I suspect most of my readers outside China are more interested in enjoying the holiday season than in spending much time following my blog, while most of my readers inside China are focusing on upcoming exams, but anyway my recent writing commitments are so intense that I haven’t been able to post much recently. For what it is worth I have a short piece appearing soon on YaleGlobal Online about why the US-China trade relationship was the “cause” of the recent financial crisis.
I have a much longer piece that will appear in the January issue of the Far Eastern Economic Review that sets out the balance-of-payments framework necessary, in my opinion, for understanding not just how the current crisis came to pass but also how bad it can become if policymakers do not react correctly. The Financial Time’s Martin Wolf has kindly asked me to prepare a shorter version of the piece to appear on the FT blog next month.
Still, for all the writing commitments, there are a few things I wanted to note in my blog entry today. Today’s New York Times has an interesting article on South Korea that I suspect is going to set the tone for a lot of what will happen in the upcoming months:
South Korea posted a current-account surplus for a second consecutive month in November, which may help ease pressure on the won, the region’s worst-performing currency this year. The surplus was $2.06 billion, compared with $1.67 billion in November 2007, the Bank of Korea said…The nation posted a record $4.75 billion excess in October…South Korea has posted current-account shortfalls every month but three this year as higher oil prices and the weaker won drove up the cost of imported goods.
A few days ago the Financial Times had another interesting, related piece.
Vietnam devalued the dong by 3 per cent on Thursday in its latest attempt to keep its export-dependent economy afloat. The government said that 2008 economic growth had shrunk to 6.23 per cent from 8.5 per cent last year and there were signs it was likely to slow further in 2009. Several analysts have warned of the threats of competitive devaluations among Asia’s exporting economies but Hanoi’s move comes after spending most of the year trying to maintain the currency’s strength to slow spiralling inflation.
…Several analysts noted that while governments have resisted pressure for protectionist policies, there are fears they might take the short cut of devaluation. Thailand and Taiwan have recently become net purchasers of dollars, provoking the Asian Development Bank to warn against “unnecessary and excessive interventions in the currency markets, especially to depreciate domestic currencies”.
Vietnam has also cut interest rates several times which, as I have argued before, in an economy whose banking system funnels credit primarily to investment, and not consumption, is as much as an export-enhancing measure as currency depreciation.
One consequence of the financial crisis will inevitably be capital outflows from developing countries. The necessary corollary of capital outflows is trade surpluses. Without running a trade surplus no country can consistently support capital outflows, and as obvious as this is, it also seems to be a source of tremendous mystery to many experts and policymakers. Keynes for example pointed this out in his fury at the way Germany was required to post war reparations in the 1920s while its ability to generate export surpluses was all but eliminated by the victorious powers. Capital exports by definition require trade surpluses.
This is just another way of saying that a lot of developing countries that had been running trade deficits will soon be, if they aren’t already, running trade surpluses. Instead of contributing their net demand to the world economy, as they had via their trade deficits, they will now be contributing their net supply.
This will not help the world imbalances. The biggest contributors of net demand are the US and non-Germany Europe, and both of these regions are seeing a rapid decline in their net demand contribution (i.e. their trade deficits are expected to shrink). To adjust to this decline the world needs new sources of net demand or else global production must contract sharply via factory closings and rising unemployment. But the largest net supply country, China, is increasing its export of net supply (its trade surplus has been rising) while several trade deficit countries in Asian and elsewhere are switching to trade surplus or otherwise trying to reduce their deficits.
This cannot be sustainable. We cannot expect production to rise while consumption declines except if it comes with a dangerous rise in forced investment (also known as inventory). The crisis cannot even begin to be considered in its final stages until this issue is resolved.
