Creditors nations are worried. Their obligors seem determined to take steps, they claim, to undermine or erode the value of their obligations – at the expense, of course, of the creditors.
Over the past two years we have become pretty used to the spectacle of Chinese government officials warning the US about its responsibility to maintain the value of the huge amount of US treasury bonds the PBoC has accumulated. More recently we have been hearing complaints in Germany about the possibility that defaults in peripheral Europe will lead to losses among the many German banks that hold Greek, Portuguese, Irish, Spanish and other European government obligations.
In both cases (and many others) there seems to be an aggrieved sense on the part of creditors that after providing so much helpful funding to undisciplined debtors, the creditors are going to be left with losses. There is, they claim, something terribly unfair about the whole thing.
To me this whole argument is pretty surreal. Not only have the creditors totally mixed up the causality of the process, and confused discretionary foreign lending with domestic employment policies, but an erosion in the value of the liabilities owed to them is an almost certain consequence of their own continuing domestic policies. It is largely policies in the creditor countries, in other words, that will determine whether or not the value of those obligations must erode in real terms.
Before I explain why I make the second point, let me address the first point. As I have argued many times before, the accumulation of US government bonds by the PBoC and the surging Greek, Portuguese, and Spanish loan portfolios among German banks were not the acts of disinterested lenders. They were simply the automatic consequence of policies in the surplus countries that may very well have been opposed to the best interests of the deficit countries.
Take the US-China case, for example. The US has been arguing for years that China had to raise the value of the currency sharply in order to rebalance the global economy and bring down China’s current account surplus and, with it, the US deficit.
China responded that it could not do so without causing tremendous damage to its economy and that anyway the problem lay with the US propensity to consume. For that reason China continued to accumulate US dollar assets. As it bought US government bonds it was able to generate higher domestic employment by running large trade surpluses, with corresponding deficits in the US. Remember that net capital exports are simply the obverse of trade surpluses (or, more correctly, current account surpluses), and one requires the other. If China buys huge amounts of dollars, the US must run a trade deficit.
Whichever argument you think is the more just – that the imbalances are mainly the fault of the US or the fault of China – since the Chinese accumulation of US Treasury bonds was the automatic consequence of Chinese policies that the US opposed, it seems a little strange that the US should feel any strong obligation to maintain the value of the PBoC’s portfolio. That is not to say that the US should not be concerned about inflation and the value of the dollar – only that the reasons for its concern should be wholly domestic.
Likewise with Germany. The strength of the German economy in recent years has largely to do with its export success. But for Germany to run a large current account surplus – the consequence I would argue of domestic policies aimed at suppressing consumption and subsidizing production – Spain and the other peripheral countries of Europe had to run large current account deficits. If they didn’t, the euro would have undoubtedly surged, and with it Germany’s export performance would have collapsed. Very low interest rates in the euro area (set largely by Germany) ensured that the peripheral countries would, indeed, run large trade deficits.
The funding by German banks of peripheral European borrowing, in other words, was a necessary part of deal, arrived at willingly or unwillingly, leading both to Germany’s export success and to the debt problems of the deficit countries. If the latter behaved foolishly, they could not have done so without equally foolish behavior by Germany, and now both sets of countries – surplus countries and deficit countries – should have do deal jointly with the debt problem.
In that case it is strange for Germans to insist that the peripheral countries have any kind of moral obligation to prevent erosion in the value of that loan portfolio. It is like saying that they have a moral obligation to accept higher unemployment in order that Germany can reduce its own unemployment. Whether or not these countries default or devalue should be wholly a function of their national interest, and not a function of external obligation.
Trade imbalances lead to debt imbalances
But aside from whether or not there is a moral obligation for debtor countries to protect the value of portfolios whose accumulation was the consequence of policies that those countries opposed, there is a more concrete reason why it does not make sense to demand that deficit countries act to protect the value of the portfolios accumulated by surplus countries. This has to do with the sustainability of policies aimed at generating trade surpluses. It turns out that the maintenance of the value of those obligations is largely the consequence of trade policies in the surplus countries.
To explain why this is the case, let me again, following my practice from last month’s newsletter, simplify matters by calling all surplus countries “Germany” and all deficit countries “Spain”. Germany and Spain jointly have put into place policies that ensure that Germany runs a large current account surplus and Spain a large current account deficit for many years. As I argued three weeks ago, I think that it is far more likely that German policies rather than Spanish policies created the huge distortions, but for our purposes we can ignore the direction of causality.
As long as Germany runs current account surpluses for many years and Spain the corresponding deficits, it is by definition true there must have been net capital flows from Germany to Spain as Germany bought Spanish assets (which includes debt obligations) to balance the current account imbalances. The capital and current accounts for any country, and for the world as a whole, must balance to zero.
In the old days of specie currency – gold and silver – this meant that specie would have flowed from Spain to Germany as the counterbalancing entry, and of course this flow created its own resolution. Less gold and silver in Spain relative to the size of its economy was deflationary in Spain and more gold and silver in Germany was inflationary there – until the point where the real exchange rate between the two countries had adjusted sufficiently because of changes in domestic prices to reverse the trade imbalances.
Large current account surpluses and deficits, in other words, could not persist because they were limited by the gold and silver holdings of the deficit countries. This was pretty much an automatic limit – although in later centuries it could be extended by central bank loans of specie – and the limit was pretty firm. In the days of Hapsburg Spain, seemingly infinite discoveries of silver in Eastern Europe and the Americas allowed Spain to act as if it had infinite capacity to run trade deficits, but of course the never-ending religious and dynastic wars that seemed so much to delight the Hapsburgs ensured that silver outflows were high enough even to drain the silver discoveries fairly quickly (in fact new silver discoveries were almost always spent before they were actually delivered).
During the imperial period in the late 19th Century this adjustment mechanism was subverted by a process described most famously by British economist John Hobson in his theory of under-consumption. Hobson argued that the imperial centers systematically under-consumed and exported huge amounts of their savings to the colonial periphery, which of course allowed them to run large and profitable trade surpluses against the periphery.
This export of money from the center to the periphery was seen as the primary mechanism of colonial exploitation. Even Lenin thought so, and wrote about it most famously in “Imperialism, the Highest Stage of Capitalism”. “Typical of the old capitalism, when free competition held undivided sway,” Lenin wrote. “was the export of goods. Typical of the latest stage of capitalism, when monopolies rule, is the export of capital.”
Since they controlled the periphery and since obligations were denominated in gold or silver, the imperial centers exporting capital never had to worry about today’s worry – the refusal or inability of the periphery to repay the capital imports. They “managed” the colonial economies and their tax systems, and so they could ensure that all debts were repaid. In that case large current account imbalances could persist for as long as the colony had assets to trade. Regular readers will remember that I discussed this in an early May blog entry in reference to a very interesting paper by Kenneth Austin.
The current account dilemma
In today’s world things are different. There is no adjustment mechanism – specie flow or imperialism – that permits or prevents persistent current account imbalances.
This means that if Germany runs persistent trade surpluses with Spain, there are only three possible outcomes. First, Spain can borrow forever to finance the deficit (of which the ability to sell off national assets is a subset). This may seem like an absurd claim – no country has an unlimited borrowing capacity – but it is not quite absurd. If Germany is very small – say the size of Sri Lanka – or if Germany runs a very small trade surplus, for all practical purposes we can treat the borrowing capacity of Spain as unlimited as long as the growth in debt is more or less in line with Spain’s GDP growth. However if Germany is a large country or runs large surpluses, this clearly is not a possible outcome.
That leaves the other two outcomes. First, once Spanish debt levels become worryingly large Germany and Spain can reverse the policies that led to the large trade imbalances. In that case Germany will begin to run a current account deficit and Spain a current account surplus. In this way German capital flows to Spain can be reversed as Spain pays down those claims with its own current account surplus. Neither side loses.
Second, Spain can take steps to erode the value of those claims in real terms. It can do this by devaluing its currency, by inflating away the value of its external debt, by defaulting on its debt and repaying only a fraction of its original value, by expropriating German assets, or by a combination of these steps.
Why must those claims be eroded? Because Spain does not have unlimited borrowing capacity (and presumably does not want to give away an unlimited amount of domestic assets). If Spain’s current account deficit is large enough, in other words, its debt must grow at an unsustainable pace and so it must eventually default (this, by the way, is a variation on the famous Triffin Dilemma). The only way to avoid default is to erode the real value of the debt, and ultimately these are variations on the same thing – Germany will get back in real terms less than it gave.
Without unlimited borrowing capacity these are the only two options, and once the market decides debt levels are too high, a decision must be made. Either Germany must accept a reversal of the current account imbalances or it must accept an erosion in the value of the Spanish assets it owns as a consequence of the current account imbalances. This is the important point. Once you have excluded infinite borrowing capacity there are arithmetically no other options.
It is pretty clear that the countries of the world represented in my example by Germany (Germany, China, Japan, etc.) are doing everything possible to resist the first option. They are not taking the necessary steps to reverse their anti-consumptionist policies and plan to continue running current account surpluses for many more years. Even Japan, for example, a country that has abandoned its old growth model and has finally been adjusting domestically for nearly two decades has been unable, or has refused, to take the necessary steps to reverse its current account surplus.
