more important step of displacing the firms that control brands, technology and captive demand, and that will be a lot harder), in competition with other would be developmental states. Which as argued above, leads the more mature DS to defend its position, and the classic way to do that is repression of the sort of hedonism that we in the west call consumption, using established policy frameworks and instruments (and yes, Stegen, aggregate uncertainty is a great deflator).
The result of current policy is simply that China creates two kinds of trade conflicts: (1) with mature DS’s (Japan and Korea) ahead of them who see China steal the cash cow portion of their lunch (but who cannot avoid manufacturing in China like the non DS MNCs) and (2) with the aspiring DSs and in general industrializing LDCs behind it who are hoping to follow Japan and Korea and now find out that the key first step (low cost OEM) is no longer available to them because China has a score of poorer provinces that will outcompete the the SE Asians with volume, local availability of inputs and if necessary labor cost for a very long time, One of the more clever things that China did was acceding to the WTO and pushing for the abolition of textile quota. And, of course, escape from Mao’s utopian vision.
For the bulk of the OECD, the China threat is manageable, because no highly developed country is competitive on cost alone and so much of added value is in non tradables (including the retail services that get Chinese products to the consumer, often generating value added far in excess of the import price). That is, until the first Chinese homegrown Chungs and Toyodas get national support for destructive policies vis a vis the industry incumbents in the OECD.
shaun noll
Right you are!
Actions such as the party’s decision to unilaterally nullify existing loan guarantees by local governments demonstrate the dangers of doing business in China.
Commercial and property law obviously mean nothing. Political and family connections trump all else.
The curtain is now rising on what we be a very interesting drama…to watch from a distance.
This is the most interesting article I have read this year.
Thank you.
Hi Michael,I’m an editor of CAIJING.COM.CN,I think you maybe know CAIJING Magazine which is the most famous economic and financial magazine in China,I’m deely impressed by your blogs and opinion here,and I sincerely hope you can launch an English blog on our website.If you are interested in my invitation,please contact me
yuzhu@caijing.com.cn
I’m looking forward to your reply.
Prof. Pettis, i was wondering if you have any comments on this CAIXIN article
http://english.caing.com/2010-03-09/100124222.html
which seems to suggest that they may indeed be planning to help HUIJIN maintain their control ratios whilst the banks recapitalize, using the FOREX reserves. I am having trouble picturing how this all could work out for the various players, namely PBOC, SAFE and CIC/HUIJIN as well as the banks’ capital classifictions…
Any guidance would be much appreciated, although i realise that this article doesn’t give us enough information about the “how”.
Have you reviewed Australia’s dodge of the global financial crisis? It relates well to your point of pumping income into households and the positive affects it was able to have here.
some thoughts up for discussion:
Prefix
Capital Allocation is critically important for any nation in the world. The people who decides where to invest the surplus-labour stored in its capital, also decides the future of the economy.
Content
I probably have not read enough into the troubles Japan had after the Plaza Accord and the 90s asset bubble. But at the very fundamental level, I believe the fail of Japan vs the success of US (3rd Industry Revolution)in the last decade of 20th Century, is the result of grand-scale capital mis-allocation.
All asset bubbles in the world is a form of capital mis-allocation, i.e. while the public lacked alternatives investments (same situation in HK in 1990s) and decided to invest its money(store for surplus-labour) in hard asset (like property etc). The value potentially to be created from the surplus-labour stalled. People start to gamble on hard asset and consume its surplus-labour stored in money. As a result, the nation’s overall value deteriorate, marginal return (in value) diminishes.
The current debt-cage monetary system in the world (per ‘Money as Debt’), causes structure problems for every nation of the world.
Alternative scenario:
if Japan have successfully completed its research in robotic science(or something else), and capitalised/industrialised its achievement, Probably Japan would have led the world into the 4th industry revolution.
thoughts?
Topic – US public debt problem
Stripping off all foreign debt (which can be a problem for US, but not yet)
The real US public debt problem is US structure problem.
any thoughts guys?
I am back in Beijing but I continue having real trouble logging on to my proxy, so I have not been able to respond to comments. Sorry, but I am hoping that in the next few days the internet cops begin to relax again and this problem will resolve itself.
When you have the leaping productivity that China has caused by the mass migration, then investment need not necessarily be efficient. “Directional investment” will be adequate until such time as China runs out of cheap labor resources (and pliant citizens who shrug at the country’s income inequities)and can no longer hide the stupid investment decisions some officials are making. Thus, Judy, to your point,”Not that the consequences are negligible.”
While China has a trade surplus, you might also say it has a demand deficit. Historically, that void was filled by foreign demand. In 2009, it was filled with government induced investment. One thing that does not get much air time is China’s lack of a consumer oriented supply chain system.
