<![CDATA[博客-财经网-名家博客-迈克尔•佩蒂斯 最近更新20篇文章]]> <![CDATA[博客-财经网]]> <![CDATA[Syriza and the French indemnity of 1871-73]]> European nationalists have successfully convinced us, against all logic, that the European crisis is a conflict among nations, and not among economic sectors. Today’s Financial Times has an articlediscussing the travails of Greece’s new Finance Minister, Yanis Varoufakis as he takes on Germany:

In a small but telling sign of the frosty relations between Berlin and the new Greek government, the German finance ministry last week criticised Mr Varoufakis for failing to follow through with a customary courtesy call following his appointment. Mr Schäuble, meanwhile, has warned Greece not to attempt to “blackmail” Berlin with demands for debt relief.

This is absurd. The European debt crisis is not a conflict among nations. All economic systems— and certainly an entity as large and diverse as Europe— generate volatility whose balance sheet impacts are mediated through different political and economic institutions, among which usually are domestic monetary policy and the currency regime. With the creation of the euro as the common currency among a group of European countries, monetary policy and the currency regime could no longer play their traditional roles in absorbing economic volatility. As a result, for much of the euro’s first decade, a series of deep imbalances developed among various sectors of the European economy. Because Europe’s existing economic and political institutions had largely evolved around the national sovereignty of individual countries, and also because the inflation and monetary histories of individual countries varied tremendously before the creation of the euro, it was probably almost inevitable that these imbalances would manifest themselves in the form of trade and capital flow imbalances between countries.(1)

We have a great deal of experience in modern history with the kinds of imbalances from which Europe suffered and continues to suffer, and from the historical precedents three things are clear. First, the imbalances that led eventually to the current crisis had their roots in hidden transfers between different economic sectors within Europe, and not between countries. It is only because of deep institutional differences among the member countries that these imbalances manifested themselves largely in the form of trade imbalances between the different countries in Europe. These hidden transfers artificially forced up the savings rates in some countries and, for reasons that I havediscussed elsewhere, it is a matter of necessity, well understood in economics (although too often forgotten by economists), that artificially high savings rates in one part of an economic system must result in higher productive or non-productive investment (in advanced countries usually the latter) or artificially low savings in another part of that system.

Second, deep distortions in savings and investment historically have almost always led to an unsustainable increase in debt, and Europe was no exception. For many years European debt has risen faster than European debt-servicing capacity, but the gap between the two has not been recognized and written down, and instead manifests itself in the form of excessively high and rising debt burdens whose costs have eventually to be assigned.

Third, and most worryingly, it has always been easy for extremists and nationalists to exploit the grievances of the various economic groups to distort the meaning of the crisis. One way is to transform it into a class conflict and another way is to transform it into a conflict among member states. Resolving a debt crisis involves nothing more than assigning the losses. In the current crisis these costs have to be assigned to different economic sectors within Europe, but to the extent that the assignation of costs can be characterized as exercises in national cost allocation, it is easy to turn an economic conflict into a national conflict.

Most currency and sovereign debt crises in modern history ultimately represent a conflict over how the costs are to be assigned among two different groups. On the one hand are creditors, owners of real estate and other assets, and the businesses who benefit from the existing currency distortions. One the other hand are workers who pay in the form of low wages and unemployment and, eventually, middle class household savers and taxpayers who pay in the form of a gradual erosion of their income or of the value of their savings. Historically during currency and sovereign debt crises political parties have come to represent one or the other of these groups, and whether they are of the left or the right, they are able to capture the allegiance of these groups.

Except for Greece, in Europe the main political parties on both sides of the political spectrum have until now chosen to maintain the value of the currency and protect the interests of the creditors. It has been the extremist parties, either on the right or the left, who have attacked the currency union and the interests of the creditors. In many cases these parties are extreme nationalists and oppose the existence of the European Union. If they succeed in taking control of the debate, the European experiment will almost certainly collapse, and it will take decades, if ever, for a European union to revive.

But while distortions in the savings rate are at the root of the European crisis, many if not most analysts have failed to understand why. Until now, an awful lot of Europeans have understood the crisis primarily in terms of differences in national character, economic virtue, and as a moral struggle between prudence and irresponsibility. This interpretation is intuitively appealing but it is almost wholly incorrect, and because the cost of saving Europe is debt forgiveness, and Europe must decide if this is a cost worth paying (I think it is), to the extent that the European crisis is seen as a struggle between the prudent countries and the irresponsible countries, it is extremely unlikely that Europeans will be willing to pay the cost. As my regular readers know, I generally refer to the two different groups of creditor and debtor countries as “Germany” and “Spain”, the former for obvious reasons and the latter because I was born and grew up there, and it is the country I know best. I will continue to do so in this blog entry.

It is a horrible irony that while the view that the European crisis is a conflict between prudent Germany and irresponsible Spain could easily tear apart the European experiment, it terribly muddles Europe’s actual experience and may create a false impression of irresponsibility. To see why, it is useful to start with a little history. Nearly 150 years ago Spain’s “Glorious Revolution” of 1868 saw the deposition of Isabella II and the collapse of the first Spanish Republic. More importantly for our purposes it also unleashed within continental Europe a conflict over the succession to the Spanish throne which ultimately, through a series of circuitous events, resulted in France’s declaration of war on Prussia in July 1870. This was widely seen in France as a chance partially to even the score over Prussia’s victory during the Napoleonic wars, but in the end France’s revanchist fantasies were frustrated. By early 1871, the French army  was roundly defeated by Prussia, which during that time had unified the various German states as the German Empire under the Prussian king.

There were at least two important results of France’s military defeat. Of minor importance for the purpose of my blog entry, but interesting nonetheless for those obsessed with modernism and with France’s late 19th Century cultural history, like me, the Franco-Prussian War will always be remembered for its role in the subsequent creation and collapse of the Paris Commune. This event left its mark on the thinking of many cherished artists and intellectuals, from Manet and Rimbaud to Proudhon and Haussman.

But the other, to me, very interesting and far more relevant consequence was the French indemnity. As part of the privilege of conquest and as a condition for ending the occupation of much of northern France, Berlin demanded war reparation payments originally proposed at 1 billion gold francs but which eventually grew to an astonishing 5 billion, at least in part because of an explicit decision by Berlin to impose a high enough burden permanently to cripple any possible French economic recovery.

To give a sense of the sheer size of this payment, usually referred to in the literature as the French indemnity, this was equal to nearly 23% of France’s 1870 GDP.(2) Germany’s economy at the time,according to Angus Maddison, was only a little larger than that of France, so Germany was the beneficiary of a transfer over three years equal to around 20% of its annual GDP. This is an extraordinarily large transfer. I believe the French indemnity was the largest reparations payment in history — German reparations after WWI were in principle larger but I don’t think Germany actually paid an amount close to this size, and certainly not relative to its GDP.

Transfer beneficiary

Astonishingly enough France was able to raise the money very quickly, mostly in the form of two domestic bond issues in 1871 and 1872, which were heavily over-subscribed. One of the most complete studies of the French indemnity, I think, is a booklet by Arthur Monroe published in 1919.(3)  According to Monroe, the first issue of 2 billion in perpetual rentes was issued in June 1871, a mere 48 days after the treaty was signed, and was heavily oversubscribed. The second issue was even more successful:

Thirteen months after announcing the first loan the government opened subscriptions for a second, this time for three billions, again in 5 per cent rentes, but issued at 842. The response to this was astounding, for more than twelve times the amount desired was subscribed, more than half of the offers coming from foreign countries.

Monroe goes on to note that “it is no small compliment to the credit of France at this time to note that about one-third of the foreign subscriptions were from Germany,” so when we think about the net transfer to Germany, it was less than 5 billion francs. Although Monroe says that more than half the subscriptions came from outside France, and one-third of those were German, with twelve times oversubscription there is no way for me to estimate how much was actually allocated to German purchasers so I have no estimate for the amount by which the 5 billion should be adjusted.

The payments were made in the form of bills of exchange and to a lesser extent gold, silver, and bank notes, and Berlin received the full payment in 1873, two years before schedule. It was during this time that Germany went fully onto the gold standard, and obviously enough the massive indemnity made this not only possible but even easy. It also guaranteed currency credibility almost from the start, and it may jolt modern readers to know that at the time monetary credibility was not assumed to be part of the German DNA, so the additional credibility was welcome.

What does all of this have to do with Syriza? A few weeks ago I was discussing with a group of my Peking University students Charles Kindleberger’s idea of a “displacement”, and I proposed, as does Kindleberger, that the 1871-73 French indemnity is an especially useful example of a displacement from which we can learn a great deal about how financial crises can be  generated.(4)  It then occurred to me that the French reparations and their impact on Europe could also tell us a great deal about the euro crisis and, more specifically, why by distorting the savings rate wage policies in Germany in the first half of the last decade would have led almost inexorably to the balance of payments distortions that may eventually wreck the euro.

It is a nice accident that the French indemnity accelerated Germany’s adoption of the gold standard, because massive transfer payments from Germany to peripheral Europe were probably necessary for many of these countries to adopt the euro, in some  ways their own version of the gold standard. Before jumping into why I think the French indemnity is relevant to the Greek crisis, I want to make three quick points:

1.  I went into more detail on how France raised the money than might at first seem necessary for the purpose of this blog entry because it actually illustrates a potentially useful point. In the first third of my 2001 book,(5) I discussed extensively the historical role of global liquidity on the evolution of national balance sheets and sovereign debt crises. One important point is to distinguish between financial crises that occur within a globalization cycle and those that end a globalization cycle. Whereas the latter are often devastating and mark the end for many years of economic growth, the former — like the 1994 Tequila crisis or the 1997 Asian crisis, or even the 1866 Overend Gurney crisis — may seem overwhelming at first, but markets always recover far more quickly than most participants expect. When markets are very liquid, and in their leveraging-up stage, they can absorb large debt obligations easily, and because they can even turn these obligations into “money”, they almost seem to be self-financing.

The 1858-73 period was one such “globalization period”, with  typical “globalization” characteristics: explosive growth in high-tech communications and transportation (mainly railways), soaring domestic stock and real estate markets, booming international trade, and a surge in outflows of capital from the UK, France, the Netherlands and other parts of Europe to the United States, Latin America, the Far East, the Ottoman Empire, and other financial “frontiers”. I would argue that this is why, despite Berlin’s expectation that the indemnity would cripple the French economy, it was surprisingly easy for France to raise the money and for its economy to continue functioning. Germany, similarly, struggled over many aspects of the WWI reparations, but after 1921-22, when global markets began their decade-long globalization boom, driven by extraordinarily high US savings (and characterized by the familiar globalization sequence: electrification of American industry, the spread of telephones, automobiles, radios, cinema, and other communications and transportation technologies, booming international trade and capital flows, the Florida real estate mania, stock market booms, and, of course, the rise to fame of one Charles Ponzi), Germany found it relatively easy to raise the money that famously became part of the reparations recycling process — until, of course, the 1930-31 global banking crisis, after which Germany was forced into default. This may be relevant as we think about any possible future European sovereign bond restructuring. Any attempts to assess their impacts based on historical precedents must distinguish between periods of ample liquidity and the radically different periods of capital scarcity. Once the liquidity contraction begins, every debt restructuring will be brutally painful, unlike now when they are absorbed almost without a thought.

2.  I explain in my book that the French indemnity actually increased global liquidity by expanding the global supply of highly liquid “money-like” assets. Of course Germany’s money supply increased by the amount of the transfer (not the full amount, because part of the subscriptions actually came from Germany), but this was not offset by an equal reduction in France’s money supply. The creation of a huge, highly liquid, and highly credible instrument, the two French bond issues, involved the creation of “money” in the Mundellian sense. While the transfer of money from France to Germany might have seemed systemically neutral, in fact it resulted in a systemic increase in global “money”.

3.  From an “asset-side” analysis, as I discuss in my January 21 blog entry, the transfer of capital over three years from France to Germany equal to more than 20% of either country’s annual GDP would have had very predictable impacts — they should have been very negative for France, as Berlin expected, and very positive for German. In fact the actual results were very different. This is because there are monetary and economic conditions under which liability structure matters much more, and conditions under which it matters much less. Economists and the policymakers they advise are too quick to ignore these differences, perhaps because there is not as well-formulated an understanding of balance sheets in economics theory as in finance theory, so that when someone like Yanis Varoufakis proposes that there are ways in which partial debt forgiveness increases overall economic value, instead of merely creating moral hazard, worried economists often recoil in horror, while finance or bankruptcy specialists (and an awful lot of hedge fund managers) shrug their shoulders at such an obvious statement.

It is mainly the third of the above three points that is relevant for the current discussion about European sovereign obligations. One might at first think that France’s indemnity, at nearly 23% of GDP over three years, might have been devastating to the economy. It certainly left France with a heavy debt burden, but its immediate economic impact was not nearly as bad as might have been expected. Wikipedia’s assessment is pretty close to the consensus among historians:

It was generally assumed at the time that the indemnity would cripple France for thirty or fifty years. However the Third Republic that emerged after the war embarked on an ambitious programme of reforms, introduced banks, built schools (reducing illiteracy), improved roads, spreading railways into rural areas, encouraged industry and promoted French national identity rather than regional identities. France also reformed the army, adopting conscription.

Far more interesting to me is the impact of the indemnity on Germany. From 1871 to 1873 huge amounts of capital flowed from France to Germany. The inflow of course drove the obverse current account deficits for Germany, and Germany’s manufacturing sector struggled somewhat as an increasing share of rising domestic demand was supplied by French, British and American manufacturers. But there was a lot more to it than mild unpleasantness for the tradable goods sector. The overall impact in Germany was very negative. In fact economists have long argued that the German economy was badly affected by the indemnity payment both because of its impact on the terms of trade, which  undermined German’s manufacturing industry, and its role in setting off the speculative stock market bubble of 1871-73, which among other things unleashed an unproductive investment boom and a surge in debt.

Do capital inflows cause speculative frenzies?

As Germany began to absorb the inflows, its current account surplus of course reversed into deficits, which by definition means that there was a large and growing excess of investment over savings. Part of this was caused by rising German consumption, but much of it was caused by surging investment. Unlike in peripheral Europe 135 years later, the capital inflows were not mediated through commercial banks into the pockets of households, businesses, and local governments but rather ended up wholly in the hands of Berlin. Germany in the 1870s had an opportunity denied to peripheral Europe in the 2000s, in other words, to control the use of the massive transfer. I will get back to this point a little later.

As money poured into Germany the German economy boomed, along with German consumption, investment (a growing share of which went into projects at home and abroad that turned out in retrospect to be overly optimistic), and into the Berlin and Viennese stock markets. By early 1873 more experienced German, Austrian and British bankers were quietly warning each other of a speculative mania, and they were right. The stock market frenzy culminated in the 1873 global stock market crisis, which began in Vienna in May, shortly after the beginning of the 1873 World Fair, and rapidly spread throughout a world brimming with liquidity (a large part of the first French indemnity payments went directly to London to pay outstanding German obligations). By September the crisis reached the United States with the collapse of Jay Cooke and Company, one of the leading US private banks, and for the first time in history the New York Stock Exchange was forced to close, for ten days. The subsequent global “Long Depression”, which lasted until 1896, was felt especially severely in Germany, one of whose first reactions was the collapse of the railway empire of Bethel Henry Strousberg, a  major industrialist at the time whose prehistory included a stint in jail for absconding from a previous job as financial agent with other people’s money (petty criminals who become industrial magnates seem to be another characteristic of globalization periods).

Within a few years of the beginning of the crisis attitudes towards the French indemnity had shifted dramatically, with economists and politicians throughout Germany and the world blaming it for the country’s economic collapse. In fact so badly was Germany affected by the indemnity inflows that it was widely believed at the time, especially in France, that Berlin was seriously contemplating their full return. The great beneficiary of French “largesse” turned out not to have benefitted any more than Spain had benefitted from German largesse 135 years later.

This is interesting. The German economy responded to French capital inflows in almost the same way that several peripheral European economies responded to  large German capital inflows 135 years later. It might seem an unfair comparison at first because the 1871-73 transfer to Germany was huge, but it turns out that the magnitude of the French transfer into Germany was broadly similar, in fact probably smaller, to the inflows into peripheral Europe. By the way I should point out that I use Spain to represent peripheral Europe not just, as I stated earlier, because I was born and grew up there, and so know it well, but also because Spanish government polices were in many ways among the most “responsible” in Europe, and so cannot really be blamed for the aftereffects. Spain’s debt and its fiscal accounts were far stronger than the European average and stronger than those of Germany in most respects.

It is hard to imagine that the amount of inflows into Germany from 1871 to 1873 could have been comparable to the inflows Spain experienced, but if anything they were actually smaller. Here is why I think they were. From 2000-04 Spain ran stable current account deficits of roughly 3-4% of GDP, more or less double the average of the previous decade. Germany, after a decade of current account deficits of roughly 1% of GDP, began the century with slightly larger deficits, but this balanced to zero by 2002, after which Germany ran steady surpluses of 2% for the next two years.

Everything changed around 2005. Germany’s surplus jumped sharply to nearly 5% of GDP and averaged 6% for the next four years. The opposite happened to Spain. From 2005 until 2009 Spain’s current account deficit roughly doubled again from its 3-4% average during the previous five years. The numbers are not directly comparable, of course, but during those four years Spain effectively ran a cumulative current account deficit above its previous 3-4% average of roughly 21-22% of GDP. Seen over a longer time frame, during the decade it ran a cumulative current account deficit above its earlier average of roughly 31-32% of GDP.

These are huge numbers, and substantially exceed the French indemnity in relative terms. Of course the current account deficit is the obverse of the capital account surplus, so this means that Spain absorbed capital inflows above its “normal” absorption rate equal to an astonishing 21-22% of GDP from 2005 to 2009, and of 31-32% of GDP from 2000 to 2009. However you look at it, in other words, Spain absorbed an amount of net capital inflow equal to or substantially larger than Germany’s absorption of French reparations during 1871-73. It is not just Spain. In the 2005-09 period a number of peripheral European countries experienced net inflows of similar magnitude, according to an IMF study, including Portugal, Greece and several smaller east European countries.

By the way in principle it isn’t obvious which way causality ran between capital account inflows and current account deficits (the two must always balance to zero). In 1871-73 it is obvious that German capital inflows drove current account deficits. In 2005-09 European countries might similarly have run large current account deficits because of the capital inflows imposed upon them, but it is also possible that they had to import capital by eagerly borrowing German money in order to finance their large current account deficits. To put it differently, German money might have been “pushed” into these countries, as the “blame Germany” crew has it, or it might have been “pulled” in, by the need to finance their spending orgies, as the “blame anyone but Germany” crew insist. For those who prefer to think in more precise terms, Germany either created or accommodated the collapse in Spanish savings relative to Spanish investment. For those — including, distressingly enough, most economists — who believe a country’s savings rate must be driven only, or mainly, by domestic household preferences, please refer to “Why a savings glut does not increase savings“.

