One nice things about writing a blog is that I don’t need to be topical. Not only can I write worriedly about rising contingent debt levels three or four years before they become obvious, but I can also revisit a controversy that took place March involving Paul Krugman and Stephen Roach. I revisit this old controversy because although the period of nasty trade dispute seems to have come to an end, with conciliatory noises being made between the major parties, trade tension is not going away. In fact it is going to become internationalized, with more noise coming from other developing countries, who have already begun complaining about RMB policy (for example last week the governors of the central banks of both India and Brazil came out with strong statements about the RMB). In the end, large trade deficits are not politically compatible with high unemployment, and in my opinion things only will get worse on both fronts.
So while this post might not be currently topical, the subject will again become so very soon. To start, and in response to many of the comments from recent postings, especially some emailed comments from friends, I wanted to work through Paul Krugman’s point on currency intervention because, as I see it, he is simply using accounting identities to set out the parameters of how to think about the issue of RMB revaluation.
Accounting identities cannot be violated, neither in practice nor in theory, although depressingly enough much of the discussion of trade balances, even when conducted by economists, brazenly violates these identities. It may make sense then to place the discussion solely in that context so that at least we can all agree where we legitimately disagree. Here is what Krugman says:
Let me start with a proposition: the right way to think about China’s exchange rate is, initially, not to think about the exchange rate. Instead, you should focus on China’s currency intervention, in which the government buys foreign assets and sells domestic assets, on a massive scale.
Although people don’t always think of it this way, what the Chinese government is doing here is engaging in massive capital export – artificially creating a huge deficit in China’s capital account. It’s able to do this in part because capital controls inhibit offsetting private capital inflows; but the key point is that China has a de facto policy of forcing capital flows out of the country.
Now, bear in mind the two basic balance of payments accounting identities:
Capital account + Current account = 0
Current account = Domestic savings – Domestic investment
By creating an artificial capital account deficit, China is, as a matter of arithmetic necessity, creating an artificial current account surplus. And by doing that, it is exporting savings to the rest of the world.
Notice the first identity. China’s current account surplus must be equal to its capital account deficit. It doesn’t matter whether you think China’s trade surplus is caused by policies that force households to subsidize producers, or that place tariffs (hidden or explicit) on imports and subsidies on exports, or that force heavy currency intervention by the PBoC. In the end, these are all one and the same thing, and will have automatic balance of payments consequences. Krugman argues that since China restricts the capital account, the PBoC’s currency intervention automatically results in the Chinese capital account deficit and the current account surplus.
If this true, what are the consequences? Let us for simplicity call the rest of the world the US. If China runs a capital account deficit, the US must run a capital account surplus. That is, it must import savings from the rest of the world. This is one of the inviolable accounting identities.
One country’s surplus is another’s deficit
Since the current account is the obverse of the capital account, this also means that the US must run a current account deficit. Here is where another accounting identity becomes very useful. The total amount of savings the US imports is defined as domestic investment minus domestic savings – in other words by definition the US imports whatever additional savings it needs to fund its domestic investment.
Remember that this is also the same thing as saying that the excess of US investment over US savings is equal to the current account deficit – because the capital account surplus is the same as the current account deficit, right?
So if the US runs a capital account surplus, it must run a current account deficit, and if China runs a capital account deficit, the US must run a capital account surplus. This all nicely balances out because if the US runs a current account deficit, China must run a current account surplus.
Remember, however, that there is no direction of causality implied here. These things must all happen simultaneously, and there is nothing in the accounting identities that tells us which caused the other. If PBoC intervention forces a capital account deficit on China, as Krugman says, then all those other things follow automatically. Alternatively, if Americans decided independently to go on a consumption binge that forced the US into a current account deficit, then all these other things must also follow automatically.
Given the sheer size of PBoC intervention, the tremendous concomitant need to sterilize and repress interest rates, and the resistance to appreciate the currency, it seems pretty clear to me that at least part of the reason for PBoC capital exports was as a policy choice. This is especially likely, I think, since the explosion in reserves at the PBoC and other Asian countries seems to have begun within a few years of the 1997 crisis.
Now if the initial cause was the PBoC capital exports, of course the Fed could possibly have foiled the capital impact of the PBoC intervention by raising interest rates and forcing up unemployment in the US.
This is the point that Martin Wolf has often made, and if the Fed had done so it might have caused private businesses to cut back on their investment more quickly than the resulting decline in savings, and the US could have effectively blocked capital imports. The rising unemployment would have reduced US consumption and US imports, which would have reduced the US current account deficit. Remember, these are just the opposite sides of the same coin and one automatically implies the other. If the excess of investment over savings declines, so does the current account surplus.
For whatever reason, right or wrong, the Fed didn’t do this. The result was that the US had to run a capital account surplus. In the US, however, there are two ways the capital account surplus must resolve itself. Since the capital account surplus is equal to the excess of investment over savings, if the capital account surplus rises, broadly speaking, either savings must decline, or investment must rise (or some appropriate combination of both in which the excess of investment over savings rises).
Jack up investment
Under these conditions it is unlikely that private investment will rise. The US current account deficit means that US demand is shifting abroad, perhaps because currency intervention has made US production less profitable and foreign production more profitable (the overvalued dollar reduces the profitability of US investment and increases the profitability of foreign investment). It is more likely for US businesses to increase investment abroad at the expense of investment at home.
That leaves two other possibilities – either total investment rises because government investment rises, or private savings must decline. The “correct” way for the US to have dealt with the US current account deficit might have been for a sharp increase in government investment, say in infrastructure spending, scientific research, education, and so on. This would have presumably improved the productivity and profitability of US production in the future, so that with lower costs, the US could have eventually regained the edge it lost with the overvaluation of the dollar. The US would have still run a large trade deficit, but this deficit would be the result of a surge in investment rather than a surge in consumption.
But if the US government did not increase investment by enough, the automatic consequence had to be a decline in the US savings rate. There are many ways this could have happened, but it had to happen. This, by the way, is why I get very impatient with all the moralistic finger-wagging, often enough by ferociously rich investment bankers, about profligate spenders living beyond their means and hard workers squirreling away their savings. This is mostly nonsense. If the US runs a trade deficit, for whatever reason, US capital imports must rise, and almost certainly that means debt will rise, and either it is producer debt or it is consumer debt. We don’t need hand wringing about declining morals to explain this.
By the same token, if China forcibly exports capital to the US, its savings rate must rise, not because Chinese households are being increasingly thrifty – in fact while China’s savings rate has surged in the past decade, the household savings rate has not, it was government and corporate savings that surged. I would in fact argue that if you include the wealth effect of negative real deposit rates, none of the increase in Chinese savings can be ascribed to household thrift but rather to policies that repress consumption.
So if Krugman is right, and the PBoC currency intervention is forcing China into a large capital deficit position, the most plausible consequences for the US must be either an equivalent rise in government investment or a decline in US savings. And of course it goes without saying that it must also result in a US current account deficit.
This is why Krugman has argued for a revaluation of the RMB. He is really just saying that the PBoC needs to do something that will reduce China’s massive capital account deficit, which will automatically bring down its current account surplus. Note that bringing down the capital account deficit is not necessarily the same thing as lowering the pace of reserve accumulation. Many people have warned that if the RMB begins to appreciate, it would set off hot money inflows that would force the PBoC into even more rapid reserve accumulation. While this is certainly true and certainly a major problem for the PBoC, what matters is China’s net capital account deficit. This consists of reserve accumulation less net capital inflows on the non-PBoC account.
Where is Krugman wrong?
So where could the flaws in Krugman’s argument be? Here are some areas we would need to consider:
1. Perhaps the PBoC intervention is not driven by Chinese policies. Perhaps it is a residual of US policies that force the US into a capital account surplus position – because of a surge in US investment (which we know didn’t happen) or an endogenously-caused collapse in US savings. In this case the root cause of the imbalances in both countries is the collapse in US savings, and for reasons that are not altogether clear the PBoC has decided to accommodate this collapse in US savings by purchasing huge amounts of USG bonds, in spite of the distortions it introduces to the Chinese economy.
2. Perhaps Krugman’s analysis is correct with regards to China and the rest of the world, but the US is not the rest of the world, and so while a Chinese revaluation would have the impact Krugman claims for the rest of the world in the aggregate, it would not necessarily have it for the US. In that case we would need to think about how different financial systems and industrial policies accommodate or refuse to accommodate capital account surpluses. My instinct is that open countries with very flexible financial systems are all likely to react in similar ways.
3. Perhaps the Chinese current account surplus is driven by “natural” factors that cannot be changed and that have nothing to do with PBoC intervention. In that case PBoC intervention is simply a residual. One commonly heard argument is that the Chinese “naturally” save a lot, and so they must always run surpluses because savings will always exceed investment. At this point of the argument wholly mistaken references are often made to China’s late Ming and early Qing trade surplus with Europe, or someone comes up with a totally irrelevant story of how he met a Chinese family that is saving for their medical bills, son’s college, or so on. This argument I think is nonsensical, for reasons I explore above, and anyway it would imply that there would have been no need for the PBoC to intervene in the currency markets because intervention would have no effect on China’s trade surplus anyway, in which case why not just let the RMB appreciate? I always find this argument a little bizarre.