In that case some mechanism or the other must erode the value of the Spanish assets the German banks have accumulated. Either Spain must devalue, or if must inflate away the real value of the debt, or it must default, or it must appropriate German assets – perhaps in the form of a large German gift to Spain. By the way you can think of the US Marshall Plan as a way of allowing Europe to appropriate US assets in the days when the problem was persistent large US current account surpluses, matched by a refusal of the US to change its domestic economic policies in a way that generated trade deficits and an inability of Europe to continue borrowing. The alternative to the Marshall Plan was either a collapse in the US export market, a European default, or a less friendly European expropriation of US assets.
Given the limits, especially debt limits, it is irrational for anyone to expect that Germany can continue to run large current account surpluses while Spain does nothing to erode the value of Spanish assets held by Germans. This is an impossible combination. We must have either one or the other. I suspect that Germany is hoping and arguing that Spain can somehow reverse its current account deficit without the need for Germany to undermine current account surplus. But this won’t work.
China, for example, implicitly makes the same argument when it demands that the US raise its savings rate while China avoids making the necessary domestic adjustments, including to the currency. But of course this means nothing more than that some other country must replace the US as the current account deficit country of last resort. This obviously cannot solve the underlying problem. It simply pushes off the imbalance onto another country, and ultimately with the same dire consequences.
This is why I find the moaning and gnashing of teeth over the possible erosion of the value of claims accumulated by surplus countries surreal. There is only one possible way to avoid that erosion of value, and that requires that the surplus countries work with the deficit countries to reverse the trade imbalances. If the surplus countries refuse to take the necessary steps, an erosion in the value of those claims is the automatic and necessary consequence. In practice that means that either the claims must be devalued or they will lead to default.
This is an abbreviated version of the newsletter that went out last week. Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at chinfinpettis@yahoo.com, stating your affiliation, please. Investors who want to buy a subscription should write to me, also at that address.
Sir,
I would like to take issue with your claim that Spain in your example “presumably does not want to give away an unlimited amount of domestic assets”. It seems like Germany could use its capital flows to Spain also to consume goods and services domestically in Spain (e.g. tourism). As this kind of capital inflow would neither lead to a run-up of debt nor requires a reversal, persistent current account deficits could very well be sustained at high levels indefinitely.
In some sense they would merely be an expression of a Spanish preference for having the things they consume sent to them (imports), while the Germans prefer to consume out-of-country. (Note that this doesn’t seem so unlikely for the real equivalents of these example countries – after all I would venture that German tourism expenditures in Spain by far exceeds Spanish tourists’ expenditures in Germany).
In that case, it seems that no CA reversal or debt reduction would ever be necessary.
Fantastic!
Absolutely insightful!
This process has already been going on though in Africa for 50 odd years now. The West continually “lends” and “gives” capital to Africa, increasing the value of African currencies and making it impossible for Africa to industrialize. African states run-up unsustainable debts that the West then “forgives” and the process continues. Africa has been kept in permanent poverty.
The same dynamic could continue indefinitely in US-China relations, with the US quickly joining Africa at the bottom of the economic heap.
Primary commodity exports from the US to China have doubled as a share of US total exports to that country in seven years from 2002 to 2009. The US is well on its way to becoming a Chinese semi-colony.
Brilliant. Clear and concise and beautiful Keynes like prose. Very approacheable and seemingly simply yet it is obvious any avenue can be discussed with as much complexity as desired. It is not at all simplistic.
The days of ‘Jenkins’ Ear” are over and playing the mercantalist shrewdly in the back eddies of vacumn under the skirt of the US hegemon given great changes is something that obviously can be done, but no one should shed a tear when the bill comes due.
Basically all of these “petty mercantalist” are either the results of sudden US hegemonic gains – such as German unification with the dimise of the USSR and then the reaping of Europe via trade to pay for it – or China’s surge where the US allowed the Chinese WTO entry and then the massive trade surplus so as to maintain security in the Pacific so as to pay attention to the Islamist pirates. (Thinking more and more the model for the Islamist Wars is to look at Pompey and the pirates.)
The Japan case in the late 80s and then into their lost decade and then some post Nikkei crash, to me suggested that any gains via a manipulated or mercantalist stance is not only fated to move to repudiation, default, or at the least a severe mark down of any asset acquired by the mercantalist (in Japan’s case and I think China’s fate) – all in value lost equal to the amount of gain realized through the mercantalist policy. Or one can jump to the “truth” and simply realize the gain never really existed in the first place.
This adds up to where either Germany sheepishly falls in line and the good result may be, as Kohl would say around 1990, the “United States of Europe”, full Hegelian Union – or this will be the end of Europe if Germany trys to hang on to any gain over and above what was required to achive union, almost two decades ago.
For China – either Kissinger’s implicit fears in his great book come about and we move to blood as the leadership blame external agents for the hard and what will be a brutal hard landing (and in the end only one external agent really comes to mind that might possibly deflect blame) or China disappears off the world stage and do a North Korean “light” and retrench so as to maintain power. Or a Blakean Orc is born.
Terrific essay Michael! (Saw the mention of Mongolian rock bands in the Sunday NY Times – seems to be a terrific scene out there.)
The choice of adjustment mechanism will be decided politically, and empirically, all political decision-making in democracies is undertaken with a short-term view. So at least in the European version of Spain vs Germany, even though selling off national assets cannot continue for ever, it is the first step that will be undertaken. The only question is how many debtor countries will have to submit to asset sell-offs before current arrangements become unsustainable – for example due to a ‘sovereign’ default.
Professor Pettis,
Good article. I agree with most of it.
Reading many of your previous articles here, it seems that you think that the policies in surplus countries are mostly responsible for the global imbalance, the policies in surplus countries are choices while the policies in deficit countries are responses. I will have to disagree with that.
There are many contributing factors that bring the imbalance to where it is now. The policy choices in the deficit countries cannot be ignored. The pro-consumption policies in deficit countries are the choices rooted in their political systems. The elected officials are mostly care about getting elected in the next election. Therefore they do whatever pleases their constituents. Problem is that what people want is not necessarily sustainable. People want to receive more and contribute less, this is just the human nature. But the politicians will give them what they want and let them live beyond their means NOW. There is very little consideration of the long term effects or what this means for the future generations (who cares, the future generations don’t vote yet). In the US, the entitlement programs, government involvement in increasing home ownership are examples. These policies will reduce the competitiveness of an economy, and these policies alone can cause current account and capital account imbalances. With the help of the anti-consumption policies in the surplus countries and the willingness of surplus countries to take the other side of the trade, things get worse and prolonged. The point I am trying to make is that the policies in deficit countries have their roots and are not merely responses.
The more I think about the solutions to the imbalance the more depressing it gets. I am glad that I don’t have to fix this. I can simply turn on sports, work on my house, or drink beers with friends.
As an architect in New York City, about three years ago I became suddenly quite interested in economics when our local financial industry managed to destroy overnight all demand for what I had spent fifteen years growing a business to do.
I will not bore you with how I’ve arrived at my beliefs, but this post of yours and the previous post to which you refer in it are parallel in many ways with a recent effort of mine to clarify exactly what the US “deficit” is on a floating fiat currency. The idea of a “debt” for the sovereign issuer of its own currency has seemed atavistic to me since the implications of fiat currency became clear to me several years ago.
I am a hobbyist in economics, so a good deal of this will probably seem naive to you, but I think it explores some implications of reserve currency status for a fiat currency beyond those you mention: http://cobblehillbilly.blogspot.com/2011/06/marginal-propensity-to-hoard.html
“As long as Germany runs current account surpluses for many years and Spain the corresponding deficits, it is by definition true there must have been net capital flows from Germany to Spain as Germany bought Spanish assets (which includes debt obligations) to balance the current account imbalances. The capital and current accounts for any country, and for the world as a whole, must balance to zero.”
And, “This means that if Germany runs persistent trade surpluses with Spain, there are only three possible outcomes. First, Spain can borrow forever to finance the deficit (of which the ability to sell off national assets is a subset).”
Stop issuing debt and make certain assets protected. If the current account surplus country doesn’t want its currency to rise, then let it buy some “Mickey Mouse” assets that could go down in value destroying what I would call excess savings. Put enough losses on the CA surplus country, and hopefully it will rethink its policies.
Wonderful analysis. I continue to be disappointed that you are one of the only–if not THE only–commentators who routinely makes the connection between China’s own policies and the value of China’s holdings of US debt and/or the inability of the US to make macroeconomic adjustments. Jut the other day, I was reading a commentary on one of the Economist blogs–a great blog, with consistently intelligent analysis–which concluded that the problem was that Americans are “fat, lazy, complacent, and proud of it.” This, after the writer had criticized Michael Spence’s recent Foreign Affairs piece for being “painfully general” in its policy recommendations.
This was illuminating to me. If an educated commentator for a publication as well-regarded as the Economist fails to see the fact that the US’ ability to adjust depends largely on other countries’ WILLINGNESS to adjust–such a basic reality–how can we expect the vast majority of people–including many of those responsible for making policy–to understand the true dynamic of things and make appropriate fiscal policy?