Meanwhile domestically the debate about how to respond to the global crisis is still raging, although it is far from clear that we have anything close to a consensus among policymakers. Today’s South China Morning Post has the following article:
A former mainland central banker has called for a halt to the country’s recent flurry of actions to loosen monetary policy, a view partially echoed by analysts. Wu Xiaoling, who was a deputy governor of the People’s Bank of China before she left a year ago, said deep cuts in interest rates and reserve requirement ratios intended to boost lending could backfire, damaging confidence and adding pressure to bank balance sheets.
“I don’t think we should do more on the monetary policy side,” Ms Wu, now a vice-head of the financial committee of the National People’s Congress, told the Economic Observer newspaper yesterday. “Intensive policy moves will not help stabilise market expectations. Instead, they will cause panic among companies and the public, making the situation worse.”
I am glad to see that there is increasing concern about further interest rate cuts, although not for the reasons cited by most. For me, interest rate cuts in China will have very different effects than they might in the US. In the US, where a great deal of credit goes to consumption, lowering interest rates can be seen as boosting consumption as much as boosting production. At any rate the US, which contributes the largest amount of excess net consumption to the world and must bring it down, has every reason to focus on production-boosting measures as well as consumption-boosting measures.
But China is different. First of all there is little to no consumer credit in China, so cutting interest rates won’t do much to boost consumption. It might do so indirectly by reducing mortgage payments (Chinese mortgages are all floating-rate mortgages) and perhaps by slowing the decline in real estate prices, but it is not clear how big an effect that might have on increasing consumption, especially since even lower interest rates aren’t likely to create much buying interest for real estate. In fact there is some evidence in China that households may actually contract spending when deposit rates are cut since they need to save more to achieve their precautionary savings targets.
On the other hand with most credit going to investment, lowering interest rates definitely reduces further the cost of production. I know that the idea of lowering interest rates in an economic contraction is firmly entrenched in economic wisdom, and I am taking what may seem like an extremely opposite viewpoint, but I doubt that cutting interest rates is what China needs to do if it is expecting to adjust to the global payments adjustment. Every domestic policy must be aimed at boosting demand, and anything that increases China’s “competitiveness” is a dangerous detour since it can only exacerbate global imbalances and increase the likelihood of trade friction.
While still on the subject of banking, there is another very interesting article from the South China Morning Post on pyramid schemes and underground banking. As the financial system in China contracts, in spite of regulatory attempts to force credit expansion, I think the informal banking sector is going to get increasing scrutiny. In addition, and the Bernie Madoff scandal should remind anyone who needs reminding, financial crises always result in the uncovering of financial scandals and fraud on a massive scale, which already seems to be happening here. Rather than comment I will quote extensively from the article:
Beijing will impose severe penalties on people involved in pyramid sales schemes, underground banking or manipulation of government statistics in a move to strengthen financial security, according to draft revisions submitted to the mainland’s top legislative body yesterday.
…Mr Li said the draft was revised to define pyramid selling as “organising, leading sales activities aimed at promoting goods and providing services that require participants to pay for the products or services in order to obtain membership” and “introducing a tiered system to force or prompt participants to attract new members to extract money and property, thereby disturbing public order”. If the changes are passed, people convicted of involvement in such activity could be sentenced to up to five years in jail, while ringleaders could be given even longer sentences in more serious circumstances. A regulation targeting underground banking has also been reviewed, according to Xinhua.
Illegal banks dealing in large financial transactions will be regarded as criminal organisations, the proposed amendments say. Mr Li said his committee added this line after the Legislative Affairs Office and the Public Security Ministry highlighted how underground banking could disturb and harm the financial order. Pyramid sales and underground banking have emerged as two major social problems in the recent weeks.
…Illegal banks are targets despite mainland companies of varying sizes relying on them for cash in the credit crisis. Illegal banks on the border help mainland businesspeople invest in the Hong Kong stock exchange.
Happy 2009, everyone. I will spend New Year’s Eve at D22 watching an amazing lineup of some of Beijing’s most brilliant musicians. I hope to see some of you there.
For someone who is in China and not a student studying for exams, your post was refreshing since most of my regularly-read China blogs have shut down for the holidays. Thanks!