4. Another common argument for natural advantage is that China has a huge surplus of cheap labor and so it must run a current account surplus. This is also sort of nonsensical since, aside from the fact that other countries with equally cheap labor don’t automatically run current account surpluses like China’s, the fact that Chinese labor is relatively cheap is also a function of domestic currency and wage policies, and anyway Chinese growth is capital intensive, not labor intensive.
5. Perhaps however there is another, more plausible, natural advantage that causes the trade surplus. One candidate might be demographic transformations taking place in China, in the US, or both.
Stephen Roach’s counterblast
One of my favorite writers on global economics, Stephen Roach, in an article in the Financial Times had several rejoinders to Paul Krugman, some plausible, some less so. First off he argued against a bilateral approach to the trade issue.
Unless the problems that have given rise to the multilateral trade deficit are addressed, bilateral intervention would simply shift the Chinese portion of America’s international imbalance to someone else. That “someone” would most likely be a higher-cost producer – in effect, squeezing the purchasing power of hard-pressed US consumers.
Roach is right that this is more than a bilateral issue, and Krugman clearly agrees, but he is almost certainly wrong in assuming that bilateral intervention would simply shift Chinese exports elsewhere, nor am I convinced that it makes sense to call for an increase in savings while deploring anything that squeezes the purchasing power of consumers. I discussed both of these issues in one of my earlier posts.
Still, what is not clear, as he points out, is what the aggregate impact on the US trade account would be. It is easy to posit a number of plausible scenarios in which a significant contraction in the Chinese trade surplus might “only” show up as an expansion in the trade surpluses of Mexico, Vietnam or some other third country (although of course that country wouldn’t necessarily see this as a bad thing).
Roach adds:
The US would be far better served if it faced up to why it is confronted with a massive multilateral trade deficit. America’s core economic problem is saving, not China. In 2009, the broadest measure of domestic US saving – the net national saving rate – fell to a record low of -2.5 per cent of national income. That means America must import surplus saving from abroad to fund its future growth – and run current account and trade deficits to attract the foreign capital. Thus, for a savings-short economy, there is no escaping large multilateral trade imbalances.
Yes, China is the biggest piece of America’s multilateral trade deficit. But that is because high-cost US companies are turning to China as a low-cost offshore efficiency solution. It also reflects the preferences of US consumers for low-cost and increasingly high-quality goods made in China. In other words, savings-short America is actually quite fortunate to have China as a large trading partner.
The last sentence is a little astonishing to me – the equivalent of Hillary Clinton begging China to keep buying USG bonds. This is basically the same thing as saying that the US is fortunate to have a large current account deficit, and begging that it be increased. But let’s ignore that. As I discuss above, to say the problem is too little savings in the US is to say nothing – it is true by definition and just part of the accounting identity.
It may very well be that American savings rates have declined for purely endogenous reasons, and that China’s capital exports are a residual impact, but at least for me it is easier to explain the fall in US savings at least partly as a consequence of the automatic adjustment necessary if there is an increase in Chinese savings. In the very next paragraph Roach makes just this point. He argues that China must reduce its surplus savings, as if these issues – low American savings and high Chinese savings – were independent. He makes the same point in his conclusion, “America needs deficit reduction and an increase in personal saving, while China needs to stimulate internal private consumption.” These are not separate issues. One can only occur with the other, so we are left with the problem of where the original distortion lies and how to resolve it.
Further on Roach says:
Yet some of America’s most prominent economists are claiming that a revaluation of the renminbi vis-à-vis the dollar would not only create more than 1m jobs in the US but that it would inject new vigour into an otherwise anaemic global recovery. Economists should know better. Changes in relative prices are the ultimate zero-sum game – they re-slice the pie rather than expand or shrink it.
He is of course right here. Ignoring the long-term impacts on growth in China and abroad, the currency game is a zero-sum game in the short term. It is a tug of war over employment, and that is exactly why China wants to maintain an undervalued currency and the US and Europe want it to revalue. This also suggests why, for all the recent signs of thawing, this issue is simply not going to go away as long as global unemployment is a problem.
I think probably the most important takeaway from Roach’s article is that this is a zero-sum game. We can resolve this problem concertedly and intelligently with the minimum cost to the global recovery (which means that Germany, Japan, and Europe have to be involved in the adjustment), or we can do so in a series of beggar-thy-neighbor confrontations. It is unlikely that the latter will involve the least cost to the global economy since the whole point of the strategy is not to minimize cost but to push as much of it as possible onto your neighbor..
And now, for something completely different
Before finishing, and in a bid to be topical, a quick word about the success of index futures, which were recently introduced into the Chinese stock market. Here is what an article in today’s Financial Times says:
Chinese investors love new financial products. Their passion, at times bordering on mania, explains why Shanghai stocks rocket in price on their trading debuts and why local equity funds can raise billions of renminbi on the day they launch. But even seasoned market professionals have been surprised by the enthusiasm with which investors have embraced stock index futures – China’s first financial futures since the mid-90s – following their launch two weeks ago.
“The volumes have exceeded everyone’s expectations,” says Dean Owen, Shanghai-based chief representative for Newedge, the French futures brokerage, which has a joint venture with Citic Group in China. Indeed, on Tuesday last week, the third day of trading, the value of stock index futures traded on the China Financial Futures Exchange exceeded the value of stocks traded on the Shanghai Stock Exchange.
This is part of an old discussion. Six years ago when QFIIs were first introduced into China there was a great deal of excitement about how the introduction of sophisticated foreign investors would help change the Chinese markets from being very speculative to being more sophisticated and value oriented. In a conference at which I spoke a senior official from the Shanghai stock exchange made exactly this point.
I disagreed with him. It seemed to me that the speculative nature of Chinese markets has nothing to do with the Chinese “love of gambling,” but rather is caused by the lack of tools available for value investing – macro data is questionable, financial statements are very poor, the corporate governance framework is at best mysterious, and the regulatory and policy framework is constantly shifting, often to achieve government objectives. Even Warren Buffet would give up trying to invest for value if he moved to China and traded A-shares.
On the other hand the market is extremely conducive to speculative activity. Speculators trade on short term changes in supply and demand factors, and in China stocks move rapidly for a number of non-fundamental reasons – changes in liquidity, regulatory and policy changes, insider activity, policy signaling, and so on.
At the conference, we agreed to disagree. I said in five years the Chinese stock markets would be as speculative as ever. He argued that it was already becoming more fundamentally driven and would advance significantly over the next five years. I am pretty sure nothing important has changed. The market is, if anything, even more speculative than it used to be.
Until the conditions that penalize fundamental investing and encourage speculation change, the Chinese stock market will be purely speculative no matter how many “sophisticated” investors or derivative instruments are available. A lot of people hoped that the introduction of index trading would allow investors to hedge and so somehow because of that would make the markets more fundamentally driven and stable.
This won’t happen. It is not because Shanghai lacks the accouterments of the NYSE or LSE that it is an unsophisticated and “speculative” market. It is because the tools value investors need – reliable information, clear corporate governance, a stable regulatory and policy framework, limited government interference – don’t exist. Index futures change none of that.
Financial liberalization and reform in China is only meaningful if it accomplished the following:
- Liberalize the setting of interest rates
- Clarify corporate governance at banks and large corporations – which means essentially make them subordinate to stockholders
- Improve macro and financial statement data
- Limit policy-driven government signaling, government interference, and regulatory changes
Without these, it seems to me that most reform and liberalization has been cosmetic.
Mr. Pettis, do you have any thoughts about the effect of an RMB re-evaluation on Taiwan’s NTD? Or how the dynamics of China’s real estate and stock markets might spill over into the real estate and stock markets here in Taipei, once the Economic Cooperation Framework Agreement — simply stated by its English acronym ‘ECFA’ in Chinese- and Taiwanese-language discussions here in Taipei — is signed?
I look forward to read more of your interesting posts in the future. Your blog gives me the sense that I am still, in some way, an outside observer in Beijing.
To let the market decide the exchange rate is the right solution. Before 1978, every price was fixed in China, rice, fish, clothes, everything. Obviously, it did not work. The first step of the reform was let the market to decide the price. They had to change from “socialist economy” to “socialist market economy” and it works very well.
China now is the 3rd biggest world economy and 1st export country. A fixed currency rate distorts the whole world economy. China should know that from their “fixed every price” experience.
Another interesting aspect to the issue is the role of differing regulatory and enforcement regimes between trading partners. China’s price advantage, correctly labelled as capital not labour driven, is also heavily influenced by the above. For example Luoyang Zhonggui technology Co. gains a major advantage price advantage by (reportedly) dumping the silicon tetrachloride waste. This alone may account for a $46,000 per ton price advantage. Once again it is the Chinese citizen who is paying the price. His/Her savings directed to companies whom then turn around and poison their neighborhood (ask Li Gengxuan) .