The structure of the balance of payments itself does not tell us conclusively which caused which, German outflows or Spanish inflows, and no one doubts that there was a strong element of self-reinforcement that was an almost automatic consequence of the payments process, as I have discussed in the January 21 entry on this blog. If it were the latter case, however, it would be an astonishing coincidence that so many countries decided to embark on consumption sprees at exactly the same time. It would be even more remarkable, had they done so, that they could have all sucked money out of a reluctant Germany while driving interest rates down. It is very hard to believe, in other words, that the enormous shift in the internal European balance of payments was driven by anything other than a domestic shift in the German economy that suddenly saw total savings soar relative to total investment. I have discussed many times before what happened in Germany that resulted in the savings distortion that convinces me that the flows originated in Germany, as it has many others.

What is interesting is how similar the consequence of the inflows were even though Berlin was able to control the disbursement of the inflows in a way of which Madrid could only dream. And yet from 1871 to 1873 the German economy experienced one of the most dramatic stock market and real estate booms in German history, and although the flow of funds into government coffers rather than through banks to businesses and households ensured that the subsequent rise in German consumption was not nearly as extreme as it was in Spain, Germany did engage in a frenzy of investment at home and abroad in which a substantial share of the inflows was effectively wasted in foolish investment. Of course unlike Spain today, there never was any question about Germany’s obligation to repay the transfer. It had come, after all, in the form of reparations demanded by a victorious army, and not in the form of loans. In fact it took the massive US lending to Germany in the 1920s for German investment misallocation to lead to wholesale default on external debt.

Syriza’s challenge

It is useful to remember this history when we confront the consequences of Greece’s recent elections. Syriza’s victory in Greece has reignited the name-calling and moralizing that has characterized much of the discussion on peripheral Europe’s unsustainable debt burden. I think it is pretty clear, and obvious to almost everyone, that Greece simply cannot repay its external obligations, and one way or another it is going to receive substantial debt forgiveness. There isn’t even much pretence at this point. This morning financial advisor Mish Shedlock, sent me (as a joke? as a sign of despair?) German newspaper Zeit‘s interview with Yanis Varoufakis entitled “I’m the Finance Minister of a Bankrupt Country”.

Even if the question of who is to “blame”, Greece or Germany, were an important one, the answer would not change the debt dynamics. It would take the equivalent of Ceausescu’s brutal austerity policies in Romania, which were imposed during the 1980s in order for the country fully to repay its external debt, to resolve the Greek debt burden without a write-down. Given that Ceausescu’s policies led directly to the 1989 revolution, which culminated in both Ceausescu and his wife being executed by firing squad, the reluctance in Athens to imitate Romania in the 1980s is probably not surprising.

But to say Greece simply cannot repay isn’t the end of the story. As Europe moves towards a more rational debt policy with Greece, I would say that there are three important things to remember:

1.  There is an enormous economic cost, not to mention social and perhaps political, to any delay. I worry about the terrifyingly low level of sophistication among policymakers and the economists who advise them when it comes to understanding balance sheet dynamics and debt restructuring. Greece’s debt overhang imposes rising financial distress costs and increasingly deep distortions in the institutional structure of the economy over time, and the longer it takes to resolve, the greater the cost.

I think most analysts understand that costs will rise during the restructuring process. I am not sure they understand, however, that delays will impose even heavier costs during the many years of subsequent adjustment. There is a lot of bad blood and recrimination among the various parties. I suspect that some of those who oppose Syriza are probably revolted by the thought that a rapid resolution of the Greek crisis would rebound to Syriza’s credit, but they must understand that dragging out the restructuring process will impose far greater long-term costs on the Greek people than they think.

My friend Hans Humes, from Greylock Capital, has been involved in more sovereign debt restructurings than I can remember, and he once told me with weary disgust that while it is usually pretty easy to guess what the ultimate deal will look like within the first few days of negotiation, it still takes months or even years of squabbling and bitter arguing before getting there. We cannot forget however that each month of delay will be far more costly to Greece and her people than we might at first assume.

2.  From what I read, much of the focus of the restructuring will be aimed at determining an acceptable and manageable debt-servicing cashflow for Greece. There is a mistaken belief that this is the only “real” variable that matters, and the rest is cosmetics. I don’t agree. Greece’s nominal debt structure will not just affect the debt-servicing cashflows but will also determine future behavior of economic agents.

There are at least two important functions of an economic entity’s liability structure. One is to determine the way operating profits or economic growth is distributed among the various stakeholders, or, put differently, to determine economic incentive structures. The other is to determine the way external shocks are absorbed. This is why the restructuring process is so important and can determine subsequent economic growth. The face value and structure of outstanding debt matters, and for more than cosmetic reasons. They determine to a significant extent how producers, workers, policymakers, savers and creditors, alter their behavior in ways that either revive growth sharply or slowly bleed away value. Incentives must be correctly aligned, in other words, so that it is in the best interest of stakeholders collectively to maximize value (this rather obvious point is almost never implemented because economists have difficulty in conceptualizing and modelling reflexive behavior in dynamic systems). Rather than let economists work out the arithmetic of the restructuring based on linear estimates of highly uncertain future cashfllows, whose values are themselves affected by the way debt payments are indexed to these cashflows, Greece and her creditors may want to unleash a couple of options experts onto the repayment formulas and allow them to calculate how volatility affects the value of these payments and what impact this might have on incentives and economic behavior.

3.  In fact the overall restructuring must be designed so that the interests of Greece, the producers who create Greek GDP, and the creditors are correctly aligned. To date sovereign debt restructurings have almost never included the instruments that reflect the instruments in corporate debt restructurings that accomplish this alignment of interests, largely because these instruments have not been “invented”. Among other things the negotiating committee might want to dust off the GDP warrants that were included in Argentina’s last debt restructuring.

If the restructuring is well designed, within a year of the restructuring I think we could easily see Greek growth surprise us with its vigor. I was delighted to see that Greece’s new Finance minister agrees. An article in Monday’s Financial Times starts with the claim that “Greece’s radical new government revealed proposals on Monday for ending the confrontation with its creditors by swapping outstanding debt for new growth-linked bonds, running a permanent budget surplus and targeting wealthy tax-evaders.” Today’s Financial Times has an article by Martin Wolf that mentions the benefits of “a growth linked bond”. In The Volatility Machine I spend chapters explaining how to create liability structures that minimize external shocks, align the interests of creditors and citizens, and improve the quality of payments for creditors, and I show why these make a restructuring much more successful for all parties concerned. This is just basic finance theory. Yanis Varoufakis should really take the lead in designing an entirely new form of sovereign debt restructuring, not just for Greece but for the many countries, in Europe and elsewhere, that will soon follow it into default.

Enough people seem to hate or fear Syriza that there will be little attempt to approach Greece’s problems with enough imagination to give either party what it needs, but in fact with the right cooperation, imagination, and intuitive understanding of how balance sheet structures change overall value creation, a Greek debt restructuring could leave both sides far better off than either side might imagine. Of course if done right this matters far more than for just its impact on the Greek economy. While everyone probably agrees that Greece simply cannot proceed without debt forgiveness, less widely agreed, but no less obvious in my opinion, is that there are a number of other European countries that also need debt forgiveness if they are to grow. Because I was born and grew up in Spain, and my French mother founded and ran a successful business there which my family and I still own, I am confident that I know the country well enough to say that even with some impressive reforms having been implemented under Mariano Rajoy, Spain is nonetheless one of these countries. I suspect that many other countries including Portugal, Italy, and maybe even France are too.

I also know, however, that Spanish debt prospects are an extremely sensitive and emotional topic, and I will be roundly condemned for saying this. Today’s Financial Times has a very worrying article explaining why Madrid wants to be seen among the hardliners in opposing a rational treatment for Greece: “when it comes to helping Greece, there will be no such thing as southern solidarity or peripheral patronage.” This is the reverse of what it should be doing. In an article for Politica Exterior in January 2012, I actually proposed, albeit without much hope, that Spain take the lead and organize the debtor countries to negotiate a sustainable agreement, but in its fear of Podemos, the Spanish equivalent of Syriza, and its determination to be one of the “virtuous” countries, it strikes me that Madrid is probably moving in the wrong direction economically. Ultimately, by tying itself even more tightly to the interests of the creditors, Rajoy and his associates are only making the electoral prospects for Podemos all the brighter.

As it is, and for reasons that may have to do with recent history, Francisco Franco, and the psychological scars he left among those of my generation, any discussion in Spain is likely to be subsumed under non-economic considerations, especially angry denunciations of moral virtue and moral turpitude. These non-economic considerations are not irrelevant. In fact some of them are very important and even admirable. But they must be understood within a more neutral context.

As far as I can tell there are at least four important reasons that opponents of debt forgiveness, not just in Germany but also in Spain, have proposed as to why demands for debt forgiveness would be a long-term disaster for Spain:

1.  Spain’s economic future depends on its remaining a member of Europe in good standing. To demand debt forgiveness (let alone a renegotiation of the currency union) would cause a financial crisis and relegate Spain to backward country status.

2.  If Spain fails to honor its debt commitments it will be considered forever an unreliable prospect and will be frozen out of future investment and trade.

3.  More importantly, it would be morally wrong. The German people provided Spain with real, hard-earned resources which Spaniards misused. It is not fair or honorable that Spain punish the German people for its generosity.

4.  Spain had a real choice, and it chose to spend money wantonly on consumer frivolities and worthless invest projects. It got itself into this mess only because of the very poor economic policies a corrupt Madrid implemented. Had Spaniards acted more like Germans and refrained from excessive consumption — the result of a flawed national character trait — it would not have suffered from speculative stock and real estate market bubbles, wasted investment and, above all, an unsustainable consumption boom and a collapse in savings. It is unfortunate that ordinary Spaniards must suffer for the venality of tis leaders, but ultimately they are responsible.

These four arguments, which are the same arguments made about other highly indebted European countries, have been made not just by the greedy Germans of caricature, but also, more importantly, by indignant locals. They genuinely believe that their country behaved stupidly and must pay the price, and it is hard not to respect their sincerity.

Blaming nations

The last of the four points is I think the most powerful of the arguments and among the most confused, and it is the one I hope I have at least partly addressed with my discussion of the French indemnity, and that I will discuss more below, but I should briefly address the first three, and of course while I refer to Spain, in fact much of what follows is as true of Greece and other heavily indebted European borrowers as it  is of Spain:

1.  There is no question that a renegotiation of Spanish debt or of its status within the currency union would be accompanied by economic hardship and perhaps even a crisis. But compared to what? The Spanish economy is already in disastrous shape and there is compelling historical evidence that countries suffering under excessive debt burdens can never grow their way out of their debt no matter how radical and forceful the reforms.

This means that by refusing to negotiate debt forgiveness, not only must Spain be prepared to live with unbearably high unemployment and slow growth for many years, which would undermine the social, political and financial institutions that are the real determinants of whether a country is economically advanced or economically backwards, but in the end after many years of suffering Spain would be forced into debt forgiveness anyway, only now with an economy in far worse shape. Historical precedents also suggest that while the real reforms Madrid has implemented seem to have failed, in fact it is the debt constraint that has prevented their impacts on productivity from showing up as economic growth. I suspect that many of these reforms have actually been very positive for Spain’s long-term productivity. In that sense I think Mariano Rajoy and his government have put in an impressive performance. Unless Madrid waits too long, they may very well even unleash tremendous growth once debt is written down, but until the debt is resolved, they will not seem to have worked. Throughout modern history even “good” reforms have failed to generate growth in nearly every previous case of overly indebted countries, unless of course those reforms sharply reduce outstanding debt.

Some economists argue the facts on the ground already contradict my pessimism. Last week Madrid announced excitedly that GDP grew by 1.7% last year, its fastest pace in seven years. TheFinancial Times pointed out that Spain was well-positioned in 2015 to continue to take advantage of lower energy costs, a weaker euro, and a cut in personal and corporate taxes, to which I would add lower metal prices, massive QE, and stronger than expected consumption. But even if these tailwinds are permanent, and they clearly are not, nominal GDP growth is still much lower than the growth in the debt burden. This is as good as it gets, in other words, and it is not good enough. As the debt burden continues to climb, and as social and political frustrations mount, Spain will slide inexorably backwards into the backward-country status it wants so badly to avoid. 

2.  There is overwhelming evidence — the US during the 19th Century most obviously — that trade and investment flow to countries with good future prospects, and not to countries with good track records. The main investment Spain is likely to see over the next few years is foreign purchases of existing apartments along the country’s beautiful beaches. Once its growth prospects improve, however, with among other things a manageable debt burden, foreign businesses and investors will fall over each other to regain the Spanish market regardless of its debt repayment history. This is one of those things about which the historical track record is quite unambiguous.

3.  It was not the German people who lent money to the Spanish people. The policies implemented by Berlin that resulted in the huge swing in Germany’s current account from deficit in the 1990s to surplus in the 2000s were imposed at a cost to German workers, and have been at least partly responsible for Germany’s extremely low productivity growth — most of Germany’s growth before the crisis can be explained by the change in its current account — rather than by rising productivity.

Moreover because German capital flows to Spain ensured that Spanish inflation exceeded German inflation, lending rates that may have been “reasonable” in Germany were extremely low in Spain, perhaps even negative in real terms. With German, Spanish, and other banks offering nearly unlimited amounts of extremely cheap credit to all takers in Spain, the fact that some of these borrowers were terribly irresponsible was not a Spanish “choice.” I am hesitant to introduce what may seem like class warfare, but if you separate those who benefitted the most from European policies before the crisis from those who befitted the least, and are now expected to pay the bulk of the adjustment costs, rather than posit a conflict between Germans and Spaniards, it might be far more accurate to posit a conflict between the business and financial elite on one side (along with EU officials) and workers and middle class savers on the other.  This is a  conflict among economic groups, in other words, and not a national conflict, although it is increasingly hard to prevent it from becoming a national conflict.

But didn’t Spain have a choice? After all it seems that Spain could have refused to accept the cheap credit, and so would not have suffered from speculative market excesses, poor investment, and the collapse in the savings rate. This might be true, of course, if there were such a decision-maker as “Spain”. There wasn’t. As long as a country has a large number of individuals, households, and business entities, it does not require uniform irresponsibility, or even majority irresponsibility, for the economy to misuse unlimited credit at excessively low interest rates. Every country under those conditions has done the same. What is more, even if the decision about the disbursement of the inflows could have been concentrated in the hands of a single, responsible entity, the experience of Germany after 1871 suggests that it is nearly impossible to prevent a massive capital inflow form destabilizing domestic markets. Germany, after all, was much better placed than Spain later was for two important reasons. First, unlike Spain today, Germany was not saddled with an enormous debt obligation which it had to repay. Second, in 1871-73 the transfers went straight to Berlin, which was able fully to control the disbursements. In 2005-09, on the other hand, the transfers to Spain left behind an enormous debt burden and were discrete and widely dispersed in ways that were almost certainly biased in favor of the most optimistic or foolish lenders and the most optimistic or foolish borrowers.

And this is a point that’s often missed in the popular debate. Over and over we hear — often, ironically, from those most committed to the idea of a Europe that transcends national boundaries — that Spain must bear responsibility for its actions and must repay what it owes to Germany. But there is no “Spain” and there is no “Germany” in this story. At the turn of the century Berlin, with the agreement of businesses and labor unions, put into place agreements to restrain wage growth relative to GDP growth. By holding back consumption, those policies forced up German savings rate. Because Germany was unable to invest these savings domestically, and in fact even lowered its investment rate, German banks exported the excess of savings over investment abroad to countries like Spain.

Why didn’t Germans, rather than Spaniards, take advantage of the excess savings to fund a consumption boom? The standard response is to point to German prudence and Spanish irresponsibility, but it must be remembered that as German and Spanish interest rates converged (driven in large part by German capital flows into Spain), because they adopted a common currency at a time when Spanish inflation had been higher than German, the real interest rate in Spain was lower than that of Germany. As German money poured into Spain — with Spain importing capital equal to 10% of GDP at its peak — the massive capital inflows and declining interest rates ignited asset price bubbles, and even more inflation, setting off in Spain what Charles Kindleberger called a “displacement”. This locked Spain into a classic self-reinforcing cycle of rising asset prices and declining interest rates.

What is more, under normal (i.e. pre-euro) conditions the Spanish peseta would have dropped and Spanish interest rates risen, but the conditions of the euro prevented both adjustment mechanisms, and to make things worse this gave Berlin’s policies far more traction than anyone expected, locking Germany into an over-reliance on capital exports to Spain, the obverse of Germany’s current account surplus. German workers gave up wage growth in order to eke out employment growth, which itself depended on an ever rising surplus. Throughout it all there was little productivity growth as German companies reduced their investment share in the economy.

Meanwhile German banks, flush with the higher savings that low wage growth, rising surpluses and growing corporate profits all but guaranteed, continued eagerly to export into Spain the savings they simply could not invest at home. So why didn’t ”Spain” step in and put an end to this process by refusing to borrow German money? Because, again, there was no “Spain”. There were millions of households and business entities all of whom were offered unlimited amounts of lending at very low or even negative interest rates, and under the conditions of euro membership Madrid could not intervene. If German and Spanish banks blanketed the country with lending proposals, Madrid could do nothing to stop it (at least not without raising domestic unemployment and igniting the  ire of Brussels and Berlin). As long as there were some greedy, overly optimistic or foolish borrowers (and in a country of 45-50 million people how could there not be?), German and Spanish banks fell over themselves to make loans. The money had to be absorbed by Spain and there was no mechanism to ensure the quality of its absorption.

Above all this is not a story about nations. Before the crisis German workers were forced to pay to inflate the Spanish bubble by accepting very low wage growth, even as the European economy boomed. After the crisis Spanish workers were forced to absorb the cost of deflating the bubble in the form of soaring unemployment. But the story doesn’t end there. Before the crisis, German and Spanish lenders eagerly sought out Spanish borrowers and offered them unlimited amounts of extremely cheap loans — somewhere in the fine print I suppose the lenders suggested that it would be better if these loans were used to fund only highly productive investments.

But many of them didn’t, and because they didn’t, German and Spanish banks — mainly the German banks who originally exported excess German savings — must take very large losses as these foolish investments, funded by foolish loans, fail to generate the necessary returns. It is no great secret that banking systems resolve losses with the cooperation of their governments by passing them on to middle class savers, either directly, in the form of failed deposits or higher taxes, or indirectly, in the form of financial repression. Both German and Spanish banks must be recapitalized in order that they can eventually recognize the inevitable losses, and this means either many years of artificially boosted profits on the back of middle class savers, or the direct transfer of losses onto the government balance sheets, with German and Spanish household taxpayers covering the debt repayments.

Who is fighting whom?

I am not rejecting the claim that “Spain” acted irresponsibly, in other words, only to place the blame on “German” irresponsibility. But it is absolutely wrong for Volker Kauder, the parliamentary caucus leader of German Chancellor Angela Merkel’s Christian Democrats, to say, according to an article in last week’sBloomberg, that “Germany bears no responsibility for what happened in Greece. The new prime minister must recognize that.” There was indeed plenty of irresponsible behavior on both sides, during which time wealth was transferred from workers of both countries to create the boom and to absorb the subsequent bust, and wealth will be transferred again from middle class households of both countries to clean up the resulting debt debacle.