Among central bankers and finance ministers, I imagine the moaning and groaning is largely political. China has a political advantage, here, and they know it, because it sounds like sophistry to say that, in fact, the debtor’s debts are largely the creditor’s fault. So, how can US financial officials convince the world politically that they’re not really entirely at fault, when the default understanding–even among a majority of the highly educated–is that (1) the US is an obese, profligate child; (2) the US has a resulting moral duty to repay its creditors in full at approximately the same exchange rate; and (3) if the US doesn’t repay in full, China and other creditors will “break our knees,” and rightfully so?
I´m sorry, but I do believe you are missing the main point and quite frankly misstating the whole argument. Whilst Germany currently is the second largest exporter, it also is the third largest importer worldwide. Per capita imports for Germany(~80mn people; ~1.1trn$ imports) are roughly 3-4 times as high as they are for Spain(~40mn people; ~0.32trn$ imports). Obviously it is possible to just focus on the current account balance, as you have done in this article and your last one(http://mpettis.com/2011/06/how-to-become-virtuous-and-save-more/), but your implied line of argument, that Germany refuses to buy from abroad and therefore the imbalances exist is not supported by the facts.
An interesting (and far more accurate) take might have been:”Why are Poland, the Checks and Hungary eating Spain´s and Greece´s lunch?”, but that would make it a question about the internal structures of the various economies, quite obviously not the agenda you are trying to push.
Your other line of argument, paraphrasing: if it weren´t for the Euro exchange rates would have moved to adjust: the polish Zloty as stayed at 4:1 to the Euro over the past 10 years, yet Poland´s bilateral current account balance is a lot more in equilibrium than Spains(whith Poland being comparable in size in terms of population, landsize, possibly having the disadvantge of only recently having joined the EU).
As a bonus, I would like to mention Switzerland(main export industries: machinery, chemicals, precision machinery), similar to Germany not just what the main export industries are concerned, but also in terms of language and mentality. The CHF/USD has moved from just below 1.30 to just above 0.80, Swiss exports must have crashed, the current account balance must be deeply negative? Check the facts you might be surprised.
Interesting article. a question though: which to you seems more likely of the two options open to the creditor nations for resolving debt problems? Especially in terms of China, do you think the policymakers will be willing to take the necessary change in domestic policies as the leadership changes over the next few years?
I recently heard that the real interest rate on U.S. bonds was negative. I guess this makes it pretty clear which way the USA wants to go.
Dear Mr. Pettis,
thank you for sharing your thoughts. I’m afraid however that the situation in Europe is somewhat different than your analysis suggests. Taking your example of Spain and Germany, a quick look at statistical data reveals that Germany did not have a very low consumption rate, higher one than Spain actually. And there are no deliberate consumption suppressing policies I am aware of. What had been surprisingly low was the investment rate, one of the lowest among European countries.
Given that economic theory suggests that capital flows to its most lucrative/ productive use and investments in an economy in a lower development state should generally offer higher marginal returns, this finding is actually not so surprising anymore. In a European context this means capital, and thus trade surpluses, flows from relatively better off northern Europe to less developed southern Europe. As long as these investments lead to growth in deficit countries the accumulating debts should be manageable. Plus this accelerated growth in deficit countries should lead to a convergence in living standards across Europe, especially so as a low investment rate is a drag on productivity and thus living standards in surplus countries.
Btw Germany in the early 90s was running a current account deficit in order to finance the heavy costs of reunification.
So in theory this common market, common currency arrangement should turn out to be quite beneficial for European countries, at least in the longer run.
In reality however it appears that some deficit countries did not invest these incoming capital flows very well but rather consumed them, which eventually lead to debt problems.
Michael: This is a very small quibble. There were two mechanisms for the adjustment of trade prices: one was the actual transfer of specie, the other was the discounting of trade paper. What World War I did – with its serial defaults first by the United States and then by the European nations – was largely destroy the dealing in trade paper among private parties. As you have so ably noted, the result was that the United States, which held most of the world’s specie, had to continue to lend money to foreign Treasuries/central banks if trade was to continue. With the abandonment of the gold standard, we now have a discount mechanism; but we lack the very thing that allowed economies to recover almost instantly from financial panics and crises – a guarantee that sovereign debt (Hamilton’s gift) would be as good as gold. All the best. LUHP
@Gregor: tourism and other services are captured in the current account. Think of tourism as an ‘export’ of services (from the host country, e.g. Spain). And for simplicity of expression, most refer to imports/exports, leaving out some of the other components which are usually small – although net transfer payments (such as foreign aid) would be a way to reduce the current account deficits, Germany probably wouldn’t agree to annual transfers of the magnitude required. 160 billion Euros (Germany) or 65 billion or so (Spain) is a lot of beach time to consume (annually). Leaving aside whether German tourists would just consume imported German beer.
I think I get the main point, and agree, that debtor and creditor countries have a shared (and maybe equal) responsibility for the result of persistent current account surpluses / deficits. It certainly does seem laughable to me that the Chinese government warns the US to protect the value of its treasury purchases; however, I am still confused about a few aspects of this.
First, why is Germany’s continual accumulation of foreign debt so beneficial to domestic employment? Is this due to structural rigidity in the German economy since presumably full employment can be achieved without subsidies and additional export production. Also, reduced domestic demand (living more frugally) seems like a cost to the German consumer. Why does the world largely consider Germany (or China) to be the main benefactor of this arrangement? If America gets inexpensive goods in exchange for paper debt obligations which will necessarily be devalued, isn’t that a great benefit? If the debt is reduced, isn’t that just like extra income? Is it fair to say the overall benefit of this mutual arrangement could go either way in the long run? (although both could also suffer due to the eventual rebalancing process)
I think I am missing something basic in my own rudimentary analysis and I am grateful for any clarification. Given the state of the world’s economy, this is a fascinating and relevant discussion — thanks for your blog posts.
Would appreciate it if someone could explain this:
“since the Chinese accumulation of US Treasury bonds was the automatic consequence of Chinese policies that the US opposed”
I understand the Chinese accumulated foreign currency e.g USD, what I do not understand why was it automatic, meaning the only option, to purchase US Treasure bonds?
Thanks!
Julia
@20 Julia
I think the sheer size of China’s foreign exchange reserves limits the options. China currently holds US$1.2trn of Treasuries. The NYSE is worth about $14trn, NASDAQ another $4trn. If China invested the lot into equity, it could spend the market valuations of ExxonMobil, Apple, Chevron and Microsoft, with a bit left over for a nice corporate office. Mr Buffet would become a small investor.
Sources:
http://www.treasury.gov/resource-center/data-chart-center/tic/Documents/mfh.txt
http://en.wikipedia.org/wiki/New_York_Stock_Exchange says $13tn, add a bit for recent rises
http://en.wikipedia.org/wiki/NASDAQ
http://en.wikipedia.org/wiki/List_of_corporations_by_market_capitalization
“[…] More recently we have been hearing complaints in Germany about the possibility that defaults in peripheral Europe will lead to losses among the many German banks that hold Greek, Portuguese, Irish, Spanish and other European government obligations. […] there seems to be an aggrieved sense on the part of creditors that after providing so much helpful funding to undisciplined debtors, the creditors are going to be left with losses. There is, they claim, something terribly unfair about the whole thing. To me this whole argument is pretty surreal.”
(1) There is nothing unfair about the thing as such, and no one would argue against it (surreal or not). What’s unfair is that all possible (and at some point anticipated) gains from such transactions would and will go entirely to the banks, but all losses will go to the taxpayer. Politicians (and their buddies, the banks) act like teenagers that roam around without thinking about consequences. Their “obligations” are at best confined to an election period, who cares what (or who) comes after that. If they find that – oops – their action has negative consequences mom and dad (the taxpayer) will take care of it. But neither politicians nor banks are “our” children that we are responsible for, they have responsibilities too – and they deliberately screw them. That’s what’s unfair. As much to the creditor countries as to the debtor countries – we all have in common that we are run by people/institutions that don’t take responsibility for their actions.
(2): The problem is not about the “many German banks” holding obligations, but about the ECB (European Central Bank) holding too many of them. If it were only Germany, the Germans could and would probably take care of it without much fuss. But they, like other European creditors, are stuck with a rigid currency and Euro-partners that all try to place their own (local) interest over that of everybody else. So much for the “union”.
Hi Michael,
Sorry for my poor understanding of economics, but the theory that you mentioned is that imbalances comes from policy of countries who surpress their consumers to boost their production. In other words, if the world has no peg currency, there will be no trade imbalance as if a country’s current account has surplus, their currency will rise in tandum and that will reduce the current surplus rite?
It’s a great summary of the aspects of an imbalanced world. What Germans don’t understand is that all their export records that make them so proud were financed with their own money. It was the Germans giving (lending) money to the Spaniards so that the Spaniards could buy their goods.
They could just as well have produced all that stuff and dumped it in the sea. The only difference is that now they live under the illusion they have accumulated massive amounts of savings, which in reality of-course they haven’t… I see it as an act of great altruism. The only option now is for the German taxpayer to save his own savings by bailing out Spain; which would be a zero-sum operation for them but at least save the rest of the world from catastrophic shock.