This has hap pended before. Taiwan gained a preeminent foothold in the production of printed circuit boards, due to its willingness to dump the lead laced by products of production. This gave such an advantage that PCB production exploded in Taiwan and literally died in the West.
This is another area where a balance sheet approach works. The west gets cheaper products + job losses. The producing countries get pollution + job gains.
Michael,
I’m not an economics major or even a finance person, so pardon if this is a silly question. I understand that one country’s surplus is another’s deficit as you’ve explained it. What I keep wondering is if this is all just accounting and it works for both countries does it have to correct? Wouldn’t these surpluses and deficits cycle up and down, like waves with very long periods, across nations as you pointed out based on policies in place. What makes this important or urgent? Can’t the natural tug of war play out with surpluses and deficits between counties going up and down? I get the impression everyone thinks there is some dire need to resolve the issue. Is this a ticking time bomb or just accounting? Regards.
-Diana
finally, some clarity! As someone with an academic background in dynamical systems modeling (Prof emeritus in CS at Oregon State) it is delightful and highly illuminating to read such a clear separation of the definitional (identities) and knowledge-based layers of the model, together with identification of the most crucial layer: the assumptions around which variables are initially perturbed and which are simply responding.
thank you!
A most excellent piece. Should be required reading for all pundits. Adds valuable institutional detail to Krugman’s posts.
I like the new format… easy to read..
Dean Baker gives the precis version;
“A drop in the dollar is the only plausible way to get our trade deficit closer to balance. A large trade deficit, by definition, means that the United States must have low national savings (barring an extraordinary and unprecedented uptick in investment). Low national saving means that we must either have large budget deficits or very low private savings, or some combination. So proponents of a high dollar (like Mr. Volcker) want a large budget deficit and/or very low private savings. It would have been helpful to point this fact out to readers.”
http://www.cepr.net/index.php/beat-the-press/paul-volcker-is-scared-that-the-trade-deficit-will-fall/
Mr. Roach is off base in part because he does place adequate emphasis on production. In order to get their own economies going and put the world in a stable economic trajectory the US and other trade deficit countries (e.g. Greece, Portugal, and Spain) desperately need to increase production.
A couple of quotes from Roach:
“The US would be far better served if it faced up to why it is confronted with a massive multilateral trade deficit. America’s core economic problem is saving, not China….. Yes, China is the biggest piece of America’s multilateral trade deficit. But that is because high-cost US companies are turning to China as a low-cost offshore efficiency solution.”
Yet some of America’s most prominent economists are claiming that a revaluation of the renminbi vis-à-vis the dollar would not only create more than 1m jobs in the US but that it would inject new vigour into an otherwise anaemic global recovery. Economists should know better. Changes in relative prices are the ultimate zero-sum game – they re-slice the pie rather than expand or shrink it.”
Pettis: “He is of course right here. Ignoring the long-term impacts on growth in China and abroad, the currency game is a zero-sum game in the short term.”
On this last point Roach is not right, and I am surprised that Pettis agrees with him. To view this properly one needs to consider exchange rate adjustment as one necessary part of an overall program to move towards balanced trade. Consider for example-what would happen if the persistent surplus countries (China, Germany, Japan, etc.) were to keep production at current levels but reduce their trade surplus to zero (net production used internally)? What would happen to the balance of the world economy? Can anyone doubt that moving in this direction would “inject new vigour into an otherwise anaemic global recovery?” This would require an increase in production by the deficit countries, which is what the US and most other deficit countries desperately need at this time. The surplus countries need to take action to make this happen and many of the needed changes have been discussed in previous posts to this site. In the case of China currency revaluation is only one needed change, and needs to be coupled with other changes that stimulate domestic demand. While it would be great if the surplus countries were to take action on there own there is no indication they are willing to do it, which supports Professor Pettis conclusion that we are headed towards increased trade tensions that will likely get ugly.
Dear Professor,
Thanks for illustrating via financial/accounting jargon how the world SHOULD BE. Now can we get back to how the world IS and what humans ARE?
Wouldn’t it be nice if we were all robots with totally predictable responses to commands?
I once tried to list all the pros and cons to convince a girl she SHOULD love me. Too bad it didn’t work.
Professor, in the beginning of “Jack Up investment”, you said “Under these conditions it is unlikely that private investment will rise”. Could you explain more than that? If as you said there are many areas (like infrastructure) where US government could have increased their spending, why private investment could not step in? Perhaps after attributing US over-consumption to long time Fed’s loose monetary policy, we need some deeper thought on why domestic investment in US has been declining during the boom years.
And I would also like to hear your opinion on the recent SEC’s lawsuit against Goldman Sachs. As someone spending most of the career on Wall Street, do you GS had deliberately design the Abacus to make money at the expense of its customers, or it is more like a show the Obama administration plotted to push for the passage of Financial Reform? Thanks a lot for your answer.
Sorry for taking so long to respond to the comments, but this weekend my music club celebrates its fourth anniversary and the festivities have been pretty hectic. Today I am up and a little groggy preparing for the last of four night’s concerts with some of our most famous musicians.
Paul, I am sorry but I don’t have a real sense of the financial and economic links between the mainland and Taiwan.
Leo, actually there is no clear right or wrong foreign exchange policy. Totally free markets can easily be distorted by capital flows. One of the few things we can say about an optimal exchange rate policy, I suspect, is that it must be consistent with domestic fiscal and credit policies or it will eventually lead to serious distortions. Robert Aliber has pointed out in my class, for example, that it is possible to manage down the currency in a fast growing economy with a robustly expanding tradable goods sector, but in that case we would have to see either inflation or financial repression, either of which has significant costs. China has chosen the latter.
Glen, yes, in fact I think of environmental degradation one of the many factors (the three most important being, in my mind, sluggish wage growth, repressed interest rates, and an undervalued currency) that shift wealth and income from the household sector to subsidize manufacturers and investors. Dumping toxic waste in the local river is clearly profitable and lowers manufacturing costs, but households have to pay for it on higher health, leisure and other costs. The whole system is geared towards forcing households to subsidize breakneck growth.
Diana, it is an accounting identity, which must be true in the way 3 + 4 = 7 must be true. One way to think of it is any time something is sold by one person, it must by definition be purchased by someone else. In that case total sales must equal total purchases.
Thanks Bruce. It worries me how much of th angry debate on both sides is senseless.
G. Stepehn, I agree with you, which is why I tried to separate out the instantaneous effect of devaluation, which simply shifts demand, to the longer term effect, which involves rebalancing and more sustainable growth.
ATP, I am not sure how describing the current trading relationship between the US and China is a case of telling how things should be rather than how they are. When people impatiently dismiss an argument about not being about real things, I suspect it is as often because they cannot understand it as because the argument is truly “unreal”. As for the girl you were wooing, perhaps she disagreed with both your theory and your practice.
BHF, in theory any investment that creates value can be financed by the private sector, but in practice it is hard for the private sector to capture all externalities, and in that case it makes sense for the government to do so. For example, it is hard to to provide good education for very poor children in a way that can be privately profitable, and yet is clearly in the country’s overall interest to do so. Also in many cases the benefits to the economy are much greater if something is provided free — anyone can use the internet, for example, with having to pay for the right to its inventor, and this has certainly increased the value of the internet. If an undervalued RMB is making it increasingly difficult for US manufacturers to be profitable, then it won’t make sense for them to invest in manufacturing facilities in the US. The US government can counteract the effect of the undervalued currency by lowering transportation costs, for example, or improving technology, in a way that might be difficult for individual businesses (or of course with tariffs, although that is not the same as increasing productivity through investment).
I really don’t have a whole lot to say about the Goldman Sachs case because I am not following it too closely, but as a former banker I do have to say i get a little cynical when corporate or institutional clients call foul when they have lost money on clearly risky products. In my 15 years experience no client has ever criticized a bank for selling risky products when they were profitable. This by the way happened here last year. Certain derivative products which Chinese companies bought from Chinese banks (and should not have bought) were fine for many years when they returned excess profits, and then when everything collapsed we heard outrage about the gall of bankers to sell such dangerous products to poor corporate treasurers, but that outrage seems to have disappeared as those products became profitable again. Weird that. I guess we all like one-way bets.
We are talking about a chicken and egg talk. Krugman is full of it. For one, China, from what I can see, impounds dollars, converts them to yuan, spends the yuan domestically and holds the dollars in the form of treasuries. There isn’t much internationally redeemable paper in China or at least they didn’t start out that way that they could do business otherwise. Second, China is on the dollar. The yuan is more like a 15 cent piece changed out of a dollar.
Roach, if I followed is closer. The US is financing a lot of consumption for people that sit on their asses and have kids with no financial means of support. I manage my family’s real estate and have some Section 8 houses. These women, who usually keep their men at some other address, show up with vouchers good for $1300 to $1500 of housing expenses. The average Chinese, from what I understand, makes about 1/3 of that. I have yet to see one of these people with a TV that isn’t nicer than the one in my house. They don’t make TV’s in the US. This money is put on the account we can’t pay, backed by the paper that comes back from China. The man who can’t get Section 8, if he pays this rent, might not be able to consume. Most working class Americans would be up in arms if they knew this type stuff went on. If this guy can consume, it has been on his credit card, which is funded by the sizable factoring fees taken in by bigger and better credit risk spenders.