Put differently, there is no national virtue or national vice here, and there is no reason for the European crisis to devolve into right-wing, nationalist extremism. The financial crisis in Europe, like all financial crises, is ultimately a struggle about how the costs of the adjustment will be allocated, either to workers and middle class savers or to bankers, owners of real and financial assets, and the business elite. Because the major parties have refused to acknowledge the nature of this allocation process, and have turned it into a fight between a creditor Germany, on the one hand, and indebted peripheral European countries on the other, I was able to make in 2010-11 one of the easiest predictions I have ever made in my career — whichever extremist parties, whether of the right or of the left, who first went on the offensive against Germany, the bankers and the currency bureaucrats, I predicted, would surge in electoral popularity and would eventually reformulate the debate.

That is why the question of debt forgiveness must be reformulated by the centrist parties first. Fundamental to the argument that Spain (or Greece, or anyone else) has a moral obligation to repay in full its debt to Germany are two assumptions. The first assumption is that “Spain” borrowed the money from “Germany”, and that there is a collective obligation on the part of Spain to repay the German collective. The second assumption is that Spain had a choice in what it could do with the German money that poured into the country, and so it must be held responsible for its having mis-used hard-earned german funds.

The first assumption is, I think, easily dismissed. Germany exported capital because by repressing wage growth, Berlin ensured the high profits and low consumption that forced up its national savings rates. Instead of employing these savings to invest in raising the productivity of German workers (in fact domestic investment actually declined) it offered them either to fund German consumption at high real interest rates (and there were few takers), or through German and Spanish banks this capital was offered to other European households for consumption or to other European businesses for investment. The offers were taken up in different ways by different countries. In countries where the offered interest rates were very low or negative, the loans were more widely taken up than in countries where real interest rates were much higher. To ascribe this difference to cultural preferences rather than to market dynamics doesn’t make much sense.

What started slowly quickly accelerated, again for reasons of market dynamics. As the huge inflow into Spain set off stock market and real estate booms, some Spanish households, feeling wealthier, borrowed to increase their consumption, and many Spanish households and businesses borrowed to buy real estate. In the subsequent frenzy, credit standards collapsed as Spanish and German banks fought to gain market share, and as optimism soared, consumption grew to unsustainable levels, until eventually Spain was so overextended that it collapsed. The same story can be told elsewhere. In fact this is what happened in Germany after the French indemnity.

As for the second assumption, that Spain had a choice, this too should be quickly dismissed. Clearly Spanish households and businesses in the aggregate behaved, in retrospect, with astonishing abandon. But could they have done otherwise — did they have a choice? Almost certainly not. Germany did not when it received the French indemnity, and I don’t think there are many, if any, cases of countries that were able to absorb productively such massive inflows. In every case I can think of, massive capital inflows were accompanied by speculative bubbles and financial crises. Even the US in 19th century — urgently needing foreign capital to finance a massive amount of productive investment that could not be financed out of domestic savings, making it the best candidate possible to receive massive foreign inflows — was not able to absorb surges in inflows without seeing the creation of bubbles, investment scandals, and financial crises. Is it reasonable to insist that Spain’s failure to choose a path that no other country in history seems ever to have chosen indicates greater irresponsibility on the part of the borrowers than of the lenders? As long as there is a widely diverse range of views among Spanish individuals and businesses about prospects for the future, as long as there is a mix of optimists and pessimists, or as long as there are varying levels of financial sophistication, I think it would have been historically unprecedented if at least some Spanish entities did not respond foolishly to aggressive offers of extremely cheap credit, especially once this cheap credit had set off a real estate boom.

In summary, I think there are several points that those of us who want “Europe” to survive should be making.

1.  The euro crisis is a crisis of Europe, not of European countries. It is not a conflict between Germany and Spain (and I use these two countries to represent every European country on one side or the other of the boom) about who should be deemed irresponsible, and so should absorb the enormous costs of nearly a decade of mismanagement. There was plenty of irresponsible behavior in every country, and it is absurd to think that if German and Spanish banks were pouring nearly unlimited amounts of money into countries at extremely low or even negative real interest rates, especially once these initial inflows had set off stock market and real estate booms, that there was any chance that these countries would not respond in the way every country in history, including Germany in the 1870s and in the 1920s, had responded under similar conditions.

2.  The “losers” in this system have been German and Spanish workers, until now, and German and Spanish middle class savers and taxpayers in the future as European banks are directly or indirectly bailed out. The winners have been banks, owners of assets, and business owners, mainly in Germany, whose profits were much higher during the last decade than they could possibly have been otherwise

3.  In fact, the current European crisis is boringly similar to nearly every currency and sovereign debt crisis in modern history, in that it pits the interests of workers and small producers against the interests of bankers. The former want higher wages and rapid economic growth. The latter want to protect the value of the currency and the sanctity of debt.

4.  I am not smart enough to say with any confidence that one side or the other is right. There have been cases in history in which the bankers were probably right, and cases in which the workers were probably right. I can say, however, that the historical precedents suggest two very obvious things. First, as long as Spain suffers from its current debt burden, it does not matter how intelligently and forcefully it implements economic reforms. It will not be able to grow out of its debt burden and must choose between two paths. One path involves many, many more years of economic hell, as ordinary households are slowly forced to absorb the costs of debt — sometimes explicitly but usually implicitly in the form of financial repression, unemployment, and debt monetization.  The other path is a swift resolution of the debt as it is restructured and partially forgiven in a disruptive but short process, after which growth will return and almost certainly with vigor

5.  Second, it is the responsibility of the leading centrist parties to recognize the options explicitly. If they do not, extremist parties either of the right or the left will take control of the debate, and convert what is a conflict between different economic sectors into a nationalist conflict or a class conflict. If the former win, it will spell the end of the grand European experiment.


I leave my readers with three questions that I hope we can discuss in the comments section:

1. If a huge amount of capital, equal say to 10-30% of a country’s annual GDP, is forcibly distributed to an enormous group of entities within that country in a short time period, and if the only way in which to distribute this capital is through a wide variety of banks, with biases such that the more optimistic and irresponsible the bank, the more it profits, and the more optimistic and irresponsible the borrower, the more it receives, is it meaningful to refer to either side as behaving “irresponsibly”, and if so, which side? Does this sound like a loaded question? If it is, can it be rephrased in a less loaded way?

2. There have been many cases of large capital recycling in history — just in the last 100 years I can think of the recycling of the US trade surplus to Germany and other countries in the 1920s, the petrodollar recycling to Latin America in the 1970s, and the recycling to the US of the Japanese trade surplus in the 1980s and the Chinese trade surplus in the 2000s. These were all accompanied in the recipient country by stock, bond and real estate bubbles and by overconsumption and wasted investment. Have there been cases of large capital recycling that did not end in tears for the recipients? If so, how were they different?

3. What about the other side of the recycling? In most cases the recycling country also experienced bubbles and rising debt. Have there been cases that did not also end in tears and if so, how were they different?


(1) The imbalances themselves occurred in forms that are widely understood and for which we have many historical precedents. I discussed these in my book, The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy (Princeton University Press, 2013). I am far from the only one to have done so. Martin Wolf’s excellent The Shifts and the Shocks: What We’ve Learned—and Have Still to Learn—from the Financial Crisis (Penguin Press, 2014) presents a schematic account of the causes of the crisis, and in The Leaderless Economy: Why the World Economic System Fell Apart and How to Fix It (Princeton University Press, 2013) Peter Temin and David Vine set out with great clarity the framework within which Europe’s internal imbalances had inexorably to lead to the current outcome.

(2) Michael B. Devereux and Gregor W. Smith, “Transfer Problem Dynamics: Macroeconomics of the Franco-Prussian War Indemnity”, August, 2005, Queen’s University, Department of Economics Working Papers 1025

(3) Arthur E. Monroe, The French Indemnity of 1871 and its Effect (The MIT Press, 1919)

(4) Charles Kindleberger, A Financial History of Western Europe, (Routledge 2006)

(5) Michael Pettis, The Volatility Machine: Emerging Economics and the Threat of Financial Collapse (Oxford University Press, 2001)

<![CDATA[Can monetary policy turn Argentina into Japan?]]> Monetary policy is as much about politics as it is economics. It affects the ways in which wealth is created, allocated, and retained and it determines the balance of power between providers of capital and users of capital. In January one of my readers kindly passed on to me a link to an interesting reportpublished two years ago by Bain and Company called “A World awash in Money: Capital trends through 2020”. According to the authors:

Our analysis leads us to conclude that for the balance of the decade, markets will generally continue to grapple with an environment of capital superabundance. Even with moderating financial growth in developed markets, the fundamental forces that inflated the global balance sheet since the 1980s—financial innovation, high-speed computing and reliance on leverage—are still in place.

There certainly has been a great deal of liquidity in the two years since the report was published, and I agree with the authors that this is likely to continue over the next several years, and maybe well into the next decade. I disagree with their assessment of the source of this liquidity — what Charles Kindleberger would have probably called the “displacement” (see Note below). I think policies that implicitly or explicitly constrained growth in median household income relative to GDP are more to blame than the changes in the financial system they cite because these plosives tended to force up the savings rate. The financial system changes are much more likely to be consequences rather than causes of abundant liquidity, although there is plenty of historical evidence to suggest that the two come together, and that they are mutually reinforcing.

I am especially interested in the authors’ claim that “the investment supply–demand imbalance will shift power decisively from owners of capital to owners of good ideas”, especially owners of “good ideas” in technology. This has happened before. Technology “revolutions” tend to take place when a huge amount of risk-seeking capital flows into very risky and often capital-intensive high-tech investments, generating large network benefits and creating tremendous rewards for successful technology ventures. Particularly for those technology projects that benefit from growing networks — railroads, telephones, video, the internet — there is a strong element of pro-cyclicality, in that early successes spur greater visibility and faster adoption, which of course creates further success. I addressed this process in a 2009 article for Foreign Policy, in which I described six waves of “globalization” in the past 200 years as having certain characteristics in common:

What today we call economic globalization — a combination of rapid technological progress, large-scale capital flows, and burgeoning international trade — has happened many times before in the last 200 years. During each of these periods (including our own), engineers and entrepreneurs became folk heroes and made vast fortunes while transforming the world around them. They exploited scientific advances, applied a succession of innovations to older discoveries, and spread the commercial application of these technologies throughout the developed world. Communications and transportation were usually among the most affected areas, with each technological surge causing the globe to “shrink” further.

But in spite of the enthusiasm for science that accompanied each wave of globalization, as a historical rule it was primarily commerce and finance that drove globalization, not science or technology, and certainly not politics or culture. It is no accident that each of the major periods of technological progress coincided with an era of financial market expansion and vast growth in international commerce. Specifically, a sudden expansion of financial liquidity in the world’s leading banking centers — whether an increase in British gold reserves in the 1820s or the massive transformation in the 1980s of illiquid mortgage loans into very liquid mortgage securities, or some other structural change in the financial markets — has been the catalyst behind every period of globalization.

Are we in such a period? We certainly were before the 2007-08 crisis, but every globalization period has been followed by a contraction which, too, has certain characteristics in common.

Because globalization is mainly a monetary phenomenon, and since monetary conditions eventually must contract, then the process of globalization can stop and even reverse itself. Historically, such reversals have proved extraordinarily disruptive. In each of the globalization periods before the 1990s, monetary contractions usually occurred when bankers and financial authorities began to pull back from market excesses. If liquidity contracts — in the context of a perilously overextended financial system — the likelihood of bank defaults and stock market instability is high.

This disruption has already occurred to some extent. After 2007-08, global GDP growth dropped sharply, the growth in global trade dropped even more sharply, we have seen soaring unemployment, and I expect that we will soon see a wave of sovereign defaults.

But this time may be different in one important way. The 2007-08 crisis may well be the first global crisis that has occurred in a period of credible fiat currency.

“Everyone can create money,” Hyman Minsky often reminded us. “The problem is to get it accepted.” Having money accepted widely is what it means to be credible, and in past crises, if money was credible it was constrained by the amount and quality of its  gold or silver backing, whereas if it was unconstrained, that is fiat money money, it was not terribly credible. Were we still living in that world, we would already have seen a wave of sovereign defaults and the forced, rapid recognition and writing down of bad debts. We would have probably also seen a collapse in several national banking systems and an even more brutal economic contraction than what we have already experienced.

No more collapsing money?

“Panics do not destroy capital,” John Mill proposed in his 1868 paper to the Manchester Statistical Society. “They merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works.”  Our ability to postpone the recognition of the full extent of these unproductive works depends in part on our ability to expand the supply of credible money. If we are constrained in our ability to expand the money supply, one impact of the crisis is a contraction in money (velocity collapses) that forces lenders to write down debt. If money can expand without constraints, however, debt does not have to be written down nearly as quickly.

With the main central banks of the world having banded together to issue unprecedented amounts of credible currency, in other words, we may have changed the dynamics of great global rebalancing crises. We may no longer have to forcibly write down “hopelessly unproductive works”, during which process the seemingly endless capital of the globalization phase is wiped out, and we enter into a phase in which capital is scarcer and must be allocated much more carefully and productively.

Instead, the historically unprecedented fact of our unlimited ability to issue a credible fiat currency allows us to postpone a quick and painful resolution of the debt burdens we have built up. It is too early to say whether this is a good thing or a bad thing. On the one hand, it may be that postponing a rapid resolution protects us from the most damaging consequences of a crisis, when slower growth and a rising debt burden reinforce each other, while giving us time to rebalance less painfully — the Great depression in the US showed us how damaging the process can be. On the other hand the failure to write down the debt quickly and forcefully may lock the world into decades of excess debt and “Japanification”. We may have traded, in other words, short, brutal adjustments for long periods of economic stagnation.

Only the passage of time will tell us whether or not this is indeed the trade-off we have made or want to make. Argentina used to be the archetype of financial crisis, when a collapse in the supply of money caused massive debt write-downs. “This time” may indeed be different in the sense that there is a very real possibility, as the authors of the Bain study propose, of many years of “superabundant” capital, instead of the scarce capital that has historically characterized the post-crisis period.

Excess capital tends to be associated with periods of tremendous technological advances, and because these are experienced primarily by the technologically most advanced countries, the next decade might bring some benefit to the world’s most advanced economies — which will be all the more noticeable in the context of the low commodity prices that presage the end of “convergence”. The idea that advanced countries may outperform developing countries may seem shocking. For the past few decades the world has gotten used to the idea that economic convergence between rich countries and poor is inexorable.

But it isn’t. Over long periods of time, convergence has been the exception, not the rule. In periods during which commodity prices are high, or the advanced economies have created artificially high demand that developing countries can exploit (during war, for example), we are usually swept by waves of optimism and a firm belief in economic convergence. But once these conditions end, the high hopes quickly abate. I have written elsewhere, for example, of Albert Hirschman’s optimism during the 1950s and 1960s that led him and many others, especially those influenced by Marxist ideas of economic growth, to believe that development was primarily a technical problem. Once we had resolved the problem, as we seemed to be doing in the heady days of the 1950s and early 1960s, we could expect fairly rapid economic convergence.

By the late 1970s, of course, development economists were despairing over the seeming intractability of backwardness. Their models of linear development (most famously W.W. Roster’s “five stages” of economic development) were gradually replaced by more complex analyses of economies as “systems”, in which complex institutional constraints could distort or prevent convergence. The now (unfairly) discredited dependence theorists, for example, argued that under certain conditions convergence was not even theoretically possible.

Hirschman too became far more pessimistic about long term convergence, and began worrying about the nature of these constraints, even pointing out how misguided optimism itself could lead to highly pro-cyclical policies that reverse the convergence process, in part by encouraging the kinds of inverted balance sheets that I discussed in my blog entry of two weeks ago. The outpouring of almost comically muddled explanations of and forecasts for the Chinese growth miracle has been an especially egregious example of the way well-intentioned economic analysis has led to, or at least encouraged, worse outcomes. China’s cheerleaders have for many years encouraged policies that we are finally recognizing as foolish.

The idea of emerging markets having decoupled from the advanced economies has died, and I suspect the idea of convergence will soon become another victim of the crisis. If the world does indeed face another decade or two of “superabundant capital” in spite of economic stagnation and slow growth, the historical precedents suggest a number of other consequences.

The brave new world of weak demand and frenzied speculation

Last week I had drinks with one of my former Peking University students and we discussed some of the ways the global economy might react to a world adjusting from a global crisis with weak demand and excess liquidity. In no particular order and very informally these are some of the consequences we thought were likely or worth considering:

  • During periods of excess capital, investors are willing to take on far more risk than they normally would. High tech is one such risky investment, and has historically done very well during periods in which investors were liquid and hungry for yield. This suggests that developed countries will benefit relatively because of their dominance of high tech, and the US will benefit the most.

But we have to make some important distinctions. The willingness to take excess risk is not necessarily a good thing socially. If it leads investors to pour money into non-productive investments, excess real estate and manufacturing capacity, or into investments that with negative externalities, excess risk-taking simply destroys wealth. The economy is better off, in other words, only if policymakers can create incentives that channel capital into entrepreneurial activity or into activity with significant positive externalities (i.e. whose social value is exceeds the value that investors can capture).

In several countries before the crisis, including the US, China and parts of Europe, a lot of overly-aggressive financing went into projects with negative externalities — empty housing, useless infrastructure, excess capacity — and it is important that this kind of risk-taken isn’t encouraged. Policymakers should consider the conditions under which excess risk-taking is channeled by the private sector into socially productive investments, for example into high tech, small businesses, and high value added ventures. With their highly diversified financial systems and incentive structures that reward innovation and entrepreneurialism, the US, the UK and perhaps a handful of “Anglo-Saxon” and Scandinavian economies, in their different ways, are especially good at this. Much of Europe and Japan are not. The latter should take steps to increase the amount by which they will benefit from many more years of high risk appetite among investors.

  • Normally, developing countries only benefit indirectly from periods of abundant capital and excess risk taking because abundant capital tends to lead increased investment in developing countries and higher commodity prices. This, however, is perhaps the first time that excess liquidity has overlapped with a period of crisis and contraction, so it is hard to know what to expect except that the days of historically high hard commodity prices are well behind us (food may be a different matter). I suspect that developing countries are going to lag economically over the next few years largely because of high debt levels.

Why? Because one of the ways the market will probably distinguish between different types of risk is by steering away from highly indebted entities. Excess debt is clearly worrying, and while there will always be investors who are willing to lend, in the aggregate they will probably discriminate in favor of equity-type risks unless policymakers create incentives in the opposite direction.

  • Developing countries almost never benefit from the high tech boom that typically accompanies periods of excess liquidity because they tend to have limited technology capabilities. Policymakers should consider nonetheless how to take advantage of what capabilities they do posses.

India for example has a vibrant innovation-based sector, but it suffers from low credibility and from regulatory and red-tape constraints that will make it hard for Indian innovation to benefit from global investors’ high risk appetites. New Delhi — and perhaps local state capitals — should focus on addressing these problems. If Indian technology companies are given the regulatory flexibility and if investors find it easy to put money into (and take it out of) Indian technology ventures, we might see India capture some of the benefits of what may be a second or third wave of information technology. 