Michael.
In short – this isn’t sustainable. the collective policy makers are looking for ways to squeeze water from rocks, and I don’t think that any of it is doing any real good.
My concern here is that for some of the economies you mention, they are closure to social instability than they care to admit, and that is what is forcing them to sand bag numbers in a way that clearly has little long term benefit.
For China, I think they have three economies that they need to balance (export, consumer, and rural), and while the first is coming off, and the second is non-existent, it is the third that I have perhaps the most interesting policies that are long term – social security, land reform, etc.
But if people are only focused on consumerism, and simply argue that the Chinese buying more is not a solution, but simply an extension of the status quo. It is buying into a belief that if the Chinese only shoulder the burden now, the world can correct itself.
…. and that for me is a more dangerous thought process
r
http://www.allroadsleadtochina.com
Happy new year. This is the most important story of 2009. Until the PTB get this we will not be on a decent path to getting out of this mess.
While you speak on pretty obscure topics, at least for lay Americans, your explanations have lead to a certain “Well, duh?” reaction because of their clarity. I think clear writing is a sign of someone who knows what he is talking about.
Have a good New Year and keep up the good work. I would appreciate a description of the entertainment to which you refer.
I great post.
Exactly to the point: the trade imbalances are the technical basis for the financial crisis.
The cycle: the USA consumers spending, the USA importing mainly from China, China exporting to USA (and Europe), China accumulating profit and reinvesting them in USA to finance the USA consumers, USA consumers spending again and so on.
In smaller term is: producers offering credit to consumers to sustain the demand of their products.
None is willing to get out of this circuit but the circuit is broken.
In an old small book (Arthur Lewis -”The evolution of the International Economic Order” 1978) – there is an even deeper understanding of the issue: the developing countries will have to rely on internal consumption if they want to build and sustain their growth. The export-lead growth is not self-sustanaible.
That fit perfectly for China (actually also for Japan and Germany)
Michael,
Thanks for an enlightening blog and for your unique perspective. I particularly appreciated your article on the Great Depression analogy (“Would a Trade War Help…”). That article was the single best piece on the current crisis that I read in 2008.
I look forward to reading your insights in the New Year.
Excellent post.
A few comments. One, I agree that US-Chinese trade was the ’cause’ of the financial crisis. But this begs the question: what is the cause (the structural explanation), for the US-Chinese trade relationship? The answer to this would seem to me to be getting closer to a more thorough analysis.
Clearly, an increasing number of developing countries competing with one another to expand their exports to excess consumption countries that are now and will be for the foreseeable future be decreasing consumption, is a dead end. This would lead to a reduction in the cost of those exports as more and more developing countries compete with each other to ‘capture’ a portion of the export market, thus forcing down profit margins and likely pressuring down wages.
Furthermore, seeing the solution as one of increasing consumption in developing countries seems obvious on the surface, but seems to me there are structural limitations to that: in order to increase domestic consumption these countries also develop the service/retail economy that allows for such domestic consumption to unfold? That takes us back to production, that is, the construction of the service/retail economy, and that will require expanding and greater access to credit. Seems like we’re running in circles here.
One has to be very careful with terminology here. The term consumption in economics has a specific meaning, which is the amount that consumers consume.
It’s very easy to get the concept of consumption confused with the concept of “aggregate demand” which is consumption + investment + government spending + net exports.
Production has to equal aggregate demand, but you can boost aggregate demand by increasing investment, government spending, or net exports. Personally, China needs to focus on boosting investment and government spending rather than consumption.
Dear Prof Pettis,
I have been reading your blog for sometime now and really appreciate the fact that you’re sharing facts you gathered and thoughts on the matters.
I have a few questions I really would like your opinion on.
1) China does not have much automatic stablizer for its economy such as social security, health care, unemployment welfare etc. It concerns me a great deal as to the social stability of this nation as unemployment edges higher. Your thoughts?