The truth of the matter is I doubt you would ever find a Chinese that could barely pay attention being provided with a credit card he can max out and then declare bankruptcy on for as much as he makes in a year. BAC was giving cards to street people. A friend of mine said his brother was a street guy who lived in a shelter and BAC gave him a $2000 line of credit on a card, just out of the blue. He couldn’t make the minimum payment nor would he care once the thing was maxed out.
There can’t be negative savings without credit, nor can there be outflow without credit. Other than balancing the books, it wouldn’t matter over the short term whether the money came back or not as long as the system continued to create credit. Of course, this has bankrupted the US and it is only a matter of time before it all deflates. Politicians don’t want to talk about this because if people understood it, there might be a revolution. In essense, the banks exported the jobs of Americans by lending them money.
US has had a current account deficit with EU for a number of years. from EUR/USD 1:1 to 1.5:1. and look at their trade deficit categories. it’s very clear that the problem is US consumption but krugman is obama’s shill.
Professor,
The comments from the Governor of the Brazilian Central Bank were taken out of context. First, he had spoken about the need to reduce consumption in the US, to address problems that are complex and global, and within these issues was also the value of the yuan. Press highlighted only the last sentence.
The Brazilian Minister of Finance also dismissed a supposed support by the Brazilian authorities to the US demands regarding the yuan. Actually, he stated in NY, just after the Spring Meetings, that if the US and other developed countries were thinking they would promote growth by forcing exports to developing countries, that would be a wrong and unacceptable policy. In the short term, all will have to overcome the crisis and developing countries are stimulating their economies and therefore doing their job. But that would be unthinkable in the medium term.
By the way, dont say I wrote that hehe, but the Governor of the Central Bank and the Minister of Finance dont agree about a lot of issues. But it is the end of Lula´s government, everyone speaks freely, election debates are very superficial, disorientation has been the norm in certain aspects. The press highlight things to get audience, put them out of context, just as they like to do with regard to the Chinese threats to dump the dollar.
Congrats for your post.
The following article (linked at Mark Thoma’s site) is arguing that China’s current account surplus/capital account deficit is unintentional. Professor Pettis, I am curious what your thoughts are about this argument…
The “real” causes of China’s trade surplus
http://www.voxeu.org/index.php?q=node/4985
“China has amassed $2.4 trillion of foreign reserves over the last two decades. This column argues that it is wrong, and even dangerous, to blame this on a manipulation of the exchange rate. Instead it proposes a structural theory emphasising that credit market imperfections require private firms to build up internal savings which have been channelled into foreign bonds.”
…
“Due to legal and financial market imperfections, private firms are financing themselves out of internal savings. The rapid growth of these self-financed firms and corresponding down-sizing of bank-financed firms creates and artificial lack of domestic investment opportunities for Chinese banks. As a consequence, a growing share of domestic savings is invested abroad and this generates a capital account deficit and matching current account surplus.”
This is almost tangential, but a rather large chunk of the US trade/current account deficit seems unrelated to China. It’s due to the import of about 10 million barrels a day of crude petroleum. I have yet to see any “real” economist mention that even in passing. Depending on prevailing oil prices, that amounts to a third or more of the US’s problem. Exactly how is tinkering with the Chinese (or US) currency supposed to fix that part of the problem?
Years ago, you might have pursued Physics. Instead you chose another road. Might now be a ripe time to come back to Physics? And let real world physical constraints temper what could be overly optimistic Economics thinking?
This blog is a great one which anyone interested in China should not miss reading; Something everyone interested in China has known for years.
Michael,
I have a question that is a bit off-topic, but I didn’t know the appropriate forum in which to address it. In attempting to quantify the sustainability of China’s GDP growth, I have been analyzing the country’s trend in Fixed Asset Investment (FAI). Accurate data seems difficult to come by, so perhaps you can help me locate more accurate numbers. But according to the numbers that I found, it looks as though FAI was around 67% of GDP in 2009–up from about 55% in 2008. Is this correct?
If so, it would seem as though the law of large numbers should begin to kick in for China. To wit, FAI has been growing 25%-30% per annum for the past decade. Obviously, this is much faster than nominal GDP. If FAI is in fact as large of a percentage of GDP as stated above, continued growth of FAI at even 20% (against double-digit GDP growth) implies that this category of GDP will comprise almost 100% of GDP growth within five years. Thus, while the world (correctly) is focusing on the sustainability of fiscal/trade positions of Western nations, the sustainability of China’s economic growth also seems to be nearing a critical inflection point.
Again, assuming the aforementioned figures are correct, the following would seem likely: (1) China will need to significantly curtail its FAI growth; (2) China must find an alternative source of growth–yet finding one capable of compensating for FAI growth will be difficult to come by; (3) Given that almost the entire world is attempting to move toward a current account surplus position while aggregate demand growth is slowing, continued expansion of the already enormous Chinese trade surplus will seemingly not be the source of compensatory growth; and (4) China’s economic health seems to be worse than many believe, given that so much of their growth has been administered through FAI.
Essentially, I am applying arithmetic and the law of large numbers to China and I am having trouble seeing how current trends can continue for much more than a year or two. If my statistics are wrong (quite possible I admit), then that is a different story. But if they are right, it would seem as though the stimulus package in China is in many ways mimicking the late-stage credit expansion in the US (i.e., the numbers became so big due to run-away securitization in the US’ case that growth from the higher base became impracticable). China’s FAI in the past three years are essentially equal to FAI from the cumulative 15 years prior. Continued growth at recent rates will seemingly only exacerbate the excess. Each year, China will have to construct more cities, buildings, plants, and roads than the year before–but it seems to be reaching the point at which this is no longer even possible due to the large numbers involved (as well as the likely poor return on said projects). Do you think that we are approaching the inflection point?
Mr Pettis
No offence meant but many of the points made sound like Brad Setser on a broken gramophone, channeling the absentee blogger by any chance?
The use of accounting identities to justify arguments regarding deficits and surpluses is always going to be oversimplifying matters. When Luca Pacioli codified the double entry accounting system, he did so on the basis that everything had to reach the point of equilibrium, i.e. plainly speaking the system works on zero sum being the ultimate result. It’s not that zero sum is the natural result, the system works on the assumption of zero sum. And zero sum in the long run.
If one believes (as I do) that Keynes is right in saying that in the long run we are all dead, we are operating in the short to medium term, which means that theoretical equilibrium is never reached for any meaningful period of time. The very existence of trade means that there are inequalities (inherent in the theory of opportunity cost and utilitarianism).
Just because an equation makes sense theoretically does not determine the cause (of its function for example what causes the deficit to arise, or whether the deficit is the result of another surplus half way round the world or whether the surplus is the cause of the deficit) or its operation in the real world vs its operation in the theoretical realm.
deja vu, pretty sure I said this quite some time ago on Setser’s blog.
Mannfm, besides the fact that I suspect you know very little about the history of credit card and consumer financing defaults in China, I would argue that China’s high savings rate is a function primarily of policies that, as a side effect, suppress consumption. I am also not sure I find the idea that the high US consumption rate is caused by “people that sit on their asses and have kids with no financial means of support” very useful or in line with economic evidence. It certainly doesn’t fit well with statistics about the number of working hours and the level of productivity of Americans compared to Europeans and people of other rich countries. Blaming welfare mothers, immigrants, and all the other “free riders” makes great newspaper stories but not so great economics. I recently met a German academic who insisted that the problems of southern Europe were caused wholly by laziness and their spendthrift natures, and was completely unable to recognize that the combination of German trade-related policies of the past two decades and the constraints of the euro could only result in one of two things: collapsed savings and high trade deficits in much of the rest of Europe, or high unemployment. But it wasn’t always so. As Keynes pointed out long ago, Versailles post-war polices could also only result in the collapse of German savings – but when what he predicted happened, it never stopped the morally smug in the rest of Europe from blaming deep-rooted flaws in the German character — which have apprently been reversed. I suspect these kinds of arguments are far more illuminating to finger-waggers than to those who look at the history and consequences of distortions in trade and credit policies.
Jay, I guess it is a lot clearer to you than to me. There is no question that US credit policies were very loose, and the Fed should have done more to tighten, but when a large number of countries use export policies to generate high savings, trade surpluses, and accumulated reserves, there must be an opposite reaction elsewhere. In spite of the urgent desire to place the full blame on either the US or China, it really seems like it shouldn’t be at all controversial to suggest that global distortions require more than one set of policies.