The engine of labor growth in China in the last decade was export oriented SMEs. These privately owned firms were, by and large, contract manufacturers. If China were now to aim this productive capacity inward, it will have to substantially retool the system.
Think what it takes to develop, produce, market, and deliver a consumer product. I would submit that China is not good at this…yet. Name a Chinese consumer brand that has world recognition? Lenovo? That’s legacy IBM. Haier? maybe but if that’s the best name,then there is a lot of work to do.
My point is not to say China cannot turn its consumer manufacturing strength into an integrated domestic “closed end system”, it is more that this change will take time.
Such a system requires good signaling, accurate and timely information about market demands. Close coordination between manufacturer, wholesaler, distributer, logistics company and retailer. Timely and accurate information is not one of China’s strong suits.
In sum, it is pretty easy to manufacture a widget to the specification supplied under a contract and get that product to port. It’s another thing to understand the consumer’s need, develop product concepts, price it appropriately, advertise it, manufacture it, distribute it and retail it. That’s a much more sophisticated system.
China can do it. But it will take time and it will take support from the Party, consistent and transparent commercial regulations that promote such a supply chain, a system of open information exchange, price signaling, and, lastly, a much better system of allocating investment capital (banking and capital markets).
re: Hua Qiao,
so your argument basically says there lacked market-economy mechanism in China, for which i agree to an extend. But the Chinese economic structure is always gona be different from the current capitalist world. There are fine lines between, traditional communism, traditional capitalism, modern capitalism, and Chinese-style communism.
All the problems you mentioned, are true for market-oriented economy. However, your assumption of modern capitalism model of China may not be the case that communist leaders are directing China.
The requirements for capital allocation and industrialization are always required for any economy, however, the people who make decisions on those things may differ in a capitalist-economy to a command-economy.
I believe the structure problem in China is the key risk for its sustainability.
anyone agrees with Premier Wen’s argument of RMB is close to its fair value, as economic shock shows CN-export drop faster than import, which indicates high currency volatility on demand side, so you should further depreciate RMB to rebalance the volatility?
I do NOT really see the logical mechanism. Anyone does?
cooldin
Wen and his clique are posturing for the domestic nationalists in advance of the transition of power to the new generation of elites, end of story.
I am interested in your term “Chinese-style communism”. Can you define it precisely ?
Hua Qiao and Cooldin,
China is a bit like the proverbial elephant described by blind men: the problem areas are vast yet form part of a whole. Indeed, the contract manufacturers are simply not connected to a domestic signalling system, except for a few inputs. So it will be very hard to switch to producing for a domestic market and probably most of these businesses lack the management resources for a more vertically integrated business model, and maybe their core skills are poorly aligned with domestic consumption patterns anyway. Nobody knows, although one should never underestimate their flexibility. Nothing sclerotic there.
To what extent the creeping influence of the corporate state/party will be able to provide a substitute (or even better, room) a true market is yet to be seen. In China’s own experience, central planning was never adequate and never taken to the “heights” of the USSR. One has to still look at the Chinese economic experience through the lens of a party/state that needs high levels of control to maintain its dominance (and the welfare of its “members”). That experience was with young economists influenced by German and Russian ideas around WWII, followed by an overenthusiastic jump into central planning for which neither the resources nor basic development were adequate. The failure led to various attempts to shock (like the Great Leap) the economy, the upper layers of society (the cultural revolution) and the last gasp of central planning (under the unlucky Hua Guofeng) was so implausible that the party under Deng decided to reduce the scope of the formal state through nis Nan Xun campaign, which resulted in the basically unstable and anarchic model that we have now, but which has made a few very rich and many more comfortable that maybe ever before (maybe during the late Ming). The real problem is now how to make a semi-modern China more manageable (or disciplined), and at the same time how to protect the interests of the country’s elite, organised in the Party and its many competing groups (and now dynasties as well. In other words, how to achieve what Deng may have had in mind, a system that benefits from an modern information society without giving up the Party’s monopoly of power (and I mean not the party as an ideological movement, but simply the association of members with their private interests). The same problem that kept Bismarck busy..
@ Hua Qiao
Nice post on the consumer orientated economy. I think a related challenge that Chinese manufacturers will face is establishing their next global competitive advantage. They can’t compete on cost forever and must eventually find ways to add value to consumers via other means.
In free markets, this change seems natural as incentive structures and free information flow will drive the increased sophistication of industries and consumers.
China’s case is different and the drive for change will rest with the government, the ultimate owners of capital. The *usual* incentives to industries and consumers aren’t as effective in driving change because they do not own the capital. Instead, incentives must be applied to the government, which, in my mind, would be less responsive to price signals. (That is, incentive structures work better when the public own capital.) Consumers globally will eventually demand more than just the cheapest goods from China and I wonder what the government will do, if anything, to encourage supply chain discovery and an industry more focused on value-add.
re: Nada
I cannot define ‘Chinese-style communism’ precisely. I just know it’s a new form of economic structure which meant to sit between planed-economy and free-market-economy.