I think that Julia (20) raises a good question.
Please explain:
“since the Chinese accumulation of US Treasury bonds was the automatic consequence of Chinese policies that the US opposed”
It’s an obvious answer to those that know the answer and a complete mystery to those who don’t.
By choosing too high a value for the dollar in their own market, China creates a surplus: They earn more dollars than they can spend. The PBoC, has to buy them up and store them. This is just like a country with an agricultural surplus that has to keep the agricultural surplus in grain bins (or destroy it). Instead of storing them in grain bins, the dollars are stored by buying Treasury securities.
Ironically, by buying and storing too many U.S. Treasuries, China’s actions may destroy its surplus dollars if they take the process too far. The Treasury bonds won’t rot, they will eventually depreciate or, in the worst case, default.
I find it helps to be able to see the beauty in Michael’s analysis to go read up on a guy called Pacioli – then a bit of Ricardo – then of course Keynes “Economic Consequences of the Peace”. Amazing how blithe and assured Keynes was in 1919 when he set the standard by describing WW I as “The European Civil War”.
I am starting to think a major error is foks are applying technical and econometric solution sets to Europe (and China) and seem to have forgoteen how to be “political economists”.
Keynes could apply probabilty and calculus with the best of them (think “probability” was his thesis) – but nothing of that ilk shows up in “General Theory” or “Economic Consequences…”. Kindleberger doesnt have a complex math, but in the description, in any of his stuff. Michael’s approach is what is needed now – brilliant political economic analysis which moves the debate from what the pie looks like (as I think he decidedly closes that debate by fully describing the current reality), to how to divide the pieces. ie Political Economics. There is no debate in what Germany and Greece and Spain are doing and have done as they dance – it is as Michael depicts – but the real debate is who does what to whom to move the ball forward. Basically Union or disunion.
Europe is a “Hegel Moment”, not a ” Minsky Moment”
I wonder if Germany took the bank lending approach rather than the “imperial power” asset gathering approach to recycling the surpluses, because of sensitivities about WWII and a German “takeover” of Europe. It’s much nicer to think Germans are lending money to Spaniards to build nice villas, rather then buying their factories, rationalizing them in Blitzkrieg efficiency, and overlording them with Teutonic rule. But, in this case the assets would be “better managed” rather than mispent, and allowing the Spaniards to increase their unit costs and naturally reduce the deficits.
Julia,
We do see CIC invest some of the $ reserve in other asset classes, but I think China’s $ reserve will mostly have to be invested in safe, liquid assets. Therefore there aren’t many alternatives other than the US government debt. But even if China invest in other dollar assets, the impact on the demand of US government debit may be limited. Because that way, the future risk adjusted return on those China invested “other” assets would be reduced. The money that would otherwise go to those “other” assets would now go to assets such as US government debt.
This sounds like the typical high-level economist talk. Concretely I would be interested in the following:
How would you re-adjust the consumption pattern of Germany vis-a-vis Spain (In the EUR area with no possibility to revalue your currency!)? As Peter said above “There are no policies in place to deliberatly suppress consumption” in Germany. Would you hence force-feed Joe Sixpack (or in this case Otto Normalverbraucher) with Tapas?
A refreshingly frank blog posting, that provides a commonsense depiction of economic reality.
David Ricardo, often credited with systematizing economics, developed the concept of comparative advantage, the win-win-win pot of gold at the end of the free trade rainbow. As a system thinker Ricardo recognized that destroyers of free trade would cause the results of free trade to be less than the sum of the parts; short-circuiting optimal comparative advantage.
In the global area, Adam Smith’s self-interest capitalism manifests itself in surplus countries’ unbridled pursuit of absolute advantage, which encompasses keeping deficit country currencies from falling with the aim of protecting the surplus countries portfolio of monetary reserves and obtaining an ever increasing share of the free trade pie. David Ricardo, applying systems thinking, appears to have realized that the unbridled pursuit of absolute advantage would be unsustainable and end badly; with the pursuit of comparative advantage as the only commonsensical and sustainable approach.
Warren Buffett, also applying systems thinking, in 2003 recommended a balance trade model, as a 21st century avocation for the pursuit of comparative advantage. Balanced trade would result in negligible trade surpluses/deficits as does optimal comparative advantage; therein lies its unique ability to provide sustainability.
Great article. To the commenters. The problem with Germany is not – according to Pettis – that they suppressed consumption neither that they did not import enough. The political issue was the low level of interest rates during decades and the high level of savings in Germany. I would like to see the commercial balance between Germany and Spain during the real estate bubble compared with the current one. Can the euro be devalued?
Thank you for this analysis. Much food for thought.
Small edit in first paragraph following the first bold heading (Trade Imbalances Lead to Debt Imbalances):
“But aside from whether or not there is a moral obligation for creditor countries to protect the value of portfolios whose accumulation was the consequence of policies that those countries opposed.“ This should be “debtor countries.”
“Why does the world largely consider Germany (or China) to be the main benefactor of this arrangement? If America gets inexpensive goods in exchange for paper debt obligations which will necessarily be devalued, isn’t that a great benefit? If the debt is reduced, isn’t that just like extra income? Is it fair to say the overall benefit of this mutual arrangement could go either way in the long run? (although both could also suffer due to the eventual rebalancing process)”
This is a fairly important question and the key to answering this is that one must stop considering national economies as if they were individual households, because they are not. Here’s my take. In China’s case, what they “get” out of their subsidy of exports at the expense of household consumption is integration within the world economy. For example, if the Chinese government wants to spurn economic growth, they an do so with either domestic or external demand, that is, either they can lower the value of the RMB to encourage exports, or keep it high, to encourage domestic consumption. What are the consequences of each path? For a poor country like China that had previously not been integrated into the world market, encouraging exports will have a number of ripple effects on the rest of the economy because if you want to export, then you have to make something that the rest of the world wants. To do that, the factory making stuff will need to figure out what the world wants and how to make it. This will involve perhaps importing foreign technology in the form of tooling, machinery, or management. So now by subsidizing exports, what China has really done is encouraged the growth of industries that compete globally, and in order to compete globally, they must keep abreast of the latest global advances in technology and management, and maybe even start innovating on their own.
It is true that the dollars acquired by china in this process are just slips of paper, but the Chinese RMB itself is just a slip of paper. These slips of paper are meaningful to households but not really meaningful to national economies. What China has really acquired in this process is a globally competitive, globally integrated industrial base, which is a real, tangible thing unlike a paper dollar. These, the workers, the firms, the factories, the know-how, this is the true measure of the wealth of a nation. China as a country is much wealthier, and will be much wealthier than otherwise even if the US defaults tomorrow and all their paper dollar holdings go up in smoke.
I don’t want to speak about Germany as I’ve never been there and I don’t claim to fully understand the relationship between Germany and the rest of Europe, but I think for a layman, understanding the “point” of all these paper pushing shenanigans vis a vis the real economy is an important prerequisite to understanding why countries do what they do.
@39 Throatwarbler:
“What China has really acquired in this process is a globally competitive, globally integrated industrial base, which is a real, tangible thing unlike a paper dollar. These, the workers, the firms, the factories, the know-how, this is the true measure of the wealth of a nation. China as a country is much wealthier, and will be much wealthier than otherwise even if the US defaults tomorrow and all their paper dollar holdings go up in smoke.”
Quite right. Sorry to make this political, but the Chinese refer to this as Comprehensive National Power. The question is: what do they plan to do with it?
@39 Throatwarbler
Fair enough, but China’s ability to “make stuff” is useless without someone to push paper. The US had the world’s top car producing capacity for many years, but eventually they ran out of customers. Now most people buy Japanese or German-made. At the end of the day, if China flops it’s stuck with gleaming factories, highly educated workers, advanced high speed rail, and no purchase orders.
If the US stops buying all the stuff it gets from China, China would also face the issue of having to finance all this overcapacity, which hasn’t been paid off yet. The US industrial sector is much weaker than it was 30 years ago, but at least there was some time to “smell the coffee” and reorient the economy towards services. If China loses major customers for it’s heavily export-oriented industrial economy, the fallout could be much worse.
One nitpick – specie doesn’t work either unless you can practice gunboat politics. Ultimately the deficit country will leave specie standard, which drops value of all assets for the exporter (except for the alread-exported specie), and likely ultimately leads to the CA balance restoration.
Long term imperialism can work as long as the periphery grows substantially faster than “mother” country. Once that limit is reached, the balance breaks as well.
In other words, the only way for a country to be a forever exporting is if it’s a small part of the world economy, with long term growth around or below world average. Anything else is unsustainable on the simple maths basis.
Prof. Pettis
You have written on this before, but this is the most detailed and understandable presentation I have seen. You should include a link to this one in future mentions of this topic. It should also be required reading for policymakers trying to sort out current economic problems.