Antonio, I think the BC governor was absolutely correct in pointing to imbalances in both of the leading economically imbalanced countries. As I say above, I just don’t see how distortions that dwarf any we have seen before in history could allow us all to claim victim status. There needed to be quite a lot of perpetrators. Unfortunately, as you know, I think that if we hope that countries won’t use export policies to shift the burden of unemployment onto their trading partners, we are going to be very disappointed. I cannot think of a single country that has agreed that it would be acceptable or in its best interest to increase its deficit or reduce its surplus, but I can count an awful lot of countries that firmly believe they will do the opposite. As you know, the math simply doesn’t work.
Doc, I saw the post. I am impressed by the fact that not just China but a whole lot of Asian countries began seriously accumulating reserves roughly one or two years after the 1997 crisis. This could have been a coincidence – all of them have stumbled onto the same “credit market imperfections” at the same time, that led all of them to see burgeoning reserves – but I find it more credible to think that Asian countries have at least some control over domestic policies, and that a seemingly rational reaction to the 1997 crisis may have resulted in just such policies.
Don K, we must be reading different things. I think quite a few real (and probably some fake) economists have mentioned the role of oil imports, along with a number of other factors that seem to play a large part in the trade deficit. The problem is that the trade deficit is a net number, and oil exports are a gross number within the trade account. It is easy to find gross items that seem to be a large share of the net numbers and so ‘explain” them.
Ryan, I need to look at the numbers, but in fact yes, my instinct is that the growing share of investment in Chinese GDP must have limits.
Judy, obviously I have failed to explain well why accounting identities are firm constraints, although the comment by Bruce D’Ambrosio suggest I haven’t failed totally. Brad is a very smart guy and I would be happy to channel his thoughts on capital flows, but in this case I suspect you may find us repeating each other’s thoughts not because one is channeling the other but rather because we have no choice but to “believe” – much in the same way, by the way, that both Brad (I am pretty sure) and I strongly “believe” that two plus three is equal to (i.e. the same as) five.
Accounting identities are not theoretically true, temporarily true, occasionally true, a form of simplification, or an ideological belief. They are necessarily true, by definition. Ignoring this does not lead to more creative economics any more than ignoring arithmetic will permit creative bridge building that allows us to construct a bridge that is longer than its length. It may well be possible that in other universes with a larger number of dimensions two plus three can be equal to something other than five, and that the current account and the capital account don’t balance, and that global trade deficits can be more or less than global trade surpluses, but unfortunately our universe is rigidly constrained and, unless we begin trading with Mars, in which case the last constraint can be somewhat relaxed, we are stuck with them.
Professor, could you please follow up on Ryan’s query? I know the headlines all circle around trade, but if you look at the fundamentals of the Chinese economy all you see is one big land developer. This development is not all internally financed by the way. Their are important international flows that are feeding this growth. How does financial repression incent overinvestment? How much longer could this conceivably continue? Does China risk a collapse in investment driven inflows when investors become aware of the low returns from new development? Can consumption possibly increase fast enough to absorb the slack from a collapse in investment? Is it possible that China may have to devalue the RMB so that exports soak up the excess capacity if consumption cannot?
I feel that the trade debate is distracting everyone from the more important issue of Chinese overinvestment.
It still reads as propaganda to force China to appreciate its currency. It is true that if goods from China have higher price, U.S. will import the same goods from other countries, given the fact that the overlap of goods produced between China and U.S. is very small. It is also true that after the currency appreciation, U.S. consumers will pay higher price (much higher price) for common goods, which makes the inflation worse. These reasons are strong enough to prevent the government as well as the congress not from doing anything material. It is even a big NO if we want to wager a trade war against China. Last but not least, China will appreciate its currency since the cost of rate hikes is too high. Though, China will do it in its own pace, leaving more room for bloggers to argue online.
Mr Pettis
Could you do a piece on Interest Rates in High debt countries such as Japan. Why do they remain low even though the ability to pay decreases every year?
Gracias
Within international trade flows there are interests that benefit and lose within each country. There are political and economic interests in the United States and in China that were mostly happy with the exchange-rate policies over the last decade. As long as these lobbies have disproportionate power within their respective countries, the account imbalances will continue to be pushed to the limit.
Mr Pettis: Accounting identities are … necessarily true
Numerically , as you argue, it is true 2+3=5, but what happens when you posit that x=y, this becomes an assumption, not just an equation. All formulas and equations operate on certain parameters and assumptions being true or holding for that equation to be operable, which is why double-entry accounting is limited by the assumptions that are inherent in the equation,it is a weakness mathematicians and accountants are all too well aware of. Not doubting the mental capacity of you or Brad but can you not see the assumptions in accounting identities, just because they are part of equations does not mean that there is no other way of looking at these entities. Introduce z into the equation along with y and x and what happens? The assumptions and parameters are messed up, the equation may not hold true any longer, this is basic theoretical math.
The accounting identities you are talking about are not carved in stone, they are linear equations that interact in a certain manner, introduce variables and the equations may no longer hold true.
Have had a look at Bruce D’Ambrosio’s post, would he like a crack at explaining linear equations and the immovable truth of accounting identities?
The goal of double entry accounting system and therefore of accounting identities is to arrive at that point in which debit + credit = 0. The desired end result dictates the equation and its variables; it is not so much immutable truth as it is an assumption of a closed system where only x&y (debit and corresponding credit) exist and x and y correspond to each other. Such assumptions are debatable, what happens when z is introduced to the equation, would it still hold true?
Whilst the world trade taken as a whole may be viewed as a “closed system” (as you adroitly pointed out, we do not trade with Mars), for individual countries, the system is not closed because of multiple trade partners(it is no longer just Country A and B trading against each other with no others like C complicating the equation), at the end of the day (in the short /medium term) individual countries may not arrive at that neat zero, however creative the accounting may be or deterministic the equation may be.
Imbalances are a fact of life, what makes it a political or emotive issue is when they lean in the opposing direction. Trade means there is an imbalance existing, if everything were equal there won’t be opportunity cost considerations, hence no trade, simplistically speaking. Not saying that there shouldn’t be a levelling up of the playing field but where were all the angry voices when colonial or neo-colonial powers were blatantly plundering the resources of colonies to fuel their own home industries and creating wealth that benefitted mainly themselves? Just because the pendulum has swung does not mean that suddenly everyone has come to realize that life is unfair.
Judy,
Not to interfere in what may be a private conversation but your sentence “Numerically , as you argue, it is true 2+3=5, but what happens when you posit that x=y, this becomes an assumption, not just an equation” says nothing. Just because x = y may be an assumption or a model, it implies nothing about the validity of 2 + 3 = 5 as an identity. The former is a theory or model, the latter is an identity. Identities can co-exist with theories and models, in fact the must, but they are still identities. What Pettis is saying isn’t be surprising or controversial. It is true BY DEFINITION.
All he is pointing out, I think, is that the debate and arguments about trade must be consistent or they have no meaning. If everyone wants to increase their trade surpluses and no one wants to increase their deficits, this is inconsistent and cannot possibly happen, any more than if everyone wants 2 + 3 to be equal to 6 or 7. This is not true just because someone’s model says it should be true. It is true because it cannot possibly be otherwise. The world may be a complex place but 2 = 3 is always equal to 5 and trade deficits are always equal to trade surpluses.
Pettis is always complaining that the debate is usually “nonsensical”, to use his word, because most people seem unable to grasp this point . Your argument that under certain conditions these accounting identities might not hold proves his point (and I am not trying to be snide here, just explaining). In fact there are no conditions in all of space and time in which these conditions do not hold — not because the model says they should hold, but because it is impossible for them not to hold.
A puzzling debate and one looking like going nowhere. How does the uncertainty surrounding a proposed model x = y have anything to do with the certainty of 2 + 3 = 5? Perhaps you are overly impressed by the “=” sign?
Professor,
You are absolutely right. As a lay person, I am frustrated because I do not understand what you are talking about and feel disconnected. If I may explain why … As a consumer, small business owner and employer, I am not irrelevant to your world of accounting. In fact, I and all other humans are subjects in your narrative without whom your accounting definitions, theories and models would simply be an abstraction totally irrelevant to the human condition. I do not make specific business decisions so I could follow certain theories in economics or finance; they are simply based on what I could only call common sense. I wouldn’t even know at the time of decision making whether in hindsight it would turn out to be a rational or irrational decision. Your accounting methods DESCRIBE consequences of my economic behavior, but does not and cannot PREDICT nor DICTATE my actions. In other words, my economic behavior horse drives your accounting cart, not the other way round. Now, isn’t this thing that we call the economy a manifestation of aggregate rational or irrational economic behavior of billions of individuals like myself? If you accept that, then you must also accept the argument that while your accounting practices may accurately DESCRIBE the economy, they do not allow you to PREDICT the outcome (eg. US employment) of any change in an economic variable (eg. RMB value) with any validity. Now, here comes the real problem … your POSTULATIONS, if experimentally acted upon, will have REAL CONSEQUENCES that, in a negative scenario, may result in human suffering. Can those who suffered hold you accountable for your theoretical misjudgment? This type of intellectual heads I win tails you suffer ‘moral hazard’ is what I find most disturbing. Ask anyone who suffered financially or personally as a result of the mathematical geniuses of the LTCM guys, who believed their model would never fail until it did.