Brazil is another large developing economy with pockets of tremendous innovation but which overall also suffers from low credibility and distorted incentive structures — and way too much debt. I am neither smart nor knowledgeable enough to propose specific policies, but policymakers in Brazil, like in India and in other very large developing economies — and they must be large in order that their relatively small technology sectors can achieve critical mass — must develop an explicit understanding of the institutional constraints and distorted incentive structures that prevent the development of their technology sectors, and take forceful steps to reverse them.

  • China is weak in high -tech innovation largely because of institutional constraints, including education, regulatory constraints, distorted incentive structures,and a hostile environment for innovative thinking (defying attempts to separate “good” innovative thinking from “bad”).  Overly-enthusiastic American venture capitalists, Chinese policymakers, and Chinese “entrepreneurs”, many of whom have almost become Silicon Valley caricatures will disagree, but in my experience most China, and certainly those involved in technology, are very skeptical about Chinese innovation capabilities. For example, when I taught at Tsinghua University, China’s answer to MIT, my students regularly joked that the only way to turn Tsinghua graduates into high tech innovators was to send them to California.

The main reason for its weak track record in innovation, I would argue, is that in China, like in many countries, there are institutional distortions that directly constrain innovation, as I explain in myblog entry on “social capital”. There are also indirect distortions, most obviously extraordinarily low interest rates and the importance of guangxi, that made accessing credit or developing good relationships with government officials infinitely more profitable, and requiring far less effort, for managers than encouraging innovation.

It is politically too difficult to resolve many of these institutional constraints nationally. In fact we are probably not even moving in the right direction — for example Beijing has recently sharply reduced internet access within China for domestic political reasons, and it is a pretty safe bet that this and other attempts to secure social stability will come at the expense of a culture of innovation.

But if Beijing is reluctant to relax constraints at the national level, it might nonetheless be willing to do so in specific local jurisdictions. If there were pockets within the country operating under different legal, regulatory, tax and cultural systems, and much more tolerant of the political and social characteristics of highly innovative societies, China might see the creation of zones of innovation that would benefit from the favorable global environment. I am skeptical about the impact of the Shanghai free-trade zone on trade or investment, for example, but it could become a more credible center of Chinese innovation under a very different legal and regulatory system  — much as Shanghai was, by the way, in the 1920s and 1930s. China has benefitted in the past from special economic zones, with different laws and regulations, dedicated to manufacturing. It might benefit in the future if it turns these into special “innovation” zones, also with very different laws and regulations —  and above all a far greater appetite for the “bad” things that are always part of highly innovative cultures, including a wide open internet and tolerance for any kind of discussion.

  • Excess liquidity and risk appetite makes it easy to lock in cheap, long-term funding for investment projects. Countries that have weak infrastructure, or whose infrastructure is in serious need of improvement, have today an historical opportunity to build or replenish the value of their infrastructure with very cheap capital. This is truly the time for governments to identify their optimal infrastructure needs and to lock in the financing. The most obvious places for productive infrastructure spending, it seems to me, are the United States, India and Africa.

The constraint in the US seems to be a politically gridlocked Congress unable to distinguish between expenditures that increase the US debt burden and expenditures that reduce it. Borrowing $100 for military expansion, higher government salaries, or an expansion in welfare benefits will increase the US debt burden, for example, but borrowing $100 in order to build or improve infrastructure in a way that increases US productivity by $120 actually reduces the US debt burden.

This mindset at the federal, state and local levels prevents highly accommodative money from flowing easily into infrastructure projects, and it means that the US will probably miss an historic opportunity to upgrade its infrastructure cheaply in ways that will boost growth for decades to come. The US must come up with institutional alternatives that will allow it to overcome these constraints, for example there has been some talk of a national development bank whose sole purpose was to raise money for infrastructure investment. That is a great idea if Congress can pull it off.

  • The constraint in both India and Africa is low credibility. Aside from concerns about the siphoning off of a significant share of the money that was earmarked for investment, especially in several African countries, foreign funding of infrastructure would come mainly in the form of debt financing, and this would almost certainly have to be denominated in dollars, euros or some other hard currency, which, given the size of the required funding, might raise questions about repayment prospects.

In the case of India it may be that under Prime Minister Narendra Modi the issue of credibility will be resolved, although my Indian friends tell me that we are far from resolving the issues of bureaucratic entanglement that hamstring attempts to put into place the kind of infrastructure that India needs. One way or the other India has a very rare opportunity, if it is able to put together a credible plan, to build out substantial infrastructure on very accommodating financing terms, and given its urgent need for infrastructure, the resulting increases in productivity would actually cause India’s debt burden to fall substantially.

For African countries the problem is far more complex. Not all African countries are the same, of course, but many if not most African economies are likely to be directly or indirectly very sensitive to commodity prices. Some African countries has been able to get funding from China beyond what has been available in the market, but as commodity prices decline, as many of the funded projects turn out to be less productive than planned, and especially as earlier loans to African and Latin American countries begin to come due, my suspicion is that China will face the same problems new lenders to African have historically faced. The path of regaining credibility for individual countries is likely to be slow and arduous.



From Charles Kindleberger’s “Anatomy of a Typical Crisis”: “We start with the model of the late Hyman Minsky…According to Minsky, events leading up to a crisis start with a “displacement,” some exogenous, outside shock to the macroeconomic system. The nature of this displacement varies from one speculative boom to another. It may be the outbreak or end of a war, a bumper harvest or crop failure, the widespread adoption of an invention with pervasive effects—canals, railroads, the automobile—some political event or surprising financial success, or debt conversion that precipitously lowers interest rates. An unanticipated change of monetary policy might constitute such a displacement and some economists who think markets have it right and governments wrong blame “policy-switching” for some financial instability.

<![CDATA[Inverted balance sheets and doubling the financial bet]]> On Tuesday the National Bureau of Statistics released China’s 2014 GDP growth numbers and reported growth consistent with what the government has been widely promoting as the “new normal”.

According to the preliminary estimation, the gross domestic product (GDP) of China was 63,646.3 billion yuan in 2014, an increase of 7.4 percent at comparable prices. Specifically, the year-on-year growth of the first quarter was 7.4 percent, the second quarter 7.5 percent, the third quarter 7.3 percent, and the fourth quarter 7.3 percent.

As nearly every news article has pointed out, GDP growth of 7.4% slightly exceeded consensus expectations of around 7.3%, setting off a flutter in the Shanghai Stock Exchange that reversed nearly a quarter of Monday’s disastrous drop of almost 8%. But although it exceeded expectations 2014 still turned in the lowest reported GDP growth since 1990, presenting only the second time since growth targeting began in 1985 that the reported number came in below the official target (the first time was in 1989). We will undoubtedly be swamped in the coming days with analyses of the implications, but I read the data as telling us more about the state of politics than about the economic health of the country.

Over the medium term I have little doubt that growth will continue to slow, and that at best we have only completed about one third of the journey from peak GDP growth to the trough. As long as it has debt capacity Beijing, or indeed any other government, can pretty much get as much growth as it wants, in China’s case simply by making banks fund local government infrastructure spending.

Most economic analyses of the Chinese economy tend to base their forecasts on the sequence and pace of economic reforms aimed at rebalancing the economy, and on the impact these reforms are likely to have on productivity growth. It may seem contrarian, then, that I forecast Chinese near term growth largely in terms of balance sheet constraints. I am not implying that the reforms do not matter to the Chinese economy. The extent to which the reforms Beijing proposes to implement reduce legal and institutional distortions in business efficiency, eliminate implicit subsidies for non-productive behaviour, reorient incentives in the capital allocation process, undermine the ability of powerful groups to extract rent, and otherwise liberalise the economy, will unquestionably affect China’s long-term growth prospects.

But I expect that any significant impact of these reforms on short-term growth will largely be the consequence of two things. The first is how reforms will affect the amount, structure, and growth of credit. The second is how successfully Beijing can create sustainable sources of demand that do not force up the debt burden — the most obvious being to increase the household income share of GDP and to increase the share of credit allocated to small and medium enterprises relative to SOEs.

To put it a little abstractly, and using a corporate finance model to understand macroeconomics, I would say that most economists believe that China’s growth in the near term is a function of changes in the way the asset side of the economy is managed. If Beijing can implement reforms that are aimed at making workers and businesses utilize assets more productively, then productivity will rise and, with it, GDP.

This sounds reasonable, even almost true by definition, but in fact it is an incomplete explanation of what drives growth. In corporate finance theory we understand that although growth can often or even usually be explained as a direct consequence of how productively assets are managed, it is not always the case that policies or exogenous variables that normally change the productivity of operations will have the expected impact on productivity growth. When debt levels are low or when the liability structure of an economic entity is stable, then it is indeed the case that growth is largely an asset-side affair. In that case for GDP growth to improve (or for operating earnings to rise), managers should focus on policies aimed at improving productivity.

But when debt levels are high enough to affect credibility, or when liabilities are structured in ways that distort incentives or magnify exogenous shocks, growth can be as much a consequence of changes in the liability side of an economy as it is on changes in the asset side. At the extreme, for example when a company or a country has a debt burden that might be considered “crisis-level”, almost all growth, or lack of growth, is a consequence of changes in the liability structure. For a country facing a debt crisis, for example, policymakers may work ferociously on implementing productivity-enhancing reforms aimed at helping the country “grow” its way out of the debt crisis, but none of these reforms will succeed.

When liabilities constrain assets

That both orthodox economic theory and government policy-making ignore the way liability structure can overwhelm the impact of asset-side management is surprising given how strong the historical confirmation. There is a long history of countries either facing debt crises or struggling with dangerous debt burdens — including many countries today both in the developed world and the developing world — in which policymakers have promised to implement dramatic policies that will improve productivity and return the economy to “normalcy”. But just as today growth stubbornly stagnates or decelerates in Europe, Japan, China, and a number of over-indebted countries, it is hard to find a single case in modern history in which a country struggling with debt has been able to reform and grow its way out of its debt burden until there has been explicit or implicit debt forgiveness. It is no accident that growth in Japan, China and Europe keep disappointing analysts, and on Tuesday the IMF yet again cut its global growth forecast by 0.3% — to 3.5% and 3.7% in 2015 and 2016. It will almost certainly continue to cut it over the next few years.

In the book I plan to write this year I hope to explore the conditions under which the structure of liabilities matter to growth, and to show how sometimes it is even the only factor that determines growth rates. It is not just as a constraint that a country’s liability structure affects growth, however. There are times when it can actually reinforce growth. There are in fact many ways in which a country’s balance sheet can significantly affect growth rates, both during growth acceleration and growth deceleration, and China demonstrates just such a case.

In fact as far as I can tell, in every case in modern history of very rapid, investment-driven growth, at least part of the growth was caused by self-reinforcing credit structures embedded in the balance sheet. One way is by encouraging additional investment to expand manufacturing and infrastructure capacity. Rapid growth raises expectations about future growth, making it easy to fund projects that expand capacity even further, and these projects themselves result in faster growth, which then justifies even higher growth expectations. Another way is by improving credit perceptions. When loans are backed by assets, rapid growth increases the value of these assets, so that the riskiness of the existing loan portfolio seems to decline, allowing the lender to increase his risky loans and the borrower to increase his purchase of assets, which of course puts further upward pressure on asset values.

There is nothing surprising about either process — we all understand how it works. But what we sometimes forget is that when this happens economic activity can easily exceed the increase in real economic value-creation, and more importantly, the same balance sheet structure can cause growth to decelerate far faster than we had expected during the subsequent adjustment period. The balance sheet causes growth to be higher than it would have otherwise been during the growth phase and slower when growth begins to  decelerate. It is not just coincidence that nearly every case in modern history of a growth miracle has been followed by a brutally and unexpectedly difficult adjustment. The same balance sheet that turned healthy growth into astonishing growth turned a slowdown into a collapse.

My 2001 book, The Volatility Machine, was about the history and structure of financial crises in developing countries, and in the book I discuss some of these balance sheet structures that exacerbate both accelerating and decelerating growth. In this essay I want to discuss concrete examples of such structures and show how they impact growth. In the book I distinguish between “inverted” and “hedged” balance sheets, and it is worth explaining the distinction. A hedged balance sheet is simply one that is structured to minimise the overall volatility of the economic entity, whether it is a business or a country.

When the balance sheet is fully hedged, the only thing that changes its overall value is a real increase in productivity. Any exogenous shock that affects the value of liabilities and assets, or that affects income and expenditure, will have opposite effects on the various assts and liabilities, and together these will add to zero. Of course the closer an economic entity is to having a perfectly hedged balance sheet, the lower the cost of capital, the lower the rate at which expected earnings or growth is discounted over time, the easier it is for businesses to maximise operating earnings without worrying about unexpected shocks, and the longer the time horizon available for both policymakers and businesses in planning.

An inverted balance sheet is the opposite of a “hedged” balance sheet, and involves liabilities whose values are inversely correlated with asset values. These embed a kind of pro-cyclical mechanism that reinforces external shocks by automatically causing values or behavior to change in ways that exacerbate the impact of the shock. When asset values rise, in other words, the value of liabilities falls (or, to put it differently, the cost of the liabilities rise), and vice versa.

Balance sheet inversion

A business or country with an inverted balance sheet benefits doubly in good times as its assets, or its earnings, rise in value and its liabilities, or its financial expenses, fall. The process is often self-reinforcing, especially when the inverted entity is a country, in which case the economy can be described as being in a virtuous circle. When Brazil began to reform its economy and instituted a new currency regime in 1994, for example, one of its greatest vulnerabilities was its extremely high fiscal deficit, more than 100% of which was explained by debt servicing costs. Most Brazilian government debt was of less than six months maturity, and nearly all of it matured within one year (short-term debt is extremely inverted). As Brazilian reforms associated with the 1994 currency regime increased overall confidence, short-term interest rates declined, and within months the fiscal deficit followed suit. This caused confidence to rise sharply, and interest rates to fall further. In Brazil interest rates fell steadily from well over 50% in the early 1994-95 to around 20% by the summer of 1998.

Of course in bad times the opposite happens – the value of assets fall while the value of liabilities rise, and the virtuous circle quickly becomes a vicious circle. Financial distress costs are not linear, and so it is not surprising that conditions usually deteriorate much more quickly than they improve. When the Russian crisis in 1998 shook confidence in emerging markets, Brazilian interest rates suddenly began rising, which caused the fiscal deficit to shoot up and so undermined confidence further, locking the country into an extremely vicious circle that took interest rates back to over 40% within two or three months. In January of the following year Brazil was forced into a currency crisis.

Inverted balance sheets, in other words, automatically exacerbate both good times and bad. Among other things this often leads to confusion about the sources of growth and value creation and the quality of management. When an economy is doing well the short-term gains for the economy that are simply a consequence of balance sheet inversion are often treated in the same way as ordinary productivity gains caused by better management when we try to judge the effectiveness of the underlying economic policies. In reality, however, they are just forms of speculative profits.

This may seem a surprising statement, but in the Brazilian case described above, for example, while part of the decline in the fiscal deficit before the summer of 1998 can be explained by better policies, at least part of the decline came about simply because of the very short debt maturities. If the Brazilian government had funded itself with longer-term debt — which would have been much more appropriate and far less risky — the fiscal deficit would not have declined nearly as quickly as it did. Part of the improvement in the fiscal deficit, in other words, was simply the consequence of what was effectively a speculative bet on declining rates, and did not reflect better fiscal policies. One unfortunate consequence, however, was that analysts and policymakers overvalued the quality and impact of government policies.

Of course when conditions turn, inverted balance sheets also provide short-term losses, although, perhaps not surprisingly, managers or policymakers almost always recognise the component of “bad luck” in their weakened performance. In 1998 I had many conversations with Brazilian central bankers, including the president of the central bank, Gustavo Franco, about taking advantage of high confidence in Brazil to borrow long-term at rates actually below the then-current 1-year rate of 20% (we were prepared to raise $1 billion of five-year money at 19%). The central bank decided against doing so at least in part because they were confident that the market was responding mainly to the quality of their monetary policies, and that as they were determined to maintain these policies, they felt it did not make sense to extend maturities until interest rates had dropped by far more. My carefully worded suggestions that at least part of their success was the result of an implicitly speculative balance sheet, and that it might make sense to reduce that risk, were not well-received.

Of course when interest rates shot up, no one doubted the role of balance sheet structures in the subsequent crisis. My point here is not a cynical one about the vanity of policymakers. It is that when a country responds very positively to policy reforms it is genuinely difficult for most economists to distinguish between growth caused by the reforms and growth caused by the self-reinforcing nature of inverted balance sheets, and the more highly inverted a country’s balance sheet, the more dramatically will good policies seem to be rewarded. Over the long term, however, because the same virtuous circle can become an equally powerful vicious circle, inverted balance sheets always automatically increase financial distress costs because for any level of debt it increases the probability of default.

Along with short-term debt as described above, external currency debt is a very typical kind of inverted borrowing because when the borrowing country is growing rapidly, the tendency is for its currency to appreciate in real terms, and this reduces its debt servicing costs as interest and principle has to be repaid in cheaper foreign currency. Of course the opposite happens when the economy stagnates, and in a crisis a rapid depreciation of the currency can cause debt-servicing costs to soar exactly when it is hardest to repay the debt. The self-reinforcing combination of rapid GDP growth in the 1990s, reinforced by rapidly rising external debt, set the stage for the Asian Crisis of 1997, during which Asian borrowers were devastated as high levels of external debt caused growth to slow and currencies to weaken, both of which caused the debt burden to soar even faster.

Other types of inverted liabilities can include inventory financing, floating-rate debt, asset-based lending, margin lending, wide-spread use of derivatives, commodity financing, and real estate leverage (in countries in which the real estate sector has a major impact on GDP growth). High concentrations of debt in important sectors of the economy, even when in the aggregate debt levels are low, can also be important (and typical) forms of balance sheet inversion.

Developing inversion

Developing countries historically have been very prone to creating inverted balance sheets during their growth phases, which is an important reason for their much greater economic volatility. This may simply be because often the least risky way of lending involves pushing the risk onto the borrower, for example by keeping maturities very short, or by denominating the debt in a more credible foreign currency. Because many developing countries are capital constrained, they often have no choice but to borrow in risky ways. In a 1999 paper, Barry Eichengreen and Ricardo Hausmann referred to this type of borrowing, “in which the domestic currency cannot be used to borrow abroad or to borrow long term even domestically”, as “original sin”.

Not included in the concept of original sin, but closely related, is the historical tendency of risk appetite to be highly correlated across the global economy. Foreign and local investors are most willing to lend to a risky developing country at a time when the whole world is benefitting from the easy availability of risk capital, and global growth is consequently high. Of course foreign capital dries up and local flight capital expands just as the world slows down and the economy begins to stagnate.

But there are other reasons developing countries typically build up inverted balance sheets. One reason may have to do with the ability of very powerful elites, in countries with limited separation of powers, low government accountability, and low transparency, to arrange that profits are privatized and losses are socialized. In that case it makes sense to maximize volatility, and inverted balance sheets do just that. Another reason may be the economic importance of commodity extraction to growth in many developing countries, and the tendency for capital to be available only when commodity prices are high and rising.