It seems clear that the persistent surplus countries are not willing to take action, or even willing to admit that they need to do anything to get their trade into balance. It looks to me like the only hope is for the deficit countries to stand up an make it clear that they are not going to play the game like this any longer. The US could do in unilaterally if need be, but a better way would be to overlay a balanced trade paradigm on the current “free trade” rules. If it was made clear that the surplus countries will be subjected to strong trade sanctions if they do not begin to move their current accouts towards balance I think we would start to see some serious action. All that is really asked of them is to simply start spending their export earnings rather than piling them up. Last year Tim Giethner made a modest proposal to limit current accout inbalances to about 4% of GDP, which was more or less brushed off and seems to have disappeared even though the 4% figure is way to high as a long term average.
My question is this: Since it is clear that these persistent imbalances are unsustainable and heading towards a disaster (slow motion train wreck seems a good description) why do we not hear a chorus of major economists and political figures calling for strong enforceable balanced trade rules? The last one of any stature that I know of was J. M. Keynes in 1944!
How could rebalancing occur without revaluation of the renminbi? It seems the currency peg is an important lever: here is where the system is manipulated, and could be changed by policy.
But today the IMF has come out saying that the effect on the trade balance of a floating renminbi would be negligible! I haven’t read any informed critiques of this analysis, and I am very curious as to your opinion. They argue that other things are more important, but even with other measures:
“The fund said that even with a package of other reforms including liberalisation of the financial sector and encouragement of household consumption and imports, the shift in the currency would increase US growth by less than 0.15 percentage points and improve the US current account deficit by between 0.02 and 0.25 percentage points. ”
(FT today)
Are they just throwing up their hands? Whatever for?
@39 Throatwarbler
I think your point is very valid with regard to acquiring tangible industrial capability. However, I wonder if what you said can equally be applied to Japan as well? IMHO, Japan’s industrial base was even more well built and technologically advanced relative to the rest of the world economies. But it did not save the country from entering a prolonged bitter period of economic adjustment.
In fact, wouldn’t China’s case of adjustment, when it happens, be even more bitterly because of her relatively low technology and labor-centric export sectors (compared to that of Japan vs. the world)?
My take is, technological and industrial advancement has little to do with natural economic processes. After all, hasn’t economic cycles gone on as far as history can trace back?
To be more specific, I thought of some scenarios that the Chinese industries may respond to an adjustment:
Stage 1: Exports, which already ran on thin margins, grinds to halt. Unsustainable debts lead to bankruptcies and unemployment
Stage 2. Factories thrive for change, trying to re-position / re-tooling for domestic consumption. I cannot be optimistic about this part since, for such a long time these players have got used to contract manufacturing and cost-saving by every possible measures but did little to build their design/creativity/innovation muscles.
Stage 3. Assuming stage 2 can be nicely done(that Chinese enterprises are now capable of running the entire design-manufacture-marketing cycle), but this is only the very beginning because it merely provides them with a ticket to compete with their western counterparts, who by now have a much more competitive pricing(due to more “normal” exchange rate, presence/lack of subsidies or tariff protection, depending how the adjustment were brought about)
the comparison between germany and china is unfair. germany does not employ any anti consumption or industry subsidizing policy like china does.
germany is simply more competitive than the rest of europe, because it has monoply in some capital goods industries .
to reverse the competitive advantage of germany the euro area must be broken up.
there is also another way of rebalancing that you haven’t mentioned and this is the reduction of consumption in deficit countries. actually the market is just forcing this on the euro’s pephery.
but beware, europe as a whole can soon become a deficit country – to china.
because china is the only significant economy with mercantilist policies
Andao, kalasend:
Prof. Pettis addressed obliquely the story of Japan in one of his earlier posts about the mechanisms of re-adjustment in a way which to me was very insightful. The common story on the street is that after the bubble economy of the late 1980s Japan has been stagnant in terms of nominal GDP growth, and had undergone a slow grinding re-adjustment of its economy from export to one more focused on domestic consumption. The bit that this story seems to leave out is just what the effect of this adjustment has been. The thing is that Japan’s per capital GDP on a PPP basis was about 66% that of the US in the 1980s, and remains around 66% up to today, and yet, as we know the US economy has not stagnated for the last 30 years and in fact has generally lead the developed world in growth, what accounts for the Japanese “stagnation”? As Pettis has pointed out, in the 1980s the the yen/dollar rate was around 200y/d, today it is 80 y/t. In fact, Japan *HAS* essentially made the adjustment that everyone wants China to make – everything else being equal, the Japanese consumer today can afford more than twice the amount of Swiss cheese, French handbags and American pickup trucks(even the considerable amount of fuel it requires), than his forefathers 30 years ago could, and as a matter of fact Switzerland’s trade surplus with Japan has been growing prodigiously since then. I am not so sure that the re-adjustment has been as bitter for your average Japanese man on the street as the nominal GDP figures would indicate.
Which sort of brings me to my second point: the fall of the bubble economy, while traumatic and value destroying, has hardly thrown Japan back into the 1950s, and I’m not sure Japanese of today would look back upon the supercharged growth of the 1970s and 80s with a great deal of regret. I guess the question that I will put forward would be “What are the alternatives?”, or more precisely, “To which country of the world can we look to for an example of growth without boom and bust cycles?”.
Gold as a sollution !
Surpluscountries can raise there fysical goldholdings and marking them quarterly market to markt (imitating the ECB concept) as the gold is the antithesis for us$, the dollar deteriorates, while the goldprice is going up !
@Matt,
Thank you for your reply. Indeed the equity markets are absolutely tiny in comparison to other markets, such as the bond market. I wouldn’t think that’s really an option to begin with.
@I’ll call myself Ken2 today
Thank you for your reply. Couldn’t China convert its USD to other currency and use these to invest in alternative options?
If they could do that technically, it means they had an option and they CHOSE to invest in US treasuries — I continue this argument below:
@Lei Jiang
Thank you for your reply. You wrote: “but I think China’s $ reserve will mostly have to be invested in safe, liquid assets. ”
Well, this is similar to a common saying that bonds are safer than stocks, which to my understanding is not correct at all. It’s just some common misconception. It depend which and how you buy stocks, just as it depends which and how you buy bonds.
So now we might have some situation where indeed the USD will lose its value and thus China’s gamble would fail, at least partially.
What I’m trying to say is that China had a choice, and they made it. Just like they have a choice in allocating their other assets, and they choose to miss-allocate plenty of.
@Julia,
You are correct. China needs to buy something — that is the inevitable consequence of their policy. But not necessarily Treasuries. But as a practical matter, there is not enough of anything else. China is buying by the hundreds of billions and cumulatively by the trillions of dollars.
China could buy other alternatives, but not in the quantities that China needs. By undervaluing the renminbi soooo much they create such an enormous foreign exchange surplus that they either exhaust any other type of asset or drive its price so high that they guarantee themselves that they will lose money. There is a limited amount of gold; they could try to buy all the world’s gold and drive its price to $20,000 an ounce, but then it would be useless as an asset because it would be so overpriced that it would lose it’s money as soon as it sold any or even stopped buying gold.
They could buy Venezuela. (Hugo would sell — he’s already borrowed a lot more from the Chinese than he will ever repay.) Then they could do Zimbabwe. But that sort of imperialism is a true money losing bet.
Only Treasuries are around in the TRILLIONS dollars that China needs and they have already distorted the value of those (which is why U.S. interest rates are so cheap).
One other reason trade surplus countries may prefer to maintain a surplus on an ongoing basis is that potentially, it allows that country to maintain both public (government) surpluses, as well as private surpluses (savings). Norway, Germany, China at least have this option, which allows the public to save at their desired rate, without having to run a government/public deficit. Whether they actually do this or not is another question.
Vinz Klortho
@I’ll call myself Ken2 today
A little irritated by your long name, but what you explain is very similar to the ben bernanke savings glut hypothesis
@I’ll call myself Ken2 today
Thanks, I think I understand now… with such a huge surplus which is mainly a result of a very weak yuan (read: Chinese Policies) China has to buy a huge amount of debt and the only reasonable debt available in large quantities is USA debt. Naturally, by doing so, they have also significantly reduced the yield on this debt.
Prof Pettis
I loved the article and blog, but there was one point i couldn’t understand.
You say “In today’s world…there is no adjustment mechanism – specie flow or imperialism – that permits or prevents persistent current account imbalances.”
However I believe there is an adjustment mechanism, which is equivalent to that under a specie standard. If Spain persistently imports from Germany, Euros would flow from Spain to Germany. Fewer Euros in Spain would reduce Spain’s money supply and would be deflationary, the opposite would occur in Germany, and prices would adjust to correct the imbalance, just like under a specie standard.
However, today, this adjustment mechanism is delayed by international capital flows. In the old days international lending of specie currency was very limited, so deficits couldn’t be financed. Therefore it is simply the fact that German banks are able (and surprisingly willing!) to lend their surplus Euros back to Spain that enables the current account imbalance to persist.
So, in short, there is an adjustment mechanism, but it is temporarily delayed by reckless lending. The lending stops, and the imbalance corrects, only when the deficit country becomes clearly and hopelessly indebted (eg Greece), and the German banks finally wake up and are unwilling to lend any more. Would you agree with this, or is there a fault in my logic?