Mr. Pettis,
Your argument with explicit assumption of a two country world (China & US) is correct: higher US budget deficit spent on infrastructure would have replaced Chinese consumer products with Chinese capital goods imported to US (on the margin). However, this logic breaks down when you remove the assumption of two country world. Chinese cannot export the type of goods that would be needed for infrastructure investment (commodities and heavy machinery (the latter are becoming more internationally competitive but this wasn’t the case 10 years ago). So, once you remove the two country constraint, but keep the insistence of Chinese on their trade surplus and add higher infrastructure spending in US, the result would be constant US trade deficit with China (no shift away from consumer goods) AND higher US current account deficit with the rest of the world (commodities and capital goods). Thus many of your conclusions made in this article fall apart.
Michael:
Always nice to review accounting identities. It’s important to understand their nature when discussing policy issues. For example, let’s all recall that in the Keynesian world, investment (I) is defined as planned investment plus unplanned; unplanned investment being inventories. The policy implications over increasing inventories are much different than those involving investment in new equipment.
So, we just need to make sure when using these terms, we are all meaning the same thing. Thanks for clarifying.
Assumptions, definitions and identities are, in my mind, the same thing. You can create a hypothetical world where, using definitions and assumptions, anything is possible. Instead of using base 10 in mathematics, we can use base 16 or 7. It’s just a matter of whether the assumptions and identities are useful in analyzing policy alternatives. Since these accounting terms are the basis for measurement, we need to know the assumptions and identities implicit in the measured terms so as to figure out the right policy adjustments.
Otherwise you end up in the classic economics joke about the physicist, the chemist and the economist stuck on a desert island with an unopened can of beans, wherein the economist’s solution is “first, let’s assume we had a can opener!”
Judy Yeo: “…theoretical equilibrium is never reached for any meaningful period of time. The very existence of trade means that there are inequalities (inherent in the theory of opportunity cost and utilitarianism). “
I can see you arguing against a lot of concepts in Economics–most social sciences don’t have any concrete facts that are proven–but arguing against accounting identities is equivalent to someone arguing why 1+1 does not equal 2 or why conservation of energy isn’t true. Unless you throw away our defintion of a sum (i.e. unless you don’t believe in modern mathematics and have your own system), the identity must hold.
People can argue about the implications of the identity or the cause of changes in the individual variables, but the identity itself must hold.
TR,
I failed to see why Judy’s arguments are so difficult to understand and why the so-called accounting identities are so magic.
2 + 3 = 5 is inviolable because 2, 3, and 5 are all numbers; x = y is a model based on certain assumptions and x and y are variables. Depend on your model assumptions and how you define your variables, you could propose a different model x + z = y that may be equally valid. And, in the real world, even if your variable definitions are strictly clear, you still have the practical challenge of collecting the right and accurate data according to your variable definition.
In the trade arena, surplus = deficit may or may not hold, you may have to introduce capital account, the resulting equation still may or may not hold, in which case you may need to take into account debts, and furthermore you may have to introduce money printing into your equation and so on.
So trying to infer so many things by applying a few simple accounting identities, including the “global imbalance,” the root cause of the financial crisis, the competitiveness of the US economy, the gloomy prospect of Chinese economy ( e.g., the stuff that Pettis did by applying lower/upper bounds on Chinese exports, consumptions and therefore inferring future growth ceiling of China’s economy) is very simplistic and misleading.
What we’re talking about here are really one’s mental models of how the real world and the complex systems (economy, international trade etc.) work, not about some mathematical axioms.
Mr. Pettis, Bill Gross, another man who thoroughly understands accounting identities, has written a new piece on the lack of common sense in the market, and quotes one of his favorite sayings, by Bernard Baruch, that I thought you would enjoy and find especially relevant to this discussion: ““Two plus two equals four and no one has ever invented a way of getting something for nothing.”
Your point that some people just do not get it is absolutely correct, and Gross makes a similar point by noting that common sense is like sex appeal — some got it and some don’t. There should be no mystery as to why accounting identities are not theories that can be proven right or wrong since they are true by definition, but because they are sometimes counterintuitive this simply flies over many peoples’ heads. Your attempt to get them to un-muddle their thinking is bound to fail. Your appeals to 2 + 3 = 5 notwithstanding, many people simply cannot understand what an accounting identity is.
Cheers, this post is a model of clarity. Agree the trade issue ain’t going away anytime soon.
I view the Mess as largely having originated from demand for USD-denominated AAA paper that outstripped conventional supply (though Fed interest rate policy and CDO shenanigans played important roles).
It seems to me the prevailing ideology of market fundamentalism dictated that the finance industry satisfy this demand. Mr. Pettis writes, “The ‘correct’ way for the US to have dealt with the US current account deficit might have been for a sharp increase in government investment, say in infrastructure spending, scientific research, education, and so on.”
Brad Setser believed that significant amounts of Chinese reserves were going into GSE paper (my guess is, the Fed basically took over the Chinese government’s position and made them whole post-Lehman). In effect, it seems there actually was a sharp increase in “government” investment but it came via prime residential loans securitized by the GSEs. This drove up real estate values; allowed Americans to dis-save and consume by means of using the home as ATM; encouraged Ponzi-financed (in the Minskian sense) subprime; and ultimately resulted in a finance sector behaving “short-term greedy” and accounting for something like 40% of US corporate profits.
Given that vast issuance of Treasury paper seems likely to continue, and that sovereign debt and the reserve currency issue looks like a long, nasty train wreck in process, it might seem silly to imagine an alternative to the GSEs. But stranger things could happen than the USD remaining the dominant reserve currency for another generation or more.
What alternatives to Treasuries or GSE debt are being proposed? My preference would be the realm of energy, and I would take for granted that no information can remain secret or proprietary. Maybe that’s like trying to fund music, or journalism?
Kudos on the site redesign, Cheers Mr. Garlitz. I wonder if other voices might be brought on board (Capital Gains and Games as a model?). “Recommended reading” links would be super.
TR and Sivaram
Thank you for your responses on “identities” note that the 2+3=5 holds only when 2, 3 and 5 are the “variables” in that equation/identity, introduce other variables and that equation may not hold. Accounting equations are not carved in stone, they were developed to help accountants and other interested parties understand and (more importantly) explain to other interested parties (particularly tax and other”interested” parties)what has been going on. The primary use of accounting equations is to help reflect the numerical effect of past transactions, the fact is, the data captured is “past”/historical, never current, it’s static in that sense and all accounting statements be they balance sheets or p&l try to extract data from a particular time period to show the performance of a particular enterprise for that period in time.
Using this as an analogy for the world economy, the “company” will continually generate new credits and debits and information is never complete till the point at which the company ceases operations, i.e. no longer a going concern. Similarly, surpluses and deficits are a matter of time perspective, until the point at which a country no longer participates in world trade (no longer a going concern) or world trade ceases completely and everyone decides to do the sums, the data captured is never complete, which means that surpluses are not necessarily always balanced off by debits/deficits.
I do not fault the idea that in the long run, it’s a zero sum game but my favourite Keynesian quote is “In the long run we are all dead.” In the long run trade may well be a zero-sum game but not in the short run or medium term; a simple prosaic question: if it were all a zero sum game even in the short run, why are we in the game? When we talk about equilibrium in the long run , it’s theoretical, unless you can envision a world and all trade coming to an end and everyone deciding to do their sums at that point in time. Any transaction that takes place necessarily changes the figures and not necessarily in the neat simplistic way that accounting equations portray them in. The accounting equations give us a window into the process but does not dictate the process itself.
But that’s digression. I think Greg caught my drift. An equation is as good as the variables (and the number of variables) you put in that equation, if surpluses are always balanced off /cancelled against debits/deficits (as double entry accounting posits), we are assuming there are no other variables and no other equations possible. Why do we make those assumptions, because we are told so by the accounting equation that we take as god-given fact? As for the law of physics, theoretical physics says that energy cannot disappear so technically the wheel should never stop turning once it’s in motion but as practical observation tells us, there is no perpetual motion. The explanation given is that part of that energy is transformed into another form of energy(heat etc), questions have surrounded this and the neat equations that we have been taught as a matter of fact . Do we ignore what we observe because it does not fit the equation? Do equations dictate reality or do we use equations to help us understand reality?Applying this back to surpluses and deficits, are we going to say that simply because one country has a surplus, another country must suffer a corresponding deficit as a result of that because our accounting equation says so? Are there no other variables, such as trade with other countries? Going further, just because country C offers country A financing (that comes from the surpluses C has accumulated), Country A is obliged to take up that financing? Does Country A have no free will or the power to say “No”? Would you, as individuals, take up a loan offered to you (if you had no need for a loan) simply because you were offered a loan? If yes, why?
Perhaps it’s just me and my student mentality but questioning alleged “facts” and assumptions is a hobby! However stupid it makes me sound! The one thing I’ve learnt all these years is how little I know so it does not matter how snide people can get, I know my limitations or shall I say my stupidity!