The confusion about whether rapid growth during reform periods has been driven more by virtuous circles or by virtuous policymaking of course also reinforces the tendency to increase inversion, especially in the late stages of a growth period when the economy reaches the limits of the growth model and begins naturally to slow. If at least part of the growth is the consequence of virtuous circles, as it usually is especially in a heavily credit-dependent economy, balance sheet inversion can be a bad short-term trading strategy because it increases the costs of an economic slowdown. If the growth is the consequence mainly of virtuous policymaking, as it is always believed to be, balance sheet inversion is a good short-term trading strategy because virtuous policymakers presumably will continue to put into place virtuous policies. 

Whatever the source of growth, the already high economic volatility typical of developing countries is exacerbated by balance sheet structures that magnify this volatility. One consequence is that we are continually surprised by much more rapid growth than expected during good times and very rapid and unexpected economic deterioration just as things start to go bad.

We often see developing countries in the late, strained stage of a growth miracle rapidly build up inverted balance sheets even more quickly than earlier in the growth cycle. I am not sure why this is so often the case, but it could be that after many years of growth, reinforced by inverted balance sheets, economic agents become convinced that recent trends are permanent. They assume, for example, that interest rates must always drop, or that the currency always appreciates, or that real estate prices always rise, or that demand always catches up with capacity, so that it makes sense to bet that the future will look like the past.

There is also a natural sorting mechanism in a rapidly growing volatile economy in which business managers who tend, for whatever reason (including the ability of powerful vested interests to create asymmetrical distributions of profits and losses) to take on too much risk will systematically outperform and take market share from more prudent business managers. Anyone who is familiar with Hyman Minsky’s explanation of how attempts by regulators to reduce risk in the financial system will cause bankers to engage in riskier behaviour fully understands the mechanism.

There are several points that I think are useful when we think about how sensitivity to balance sheet structures might help us in forecasting growth, especially in countries that have a lot of debt and other institutional distortions:

All balance sheets are not the same. Liabilities can be structured in such a way that the performance of the asset side (or of operations) can be significantly affected. One of the ways in which this can happen is when liabilities exacerbate or reinforce operations or changes in the value of assets.These kinds of balance sheets are inverted, and they can embed highly pro-cyclical mechanisms into an economy.

There are many forms of inverted balance sheet structures, some of which are very easy to identify (external currency debt, margin financing, short-term debt) and others much more difficult to identify (an economy’s over-reliance on any single agent or industrial sector can create a kind of balance sheet inversion, for example, that is difficult to explain). The key consideration is when factors or policies that change underlying productivity are correlated, causally or not, with other parts of the balance sheet that affect the economy’s overall performance in the same direction.

Highly inverted economies are more likely to experience periods of exceptionally high growth or exceptionally deep stagnation, and the latter almost always follow the former. As far as I can tell, most growth miracles in modern history are at least partly the result of highly inverted balance sheets. This probably why they often seemed to grow far faster than anyone originally thought possible, and why most growth miracle economies subsequently experienced unexpectedly difficult adjustments. 

It is often difficult to tell the difference between growth caused by fundamental changes in productivity and growth caused by pro-cyclical balance sheet structures — i.e. between virtuous polices and virtuous circles. This often causes analysts to overvalue the quality of policymaking or the underlying economic fundamentals during a period of rapid growth. As an aside, in my experience on Wall Street I can say that it can be very difficult to explain balance sheet inversion to the policymakers that preside over very rapidly growing economies, and it is never a good marketing strategy for a banker.

In the late stages of a period of rapid growth, as the economy is beginning to slow as it adjusts from the imbalances generated during the growth period, it seems to me that there is a systematic tendency to increase balance sheet inversion as a way of maintaining growth or of slowing the deceleration process.

Inventory can increase volatility

The last point  of course is especially important in the Chinese context. The Chinese economy is clearly slowing, and debt is clearly rising. There is increasing evidence of highly inverted balance sheet structures within the Chinese economy, but I do not know if this is because balance sheet inversion is increasing or because a slowing economy causes pressure to build within the financial sector, and this makes visible risky structures that had been in place all along.

At any rate, it makes sense both for policymakers and for investors to try to get some sense of the extent of inversion in the economy. Most economists now expect that China’s economy will continue slowing, with most economists considering an eventual decline in GDP growth to 6% as the lower limit. Others, myself included, expect growth to slow much more than that. Of course the more inverted the Chinese balance sheet, the more any fundamental slowdown will be exacerbated by automatic changes in the country’s balance sheet.

This makes it very useful to get a sense of how balance sheet inversion can occur in China. Last Tuesday I saw three articles, two on Bloomsberg and one in the Financial Times that struck me as interesting examples of different kinds of balance sheet inversions. The first article reported that China was, according to Bloomberg, importing record amounts of crude oil as prices collapsed:

China’s crude imports surged to a record in December after a buying spree in Singapore by a state-owned trader and as the government in Beijing accelerated stockpiling amid the collapse in global oil prices.

…Chinese demand is shoring up the global oil market as the country expands emergency stockpiles amid crude’s slump to the lowest level in more than five years. The Asian nation’s consumption is forecast to climb by 5 percent in 2015, while the government is set to hoard about 7 million tons of crude in strategic reserves by the middle of this year, predicts ICIS-C1 Energy, a Shanghai-based commodities researcher.

Stockpiling oil in this case has a complex relationship within the balance sheet. On the one had it can be described as a kind of hedge. China is naturally short oil because it is a net importer. In that sense China benefits when the price of oil declines, and suffers when the price of oil rises.

Stockpiling oil, then, is a way of hedging. If oil prices continue to drop, China will lose value on its inventory position, but because the Chinese economy will be better off anyway, the losses China suffers from its stockpile simply reduce the overall benefit to China of lower prices. Meanwhile if oil prices should rise, China will suffer in the same way that all energy-importing countries suffer, but it will profit from its stockpile, and this profit will reduce the total loss. In that sense oil stockpiles reduce overall volatility in the Chinese economy, just as they do for any country that is a net importer of energy.

If China were a small country whose economic performance was largely uncorrelated with the economic performance of the world, this would be the end of the story. But China is not. Given how important the external sector is to China’s economy, growth in China is likely to be highly correlated with growth in the global economy.

This changes the picture. When the world is doing poorly, it is likely that oil prices will decline further and that China’s economy will do worse than expected. In that case, the more China stockpiles oil, the greater its losses. Oil prices in other words can be positively correlated with China’s economic performance, and stockpiling oil actually increases volatility because China profits on the stockpile when growth is higher than expected, and loses when it is lower than expected.

The second article, also in Bloomberg, told a similar story about iron ore:

Iron ore imports by China rebounded to an all-time high last month, capping record annual purchases, as slumping prices boosted demand for overseas supplies in the biggest user and some local mines were shuttered over winter.

China is by far the world’s largest consumer of iron ore, taking up very recently as much as 60% of all the iron ore produced in the world. What drives China’s voracious demand for iron, of course, is its extraordinarily high investment growth rate. For nearly five years I have warned that because I expected Chinese growth rates to drop significantly, I also expected the price of iron ore to collapse (and I have always added that in this context the word “collapse” was wholly appropriate). Clearly this has happened. There is a very high positive correlation between Chinese GDP growth and the price of iron ore, and so iron and steel inventory necessarily increases balance sheet inversion. If China slows further, it will take additional losses on its inventory as iron ore proies drop further. If Chinese growth picks up, China benefits from its stockpiling strategy.

Stockpiling iron ore might seem like a good idea for China if iron ore is so cheap that its price can no longer decline. In that case stockpiling iron or steel creates a hugely convex trade that more than compensates for the additional volatility that it adds to the Chinese economy.  There are many investors, especially in China, who believe that iron ore prices have fallen so dramatically in the past two years that we have effectively reached the point at which the downside is minimal compared to the upside.

What to watch for

This may be true, but I think we have to be very skeptical about such arguments. Iron ore currently trades in the mid $60s, roughly one third of its peak in the $190s in late 2010 and early 2011, if I remember correctly. Many analysts believe that this decline has been so dramatic and astonishing that it cannot possibly continue. I disagree. At the turn of the century I think iron ore traded below $20, and it seemed at the time that prices could only decline even further. Current prices, in other words, only seem astonishingly low compared to their peak prices, which were driven by a surge in demand from China that was completely unprecedented in history. By historical standards, iron ore is not cheap at all. I have been arguing for years that a collapse in iron ore prices was inevitable, and iron would actually drop below $50 by 2016-17, perhaps even to $30-40 before the end of the decade, and I see no reason to assume that we are anywhere near the bottom.

Whether or not I am right about iron ore, the main point is that hard commodity prices have been driven to historically high levels largely because of China’s disproportionate share of global demand, with both prices and Chinese demand beginning to surge in 2003-04. Prices are highly positively correlated with Chinese growth, in other words, and stockpiling necessarily exacerbates both growth acceleration and deceleration.

Finally the third article, in the Financial Times, told what at first seemed to be a very different story:

Local governments in some of China’s smallest cities are snapping up an increasing amount of their own land at auctions, in a destructive cycle designed to prop up property prices but which is ravaging their own finances.

Local government financing vehicles in at least one wealthy province, Jiangsu, which borders Shanghai, accounted for more land purchases than property developers did in 2013 — the last year for which data were available — according to research collated by Deutsche Bank. The data signal that already cash-strapped local governments are switching money from one pocket to another rather than booking real sales.

Clearly it is extremely risky for local governments, who are highly dependent on land prices for their revenues, to increase their exposure to land prices by buying up land at auctions. This is an obvious case of balance sheet inversion at the local government level. Some economist might argue that while it may increase risk at the local level, it does not do so at the national level. It simply represents a transfer of wealth from one group of economic agents to another. If real estate prices fall, for example, local governments will be even worse off than ever, but property developers will be better off because they are less exposed than they otherwise would have been.

There are at least two reasons why this may be totally mistaken. The first reason is that by propping up real estate prices local government may be helping powerful local interests who only want to sell their real estate in order to fund disinvestment or flight capital. The second, and far more important, reason has to do with the fact that financial distress costs are concave, not linear. If there is a transfer of wealth from one indebted entity to another, the latter benefits at the former’s expense. But the reduction of financial distress costs for the latter must necessarily be less than the increase for the former. Taken together, there must be a net increase in financial distress costs for China and a net increase in volatility within China. This is not the place to explain exactly why this must happen (I will do so in my upcoming book), but if it were not true, then it would not be the case that a country could suffer from excessive domestic debt.

My main point is that orthodox economists have traditionally ignored the impact of balance sheet structure on rapid growth, but liability structures can explain both very rapid growth and very rapid growth deceleration. It is unclear to what extent balance sheet inversion explains part of the Chinese growth miracle of the past decade, but it would be unreasonable to discount its impact altogether, and I suspect it’s impact may actually be quite high. To the extent that it has boosted underlying growth in the past, for exactly the same reason it must depress underlying growth in the future.

What is more, because we are in the late stages of China’s growth miracle, we should recognise that historical precedents suggest that balance sheet inversion will have increased in the past few years, and may continue to do so for the next few years, which implies that a greater share of growth than ever is explained not by fundamental improvements in the underlying economy but rather by what are effectively speculative bets embedded into the national balance sheet. Besides commodity stockpiling and real estate purchases by local governments, we have clearly seen an increase in speculative financial transactions by large Chinese companies (the so called “arbitrage”, for example, in which SPEs have borrowed money in the Hong Kong markets and lent the money domestically to pick up the interest rate differential as well as any currency appreciation), which is the Chinese version of what in the late stages of the Japanese growth bubble of the 1980s was referred to as zaitech.

We have also seen growth in external financing, which is the classic form of inverted debt for developing countries. The main thing to watch for, I think, is one of the most dangerous kinds of balance sheet inversion, and is especially common when growth has been driven by leverage, and that is the tendency for borrowers to respond to credit and liquidity strains by effectively doubling up the bet and shortening maturities. I don’t know if this is happening to any worrying extent, but when we start to see a dramatic shortening of real maturities, it should be a warning signal.

<![CDATA[Interview on Chinese CPI and PPI data for December]]> The National Bureau of Statistics released today CPI and PPI data for December 2014. People’s Dailysummarizes the CPI data, which came in pretty close to market expectations:

China’s consumer prices grew 2 percent in 2014 from one year earlier, well below the government’s 3.5 percent target set for the year, official data showed on Friday. The increase was also below the 2.6-percent growth registered in 2013. Growth in the consumer price index (CPI), the main gauge of inflation, rebounded to 1.5 percent in December from November’s 1.4-percent rise, its slowest increase since November 2009. On a monthly basis, December’s CPI edged up 0.3 percent against the previous month, reversing a downward trend reported since September.

The People’s Daily also summarizes the PPI data, in which November’s 3.3% decline in prices was quite a bit worse than the 3.1% decline the market expected: PPI

China’s producer price index (PPI), which measures inflation at wholesale level, dropped 3.3 percent year on year in December, the National Bureau of Statistics said on Friday. In 2014, the country’s PPI fell 1.9 percent year on year.

Several journalists contacted me asking me to comment on the implications of the latest data, and I thought I would compile for my blog interview questions and responses from two of them. Before doing so I wanted to quote from one more People’s Daily article, in which the writer proposes very automatically a widely-held view about the monetary implications of disinflationary pressures:

China’s consumer inflation remained weak in December, while price declines at the factory gate level continued to deepen, suggesting weakness in the world’s second-largest economy but giving policy makers more room to take easing measures.

Here are the questions and my responses:

  • The current data suggests that China is facing deflationary pressures, much like Japan has since the early 1990s. How will this affect the world compared to Japan’s deflation?

It will be very different. Japanese deflation occurred in an environment of fairly robust global growth. The US was just beginning the surge in productivity associated with the spread of information technology. International trade was expanding rapidly. Many developing world economies, and all of Latin America, had emerged from the terrible Lost Decade of the 1980s determined to reform and liberalize their economies. A lot of developing country debt had been written down or was in the process of being written down, and relatively speaking debt levels around the world were low and rising. Commodity prices were low, but stable, and less than a decade earlier, the Fed and other central banks around the world had been fighting off very high levels of inflation. In that environment disinflationary pressures were welcome.

Today, conditions are very different. Non-food commodity prices have declined significantly and will continue to drop a lot more. Because debt levels are extremely high everywhere many countries will be forced into deleveraging, and I suspect  it will be another five years or so before the world seriously engages in the process of restructuring sovereign debt with partial or substantial debt forgiveness. Most importantly, the two main sources of income inequality have not been resolved. First, within the household sector in the US, Europe, China, Japan and a number of other countries, the level of income inequality is nearly as bad as it has even been. Second, at the household level in countries like China and Germany the household share of income is far too low.

This combination has left us with weak consumption, excess savings and excess capacity. Without a major infrastructure investment program in the US, India, or possibly Europe, there simply isn’t enough global demand to absorb the global capacity that has been built up over the last couple of decades. So there is no appetite for disinflationary pressure in today’s global environment, whereas two decades ago the deflationary pressures that Japan might have unleashed were welcome.

I am not sure however that Chinese deflationary pressure is going to matter much to the rest of the world because China is as much a victim as it is a cause of global disinflation. The Chinese economy is simply participating in a greater global environment in which consumption is too low and the resulting excess capacity leaves the private sector unwilling to invest. But Chinese deflation is certainly not going to help.

Where China faces a problem, like many other countries, is in the relationship between debt and deflation. In a deflationary environment unless productivity growth rates are high, it is very difficult to keep the value of assets rising in line with the value of debt. There is a natural tendency for asset values to decline in line with deflation, whereas the nominal value of debt is constant (and, when interest costs are added, the nominal value of monetary obligations actually increases). Of course if the value of debt rises faster than the value of assets, by definition wealth (equal to equity, or net assets, in a corporate entity) must decline. This is why highly indebted countries and businesses struggle especially hard with deflation.

This is a problem for many Chinese borrowers. For nearly two decades, when nominal GDP growth was as high as 20-21% and the GDP deflator at 8-10%, even if they were horribly mismanaged the nominal value of assets soared relative to debt. Very low interest rate – around 7% for preferred borrowers – made servicing the debt almost an afterthought. Under those conditions it was pretty easy to ignore debt costs, and even easier to pick up very bad investment habits. Now that nominal GDP growth has dropped to around 8-10%, and could be substantially lower in a deflationary environment even if growth did not continue to decline, as I expect it will, those bad habits have become brutally expensive.

This is why borrowers are crying out for relief in the form of lower interest rates. But while lower interest rates do provide short term relief, they do not address the fundamental problem, and even allow some borrowers the lassitude to make the underlying problem worse. This puts the authorities in a tough spot.

  • We are seeing reforms in many countries, especially Europe, China and Japan to open up their economies and to liberalize the labor and financial markets. When will these reforms begin to affect growth?

Unfortunately they probably won’t. Japan during the past two decades, and European countries like Spain during the past six years, should remind us very clearly of a very old story. When debt levels are low, reforms aimed at improving productivity, if they are correctly designed and implemented, can result in the higher productivity and GDP growth that could, in principle, allow a country to “grow” its way out of debt. When debt levels are high, however, reforms almost never result in faster growth. When growth is most needed, when a country is suffering from excessively high levels of debt, it is hard to find many cases in which the aggressive implementation of reforms led to growth rates fast enough for the debtor to grow its way out of debt.

This seems very counterintuitive at first, even if the history behind it is quite abundant, and very few economists seem aware of the problem (which is why most economic forecasts mistakenly focus on the pace with which reforms are likely to be implemented, and are always disappointed), but in fact the reasons are not so hard to understand. The combination of very high levels of debt and excess manufacturing capacity can lock an economy into a self-reinforcing deflationary process in which growth stagnates and debt rises faster than debt servicing capacity. When debt levels are perceived as excessive, there is downward pressure on growth for at least two reasons.

First, spending on both consumption and investment declines as households and businesses cut back on disbursements in order to repay debt (I think this is what Richard Koo refers to as “balance sheet recession”). Second, high debt levels and weak credit perceptions distort the distribution of operating earnings (at the corporate level) or the distribution of the benefits of GDP growth (at a macroeconomic level) in ways that reduce growth and increase balance sheet fragility. In finance this second reason is referred to as financial distress. By lowering growth to well below growth capacity, the combination of reduced spending and financial distress causes the real debt burden to increase. Of course an increasing debt burden reinforces the poor performance of the economy in a way familiar to anyone who has read Irving Fisher on debt-deflation.

  • Comparing the causes in China and Japan, how long do you expect China will take to overcome deflation – several years, or more? What are the biggest challenges to tackle and what policies should Beijing implement?

How long it takes for China to overcome deflationary pressures depends, I think, really on two very different sets of policies. First, Beijing must aggressively tackle the country’s debt burden. For example if local governments are forced to sell off assets and use the proceeds to write down or repay debt, they can reduce the debt burden without reducing total spending. I think most policymakers and understand this, but there is another stronger reason to liquidate assets to pay down debt. Strengthening the liability side of the balance sheet changes the way assets are managed (the process is far better understood in finance theory than in economics), and the result is nearly always more productive use of the assets.