I think encouraging Germany/Japan/China to abandon anti-consumptionist policies is a waste of time, simply because they dont want to listen. Similarly I have little faith in banks to know when to stop lending to a deficit country (i work for a leading european bank and have seen what passes for risk management). The only realistic solution is for deficit countries to impose limits on the amount of foreign capital which enters their economy. Without financing, the current account deficit cannot exist. This would be a blunt tool, which would no doubt create inefficiencies, but the current system almost guarantees that Spain will end up like Greece, and I dont think anyone is prepared for that.
Would be interested to get feedback from other readers of this blog.
Thx
Patrick
@ Patrick,
I think the best way to solve this is to just simply default. It will be very painful for those surplus countries as their paper holding suddenly becomes worthless overnight. It will force surplus countries to realise their mistake and reverse the anti – consumer policies.
Problem is what if default crash the entire capitalist markets…
I apologize for taking so long to respond to the many interesting comments, but I only got back yesterday from a long trip.
Lei Jiang, I don’t disagree with you at all. I do think that part of the reason for the imbalances must be misguided policies in the deficit countries, but the main point I want to make is that the claim that the imbalances are caused primarily or exclusively by deficit countries is wrong. As Keynes pointed out, trade imbalances are as much or more the result of surplus country policies aimed at generating domestic employment at the expense of their trade partners. But the deficit countries must also adjust. For example, the US should impose consumption or oil taxes to reduce US consumption and force up the savings rate. Of course if there isn’t a corresponding policy in the surplus countries, such a policy would cause a sharp slowdown in global growth.
Steven H, no. I don’t think the surplus countries are interested in adjusting, and so the way the global adjustment will eventually take place is almost certainly through trade intervention. That is why I continue to be a pessimist about international trade.
Lark, the IMF reports all have to conform to political needs, but in this case I think their focus on interest rates is correct. In my opinion raising interest rates is far more important to Chinese rebalancing then raising wages or the value of the currency. The problem of course is that if they do so, we would see a surge in financial distress among SOEs and local governments as well as huge rise in the PBoC’s net indebtedness. Unfortunately the longer they wait the more painful it will be.
Patrick, remember that Spain’s net export of euros to Germany via the current account is exactly matched by Spain’s net import of euros from Germany via the capital account.
Prof Pettis
I agree that the current account and capital account must balance. But i cannot understand why gold provides better automatic adjustment mechanism than Euros. Germany and Spain cannot print Euros. If the Eurozone switched to gold instead of euros, and German banks retained their willingness to lend their surpluses to Spain (ie all things being equal), then surely the current account imbalances would persist in much the same way?
But all this is getting away from the point of your article. Are there any books you can recommend to help me understand the adjustment benefits of gold over an “external” fiat currency?
Thx
Patrick
@Michael Pettis
“Patrick, remember that Spain’s net export of euros to Germany via the current account is exactly matched by Spain’s net import of euros from Germany via the capital account.”
I believe you are wrong on this point, what the current situation is concerned, at least in terms of organic flows. By the looks of it Spanish net exports of Euros to Germany via current account, seem to be matched via Target2 (im-)balances as German and other banks are ever more unwilling to lend to the countries of the periphery. (See here: http://www.voxeu.org/index.php?q=node/6599 , here: http://www.voxeu.org/index.php?q=node/6625 and here: http://www.nber.org/~wbuiter/originalsinn.pdf )
Thanks, Professor Pettis.
I am more sympathetic to the surplus countries than Michael is. China and Germany are right to try to save, because they have an ageing population. They chose whether to do so by investing at home or by accumulating net foreign assets according to the prospective returns and risks on offer. The bonds that Germany and China bought were sold freely to allcomers by Spain and the US for their own reasons, and the bid from the likes of Germany and China meant that that the interest cost of this debt was relatively low. Unless they were willing to accept lower living standards when this debt became due, it was up to Spain and the US to make provision to service it in future either by making their own investment in net foreign assets or by domestic fixed capital formation. But, as Lei Jiang (6) says, their governments did nothing to discourage the capital inflows from being spent on consumption.
Patrick (57) raises some points that I have considered in the past. You are right that, within the eurozone, there are mechanisms that should choke off payment imbalances that are not offset by capital flows (which have stopped), but these have been circumvented by ECB loan collateral policy. You might be interested to read this blog post of mine which explains how this works: http://reservedplace.blogspot.com/2011/07/right-on-target.html If the USA had been really unhappy with Chinese purchases of treasuries, I think it would have been possible to limit them, as I explain here: http://reservedplace.blogspot.com/2008/10/just-say-no.html I can only assume that the US did not do so because they were enjoying the low yields on their debt.
As Lei Jiang mentioned, it’s the deficit countries choice to import more than they actually can afford. Second, we only lend money to borrowers who are willing and capable of repaying their debt. For the uncertainty of geeting paid back, there’s a premium which has to be charged.
US sovereign debt is clearly the largest debt market out there. Nevertheless, there are plenty of other options for investing.
Finally, isn’t it a bit oversimplified calling surplus countries “Germany”, regarding China’s pegged currency, the Yen more or less free floating, and Germany, sharing the Euro with Spain?
Dear Mr. Pettis,
Thanks for putting up these blogs, very clear thinking and very helpful.
A question though about something that I struggle to understand about Chinese Economy and usual commentary…. Oveinvinvestment led to overcapacity, but I dont see it link to inflation? Shouldn’t this lead to deflation?
I see the issue with Chinese economy as a structural issue and I think monetary action are not going to correct these imbalances within the economy. So government targetting inflation here seems meaningless to me. You have quotes inflation as a problem, should that be temporary based on what we know about the economy?
Your thoughts would be much appreciated!
@RebelEconomist. You say: “But, as Lei Jiang (6) says, their governments did nothing to discourage the capital inflows from being spent on consumption.”
This is not exactly true. In the case of UK and US, investment was low-medium and the current-account deficit mainly financed consumption, i.e. they substituted foreign savings for national savings.
However, in the case of Spain, investment was high (around 28-30% GDP) and savings were medium-high, too. The current account-deficit mainly financed excess investment, i.e. housing and infrastructure projects (high-speed rail, airports, etc.). The need for these investments is now in doubt.
I think Lei has a point. Without chronic budget deficits in the US and growth in Treasury debt, the situation would be quite different. Chinese dollar holdings would have been inflationary, regardless of where they were invested; they would either flood private capital markets or, if purchasing bonds, would force other investors elsewhere. By growing treasury debt, the US essentially provided a garbage dump for all of this foreign investment. Rebalancing and inflation were both deferred. If treasury issuance and Chinese intervention follow the same parabolic curve, then the imbalance can persist indefinitely – or a least, until someone sneezes. And then the pain of the adjustment corresponds directly to the length of time it was delayed.
I remember reading a Galbraith article from the nineties. Like many economists of the new (post-Keynesian?) school, he was thrilled by the fact that deficit spending was not “crowding out” private investment, as foreign investors were buying the increase. He urged more deficits, and as we see this prescription was followed. Krugman today argues for much the same thing. They either ignore or do not understand the fact that a capital surplus is inflationary and that sequestering this into treasury bonds is a bit like building your fireplace out of TNT. When winter arrives you find yourself in a real dilemma.
The point being, that it takes two to tango.
Sancho P.
The problem is not necessarily the volume of imports per se; it is what is imported. Capital goods are better, because they can contribute to increased income later with which to service the debt. For you, I offer an example from Mexican/US trade. If the US imports tequila from Mexico, this will not increase its income in future years (in fact, it might even make it worse!); if the US imports cement, say to construct new bridges across the Mississippi at Mineapolis, its future income might well be higher, because it saves the cost of collapsing bridges. A particular problem for the US I think is that many of the highest returning capital projects are public, against which Americans tend to have prejudice, as I tried to explain here: http://reservedplace.blogspot.com/2008/04/us-economic-policy-shot-in-foot-2.html While it may be the case that China shares some of the blame for any difficulty that the US faces with its debt burden, in my opinion, the American share of the blame is larger. No doubt the Americans would like to repudiate some of their debt to China, most likely by finding excuses to target higher inflation, but they should not pretend that this is fully justified by China’s behaviour.
Diego Mendez,
You are right – in Spain’s case, the problem was malinvestment more than consumption. However in common with the US and the UK, the Spanish government ought to have seen the danger and intervened in some way (eg by requiring larger downpayments on house purchases). But, as Lei Jiang said, western governments chose to court popularity and re-election by cheerleading and taking credit for the boom. Hopefully, the crisis will encourage voters in democracies to become better-informed and more questioning of their politicians in future.
I forgot to add, I think one motivation for China’s build-up of reserves has been that, unlike Western politicians, China’s leaders have recognised the danger of mailinvestment when investing nearly half of GDP in domestic fixed capital formation, and wisely sought to divert some Chinese saving into accumulation of overseas assets.
RebelEconomist, Pettis is more persuasive because he sets things out very logically whereas i think you are just asserting. For example he says that if China exports a large amount of capital it must run a current account surplus. This is obviously true. He then argues that PBoC intervention means very clearly that China has a policy of forcefully exporting capital, so therefore that policy must result in a trade surplus. This also seems pretty true.