JackWen:
why accounting identities are not theories that can be proven right or wrong since they are true by definition
And all definitions are true because we define them as truth?
Which means if bird poo were to be defined as:
what exits a flying bird at high velocity+ is smelly and dirty = bird poo
the smelly excrement left on statues when a pigeon hops away(note:no flying involved) is no longer bird poo because the pigeon did not fly away, it merely hopped.
All I can say is; ain’t got no sense, never mind sex appeal.
Judy Yeo,
I understand your above contentions regarding accounting identities and equations but they are wrong. Here is why:
You distinguish a numerical equation from an accounting identity but they are the same thing. In a linear equation, we use letters to represent ‘variables’. The word ‘variables’ is self-explanatory. Variables change. BUT the equation must still hold true.
In the world of trade and macroeconomics, there are buyers and sellers.
In the world of accounting, there are debits and credits.
In fact for every buyer, there must be a seller and vice-versa. If there isn’t someone or some organisation will lose money (as he couldn’t sell what he produced) and his goods must be destroyed or given away for free.
Accounting does not show a “snapshot” of a point in time as you claim. Actually the balance sheet is a snapshot, or a point in time. But the P&L is the “movie”. It shows a movie of what transactions took place during the period. Moreover the cash flow statement shows the reconciliation of cash to the other transactions.
Where you are partially correct is the time issue. As you contend (correctly), a business is a going concern, until it ceases to operate. Accounting is used to collect information and report it at varying points in time. At end of financial year, this is for financial stakeholders, but perhaps weekly or daily for management budget information.
Where you write “in the long run we are all dead”, I think you are missing the point completely. Of course equilibrium may not come about for the long run. A company’s share price may not show its intrinsic value for years. That doesnt mean it won’t happen, and as you (correctly) point out it doesnt mean variables won’t change in the meantime.
However, that doesn’t mean that the equation doesnt hold true in the meantime, and the INEVITABLE outcome of a sustained period of disequilibrium is an economic crisis, when things even out. That is exactly what happened in 07/08.
The long run changes depending on your age. If you are 20, the long run could be 40 years. If you are 60, it could be 5 years.
But you can think of it like holding a float underwater. The longer and further it is pushed under, the harder it will bounce back and (over)correct.
Every year, when each country publishes its national accounts, the accounting identities will hold true.
Free trade is NOT a zero some game. The pie will grow as synergies are discovered. But accounting identities are infallible and in the instance that a country lives beyond its means and accumulates debt, you will see a ‘Greece’ eventually, the only if is how bad.
And you have to ask yourself, if the global financial system is broken, who will remain unscathed?
Thomas Pan,
You say it’s propaganda for Americans to force China to appreciate the yuan against the dollar but apparently you believe it is just god neighborliness for the Chinese to force America to appreciate the dollar against the yuan. Why is that?
Also people like you keep saying that China shouldn’t revalue because it will cause prices to rise and so will hurt the American consumer, but why are Chinese apologists so worried about American consumers and so indifferent to Chinese consumers? Aren’t Chinese consumers the ones you should be worrying about? And who is this American consumer you are talking about? Isn’t he the guy who is demanding that the US take action against Chinese currency manipulation? Could it be because the American consumer is also the American worker, and he is more interested in protecting American jobs from Chinese currency manipulation than he is about protecting cheap consumption? If you really want to help the American consumer, then you should be advocating a revaluation of the RMB. That is what the American consumer is asking for.
This is a dialogue of the deaf. No, Judy, definitions are not true because we define them to be true. Definitions are identities. It is not because we have agreed that 2 + 3 = 5 that it is true. It is true by definition, and we could all agree tomorrow to disbelieve it, but as long as we maintained our defintions of “2″, “+”. “3″, “=”, and “5″, the indetity would be true regardless of whether or not we agreed that it was true. Your bird poo example shows that you have totally failed to grasp this simple idea. You keep claiming that since theories might or might not be true, and that since identities are theories, then identities might or might not be true. Wrong. Identities are not theories. And long term and short term are totally irrelevant. 2 + 3 = 5 is not true if we take it over the long term. It is true in every state of being.
Tony S: Variables change. BUT the equation must still hold true.
Isn’t that because of the way you structure the equation. What I’m saying is, when you introduce morevariables into the equation, it is no longer the same equation. Where x+y=0, x+y+z may not necessarily= 0, that’s what I mean by adding variables to the equation. Are there variables we could add or just because it has never been considered in that light , these variables could never exist?
Tony S:
the P&L is the “movie”. It shows a movie of what transactions took place during the period. Moreover the cash flow statement shows the reconciliation of cash to the other transactions.
All I can say is this movie has sequels and along the line of the neverending story because it is renewed quarterly or annually at the very least. If you understand that you will also understand that transactions are taken in aggregate and that what shows up in accounting reserves are not necessarily what is available in liquid assets (hence the need to reconcile). The very fact that there needs to be reconciliation shows that when you cannot get the desired result working forwards through the various equations, you work back to get the results. In that sense, accounting equations are deterministic, you cannot close accounts till that balance is achieved (that is credit and debit are offset) it does not allow for any other result.
JackWen
My question to you would be where 2+3=5 is expressed as x+y=w, would x+y+z=w? I would be very worried if 2+3+4 still=5. That is what I mean by introducing variables to an equation. Perhaps I was amiss in explaining this .
FYI, here’s the random house definition of “identity”:
Logic .
an assertion that two terms refer to the same thing
Mathematics .
an equation that is valid for all values of its variables.
The point I was trying to make is, just because you construct an equation does not mean that all other equations are no longer possible, introduce (see the linear equation above) another variable and the equation starts looking highly questionable.
Random house’s definition for “definition”, pardon the pun, ’twas irresistible:
the act of defining or making definite, distinct, or clear.
or
the formal statement of the meaning or significance of a word, phrase, etc.
definitions are not identities. pretty sure the science people are eager to disassociate themselves from the less exact arts faculty.how you define something depends much of the time on context .
Obviously my sense of humour is an acquired taste. Equations for defining bird poo are too prosaic for intellectuals such as yourself. if you cannot see the point I was making, must be my fault.
Tony S
sorry to be replying in such a longwinded fashion. Forgot one thing.
The formulation of such equations assumes balance because it assumes already that credit must = debit, it assumes equilibrium at that point. My question is, why? If equilibrium is purely theoretical and the world has always been offkilter, can there be no other equation formulated? One that does not start with assuming equilibrium and end with insistence on an equilibrium that may not exist.
The point about the long run is not simply a matter of age or years but that we operate in the short and medium term and we may never get to see the long run. Those who do may not even have been around at the time the trigger event took place. Hindsight is 20/20 but try defining the long run or time itself and you’ll come up against a whole host of problems. BTW, try looking for the keynesian definition of long run?
You’re making this far too complicated.
China forces its capital exports through its FX policy. Dollars spent into China are forced back out through net dollar purchases by the PBOC.
That automatically adds to Chinese saving and subtracts from non-China saving – by accounting identity.
This is all very operational – not theoretical.
Tony S
Sorry to be posting again, but forgot something.
The formulation of such equations assume equilibrium where debits will= credits. Which is why they end with debits=credits. No equation can subvert its assumptions, because they are the basis for its existence. In this sense, accounting equations are deterministic, the outcome is predicated on the assumptions made.
My question is can we formulate assumptions that do not start with assuming equilibrium and end with insisting on that theoretical equilibrium when the world we live in is so often off-kilter?
As for the long run, it’s not a matter of years or even age, it is a matter of us operating in the short run or medium term. We may never get to see the long run, the long run is part of hindsight, often on the part of people who may not have existed at the point where the trigger event took place. BTW it is Keynes’ idea, maybe you can track where it comes from? or the definition?
I went to Walmart to buy some shoes. They were out of stock so I bought some variables instead. I still don’t know how much they cost.
Seriously, Judy I think the temporal factor is misleading you. They are only variables until one assigns a value. Once values are assigned the equations follow the certitude of their mathematical arguments.
Michael,
A bit late perhaps but the first part of your post is too complex to respond to. One thing: the zero sum perception may not please economists, but it is important. Who cares if your gains are someone else’s ;losses, if you can keep them. Politicians (democratic or otherwise, rarely seem to think otherwise. Which does not necessarily make them irrational.
What I like about this piece is the part about Chinese financial markets and investors. As you imply, there is no reason to believe that Chinese investors as a group are more innately risk-loving than investors elsewhere (if they were, one would expect ethnic Chinese or non-Chinese nurtured under “Chinese” circumstances, to have specific investment characteristics. As far as I know, no one has produced any respectable research into this. Consequently the question is justified as to why the PRC financial markets come up with more “sophisticated” investment products while common investors continue to be disadvantaged (vis a vis insiders like the gvt, management, otherwise influential investors) in ways unthinkable in western/democratic/capitalist (etc) countries. People tend to not always get what they deserve, and in the marxian world of ideas that appear to continue to influence policymakers thoughts, power, rather than fairness determines the range of services the people get. In the case of investment, the powerful prey on the powerless, which allows for financial innovation but not for good governance and transparency..