The second set of policies that Beijing should implement to protect the country from a lost decade of much slower growth is to create alternative sources of demand as quickly as possible that do not require credit expansion. I can think mainly of two ways, and both of these are implicit in the reforms proposed during the Third Plenum, in October 2013. First, substantial direct or indirect wealth transfers from the state sector to Chinese households will unleash a surge in household consumption as household income rises (and because the interest on bank deposits is an important source of income for most middle and lower middle class households, if the authorities reduce interest rates, as struggling borrowers are demanding, China actually moves in the wrong direction). The constraint here of course is political, because the elites who benefit from the state control of these assets are likely to be highly resistant to any such transfer.

Second, substantial reform in corporate governance within the banking system should be aimed at causing a substantial shift, as rapidly as possible, in the credit allocation process, so that state-related entities that systematically malinvest, like local governments and state-owned enterprises, receive a smaller share of credit while small and medium enterprises, who tend in China to be far more efficient users of capital, receive a much greater share. Of course there will also be a significant political constraint here too, and for the same reasons.

It will be hard to do either very quickly. The sets of policies that lead to either outcome are politically difficult to implement because they force a disproportionate share of the adjustment costs onto the very powerful sectors that received a disproportionately large share of China’s growth in the past two decades. What’s more, the consumption impact of wealth transfers to the household sector will lag, depending on how credible they are, while reforming the financial sector is always a slow and disruptive process.

It may take many years before China can make the necessary changes. During this time government debt will have to rise as the government absorbs the employment consequences of these disruptions, and unfortunately higher debt will itself put downward pressure on growth. It isn’t easy, but of course the history of reforms in highly indebted economies has never suggested that this would be easy, and so far it seems like Beijing is pretty determined to do whatever it has to do.

  • To what extent will an acceleration in price reform help China combat disinflation?

Price reform will help much less than everyone thinks. China’s very weak consumption share of total demand has very little to do with inefficient pricing. It is almost wholly a function of the very low household share of GDP, and the only reforms that matter are reforms either that reduce the implicit transfer of wealth from households to large businesses and the state – for example allowing banks to pay higher real deposit rates, or eliminating subsidies for businesses, including land subsidies – or reforms that directly increase household wealth, including houkou reforms and improvements in the social safety net.

  • As deflation also hurts Japan and Europe, what might that affect the global economy and monetary policy?

Excess capacity is a global problem, and not just a Chinese one, but the implications for monetary policy are very different in countries like China and Japan than they are in countries like Europe and the US. The monetary and financial structures of some countries create a very different set of institutions than in others, and one result is that policy responses that might seem to make sense in the US are actually harmful in China. For example lower interest rates and weaker currencies in the US and Europe might create inflationary pressure, so that the proper response to harmful deflation might very well be to reduce interest rates and to encourage currency depreciation.

It turns out, however, that under certain conditions lower interest rates and depreciating currencies may actually exacerbate deflationary pressure. Unfortunately these conditions probably apply to China and Japan. For some reason people are often shocked when I say this, even though you would have thought they would have wanted some way to explain why the roughly 35% depreciation of the yen during the last three years has not unleashed inflation, and has instead been accompanied by weaker, not stronger, consumption. Or again it should have been at the very least intriguing that during the last decade in China we have seen extraordinarily rapid monetary expansion but we have never suffered runaway CPI inflation, and in fact the inflation we have seen has been caused mainly by food shortages, not by loose money.

  • How can tighter monetary policies combat deflationary pressures in Japan or China?

You get inflationary pressures when demand rises faster than supply, and deflationary pressures when the opposite happens. This is pretty easy to understand. So what matters is how monetary policies or monetary conditions affect the relationship between supply and demand. In Japan and China, especially the latter, weak consumption and high savings are not driven by very high personal savings preferences. They are driven by the low household income share of GDP. When the BoJ takes steps aimed at changing inflation expectations, for example, they are always surprised because these policies do not seem to affect Japanese psychology at all.

But in fact they probably do, it’s just that the psychology doesn’t matter. With so much being said in the press about the collapsing yen and about policies aimed at forcing up Japanese inflation, it is hard to believe that the Japanese aren’t aware of policies that are supposed to create inflation. But if there is a psychological impact, why doesn’t inflation rise?

Probably because low inflation has very little to do with Japanese household psychology. As I see it, because a weakening yen raises the cost of imports, it reduces the real value of Japanese household income while, at the same time, subsidizing the tradable goods sector. The tradable goods sector in Japan is much larger relative to the household sector than it is in the US, so perhaps it is not surprising if, unlike in the US, a weaker yen increases the growth in household income by the same amount or by less than it increases the growth in the tradable goods sector (adjusted for any change in “psychology”, of course). In that case there shouldn’t be any inflationary pressure. If consumption does not rise faster than production, after all, why should prices rise? In the end it might well take a stronger yen to force up demand relative to supply, although I suspect credibility is so low that it would take many months before the impact were felt.

Something similar happens in China, where the household income share of GDP is a much greater constraint on consumption that household psychology. In the US and Europe, deflationary pressures increase the ability of central banks to loosen monetary conditions, and because too many economists assume too easily that what is likely to be true in the US must be true everywhere, deflationary pressures in China are unleashing calls for lower interest rates and greater credit expansion in China. This is why I copied the People’s Daily article at the beginning of this blog entry.

In the US lower interest rates tend to be inflationary because a substantial portion of credit is consumer credit. What is more, lower interest rates have a positive wealth effect for American households because they tend to be associated with higher real estate prices, a stronger stock market, and of course stronger bond markets. When interest rates are lowered, the positive impact on American consumption is greater than the positive impact on American production, so prices usually rise.

In China, however, most credit is delivered to businesses, not households, and is aimed at increasing production, not consumption. What is more, for Chinese households, bank deposits form a far greater share of total financial savings than they do for American households. Lower interest rates, in other words, generally have a negative wealth effect in China largely because reducing the interest rate on bank deposits makes most Chinese feel poorer, not wealthier. An IMFstudy in 2011 confirmed the relationship.

This is why deflationary pressures in China indicate that we probably need monetary tightening, not loosening. I know this sounds extremely counterintuitive, and so violates what we have learned about the world by assuming that the world looks a lot like the US, but there is both a logical argument behind it and what I think is overwhelming historical evidence. The convention that any economic variable that works one way in the US must work the same way in China is one of those assumptions that is implicit in so much that is written about the Chinese economy, and yet is made by foreign and Chinese economists who would indignantly reject the assumption were it ever made explicitly.

Post script: will easing price controls cause prices to rise?

The day after I posted this entry I saw in the South China Morning Post that the weak CPI and PPI data were likely to strengthen calls for deregulating price controls. According to the article:

Fresh confirmation of persistent deflationary pressures on the mainland, with a consumer price gauge stuck near a five-year low, has prompted calls for further action to ease government price controls on energy and other key industrial inputs. Perhaps even more telling than stubbornly low consumer prices, a slide in producer prices has extended to 34 months. The entrenched factory-gate deflation might warrant a policy response of similar resolve to the leadership’s battle against corruption.

…In a sign that the delayed price reform may accelerate this year, the commission released a document on Monday for the liberalisation of tobacco leaf prices, fees charged at ports and some prices related to rail transport and civil aviation.

Price reforms in China mean, for the most part, removing price subsidies or controls that keep prices down. It may therefore seem intuitively obvious that eliminating these policies will cause average prices to rise, but this isn’t the case. China’s very weak consumption share of total demand has very little to do with inefficient pricing. It is almost wholly a function of the very low household share of GDP. Raising the prices of individual goods will not cause overall demand to rise relative to supply, and so will have no net impact on inflation.

Let’s assume, for example, that Beijing were to increase tobacco taxes so that Chinese smokers pay more for cigarettes.

  1. If smokers decide in response to higher cigarette prices to reduce their savings by exactly the same amount as the higher spending on cigarettes, the result would be a one-off increase in cigarette prices and nothing else would change. This would cause a temporary jump in CPI inflation. 
  1. If they spend all of their income on consumption (which is likely to be the case for poor people), or if they saved a fixed amount of their paycheck (which is likely to be the case for migrant workers and for many other types of savers), the increase in cigarette spending would be matched, kuai for kuai, with a reduction in other consumer spending. Cigarette prices would rise, but the price of other consumer goods would decline by the same amount, so that the net impact on CPI inflation would be zero.

There are perfectly good reasons to reform prices. Price reform can lead to a more efficient use of resources. If subsidies to businesses are paid indirectly or directly by households, price reforms also help rebalance the economy, which indirectly creates inflationary pressures. But it is a mistake to think that price reforms are directly inflationary. The only way to cause prices to rise is to increase demand relative to supply, and in China, where low household income is the main constraint on consumer demand, the only substantial way in which to spur CPI inflation is to increase the household income share of GDP.

<![CDATA[My reading of the FT on China’s “turning away from the dollar”]]> The Financial Times ran a very interesting article last week called “China: Turning away from the dollar”. It got a lot of attention, at least among China analysts, and I was asked several times by friends and clients for my response. The authors, James Kynge and Josh Noble, begin their article by noting that we are going through significant changes in the institutional structure of global finance:

An “age of Chinese capital”, as Deutsche Bank calls it, is dawning, raising the prospect of fundamental changes in the way the world of finance is wired. Not only is capital flowing more freely out of China, the channels and the destinations of that flow are shifting significantly in response to market forces and a master plan in Beijing, several analysts and a senior Chinese official say.

While this may be true, I am much more skeptical than the authors, in part because I am much more concerned than they seem to be about the speed with which different countries are adjusting, or not adjusting, to the deep structural imbalances that set the stage for the global crisis. My reading of financial history suggests that we tend to undervalue institutional flexibility, especially in the first few years after a major financial crisis, perhaps because in the beginning countries that adjust very quickly tend to underperform countries that adjust more slowly. As I have written many times before China’s high growth and very large capital outflows suggest to me how difficult it has been for China to shift from its current growth model.

Beijing has been trying since at least 2007 to bring down China’s high savings rate, for example, and yet today it remain much higher than it did seven years ago. Chinese capital outflows, in other words, which are driven by its excessively high savings rates, may have less to do with master planning than we think, and certainly when I think of the most dramatic periods of major capital outflows in the past 100 years, I think of the US in the 1920s, the OPEC countries in the 1970s, and Japan in the 1980s. In each case I think we misinterpreted the institutional strengths and the quality of policymaking.

Any discussion about China’s future role in global finance or about the reserve status of the dollar or the RMB is so highly politicized that you cannot approach the topic in the same way you might approach an article about the Mexican peso, or even the Russian ruble, but I figured that there are a lot of interesting points about which a discussion might anyway be illuminating. To begin with, there is much in the article with which I agree, but also some things with which I disagree. About the latter I have basically three different “sets” of disagreements:

  1. In some cases my interpretation of both the information and the implications provided by the authors is a lot more skeptical than theirs.
  1. The authors provide the views of several analysts concerning the impact on the US bond markets and US economy more generally of reduced PBoC purchases of US government bonds, and these views range from neutral to very negative. I would argue however that in fact these views fail to understand the systemic nature of the balance of payments, in which any country’s internal imbalances must necessarily be consistent with its external imbalances. They assume implicitly assume that PBoC purchases only affect the demand for US government bonds, whereas in fact the flow of capital from one country to another must automatically affect both demand and supply. In fact the impact of reduced PBoC purchases of US government bonds is likely to be net positive, and while this view is probably counterintuitive, and certainly controversial, in another part of the article the authors cite a Chinese official whose statement, had they explored the implications fully, would have explained why.
  1. There is one point that they make which I think is fundamentally wrong, although a lot of people, including surprisingly enough economists and central bankers, have made the same mistake. It is not fundamental to their argument overall, but I think this mistake does indicate the level of confusion that exists about the way reserve currencies work and it is worth drawing out.

The first set of disagreements concern issues on which reasonable people can disagree, and while I have always been on the skeptical side, I also recognize that only time can resolve the disagreements. For example in discussing some of Beijing’s recent activity in driving the internationalization of the RMB the authors say:

What is clear is that Beijing’s intention to diversify the deployment of its foreign exchange reserves is strengthening. Over the past six months, it has driven the creation of three international institutions dedicated to development finance: the Shanghai-based New Development Bank along with Brazil, Russia, India and South Africa; the Asian Infrastructure Investment Bank and the Silk Road Fund.

There certainly have been many announcements in the past few years, not just about new global institutions that are being planned, but also about currency swap agreements and other actions taken by foreign central banks related to RMB reserves, and each of these has created a great sense of excitement and momentum. I have often thought the amount of attention they received significantly exceeded their importance, and while I won’t mention specific cases because that may come across as a little rude, some of the countries whose central banks negotiated currency swap lines with the PBoC are either credit-impaired enough that any implicit extension of credit would be welcome, or are primarily making a political statement. In at least one case the currency swap is denominated in both RMB and the counterpart’s national currency, but is actually settled in US dollars, and so is little more than a dollar loan indexed to RMB.

How certain are today’s predictions?

I am also very skeptical about the long-term importance of the various development banks that are in the works. It is not clear to me that the incentives of the various proposed members are sufficiently aligned for there to be much agreement on their loan policies, nor is it clear to me that all the members agree about their relative status and how policy-making will occur. It is easy enough to agree in principle that there is a lot of room to improve the existing infrastructure of global financial institutions – mainly the Bretton Woods institutions – but that may well be because the needs of different countries are either impractical or so heterogeneous that no institution is likely to resolve them.

We do have some useful history on this topic. The Bretton Woods institutions were established when one country, the US, was powerful enough to ride roughshod over competing needs, and so the misalignment of interests was resolved under very special and hard-to-replicate conditions, but since then it is hard to think of many examples of similar institutions that have played the kind of transformative role that is expected of the institutions referred to in the article. It is not as if proposals to change the global financial system have not been made before – I remember that burgeoning reserves among Arab OPEC members in the 1970s, or Japan in the 1980s, also generated waves of activity – but change is always easier to announce than to implement. This doesn’t mean that the new institutions being proposed will not have a very different fate, of course, but I would be pretty cautious and would wait a lot longer before I began to expect much from them.

There is anyway a more fundamental reason for long-term skepticism. As the authors note the creation of these institutions is driven largely by China and is based on current perceptions about longer-term trends in China’s growth. Historical precedents suggest however that it may be hard to maintain the current momentum. Rapid growth is always unbalanced growth, as Albert Hirschman reminded us, and what many perceive as the greatest economic strengths of rapidly growing economies are based on imbalances that also turn out to be their greatest vulnerabilities. The fact that the US in the 1920s, Germany in the 1930s, Brazil in the 1960s and 1970s, Japan in the 1980s, China during this century, and many other rapidly growing economies generated deep imbalances during their most spectacular growth phases should not be surprising at all, but it is important to remember that all of them subsequently suffered very difficult adjustments during which, over a decade or more, these imbalances were reversed (Germany after the 1930s of course “adjusted” in a different way, but it was already clear by 1939-40 that the German economy was over-indebted and substantially unbalanced).

The reversal of these imbalances involved adjustment processes that turned out very different from the predictions. While the periods of spectacular growth always get most of the attention from economists and journalists, and always create outsized expectations, the real test over the longer term is how well the economy adjusts during the rebalancing period. We can learn much more about long-term growth, in other words, by studying Japan post-1990, or the US post-1930, for example, than we can from studying Japan pre-1990 or the US pre-1930. Until we understand how adjustment takes place, and the role of debt in the adjustment process, the only safe prediction we can make, I suspect, is that the momentum that drives Beijing’s current activity will not be easy to maintain.

A second area in which reasonable people can disagree is on the quality and meaning of recent data. “The renminbi’s progress has been more rapid than many expected,” according to the authors. This may be true by some measures, but there has been a great deal of discussion on how meaningful some of the trade and capital flow numbers are, especially when compared to other developing countries much smaller than China. It is true that the use of the RMB has grown rapidly in recent years according to a number of measures, but so has that of currencies of other developing countries – Mexican pesos, for example – and at least part of this growth may have been a consequence of uncertainty surrounding the euro. We have to be careful how we interpret the reasons for this growth.

What is more, when you compare the share of foreign exchange activity – whether trade flows, reserves, or capital flows – that is denominated in RMB with the share in the currencies of other countries, including other developing countries, what is striking is how remarkably small it still is relative to the Chinese share of global GDP or of global trade. There are obvious reasons for this, of course, but it will be a long time before we can even say that the RMB share is not disproportionately small, and it has a long way to go just to catch up to several developing countries in Latin America or Asia. It is too early, in other words, to decide on the informational content of the growing RMB share of currency trading.

There has also been a lot of debate and discussion about how much of this data represents fundamental shifts in activity anyway. It is clear that a lot of trade is denominated in RMB for window-dressing purposes only – a mainland exporter that used to bill its client in yen, for example, will reroute the trade through its HK subsidiary, and bill the HK sub in RMB before then selling it on to the final buyer in yen. This shows up as an increase in the RMB denominated share of exports, but in fact nothing really changed. There has also been currency activity driven by speculation, or by political signaling, or by the need to disguise transactions, and so on. So much has already been said over the past few years on these issues that I don’t have much to add, but it is worth keeping in my mind as we try to assess the informational content of this data that there may be strong systemic biases in the numbers

How does the RMB affect US interest rates?

I think there is a small but growing awareness of why Keynes was right and Harry Dexter White wrong in 1944 about the use of bancor versus dollars as the global reserve currency. There is a cost to reserve currency status, even though a global trading currency creates an enormous benefit to the world.

When any single currency dominates as the reserve currency, however, the cost can be overwhelming unless the reserve currency country intervenes in trade. The UK paid that cost heavily in the 1920s and less so in the 1930s after it began to raise tariffs (people forget that sterling reserves exceeded dollar reserves during this period), which is why Keynes was so adamant that the world needed something like bancor. It is in light of the debate over the value of reserve currency status that I find the discussion about the impact a shift in the status of the RMB might have on US interest rates the more interesting part of the article. According to the authors:

Not only is China’s desire to buy US debt diminishing, so is its ability to do so. The banner years of Treasury bond purchases, during which holdings rose 21-fold over a 13-year period to hit $1.27tn by the end of 2013, were driven by an imperative to recycle China’s soaring US dollar current account surpluses. But these surpluses are narrowing sharply — from the equivalent of 10.3 per cent of gross domestic product at the peak in 2007 to 2.0 per cent in 2013. In fact, if financial flows are taken into account, China ceased over the most recent four quarters to be a net exporter of capital at all.

Actually if financial flows are taken into account, China has not ceased over the most recent four quarters to be a net exporter of capital. I think the authors are confusing capital exports through the PBoC (increases in central bank reserves) and capital exports more generally. China’s net capital export, by definition, is exactly equal to its current account surplus, and while it is true that China’s current account surplus has narrowed from its peak in 2007 to its trough in 2013, it has risen very rapidly during 2014. In fact I think November’s current account surplus may be the largest it has ever posted.