He then argues that if China has a trade surplus, someone must have the offsetting trade deficit. This is too obvious to need any further explanation. Finally he points out that probably because the US is the only big enough and open enough market in which to accumulate government bonds, the US must run the trade deficit. This seems pretty true to me. The only other big market is Europe, but whenever the euro rises too much against the dollar the Europeans threaten trade action. So that just leaves the US.
Of course it might be better if the US imported capital goods rather than consumer goods, but as Pettis also explains, the trade deficit in the US means there is less, not more, incentive to invest in the US, and one way or the other there has to be a trade deficit, so unless the US government increases investment, consumption must go up.
So far all of this is just logical. it seems to me you are saying that China has the right to force the US (but not other countries, apparently) to choose between more government investment of more consumption, and if the US makes what you think is the wrong choice, then the fault must be mainly that of the US.
But then by that token you should also argue that the US has the right to force China to run a trade deficit by opening up its markets and allowing foreigners to export capital to China. But no one ever makes that argument. China has the right to force others to accept its capital exports, but the US does not have that right.
And you say that “one motivation for China’s build-up of reserves has been that, unlike Western politicians, China’s leaders have recognised the danger of mailinvestment when investing nearly half of GDP in domestic fixed capital formation, and wisely sought to divert some Chinese saving into accumulation of overseas assets.”
That is a pretty strong statement and, if true, one that will come as a surprise to most China economists. You are saying that because they saw the problem of malinvestment — I guess back in 2003 when the reserves started surging — they decided to divert some of it to foreign investment. if this were true, it is hard to explain why it was only in the last two or three years that Beijing has started to acknowledge that there may be an overinvestment problem and why there has been such an enormous acceleration of investment since 2003.
But even if it is true, which i really doubt, it still undermines your own argument. You say that the US trade deficit is caused by US, not Chinese policies, and then you say that China decided because of malinvestment at home to run a large trade surplus. This sounds like it was their policies that are at the root of the imbalances.
DM,
You are right; I don’t know that taking pressure off domestic investment has been one motivation for Chinese exchange rate policy. By “I think”, I really meant “I suspect”. Actually, I doubt whether anyone is entirely clear about the motives for China’s exchange rate policy, including the Chinese authorities themselves. Given that they have not devalued the renminbi since 1994, including 1998 when there was pressure to do so, the Chinese authorities seem to have drifted into a policy of export promotion by being wary of changing something that seemed to be working, rather than as their original plan.
But my main point is that, instead of lecturing China to boost its domestic consumption (“like us” they might add), given China’s reluctance to change, the Americans should have taken their own policy steps to either deflect the resulting reserve capital inflows ( http://reservedplace.blogspot.com/2008/10/just-say-no.html ) or live with them ( http://reservedplace.blogspot.com/2008/04/us-economic-policy-shot-in-foot-2.html ), but the Americans did neither. Moreover, I think to some extent, the driver of the US current account deficit was the securitisation boom in the US – ie the irresistible force of the US boom met the immovable object of the fixed renminbi. Note that US bond spreads to treasuries narrowed during the boom, not widened as should be expected if it had been led by reserves inflows ( http://reservedplace.blogspot.com/2008/05/enigma-inside-conundrum.html ).
Patrick, yes you are right, under the gold standard countries can balance trade flows by gold loans, but historically the mechanism was always very limited, was imposed mainly during times of significant stress in the balance of payments, and required substantial credibility. Large gold loans were pretty much limited to a handful of the most important central banks. There is also the problem of quantity – adjustments under the gold standard tended to be far more brutal because monetary easing was especially difficult during periods of stress.
James, remember that by referring to “Spain” and “German” I am simply having them stand in for all deficit and surplus countries respectively. In that case the current and capital accounts always matched perfectly.
RebelEconomist, it may very well be that China and Germany should save because of aging economies (I am skeptical), but in that case they should not be saving in a way that forces down the savings rates of other ageing countries, against whom most of their surpluses are balanced. This is just a form of beggaring thy neighbor, or perhaps more accurately, beggaring thy neighbor’s pension.
And I agree with DM. It may very well be true that the US should have increased fiscal spending on infrastructure (I believe it is true), but it is not clear to me that China or anyone else has the right to force the US into choosing between trade protection or unemployment, if it refuses to absorb China’s surplus, and infrastructure investment or consumption, if it agrees to absorb the surplus. Those were the only options open to the US when China began accumulating USG bonds on such a massive scale. After all I think most of us would disapprove of actions that forced China into a similar position. Certainly when it seemed that China was going to force that position onto Japan when it began to buy JGBs the Japanese did not react as if they should have no say in the matter. There were very strong statements about outsiders forcing up the value of the yen. If the US needs to improve infrastructure, and I think it does, it should do so regardless of Chinese trade policies.
Luhar, this is a very complicated and sticky question. In fact for much of the past two decades most economists agree that Chinese overcapacity was deflationary. In fact I think financially repressed systems have an automatic mechanism for converting CPI inflation into asset price inflation, that is why I spite of massive monetary buildup we haven’t seen persistent inflation in China.
Very good point, Diego. I know I may be swimming against the current here, but I really don’t think Spain’s policies were as bad as they have been made out to be and as responsible for the crisis as everyone seems to think. Clearly Spain needed more labor flexibility, less corruption, and many other things, but they needed these not just in the past decade but rather in the past two or three decades. The huge imbalances were created mainly in the past decade, so blaming them on Spanish distortions that stretch back to the 1970s and 1980s seems a little misguided to me. As to RebelEconomist’s argument that the problem is that “western governments chose to court popularity and re-election by cheerleading and taking credit for the boom,” once again I am very skeptical. It seems to me that Germany was no less eager to promote distortions for exactly the same reason – to court popularity and re-election. As for non-Western countries, anyone who does not believe that Chinese policies have been aimed at getting short-term support for continued CPC leadership has not spent much time in China. For obvious reasons I don’t want to go into too much detail, but the view of most Chinese is that there are very few countries in the world whose leaders have not been willing to sacrifice long-term benefits for short-term gains.
RebelEconomist, we do seem to agree on at least one point. In my book I argue that globalization cycles (as I see it there have been six major ones in the past two centuries), with their attendant trade, capital flow and technology expansions, are driven largely by sharp increases in underlying liquidity that lead to higher appetite for risk. Like you I think that liquidity expansion underpinning the latest globalization cycle was largely a consequence of securitization, especially mortgage securitizations, which converted a vast pool of illiquid assets into the most liquid assets in the world. However I am not sure why you would have expected credit spreads to widen if liquidity was driven by reserve accumulation. Credit spreads almost always narrow during periods of declining base rates, and have done so during every globalization cycle.
Actually, Michael, I see no problem in every country trying to achieve a current account surplus, like I see no problem in every firm trying to be profitable. It is of course impossible for all countries to achieve that aim, but what ought to happen is that the resulting bid for financial assets should lower the cost of funding for physical investment and so bring forth more of it, which is, in the absence of inter-planetary trade, the only way that the world as a whole (which I believe is ageing) can save more. In other words, trade in inter-temporal substitution opportunities can benefit us all. The Americans apparently used to believe this too when they were the ones with savings to invest in, say, banana plantations in Latin America, but when foreign countries want to buy their assets, it’s a different story.
Now here is where I would draw a distinction between China and Germany. In China’s case, they limit inward investment, so I do think that it would be reasonable for the Americans to respond in kind (on the capital account, rather than, say blocking imports of Chinese steel). In Germany’s case, as far as I know their capital account is open, so they seem blameless to me.
Of course, both China and Germany have to accept that their investments are risky, but that does not mean that they cannot expect America and Spain to make their best endeavours to fulfill the contract that they took on when they sold their debt into the capital market. It would be particularly reprehensible of the USA to short-change China at a time when US taxation is around a historic low proportion of GDP.
@Michael Pettis
“Patrick, yes you are right, under the gold standard countries can balance trade flows by gold loans, but historically the mechanism was always very limited, was imposed mainly during times of significant stress in the balance of payments, and required substantial credibility. Large gold loans were pretty much limited to a handful of the most important central banks. There is also the problem of quantity – adjustments under the gold standard tended to be far more brutal because monetary easing was especially difficult during periods of stress.
James, remember that by referring to “Spain” and “German” I am simply having them stand in for all deficit and surplus countries respectively. In that case the current and capital accounts always matched perfectly.”
I´m sorry, but you really can´t have it both ways: Either you really discuss Patrick´s point in terms of the Euro being in a certain way equivalent to the gold standard for Euro countries, or you give some explanation why target2 financing is market based in your opinion. It seems fairly strange to argue as if Spain and Germany were part of a(gold based) currency system in one paragraph, whilst declaring them “just standins” for the total debtor/surplus nations under a pure fiat system in the next. Why not a) comment on the valid points Patrick made in his first point, b) comment on financing via target2 or c) agreeing that trying to make an argument using two elements of a currency area is inappropriate?
It´s hard to have it both ways, and quite frankly it seems a bit disingenious.
rebeleconomist,
Given the methods that you espose in your “just say no” blog: http://reservedplace.blogspot.com/2008/10/just-say-no.html , I find it strange that you have not commented on the paper by Kenneth Austin that Prof. Pettis cites above. Austin notes: “..the US can unilaterally end…its colonial status
as importer of Asia’s surplus savings. It can do so by restricting the use
of the dollar as a reserve currency.” He argues that if U.S. took such measures: “US’s ability to manage its economy would improve.” Do you agree?