2) This is a follow up question on Q1. Many pple believe that the large amount of FX reserve and the fact that Chinese govt have the potential to tap into the bond market could be used to stabilize the economy. However, I feel that the FX reserve could be depleted very quickly when “hot $$” flows out. On the front of the bond issuing, I think that China does not have such power, as to there is limited buyers. a) if sold in domestic market, that will take liquidity out of the financial system, not a good thing to happen. b) there seems to be lack of international buyers as US will be at the same time issuing huge amt of treasury which looks much safer even at 2%. Your thoughts?
Thank you and happy new year.
Richard, as I see it one of the problems facing policymakers is that they have two very distinct set of problems. One set includes all the much-discussed issues of income inequality, rebalancing the economy, reducing savings, etc. These are problems that will only be solved, if at all, in a term measuring years at least and possibly decades. The second set of problems has to do with the speed of the global adjustment and ensuring that China does not get caught in a whirlpool. People may disagree, but I think policymakers are focused almost exclusively on the second set, and in many cases its resolution may actually impede the resolutions of the first set. As my friend Arminio Frga has said repeatedly during his visits here, make your tough adjustments when things are going well or else you will be forced to make them when things are going terribly.
Thanks Mike, Tyaresun, and David, and thanks Luigi, I will look up the book..
Don, it has become fiendishly hard to discuss this issue without getting into a blizzard of accusations about being anti-China or anti-US, so I will simply say that I ma very impressed by the fact that the three great imbalances (which of course are all part of the same imbalance) – the collapse in US household savings to historically unprecedented levels, the ballooning of the US trade deficit to historically unprecedented levels, and the massive accumulation of Asian trade surpluses and foreign currency reserves to historically unprecedented levels – all began occurring in the year following the Asian crisis of 1997. It is notoriously difficult to establish causality in balance of payments relationships, but I am left assuming either that a)Americans in 1998 experienced a religious conversion that caused them to become insatiable consumers, and their binge buying forced trade surpluses and excess reserve accumulation onto an unwilling Asia, or b)that the Asian crisis set into motion a number of policies aimed at preventing a recurrence, which policies found an equilibrator in the US consumption binge, and these policies got out of hand.
Having said that, and so as to avoid charges of being anti-anyone, let me insist that no large country and few small ones that were parts of the global balance of payments can claim to be victims – this was the great cocaine party of all times and no one wanted it to stop, in spite of the fact that most of us knew about the increasing heart palpitations.
Twofish, of course you are right about the distinction, but it doesn’t affect the underlying argument because the point is that there is an imbalance that must be addressed. I am not smart enough to say what is the best way to address it, but I am smart enough to see that the arithmetic doesn’t work.
Leon, to answer your first question requires a much finer understanding of the social and political dynamics in China than I would care to profess. There is no doubt in my mind – or in many others’, it increasingly seems – that unemployment will rise in 2009 and has already risen dramatically among college grads in the past two years even with outsized growth. As for your second question, I think we have to be clear on what you can and cannot do with reserves. Foreign currency reserves are useless for domestic spending since they would require an about-face by the PBoC – to convert from a huge buyer of dollars into a seller – that would cause the RMB to soar and exports to collapse. High reserves allow them to support increased imports and some capital outflow if their monetary and fiscal expansions lead to either. I share your worry about how stable hot money is likely to prove.
Michael
the one issue I have with the two standard lines of thought is that they do not accruately portray that China has a number of very different economies. Sure, there is a problem with income gaps – but that is largely a result of having an export economy moving much faster than the rural/ domestic economy.. and this leads to a whacky consumer economy..
Maybe that isn’t very scientific, but when looking at the programs/ subsidies that they are announcing, I really view them in rural, consumer, and export.
With regard to the whirlpool, the numerous subsidization announcements (banks, airlines, mobile phones, auto, etc) and large industry mergers that involve 2-3 major players or 4-6 smallers ones “hugging together for warmth” (steel, AL, logistics, etc )are showing the breadth of this being quite wide already.