It is true that PBoC reserves have not increased in 2014, and have actually declined, although this may be mainly because the non-dollar portion of the reserves dropped dramatically in value, so that in dollar terms they have declined, but this was not because net exports have declined and it is not even a policy choice. Because the PBoC intervenes in the currency, it cannot choose whether to increase or reduce its accumulation of reserves. All it can do is buy the net inflow or sell the net outflow on its current and capital account, so the fact that we have seen massive capital outflows from China in 2014 means that it is exporting more capital than ever, but not in the form of PBoC purchases of foreign government bonds.

The trend, in other words, is no longer narrowing current account surpluses and less capital export but rather the opposite. An investor they cite thinks we will see a reversal of this trend: “I absolutely think we are going to see smaller Chinese current account surpluses in the future”, he says, “because of greater Chinese spending overseas on tourism and services and greater spending power at home may lead to more imports.”

I think we have to be cautious here. In order to protect itself from a rapidly rising debt burden, China is trying to reduce the growth in investment as fast as it can. It is also trying to reduce the growth in savings as fast as it can, but there are only two ways to reduce savings. One is to increase the consumption share of GDP, but this is politically very hard to do because it depends on the speed with which China directly or indirectly transfers wealth from the state sector to the household sector. The other is to accept higher unemployment.

Because the current account surplus is by definition equal to the excess of savings over investment, an expanding current account surplus allows China to reduce investment growth at a faster rate than can be absorbed by rising consumption – without rising unemployment. But with Europe competing with China in generating world-record current account surpluses, and with weak consumption in Japan, it isn’t easy get the rest of the world to absorb large current account surpluses.

Put differently, the biggest constraint on China’s export of its savings is not domestic. It is the huge amount of savings that everyone wants to export to everyone else, but which neither China nor any developing country wants to import. Still, I suppose in principle we could see a huge shift in capital flows, with less going to the US and to hard commodity exporters (as commodity prices drop) and more going to India, Africa, and other developing countries. At any rate over the long term the authors are concerned about the impact China will have on capital flows to the US:

All of this leads to a burning question: how convulsive an impact on US debt financing — and therefore on global interest rates — will the changes under way in China have? Analysts hold views across a spectrum that ranges from those who see an imminent bonfire of US financial complacency to those who see little change and no cause for concern. 

The great concern, the authors correctly note, is the idea that the US has come to depend on China to finance its fiscal deficit. If China stops buying US government bonds, the worry is that the US economy may be adversely affected, and even that US government bond market will collapse and US interest rates soar:

A decade ago Alan Greenspan, the then chairman of the US Federal Reserve, found his attempts to coax US interest rates upwards negated by Beijing parking its surplus savings into Treasuries. Arguably, says Mr Power, a bond bubble has existed ever since. “If China is now set to redeploy those deposits into capital investment the world over, does this mean the [Greenspan] conundrum will be at last ‘solved’ but at the cost of an imploding Treasury market?” Mr Power asks. “If so, this will raise the corporate cost of capital in the west and put yet another brake on already tepid western GDP growth.”

Because PBoC purchases of US government bonds are so large, it seems intuitively obvious to most people that if the PBoC were to stop buying, the huge reduction in demand must force up interest rates. But this argument may be based on a fundamental misunderstanding of how the balance of payments works. First of all, greater use of the RMB as a reserve currency does not mean that the PBoC will buy fewer US government bonds. On the contrary, higher levels of RMB reserves in foreign central banks will by definition increase capital inflows into China. In that case either it will force the PBoC to purchase even more foreign government bonds, if the PBoC continues to intervene in the currency, or it will cause some combination of an increase in Chinese capital outflows and a reduction in China’s current account surplus. This is an arithmetical necessity.

If the RMB becomes more widely used as a reserve currency, it could certainly result in lower foreign demand for US government bonds, but not lower Chinese demand. This, however, would not be bad for the US economy or the US government bond market any more than it would be if the PBoC were to reduce its demand for US government bonds. China, and this is true of any foreign country, does not fund the US fiscal deficit. It funds the US current account deficit, and it has no choice but to do so because China’s current accounts surpluses are simply the obverse of China’s capital account deficits. This may not seem like an important distinction in considering how lower demand will affect prices, but in fact it is extremely important because any change in a country’s capital flow can only come about as part of a twin set of changes in both the capital account and the current account.

This is true for both countries involved. There is no way, in other words, to separate the net purchase of US dollar assets by foreigners with the US current account deficit. One must always exactly equal the other, and a reduction in the former can only come about with a reduction in the latter. So what would happen if the PBoC were sharply to reduce its purchase of US government bonds? There are only four possible ways this can happen:

  1. The reduction in PBoC purchases of US government bonds was matched by an increase in purchases by other Chinese institutions or individuals of US dollar assets. This is mostly what seems to have happened in 2014, and because the PBoC intervenes in the currency, fewer purchases of government bonds by the PBoC was not a choice, but rather the automatic consequence of increased foreign investment by other Chinese institutions or individuals. The impact on the US economy would depend on what assets the other Chinese institutions or individuals purchased. If they purchased risk-free US assets there would be no net impact. If they purchased risky US assets there would be a small, barely noticeable increase in the riskless US interest rate, matched by an equivalent reduction in the US risk premium.
  1. The reduction in PBoC purchases of US government bonds was matched by an increase in purchases by other foreigners of US dollar assets. The impact on the US economy would depend, again, on what assets the other foreigners purchased. If they purchased risk-free US assets there would be no net impact. If they purchased risky US assets there would be a small, barely noticeable increase in the riskless US interest rate, matched by an equivalent reduction in the US risk premium.
  1. The reduction in PBoC purchases of US government bonds was not matched by an increase in purchases by other Chinese or foreigners, so that there was a commensurate decline in the US current account deficit. Because the US current account deficit is equal by definition to the excess of investment over savings, there are only two ways the US current account deficit can decline. If there is no change in US investment, US savings must rise, and in an economy with underutilized capacity and unemployment, this will happen as unemployed workers and underutilized capacity are put to work, either to replace imports or to increase exports. Workers with jobs save more than workers without, and companies with less underutilized capacity save more than companies with more because they are more profitable. More profitable businesses and fewer unemployed workers results in higher fiscal revenues and lower fiscal expenses, so that fewer foreign purchases of US government bonds is accompanied by a lower supply of government bonds.
  1. Finally, because the US current account deficit is equal by definition to the excess of investment over savings, the only other way the US current account deficit can decline is if there is no change in US savings, in which case, US investment must decline. Businesses close down American factories and otherwise reduce business and government investment. This causes GDP growth to drop and unemployment to rise.

What determines US savings?

These four, or some combination, are the only possible ways in which the PBoC can reduce its purchases of US government bonds. It is pretty obvious that the best outcome, the third scenario, requires fewer foreign purchases of US assets, as does the worst, the fourth scenario. It is also pretty obvious that what the PBoC does in largely irrelevant. What matters is whether the US current account declines. Because not only are Chinese institutions and other foreigners eager to purchase US assets, and because demand abroad is so weak, the US current account deficit is in fact likely to increase, as foreigners purchase even more US assets. The US current account deficit will only decline if growth abroad picks up or if the US takes actions to reduce its current account deficit – perhaps by making it more difficult for foreigners to invest their excess savings in the US.

If the US were to force down its current account deficit, would US savings rise or would US investment drop – put another way, is a lower current account deficit good, or bad, for the US economy? For most people the answer is obvious. A lower US current account deficit is good for growth. In fact much of the world is engaged in currency war precisely in order to lower current account deficits, or increase current account surpluses, by exporting their savings abroad.

For some analysts, however, a reduction in foreign purchases of US assets would be bad for US growth because, they argue, the US is stuck with excessively low savings rates. Because there is no way to increase US savings, a reduction in foreign purchases of US assets must cause US investment to decline.

These analysts – trained economists, for the most part – are almost completely mistaken. First of all, it does not require an increase in the savings rate for American savings to rise. Put differently, if unemployed American workers are given jobs, US savings will automatically rise even if the savings rate among employed workers and businesses is impossible to change. Secondly, these economists mistakenly argue that the reason the US runs a current account deficit is because US savings are wholly a function of US savings preferences, which are culturally determined and impossible to change. Because these are clearly lower than US investment, it is the unbridgeable gap between the two that “causes” the US current account deficit.

But while the gap between the two is equal to the current account deficit by definition, these economists have the causality backwards. As I show in the May 8 entry on my blog, excess savings in one part of the world must result either in higher productive investment or in lower savings in the part of the world into which those excess savings flow. This is an arithmetical necessity. Because China’s excess savings flow into the US – mostly in the form of PBoC purchases of US government bonds – the consequence must be either more productive investment in the US or lower savings.

If productive investment in the US had been constrained by the lack of domestic savings, as it was in the 19th Century, foreign capital inflows would have indeed kept interest rates lower, and because these foreign savings were needed if productive investment were to be funded, the result in the 19th Century was higher growth. But while it is true that in the US today there are many productive projects that have not been financed – the US would clearly benefit from more infrastructure investment for example – the constraint has not been the lack of savings. No investment project in the US has been turned down because capital is too scarce to fund it. In fact more generally it is very unlikely that any advanced economy has been forced to reject productive investment because of the savings constraint. It is usually poor planning, dysfunctional politics, legal constraints, or any of a variety of other reasons that are to blame.

This means that if China’s excess savings flow into the US, there must be a decline in US savings, and the only way this can happen is either through a debt-fueled consumption boom or through higher unemployment. The analysts interviewed in the Financial Times article argue that if there were an interruption to PBoC purchases of US government bonds, the adverse consequences could range from fairly minor to the extreme – a collapse in the US government bond market – but in fact the only necessary consequence would be a contraction in the US current account deficit. While there are scenarios under which this could be disruptive to the US economy, in fact it is far more likely to be positive for US growth.

As counterintuitive as this may at first seem, several economists besides me have made the same argument, and I provide the full explanation of why fewer foreign purchases of US assets will actually increase both American savings and America growth in Chapter 8 of my book, The Great Rebalancing. What is more, the fact that the US government has put pressure on Beijing to revalue the RMB in order to reduce the US current account deficit is simply another way of saying that Washington is pressuring Beijing to reduce the amount of US government bonds the PBoC is purchasing. After all, if large foreign purchases of US government bonds were good for the US, Europe, China, or anyone else, it must follow automatically that large current account deficits are good for growth and help keep interest rates low.

And this cannot be true. Remember that by definition, the larger a country’s current account deficit, the more foreign funding is “available” to purchase domestic assets, including government bonds. And yet instead of welcoming foreign funds and the associated current account deficits, countries around the world are eager to export as much of their savings as they can, which is another way of saying that they are eager to run as large current account surpluses as they can.

The arithmetic of the balance of payments

In fact there is evidence even within the article that Chinese purchases of US government bonds, far from boosting US growth, either by keeping interest rates low or otherwise, actually causes a reduction in demand for US-produced goods and services. This becomes obvious by recognizing the inconsistency between Chinese behavior and Chinese claims that they are seeking to diversify reserve accumulation away from the dollar. The inconsistency is made explicit when the article cites a famous incident in 2009.

“We hate you guys”, was how Luo Ping, an official at the China Banking Regulatory Commission vented his frustration in 2009. He and others in China believed that, as the US Federal Reserve printed more money to resuscitate American demand, the value of China’s foreign reserves would plunge. “Once you start issuing $1tn-$2tn...we know the dollar is going to depreciate so we hate you guys — but there is nothing much we can do,” Mr Luo told a New York audience.    

Mr. Luo, of course, turned out to be wrong, and the value of China’s dollar-denominated foreign reserves did not plunge. On the contrary, if the PBoC had purchased more dollars instead of fewer dollars, it would have avoided some of the currency losses it has taken since 2009. But while it might have been useful to explain why Luo was wrong about the plunging dollar, what really needed explaining is why “there is nothing much we can do”.

Actually China did have a choice as to whether to buy dollars or not. Luo was right about China’s lack of choice only in the sense that as long as Beijing was determined to run a large current account surplus, and as long as purchasing other currencies would have been too risky, or too strongly resisted by their governments, the PBoC did not have much of a choice. In China the savings rate is extremely high for structural reasons that are very hard to reverse. This means that the investment rate must be just as high, or else the gap between the two must be exported. Put differently, if China cannot export excess savings and run a current account surplus, either it must increase domestic investment or it must reduce domestic savings. This is just simple arithmetic, and is true by definition.

With investment rates among the highest in the world, and with much of it being misallocated, China wants to reduce investment, not increase it. Rising investment is likely to cause the country’s already high debt burden to rise. But as in the case of the US, the only way it can reduce its savings is with an increase in consumer debt or with an increase in unemployment.

Because none of the options are desirable, China can only resolve its imbalance between supply and demand if it exports the excess of savings over investment, or, put another way, it must run a current account surplus equal to the difference between savings and investment. But because China is such a large economy, and the gap between investment and savings is so large, this is an enormous amount of savings that must be exported, and China must run an enormous current account surplus that must be matched by the current account deficit of the country to whom these savings are exported. The US financial market, it turns out, is the only one that is deep and flexible enough to absorb China’s huge trade surpluses, and, perhaps much more importantly, it is also the only one whose government would not oppose being forced to run the countervailing deficits.

Had the PBoC tried to switch out of dollars and into Japanese yen, or Swiss francs, or Korean won, or euros, or anything else, it would have met tremendous resistance. In fact it did try to purchase some of those currencies and it did meet tremendous resistance, which is why its only option was to buy US government bonds. I explain why in my book as well as in another one of my blog posts.

Luo’s statement implies very directly that the only meaningful way to protect the PBoC from being forced to buy dollars is not by increasing the use of the RMB in international trade but rather for China to run smaller surpluses. It certainly did have a choice, but because the alternative was so unpalatable, Beijing felt as if it had no choice. China bought US government bonds not because it wanted to help finance the US fiscal deficit but very specifically because if it didn’t it would be forced either to increase domestic debt or to suffer higher unemployment.

This point is a logical necessity arising from the functioning of the balance of payments. Both Lenin andJohn Hobson explained this more than 100 years ago: countries export capital in order to keep unemployment low. If the RMB becomes a reserve currency, Beijing will have to choose whether, like the US, it will allow unrestricted access to its government bonds, or whether, like Korea, it resist large foreign purchases.

If it chooses the latter, the RMB cannot be a major reserve currency. If it chooses the former, the RMB might indeed become a major reserve currency, but this will force China to choose between higher debt and higher unemployment any time the rest of the world wants more growth. The result of a rising share of reserves denominated in RMB at the expense of a declining share denominated in dollars is really Washington’s goal, in other words, and not Beijing’s.

Can China invest its current account surplus at home?

At the beginning of this entry I said that the authors made one assertion that is fundamentally wrong, although so many economists get this wrong that it would be unfair to blame the authors for failing to do their homework. The mistake isn’t necessary to their argument, but I bring it up not just because it is a mistake commonly made but also because it shows just how confused the discussion of the balance of payments can get.

Early in the article the authors cite Li Keqiang’s “10-point plan for financial reform” which includes the following

Better use should be made of China’s foreign exchange reserves to support the domestic economy and the development of an overseas market for Chinese high-end equipment and goods.

They then go on to make the following argument:

As a mechanism towards this end, China is earning a greater proportion of its trade and financial receipts in renminbi. Because these earnings do not have to be recycled into dollar-denominated assets, they can be ploughed back into the domestic economy, thus benefiting Chinese rather than US capital markets.

This is incorrect. The amount that China invests at home and the amount of foreign government bonds the PBoC must purchase are wholly unaffected by whether China’s trade is denominated in dollars, RMB, or any other currency.

There are two ways of thinking about this. One way is to focus on the trade itself. If a Chinese exporter sells shoes to an Italian importer and gets paid in dollars, the exporter must sell those dollars to his bank to receive the RMB that he needs. Because the PBoC intervenes in the currency, it effectively has no choice ultimately but to buy the dollars, and the result is an increase in FX reserves. This is pretty easy to understand.

But what happens if the next time the Chinese exporter sells shoes to the Italian importer, he gets paid in RMB? In that case it is the responsibility of the Italian importer, and not the Chinese exporter, to buy RMB in exchange for dollars. This is the only difference. The Italian importer must obtain RMB, and she does so by going to her bank and buying the RMB in exchange for the dollars. Her bank must sell the dollars in China to obtain RMB, and once again because the PBoC intervenes in the currency, it effectively has no choice ultimately but to buy the dollars. The result once again is an increase in FX reserves.

The other way to think about this is to remember that the change in FX reserves is exactly equal, by definition, to the sum of the current account and the capital account. This is because the balance of payments must always balance. China’s current account surplus is wholly unaffected by whether the trade is done in dollars (the Chinese exporter is responsible for changing dollars into RMB) or in RMB (the Italian importer is responsible for changing dollars into RMB). In either case, in other words, PBoC reserves must rise by exactly the same amount.

What about Chinese investment? It too is wholly unaffected. The current account surplus, remember, is equal to the excess of Chinese savings over Chinese investment. If the current account surplus does not change, and savings of course will not have been affected by the currency denomination of the trade, then domestic investment must be exactly the same.

<![CDATA[Should Beijing raise subway fares?]]> By Michael Pettis · October 30, 2014 

Reuters had an article yesterday about the rumors, and I too have heard about this over the past couple of months, that Beijing will raise subway prices. This topic is pretty specific and specialized compared to what I normally write about on this blog, but because a friend asked me to discuss the topic with him for an article he was writing, I did do some thinking which although hurried I thought might be of interest to some readers, mainly because thinking about the “correct” subway fare in Beijing is a useful way to think about infrastructure investment more generally.

For many years there had been a huge battle (well, actually a tiny battle because one aside consisted of no more than three or four China specialists) about the extent of misallocated investment in China. For a while this debate focused on manufacturing capacity, but once it became obvious (around 2009 at the latest, I would say) that SOEs were clearly destroying value in the aggregate on a huge scale, the China specialists who remained optimistic about the quality of investment – including virtually the entire research and sell-side – shifted their attention to infrastructure, which is much harder to value and so much harder to criticize as wasteful.

I have to confess that the reason I started saying in 2006-07 that China was eventually going to replace 1980s Japan as the global archetype of investment misallocation was not because I had a lot of data proving my case. Overinvestment is almost impossible to prove until after the fact, especially when you consider the circularity of the data – the growth assumptions feed into the valuation of the investment, which then feeds back into the growth assumptions.

My reasons were much more “systemic”. I did not believe it was possible for any country not to experience significant wasted investment after so many years – more than a decade in this case – of the highest investment growth rate in the world funded by massive credit expansion at such incredibly low lending rates (roughly one-third the nominal GDP growth rate, and 1-3 percentage points below the GDP deflator). Add more spicy ingredients to the stew – first, the very limited experience of Chinese bankers and regulators, and most of that in a one-way market, second, widespread moral hazard, third, weak corporate governance, fourth, very fuzzy data, and finally, no enforced system of accountability – and I found it impossible to doubt that investment was being dangerously misallocated.