But I think running a new economic model for a country with the size of China is very dangerous. The Soviet Union failed their traditional communist model after the cold war. At the same time, the capitalist model is correcting itself after each recession e.g. great depression.
I don’t know either the self-correction capitalist model or the chinese-style communist model would reach the final stage of social balancing (social balance – politically stable, and economic factors are balanced e.g. consumption vs investment).
I believe all of these fall into the same old question – wealth re-distribution.
Hi Rien,
Im impressed with your knowledge of China, in particular post 1949. I also wonder where did you find the economic data for Mind dynasty and its economic structure. I always had difficulties to collect any data pre-1st Opium War.
Meanwhile, I am wondering whether market price signal BEST allocates resources, or do we have other alternatives!???!
Pre WWII, Russia Economic model help Russia to proceed into industrialized country from agriculture based economy in 5 yrs. Which indicates planed-economy resource allocation was very efficient for a certain stage of development. Afterwards, we all agreed market-economy is better and more efficient. But do we still have other mechanism for resource allocation?!?!?!
Question for Prof. Pettis:
Premier Wen recently suggested that the yuan is not undervalued – this in spite of the fact that some economists have claimed that the yuan is undervalued by as much as 40 percent. What’s Wen’s argument, and is it reasonable? How does one account for the weakening of the yuan vis-a-vis many world currencies at a time when the Chinese economy is apparently the top-performing major world economy? I’m confused.
Again, I’m a history guy with deep deficiencies in both economics and finance. Any help answering this question will be much appreciated.
p.s. – you really must consider using a VPN
Cooldin,
1. There is a set of good articles on Chinese economic history on Wikipedia. Not much in the way of statistics though. But very useful references, especially for those who read Chinese. For a slightly more scholarly piece:
http://eh.net/encyclopedia/article/deng.china
My choice of the late Ming as an era of prosperity (and not the reign of the Kangxi emperor) is basically that during that period there was apparently more of a market economy than in previous or later pre-modern periods, important foreign trade, innovation and (more ambivalent as an indicator) rapid population growth (but apparently with a general surplus over subsistence for the rural population).
2. A market economy with a very high signal to noise ratio and very low friction should allow rational and well informed actors to achieve almost optimal resource allocation, since that would be circumstances approaching the Arrow-Debreu (“AD”) model. Current Chinese reality suggests a considerable distance from AD and even if one believes in the relevance of the AD model for economic management, there may be more effective ways to deal with the circumstances that reduce China’s allocative efficiency than continuing the current mixture of non-planning state capitalism and anarchic private capitalism that do not structurally complement each other. To what extent more planning (not necessarily more priority for very (and even technically efficient) large SOEs) would be able to outperform the status quo (which is unstable in my opinion and probably a concern to the State Council) is impossible to say in the absence of either a path towards much better institutions and “rule of law” that are required for a market economy to develop its efficiency potential, and the absence of a good example of successful central planning. But in both cases (more planning or more market infrastructure), the result would be different from what we have now. There is a point where people feeling the stones start to wonder if they will ever cross the river. The previous planning examples (mainly the Russian Gosplan approach plus a few variations like the Kombinate in the former DDR have indeed produced a set of industrial producers with large enough scale for the era, but that works only when you want to leave the producer aristocracy determine quality and quantity of output. I guess that the working life of Chen Yun is a vivid illustration that during that period no one had figured out how central planning could keep the population of China reasonably quiet. The developmentalist (selective planning) model of Japan (and earlier various phases of Germanindustrialization policy ) was based on a strong elite consensus that national economic development was too important to leave to the market and a belief that selective trade management would be feasible (up to a point, but feasible enough) in combination with an orchestration of technological capacity growth, emphasis on science&engineering, paternalistic treatment of workers and the maintenance of a socialized reserve army of workers in the rural sector. More or less..The problem for China with this third model (selective planning) is that China is too big, too diverse and lacks the longer term space in international trade. As we know, once pre WWII Japan and pre WWI Germany caught up with their industrial examples in more liberal economic systems, they ran into stability problems both economically and politically. But they did not, as China might experience if it would “copy Japan” run out of export market space…
All in all, I think that there is no solution for the longer term problems of China’s political economy that combine increasing and widespread prosperity and the current CPC (a much more disciplined and cohesive organization might have a chance to pull (for say 10 years) off a developmental state model with selective export orientation and strong improvement in state provision in areas that citizens tend to case about in democracies: education, health and safety nets and public safety (incl safety from shoddy builders etc). It looks like the centre would be very happy to go in that direction but there would be far too many powerful losers, so it cannot be done. The one thing that I think will give an indication of which way things are going would be the hukou reforms that are being considered.
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