Not saying the plug has been pulled, but it is closer than any of the Chinese press is letting on/ Western press understands.
Have a good new year.
R
Michael, Happy New Year! Great job with your analysis and blog.
I see Marty Feldstein is pushing DoD spending as a sure fire means of cranking up US demand.
What’s happening with Chinese defense? Are they planning on any massive defense buildup?
Happy New Year and thanks for the great blog!
I’m outside of China and for some reason i’m glued to this blog very similarly to the way i was glued to calculated risk a year ago. something seems very wrong with the global debtor/creditor dichotomy and i don’t like it…it also seems that the US/China relationship is at the epicenter…we’ve seen the devastating fallout of the US side of the equation has, so it really begs what impact China’s side will have.
Why was the US-China trade relationship the “cause” of the recent financial crisis?
I think one of the most important cause was the demolition of the progressive taxation system in the U.S. “Reaganomics” seems to create income disparity and excessive capital accumulation. Those who have excessive capital speculate and create economic bubbles, which in turn caused the reckless expansion of the credit. This combined with the fact that the real income has been stagnant for the vast majority of Americans, is one of the most important cause of the current crisis.
Happy New Year! Michael. I am a fan of your blog.
I wasn’t able to make it to D22 this time. I will make sure that it’s on my schedule next time I am in town.
I am not sure how much developing countries can do to depreciate their currencies to boost export and therefore exacerbate the global payment imbalance problem.
Major central banks around world are all expanding their balance sheets and cutting interest rates. US interest rate is at 0, quantitative easing is underway, USD may soon (or have already) reverse its course and start weakening. US may also have to use weak dollar to fight deflations. I have not heard of US officials talking about a strong dollar lately. If every country tries to depreciate its currency then nobody would really be able to do much on that. (We cannot depreciate against other planets.)
I also don’t think cutting interest rate in China will boost production by much. With current economic environment, if the risk/reward does not justify an investment, who is going to lend and who is going to borrow?
Leon: China does not have much automatic stablizer for its economy such as social security, health care, unemployment welfare etc. It concerns me a great deal as to the social stability of this nation as unemployment edges higher. Your thoughts?
There is one big automatic stabilizer in that someone with a rural residency permit is entitled to land to farm, which means that they can go home and won’t starve. The existence of this stabilizer was one reason I thought the notion of allowing peasants to sell away their agricultural land rights was something that needed a lot of thinking about.
Michael,
But China being the net exporter, what reasons does it have to push for protectionism? I understand why it would continue to push export, and why would it push for something like Smoot-Hawley? World can’t live without Chinese goods, but not many people in China can afford imported goods.
Reading the history, the Fed is injecting liquidity massively and quickly. And doesn’t this mean that seeing the Smoot-Hawley, the policy makers will try to avoid something like it?
Thanks.
Also, I read the recent Economist post on Smoot Hawley (http://www.economist.com/finance/displaystory.cfm?story_id=12798595) and it seems like there was no logical reason for it and many economists and advisors were opposed to it loudly at the time.
Doesn’t this mean that if the same happens, more will voice their objection and there is more chance the policy makers will actually listen as they can also see the history?
I would be interested to hear your comments on how monetary policies in China and the US contributed to imbalances of the scale reached during the past decade. China could not have amassed US$2 trillion in forex reserves without distorting the value of the yuan, and asset prices and the cost of capital in the US could not have been distorted (up/down respectively) without some help from a party other than the US Fed. I am not assigning blame (if I were to do so, most would go to US Fed), but how would you assess the enabling role played by China’s currency regime?
Groucho, I suspect that with everyone in China proposing new ways to spend money, it would be very surprising if the military, who from what I understand have seen a tremendous increase in their political power under President Hu, aren’t also in line with lots of nifty new projects. Nothing makes a general happier than shiny new toys, but military spending is top secret in China and I certainly don’t have any good information.