Glen M et al
Please see my reply on my own blog/journal. Not quite fair to continually post on Mr Pettis’ site. He’s probably quite fed up by now. http://judyjl.livejournal.com
As for zero-sum game, look at this definition and ask yourself whether you are positing zero-sum game or not when you say that surpluses must be balanced off by deficits:
In game theory and economic theory, zero-sum describes a situation in which a participant’s gain or loss is exactly balanced by the losses or gains of the other participant(s). If the total gains of the participants are added up, and the total losses are subtracted, they will sum to zero. Zero-sum can be thought of more generally as constant sum where the benefits and losses to all players sum to the same value of money (or utility). Cutting a cake is zero- or constant-sum, because taking a larger piece reduces the amount of cake available for others.
Let me summarise my argument:
If you assume there is equilibrium and then say that x+y=0, x and y are necessarily the same numerical value, just that one is a positive value and the other is a negative value. What I’m questioning is whether the assumption of equilibrium (reaching the desired result of zero) is valid. If you say it is valid, why? Explain your assumption. Does it hold for all range of values? Could it be that in certain cases, it does not neatly resolve itself into a zero? Just because it is an accounting identity does not mean it is infallible because its assumptions are not questioned.
What ever happened to 1+4? or (-2)+7?
Glen M et al
Please see my reply on my own blog/journal. Not quite fair to continually post on Mr Pettis’ site. He’s probably quite fed up by now. http://judyjl.livejournal.com
As for zero-sum game, look at this definition and ask yourself whether you are positing zero-sum game or not when you say that surpluses must be balanced off by deficits:
In game theory and economic theory, zero-sum describes a situation in which a participant’s gain or loss is exactly balanced by the losses or gains of the other participant(s). If the total gains of the participants are added up, and the total losses are subtracted, they will sum to zero. Zero-sum can be thought of more generally as constant sum where the benefits and losses to all players sum to the same value of money (or utility). Cutting a cake is zero- or constant-sum, because taking a larger piece reduces the amount of cake available for others.
Let me summarise my argument:
If you assume there is equilibrium and then say that x+y=0, x and y are necessarily the same numerical value, just that one is a positive value and the other is a negative value. What I’m questioning is whether the assumption of equilibrium (reaching the desired result of zero) is valid. If you say it is valid, why? Explain your assumption. Does it hold for all range of values? Could it be that in certain cases, it does not neatly resolve itself into a zero? Just because it is an accounting identity does not mean it is infallible because its assumptions are not questioned.
wonder why my earlier comment disappeared?
Hi Michael,
I have copied the data(appended at the end of this post) on National Defense Consumption Expenditures and Gross Investment from another economic blog:
Given that the US military and war expenditures are of thrillions annually in magnitude, I have read comment that the trillions US spent on wars and military should count to its debts and also trade deficits. Importing more than what a peaceful US needs or needed for reason of wars add to deficits.
I would appreciate your opinion on whether a significant reduction in the US’s huge annual expenditure on military and wars, including potential future increases in new wars, would help in anyway to reduce US’s trade deficits?
http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=108&ViewSeries=NO&Java=no&Request3Place=N&3Place=N&FromView=YES&Freq=Qtr&FirstYear=2005&LastYear=2009&3Place=N&AllYearsChk=YES&Update=Update&JavaBox=no#Mid
January 30, 2010
National Defense Consumption Expenditures and Gross Investment, 2000-2009
(Quarterly at annual rates, Billions of dollars) *
Qtr1 Qtr2 Qtr3 Qtr4
2000 ( 360.6) ( 376.9) ( 372.7) ( 374.0)
2001 ( 383.7) ( 389.7) ( 395.6) ( 402.8) Bush
2002 ( 420.3) ( 431.9) ( 440.4) ( 458.2)
2003 ( 466.4) ( 507.2) ( 503.1) ( 515.1)
2004 ( 535.9) ( 545.6) ( 565.4) ( 556.2)
2005 ( 578.5) ( 586.1) ( 606.1) ( 585.5)
2006 ( 615.5) ( 624.1) ( 623.3) ( 636.6)
2007 ( 636.7) ( 656.6) ( 674.4) ( 680.8)
2008 ( 703.6) ( 725.6) ( 763.6) ( 758.9)
2009 ( 750.7) ( 776.2) ( 795.8) ( 793.8) Obama
* Seasonally adjusted
[This is merely the basic defense budget, not including tens of billions of dollars in spending on the Central Intelligence Agency and for the nuclear arsenal]
Minnirenter, financial repression is a key component of overinvestment. When financing costs are subsidized, an almost automatic consequence is that many projects which are not economically viable suddenly become profitable nonetheless because their profits are augmented by transfers from the household sector. I am not sure however that investor “awareness” in China matters as much as it might in some other countries because they have few investment alternatives. If you take your money out of the bank, your are left with cash, which earns no interest at all and is subject to most of the risks of bank deposits, or overprices assets.
RS, I think interest rates are low in Japan for many of the same reasons they are low in China (another highly indebted country, if debt were correctly counted, although not nearly to the extent of Japan, at least as of yet). Most savings are in the form of bank deposits and deposit rates are set by the regulator, not the market.
Danat, I am not sure I understand your argument at all. Which conclusions fall apart?
Rein Huizer, I agree. The idea that Chinese are more speculative and less sophisticated about investing than others makes no sense to me. Investors respond to the conditions in the market. Chinese investors are no different.
TC, US military spending for Iraq/Afghanistan creates two problems for the US. First, as you note, it increases net “consumption” (of military goods and services) substantially and so might increase the consumption imbalance in the US. I say “might” because in principle the US can US tax policies to counteract the effect, but that is where the pother problem lies. Unpopular wars have often been associated with stock market booms (think of the Vietnam War and the “go-go” 1960’s stock markets) and I suspect that is because the US government refuses to finance them with taxes and instead finances them with debt and monetization. In my reading this temporarily increases liquidity and leads to asset price surges and, ultimately, bubbles. A significant reduction in US military expenditures would be a very large positive for the US economy.
Thanks for the interesting post. Couple of things I don’t get.
1. Identity of absolute value of any country’s current account and capital account. What with intl. reserves? (I.e. positive net current account means more money comes in than goes out. It seems obvious that the excess need not necessarily be invested abroad. It can stay at home in form of reserves.)
2. Capital account = Domestic investments – domestic savings. Again, what with the available domestic savings stock? (I.e. suppose there’s 1bn new investments in a country in a given year, but only 800m new savings. 200m further financing is needed. That can come from abroad, thus entering the capital account, BUT also from within, which I would not expect to pop up in the capital account)
3. How is a weak currency in itself supposed to drive domestic capital out (as Krugman argues)?
4. “if the capital account surplus rises, broadly speaking, either savings must decline, or investment must rise” …or consumption must rise, not?
Say Citi issues an international bond of 1bn, all bought by foreigners. Thus in the first step net +1bn onto the capital account. Then, Citi may indeed invest that 1 bn (thus increasing domestic investments) BUT it may also simply lend it to US consumers, who then buy 1bn worth of goods. Here, no any impact on neither domestic savings nor investment, only on consumption / current account.
5. And finally…
“”America needs deficit reduction and an increase in personal saving, while China needs to stimulate internal private consumption.” These are not separate issues. One can only occur with the other”
Why? Suppose US imports from China decrease for whatever reason. And China decides to simply close the involved factories. Totally separate.
Thanks in advance.
Hi Michael
I quoted a sentence from your write-up above ” If the US runs a trade deficit, for whatever reason, US capital imports must rise, and almost certainly that means debt will rise.”
What do you mean by the U.S. CAPITAL IMPORT and U.S. CAPITAL EXPORT? i am bit confused?
I think the U.S. capital import is not the import of goods and services from other countries by U.S., it’s more like the U.S. investment in foreign country, am i right?
Can you also explain a bit further on the correlation between trade deficit and capital imports.
Thanks
It is disappointing not to get an answer on my very concrete questions (comment 69) which concern the very core of professor Pettis’ argument – his accounting identities.
@Frank P
1. Reserves are part of the capital account, if you like. The vocabulary is kind of messy (financial/capital account).
2. You talk about “the domestic savings stock” first, then argue with flows later. Also, if savings is below investment, the overhang has to be financed by foreigners – else investment goes down to match domestic savings.
3. If you expect your weak currency to devalue in the future (by large jumps), then you will move your savings abroad and into currencies that are more stable.
4. Well, you start to put dynamics into the identity game, and this messes things up. Which is not bad. So, of course an economic imbalance can change consumption and with it GDP. That seems to be the whole point of the Chinese strategy of a depresed exchange rate.
5. If China continues to lend excessively to the US, how will consumers there start to increase their savings? The US interest rate will stay very low, and this is not a good incentive to increase savings. As well all know, people react to incentives. (However, deleveraging might be more important right now than thinking about “saving”. Low interest rates might not be enough to increase the amount of debt in the economy, which is why Richard Koo calls it a “balance sheet recession”.)
best,
Dirk