Am I correct in assuming 1) that you don’t agree that it would actually benefit the U.S. and 2) you believe that since the U.S. doesn’t take such measures, Chinese exchange rate policy is not actually against American interests?
Please respond because I am still not clear what you are actually are trying to say.
@RebelEconomist
“It would be particularly reprehensible of the USA to short-change China at a time when US taxation is around a historic low proportion of GDP.”
This line of reasoning seems too reductive: the US is no more short-changing China than vice versa, seeing as how China, in a bid for short-term gain, has forced the US into a set of unsavory options, ranging from protectionism to high domestic unemployment. The only blame that could be assigned to the US is that it has, if anything, been far too reticent to respond in kind to China.
By asserting that it is ok, or even ideal, for all countries to pursue surpluses, you equate sovereign states with businesses seeking profitable quarters (I do not agree completely, since such an analogy seems to view a surplus as “winning” and a deficit as “losing,” but I do think you are partially correct in drawing parallels between government and business). If you were to continue that business analogy, you could just as easily point out that businesses, unlike individuals or households, routinely borrow money that they cannot repay, and do not make repaying said debt a top priority. The simplistic moral calculus that concludes that the US would be advocating “reprehensible” behavior by not repaying China fails to account for how sovereign states do not behave like virtuous (or unethical) persons interacting with their bankers:
http://motherjones.com/mojo/2011/07/government-budget-vs-family-budget
@James T
I think you should give Michael a break about understanding TARGET2. It is quite difficult to get to the bottom of! As far as I know, I am the only analyst who has emphasised the role of ECB collateral policy, which I think is key. The chronic imbalances that Hans Werner Sinn has noted are not merely normal in a monetary union; they would be unlikely to develop in the Federal Reserve System. I tried to make this case over at VoxEU, but they don’t seem to take comments.
@I’ll call myself Ken2 today
I cannot read the Austin paper because I am not a subscriber to the journal. My position is that the US should have attempted to accommodate the reserves inflows first, and only resorted to reserves control against the Chinese (and any other reserves accumulators with restricted capital accounts) if the accommodation policy failed. And yes, I do think that the US could have used the reserves inflows to its advantage: http://reservedplace.blogspot.com/2008/09/mad-about-mercantilism.html Although a second-choice policy, reserves control could have made it easier to manage the US economy, by holding up US long term interest rates.
Of the first choice policies, the US foreign exchange reserves policy has been particularly negligent. The US has had roughly the same amount of foreign currency reserves for years, and the US authorities seem to do no objective analysis of what the right size of their reserves is (while offering their advice to other countries) in the face of growing international trade and financial flows. They could have diverted some if not all of the reserves inflows into their own reserves accumulation in euros, yen, sterling, etc, which besides making provision to repay the Chinese, would have spread the impact of China’s exchange rate policy to other countries and hence given the US support against China. But no, the Americans failed to organise themselves to resist consuming the resource inflows. And they have been like this for years – the Triffin paradox was incorrect; under Bretton Woods, the Americans were supposed to back dollars with gold. The USA has been like a bank manager who spent the deposits coming into his bank, arrogantly assuming that his own growing wealth would enable him to find a way to repay if the depositor asks for them back.
@Michael
Thanks for hosting this discussion!
@I’ll call myself Ken2 today
I did respond but my comment seems to have been lost. I cannot read Austin’s paper because I do not subscribe to the journal in which it is published. Briefly, I think that reserves inflows are potentially advantageous for the US (a point I argue here: http://reservedplace.blogspot.com/2008/09/mad-about-mercantilism.html ) so my first choice would be for the US to try to accommodate them, and only if that fails in the sense that the US is still having trouble managing the effects of the reserves inflows in its economy, resort to the second choice of reserves control, applied only to those countries which restrict inflows on their own capital account.
@rebeleconomist
You can get the Austin paper by following the link above and accepting the free one-week trial subscription directly to the right. Or just go to: http://www.world-economics-journal.com/Security/TrialSign-Up.aspx and then follow Michael’s link. You can download whatever you like from World Economics.
I can’t see how your first choice policy of the US spreading the misery by buying euros and yen would have ultimately been very effective. It would do nothing except infuriate America’s usual allies.
But your point:
“The US has had roughly the same amount of foreign currency reserves for years, and the US authorities seem to do no objective analysis of what the right size of their reserves is (while offering their advice to other countries) in the face of growing international trade and financial flows.”
misses one of the beauties of floating exchange rates: It eliminates intervention in the forex market. Whatever forex the central bank has when a country floats just gets stored in the attic. You really don’t want to sell it because then you would be intervening, leading to larger trade surpluses. Your stock of forex is just one more museum exhibit in the capital.
But ultimately, you imply that the best thing for the US would be to stop China’s reserve purchases. The question is how.
Download the Austin piece and get back to us.
@Alex
Actually, I was surprised at how that MJ article fails to make the case that the US is different from a family or a business – better arguments might have been that a country cannot be liquidated and, in the case of the USA, is monetarily sovereign. If the US had wisely invested its reserves inflows, it would have earning assets to show for them, just like a family using a mortgage to buy a house. Similarly, business are supposed to take on debt to finance projects rather than just pay their employees more (OK, idealistic, I know!), and if they never pay down debt, it is because they can roll it over rather than because they default. And if a business does default, the owners of the business are liable to lose their stake.
@I’ll can myself Ken2 today
I dislike the idea of a trial subscription to a journal I have no intention of subscribing to just to get one article. Considering that Kenneth Austin seems to be a public employee, it’s a bit annoying that his work is not freely available anyway. Nobody pays me to write what I do, but I don’t mind because I care more about getting my ideas across.
I agree that US reserves accumulation in euros and yen might have annoyed the eurozone and Japan sometimes (not in 2000 and 1998 respectively), but if the US had explained the purpose of the policy, it would have focussed attention more on China than the US, and considering that both the eurozone and Japan have quite large dollar reserves, it would be hard for them to complain anyway. If the US claims that it does not need reserves because it allows its exchange rate to float, the intervention involved in selling them off would have been consistent with its “stong dollar policy”. No, I think the true rationale for the frozen US reserves “policy” is fear of getting blamed for any difficulties arising from any change.
So what the world needs for ‘sustainable trade’ is a tariff policy that compensates for the mispricing of currencies, regardless of the reason why they are mispriced — ie, deliberately mispriced to stimulate trade, or accidentally mispriced, because of investment flows.
A country that consistently exports 10% more than it imports, in goods and services, (“China/Germany”) needs to have a 10% tariff imposed on it by all of its trading partners. It’s currency is self evidently set too low, and the 10% tariff would compensate for this.
Similarly, a country that consistently imports 10% more than it exports, (“US/Spain”) should impose a 10% across the board tariff on all imports. It’s currency is self evidently set too high, and the 10% tariff would compensate for this.
This would work even if the countries had the same currency, saving Spain and Germany the pain and inconvenience of dissolving the Euro.
@ Lei Jiang (“The pro-consumption policies in deficit countries are the choices rooted in their political systems. The elected officials are mostly care about getting elected in the next election. Therefore they do whatever pleases their constituents.”)
Your suggestion that a democracy tends to go on spending binges is too generalizing. Germany is a democracy after all, and still a surplus country, as actually used as an example in this blogpost.
i think you are quite wrong about germany.
the german government has been pushing for debt restructuring for peripheral governments involving losses for the banks that have lent to them, including german banks.
it is france and the ecb that have been opposing debt forgiveness. france is concerned about the cost of bailing out its own banks. the ecb is worried about the destruction of its balance sheet and resulting loss of independence.
In a closed system this argument would be classically true. And it is unfortunate that the EU tends to operate as a ‘closed’ system: most of the trade is between member countries, which has led to the current crisis. Unless trade ‘borders’ expand, your argument holds. It is only by spreading a EU country’s surplus across say several non member country counterpart ‘deficits’ that the problem will be alleviated. However, there is a limit to how many countries out there are interested in say rolls royce engines. Would Afric buy harvester combines? The problem is that the West has ceded high margin low value goods production to developing economies, leaving itself with a limited market for its niche high end goods and services
The whole isse boils down to the flaws of the Euro. Would “Spain” not be part of the EMU and kept the Pesetas, their currency would have depreciated significantly over the last 10 years vs the Euro. Their interest rates would stay above 10% and Spain would be perceived as a “cheap” country to visit and potentially produce in. With time, Spain would attract capital and potentially improve their competitiveness on the world market. The Euro will eventually crumble when domestic politics in Northern Europe become hostile and politicians realize finally that they will be sacked.
I think that what you published was actually very logical.
However, what about this? what if you composed a catchier title?
I ain’t suggesting your content isn’t solid, however suppose you added
a post title that grabbed a person’s attention? I mean Current account dilemma is kinda vanilla. You ought to glance at Yahoo’s front
page and note how they write post titles to get people to open
the links. You might add a video or a picture or two to grab people interested
about what you’ve got to say. Just my opinion, it would make your website a little livelier.