Seatrus, I am sure there is no single “cause” but rather a confluence of cause, but I don’t see any historical evidence that in previous periods of rising income inequality in the US the trade deficit ballooned to anywhere near recent levels, and I believe that the recycling of the US trade deficit was a great source of global liquidity expansion. After all in China we have seen an even more rapid increase in income inequality, and although there certainly has been speculative bubbles and credit growth, they did not lead to large deficits. I am also not sure how causality runs between rising income inequality and excess credit expansion.
Lei Jiang, I think competitive devaluations will occur against the dollar. Of course not everyone can devalue their currency, but everyone can inflate. You may be right about lower interest rates not spurring new production facilities (no one wants to borrow to build new factories), but by lowering interest costs it may make it easier for companies to run inventory longer and to keep production facilities open that might otherwise close.
AC, when I talk about “Smoot-Hawley” I don’t mean only import tariffs but rather any policy that has the result of increasing the export of overcapacity abroad. I am not sure what you mean by saying that the world cannot live without Chinese goods, but I think the world will soon be awash with goods from China and other developing countries that no one wants. I hope policymakers avoid Smoot-Hawley policies as I have defined it, but so far they seem to be doing the opposite, as have, by the way, lots of other countries. This is how trade frictions develop. Whether policymakers will avoid the mistake of the past – you are much more optimistic than I am. At any rate it is not clear to me that trade friction will be nearly as bad for trade-deficit countries as for trade-surplus countries, which means that for individual countries it may not necessarily seem like a bad idea.
Hilton, I have argued many times that I think the post-1997 decision by several Asian countries to accumulate large reserves and run large trade surpluses (all aimed at avoiding a repeat of 1997) was one of the key sources of the global imbalance. I have a piece in the up[coming YaleGlobalOnline and the January issue of Far eastern economic review that go into this, as well as many previous blog posts.
Love the blog.
Many people are quick to blame the profligate American consumer for overconsumption and causing the massive trade imbalance, but I’ve been thinking about this by applying an Austrian Business Cycle Theory concept. (I dislike them immensely, but they are an interesting tribe with some insightful thoughts, at times). Anyways the ABCT argues that artificially lowering interest rates encourages short-term investment in place of deferred investments (aka savings). This leads to malinvestments which cause bubbles and imbalances. So, perhaps free trade as its been structured created price distortions that lead the consumer to consume now instead of save, a sort of “malconsumption.” An outcome which can be certified by any number of statistical indicators. These price distortions could be caused by currency manipulation, credit expansion, wage arbitrage, etc.
This sort of thought leads me to agree that the *cause* of the current world financial crisis were global trade imbalances. But I would say the “root” cause would be the actions of both the mercantilist trade surplus countries and the inactions of the deficit countries. Just a thought.
Mr. Pettis,
Thanks for taking time from your busy holiday schedule to share your thoughts.
My question is that what metric are you using to determine whether the net export position is becoming too big of a drag on the economy? The reason I ask is that 2/3 of US aggregate demand comes from household consumption, and that pretty much dwarfs the current account deficit even at its current 7% and decreasing. I recently read Greenspan’s Age of Turbulence where he states that the bigger phenomenon is the increasing leverage of all US economic actors, from the households to the banks to the government, and that the current account is merely a reflection of these leveraging activities spilling over across borders. Doesn’t he ratio of the current account deficit vs. consumption as a percent of GDP support this view?
I think you are thinking like sukrat, but I think you should cover the other side of the topic in the post too…
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Good post on the overriding role of trade imbalances in the crisis, a view I share. What surprised me, though, is your view that China is doing little to boost its domestic demand. (It partly invalidates my own assumption cited in your “website” box above.) But we keep reading here in Europe and in the U.S. press that China has uncorked a big domestic infrastructure program. What happened to that? In any event, if I am right about the effect of financial deflation in the United States, the surplus countries better start stimulating their own demand or prepare to face their own price deflation. Your thoughts?
I am unable to understand this post. But well some points are useful for me.