Some of the China specialists argued that because China was so far from the technological frontier, and because its per capita capital stock was so low, anyone who worried about wasted investment was implicitly using the wrong (inevitably “Western”) model to evaluate China. Maybe other countries, if they were rich, could suffer from massive overinvestment, they argued, but a very poor, low-capital-stock country far from the technological frontier like China could not, and anyway “Western” models don’t apply to China.

Obviously economists who cover China are not very familiar with other developing countries. Nor do they realize that China’s “exceptionalism” is hard to distinguish from the exceptionalism that characterizes nearly every other country in the world, if you believe the country specialists. Foreign analogies and recourse to history always illuminate the rest of the world, but never, apparently, the country in which we specialize.

At any rate analysts got it almost exactly backwards when they suggested that because China was poor and had much less capital stock per capita than, say, the US, China’s ability to absorb additional investment was necessarily high. This was an argument popular perhaps in the 1950s and 1960s, in the days of W.W. Rostow’s linear “stages of growth”, but among development economists, and certainly the more careful ones, it is hard to find anyone left who still believes that distance from the frontier conferred much of an advantage. Just last month on his blog Dani Rodrik, in my opinion one of the most thoughtful and careful development economists around, was warning readers away from any kind of convergence thesis.

If anything the contrary is true. Countries with lower capital stock per capita are less able to absorb massive increases in investment. Usually they are poor precisely because they have a very limited institutional ability to absorb capital productively. This is what it means to be backward, or poor, although of course there is an element of tautology in here.

But as a rule the further you are from the technological frontier, the less investment you can absorb profitably, and the more urgently you need institutional reform to increase your ability productively to absorb what investment you have. After all modern history is filled with stories of poor countries that had growth miracles driven by a massive attempt to “catch up” in investment, and in every single case debt caused investment to stop long before they had caught up.

Are subway fares too low?

I think it helps to see why increases in investment are not automatically productive when we think about how to price subway fares. According to the Reuters article, reference to which began this blog entry:

Beijing’s subway commuters may soon face their first ticket-price hike in seven years. For a socialist country, such small economic tweaks have big implications above ground. The capital’s metro is a triumph of central planning. The cost of a trip has been flat at $0.33 since before the 2008 Olympics, regardless of distance. During that time, per capita disposable income in Beijing has increased by more than 80 percent.

Now authorities are discussing two new plans which would base prices on distance, with discounts for frequent users. In a country whose government is nominally communist, raising everyday prices is fraught with anxiety. If market forces governed and passengers had to pay their way, prices would have to quadruple, according to figures cited by officials working on the new plans.

For those who don’t know Beijing well, when I first moved here in 2002 the city was poorly served by its subway system. This huge and sprawling city only had two lines, one running along Chang’an jie, often called the “Champs-Elysées” of Beijing, which runs east-west through Tiananmen Square, and the other circling around the inner city where the old city walls used to be before they were knocked down – in the 1960s I think – below what is now the Second Ring Road.

Since then, and especially during the build-up to the Olympics in 2008, the city has exploded with subway lines so that Beijing has become, in my opinion, one of the best served cities in the world for its subway system. The outer districts of the city are not well-served by subway (although there are plenty of buses) but, within the city proper, getting around by subway is very easy and fairly quick, including all the way out to the Wudaokou District, where China’s two most famous universities, Peking University and Tsinghua University, as well as many famous and less famous schools, are located. I do most of my travel within the city by bicycle or taxi, but for longer trips I usually take the subway, from my home or office to the university, for example, because traffic in Beijing can be terrible and almost always takes a lot longer than the subway.

The real problem with driving I Beijing, by the way, is not just the traffic jams, but mainly the uncertainty about how long it can take to get anywhere. In Mexico, it seems to me, the traffic is horrible but predictable, so that you are pretty sure that you will be 45 minutes late for every meeting. In fact during my days as a Wall Street debt trader whenever I was in Mexico and arrived at a senior government official’s office fifteen minutes late, instead of apologizing profusely for being late I felt I had to apologize profusely for coming early. The secretary inevitably looked shocked and no one was prepared to meet me.

In Beijing, on the other hand, I have arrived at meetings anywhere from 20 minutes early to one hour late. It is really hard to predict how long a car trip might take. This makes the subway hugely valuable because you can usually time your trip to within 5-10 minutes.

As an aside, in Beijing someone as “important” as a PKU professor like me shouldn’t take the subway. It is low status. If you see a middle-aged well-dressed person on the subway (not that I am ever well-dressed) he is almost certain to be foreign. Two weeks ago for example I had been asked to join two very wealthy Chinese – one a billionaire, I think – for coffee. When I got up to leave to get to my class, one of them very kindly said he would have his chauffer pick me up immediately and take me to Peking University. When I thanked him and told him I didn’t really have time to take a car and would have to take the subway, both of them shot me shocked glances, and one of them even commented on my dedication.

Is the Beijing subway too cheap? I really don’t have much to say about whether or not Beijing should raise subway prices because this is really a political question, not an economic one, but there are a few things we would want to think about. Beijing subway tickets are almost certainly priced very low, and even with the incredibly cheap financing available for years to fund Chinese infrastructure projects (although I don’t know if the funding was long-term and fixed rate) the system currently loses money. Is this a bad thing?

Before addressing the question we should remember that changing prices does have an income transfer impact, and higher fares will adversely affect a rider to the extent that subway transportation costs comprise a relatively large share of his total income (the poorer a regular rider is, the more it will affect him). On the other hand by raising fares, the higher revenues are usually “returned” to residents either in the form of lower fees and taxes or in the form of higher quality city services. The wealth distribution impact depends mainly on whether the higher revenues go directly or indirectly to people who are poorer or richer on average then the average subway rider.

The costs and benefits of subways

I don’t have any data on how higher subway fares will affect Beijing’s future fiscal revenues or expenditures, but it is worth remembering that higher subway fares can easily cause an implicit wealth transfer from ordinary riders to the better off, and this will have a negative impact on consumption. For many workers, an extra $10 a month in subway fares will reduce other consumption by exactly that amount, and if the revenues or the city are then spent, say, on better parking facilities (something Beijing urgently needs), the beneficiaries will mainly be car owners, who tend to be wealthier. The $10 increase in their wealth will almost certainly mean less than $10 increase in their consumption.

I have not nearly enough data to say what the impact will be, but we should remember that if the subway fare increases causes a transfer of wealth from one social group to another, it must have a savings and consumption impact, and no economic analysis is complete until we have figured this out. The article says Beijing would have to quadruple subways fares to make the system pay its way, but I think most subway systems around the world run at a loss, and there are perfectly good reasons for this. It depends on how you think about the real value of the subway system, and to whom:

  1. If you care about the overall welfare of Beijing, the benefits are maximized when every Beijinger actually uses the subway whose use of the subway creates value for him that exceeds the cost to all Beijingers of one more rider. The “revenues” of the system, in this case, include the total increase in the value of Beijing’s economy created by a well-running subway and less commuting time, plus the total increase in the “happiness” of Beijingers that the subway creates (in terms of ease of travel to see your grandmother, the ability to take your kids to far-away parks and facilities, etc).

Not every person’s fifteen minutes of saved time has the same value, of course. Wealthier and more productive people create more value when their time is saved than poorer and less productive people – and if that sounds sinister all it means is that a poor person would probably pay less to reduce his weekly commuting time by fifteen minutes than a wealthy person would. If we force them both to pay the same amount for each of them to save commuting time, we are basically transferring money from the poorer person to the richer.

The cost of the system per each additional user is mainly the cost to the system of additional fuel, personnel, and wear and tear, but there are also some externalities involving the negative cost to others of having an extra person on the subway (crowding, for example, is unpleasant and creates a cost to others). In that case you want a price low enough so that everyone whose use of the subway adds net value to Beijing – that is the “revenues” as defined above exceed the “costs” – will decide to take the subway. The price cannot be any lower, otherwise you will get people using the subway who provide little benefit to the city (e.g. who might take the subway to ride just one stop, rather than walk) or who create excessive costs (e.g. beggars who come to Beijing and sleep in the subway just because they can get free shelter, or wild young people who hang out and annoy riders).

The right price, in other words, brings enough users so as to maximize the gap between the economic benefits and the “happiness” of all Beijingers and the economic costs and the unhappiness, remembering of course that more productive Beijingers create higher “revenue”. By the way “happiness” is not a wooly, uneconomic concept. Like clean air it is part of household income, and Beijingers will tolerate a little lower income, or save a little less of their current income, if their “happiness” is increased in some other way. It is not just bread, that matters, in other words, but also circuses.

  1. If on the other hand you are in the Beijing mayor’s accounting office and care only about maximizing Beijing’s financial revenues, again, the benefits are maximized when everyone whose use of the subway creates financial value for Beijing that exceeds the financial costs to Beijing of his use of the subway. The value however is measured both in terms of the direct subway fare plus the indirect additional taxes Beijing collects. Using the subway, remember, lowers business costs and creates more businesses and higher profits that can be directly or indirectly taxed by Beijing. A better environment for business is one of the main externalities associated with a well-functioning subway system, and one of the ways to think about pricing and designing the subway is in terms of what kinds of businesses – how productive are they – it encourages (I am assuming Beijing tax revenues are directly affected by the value creation of Beijing businesses, which isn’t always the case).

As an aside some people might wonder about how to think about all the advertisements in the subway, aren’t they part of the revenues? I am not sure. I have so far ignored advertising revenue because it is both revenue to the subway and a tax-deductible expense for Beijing businesses, and I have no idea how businesses are taxed. Because there is a lot of tax cheating, advertising is probably net revenue for the city, but I am just guessing.

Either way, the cost to the mayor’s accounting office is mainly the cost of additional fuel, personnel, and wear and tear for each rider, plus the negative cost of reduced tax income if crowded subways cause businesses to buy cars, etc. Notice I exclude the interest cost on capital outlays because I assume these costs must be paid even if the whole subway system were closed down tomorrow. Sunk costs affect the evaluation of whether the Beijing subway system was economically a good idea – if the present value of total revenues minus the marginal costs is greater than the sunk cost of building the subway system, it was a good investment – but they do not affect pricing.

In this case Beijing would want to set a price low enough so that everyone who creates financial benefits, either by increasing taxes paid to Beijing or by increasing subway fare collection, that exceed the financial costs to Beijing of the marginal rider decides to use the subway. But the price can be no lower otherwise of course the financial costs to Beijing for each extra rider exceed the financial benefits.

  1. If you care only about the profitability of the subway system, however, perhaps because it is a private enterprise and you own shares in it, things get a little more complicated. At first you might think that, just like in your textbooks, you should set prices such that every rider whose value (the subway fare plus advertising revenues) exceeds the cost of the marginal rider (which consists mainly of additional fuel, personnel and wear and tear), decides to ride the system, in other words the price of the subway fare should just be equal to the marginal cost of the next rider.

This is not necessarily true, however. If you want a price that maximizes the gap between total fares and ad revenues and the total marginal costs of running the system, in a competitive system this would end up being equal to the marginal cost, but as a monopolist (and you are sort of a monopolist) you can squeeze the system and maximize profits by charging the higher monopolist price. These higher profits will come either at the greater expense of Beijingers overall or, depending on how you design your pricing, at the greater expense of both Beijingers overall and the Beijing government, but the subway company will be more profitable.

The value of infrastructure

Notice you can extend this as framework high as you like. You can measure the value of the Beijing subway system, for example, to Hebei province (of which Beijing technically is separate, but only because it became a legally separate municipality), or to China, or to the world, etc. Thinking about maximizing the benefit to China might not seem very different from maximizing the benefit to Beijing or Hebei, but it can be different if the subway is designed in part to foster certain business clusters.

For example if you spend a great deal of money supporting the high-tech Zhongguancun area of Beijing, in the hopes of drawing high-tech entrepreneurs from the rest of China to Beijing, because these are high value added jobs, if you are successful this would probably create a great deal of additional value for Beijing. It also creates value for China if the clustering itself creates value, but your strategy might only cause high-tech entrepreneurs from, say, Xian to move to Beijing, in which case Beijing’s gain is matched RMB to RMB by Xian’s loss, from which the moving costs should be deducted, and China overall has had to pay extra for the extra Zhongguancun facilities for no net national benefit.

This is not a purely theoretical example. In many countries, the US for example, different cities and states often compete with each other for foreign businesses by offering tax concessions, facilities, etc. and although the winning city might come out ahead, the country overall might not. When Bo Xilai was mayor of Chongqing, at least part of his success in spurring an economic renaissance came from using tax breaks to get major multinationals to move their China headquarters from wherever they were originally to Chongqing. While this was probably a good deal for Chongqing (“probably”, and not “certainly”), it was almost certainly a bad deal for China overall.

This analysis has been very abstract and has lots of moving parts, but I hope it does remind us that the value of infrastructure is not always obvious and it can be positive when we define the relevant entity one way and negative when we define it another way. There are, I think, at least six conclusions I would focus on in deciding how to price subway fares or value infrastructure:

  1. The way to measure the value of the system depends on whose value you care about, and to maximize value you want to maximize the gap between their definition of revenues and their definition of costs (or, to be pedantic, you want to maximize the present value of the gap). What is bad for the company that runs the subway might nonetheless be good for Beijing, and it is probably for this reason that most subway systems around the world lose money.
  1. The value of the subway system consists not just of the subway fare, and the costs are not just the variable costs associated with each additional passenger. Both costs and values depend on whose value you care about maximizing. Depending on whose value you assign the subway, the gap you must maximize includes not just direct costs and revenues but also what economists call externalities, some of which, like clean air, have tremendous economic value but are hard to define, and depend on how heavily you discount future benefits.

Take clean air, which is one of the undoubted benefits of the subway system. Cleaner air will save Beijing, and China, a fortune by reducing the amount of time workers are home sick, increasing worker productivity, and reducing health care costs (although clean air will also increase pension payments), but much of these savings occur far in the future. Their value today depends on the rate at which we discount them, which itself depends on many things. In part, for example, the discount rate depends on the expected short-term and long-term stability of government, the extent of corruption, and the system of accountability.

A very stable political system, in other words, in which leaders are given direct praise or blame for their policies, that expects to be around for many more decades, and that suffers from very little corruption will almost certainly place a much higher value today on the future rewards for clean air than otherwise. A city enjoying stable growth today will probably also place a higher value on these future benefits than one suffering from unemployment. Short-term benefits are also valued differently depending on how they are perceived. A very visible international city, for example a capital city like Beijing, may value clean air differently than a little-known provincial city because dirty air in Beijing creates a much worse international perception.

  1. One of the things that affects the “value” of the subway to Beijing is the average productivity of the people who are saving time by taking the subway, at least if traveling by subway saves time compared to the alternative (and unless you are important enough an official that the police block traffic for your car, it certainly will). The more productive the subway passengers on average are, in other words, the greater the increase in economic or household wealth per unit of time saved (assuming more productive people value their leisure time higher). Of course the obsession with status in China means that, excluding foreigners, subway users are likely to be less productive on average than Beijingers who take cars and taxis. One of the ways that Beijing can increase the value of the subway might be to create greater incentives for higher status people to ride the subway.
  1. Many people will tell you that a particular piece of infrastructure, like the subway system, is a good investment or a bad investment depending on how actively it is used. We often hear people say, for example – in opposition to those of us who worry that high-speed trains (HST) are an example of overinvestment – that HST in China can clearly be judged as good investments for China (the total benefits to China including externalities exceed the costs) because you have only to check their use – the train is very popular and most of their seats are occupied.

This claim is, of course, total nonsense, and even a little frightening when an economist makes it. The number of HST seats that are occupied, like subway seats, airplane seats, or ferry seats, is wholly a function of the ticket price and the number of seats available (cutting the number of daily HST trips by one half might sell more seats on each train, but reduce the economic value of the HST system). If you build a ferry across the Huangpu River in Shanghai that is so expensive that each seat should be priced at $200 to justify the cost, but you price tickets at $1, every seat in the ferry will probably be taken on every trip, but the ferry will still be a huge money loser for Shanghai.

  1. There is room for discriminatory pricing on the Beijing subway (and on nearly any infrastructure project) depending on how you decide to value the subway system. You can favor Beijingers relative to out-of-towners by raising each fare substantially and selling discounted long-term passes to residents. Even if this reduces revenues for the subway system it may increase “revenues” for Beijing.

You can favor business by offering discounted passes to qualified businesses. You can create premium and second-class wagons, so that richer people who want a comfortable and higher-status way to ride can be induced to take the subway. In order to change overall behavior in ways that increase total value, you can charge more during times when some people have to take the subway anyway, and others can change their schedule, like during rush hour, and less during less popular travel times, when each subway seat costs nearly as much to run but generates no revenue. It all depends on whose value you want to maximize.

  1. In none of the various ways that I describe of valuing the subway system will you automatically get to the Adam Smith ideal of setting the price of each ticket exactly equal to the marginal cost of the next rider. If you care about the welfare and incomes of all Chinese or all Beijingers, or about maximizing Beijing’s total tax revenues, the correct price is probably lower than the Smithian price. If you care only about the subway system’s profits, because you have a quasi-monopoly (buses are probably your main competition), you will set them above the Smithian price.

Subway fares and rebalancing

Of course none of this tells us what the right price should be for a ride on the Beijing subway, but theReuters article does suggest one possibility, that of adjusting the pricing according to distance traveled, that might not be in Beijing’s best interests. The article suggests that the cost of each ticket might vary depending on how long your trip.

But this kind of pricing might hurt those who live furthest from the center, the poorest, in favor of those who live closest, who tend to be richer. Aside from the adverse social impact, if it results in a wealth transfer from the poor to the rich, it might actually reduce overall consumption just when Beijing most urgently needs to raise it.

On the other hand there is no reason for there to be a uniform price mechanism. The point of differential pricing should be to extract more value from those who can pay and to help change behavior in way that increase total value. And although one of the great virtues of any subway system is its simplicity, maybe differential pricing can be applied according to highest and lowest hours of use, and if there is going to be a geographical distinction, why not simply charge more for riders that get on or get off within the Second Ring Road, where there tend to be a lot more tourists and wealthier Beijingers?

Standing a little further back, it occurs to me that we may be seeing not just Beijing but a lot of other cities thinking seriously about re-pricing municipal services over the next few years. I have argued many times before that China’s rebalancing requires both economic decentralization and further political concentration, and this almost certainly means that the middle, SOEs and local power centers, is going to get squeezed.

One way to squeeze local governments is to limit their access to revenues and spending. Land reform may reduce municipal revenues. Lending caps may make it hard to borrow. Both are being talked about. If all of these things happen, Chinese cities may increasingly turn to the sale of assets (including locally-owned SOEs) and charging higher fees for municipal services. As China adjusts this is probably not just going to be a Beijing story.

<![CDATA[中国经济增速放缓对世界有什么影响?]]> 佩蒂斯:中国非世界经济引擎 十年后增速不超3%-4% 






First published on December 2, 2014 

Two years ago it was hard to find analysts who expected average GDP growth over the rest of this decade to be less than 8%. The current consensus seems to have dropped to between 6% and 7% on average.

I don’t think Beijing disagrees. After assuring us Tuesday that China’s economy – which is growing a little slower than the 7.5% target and, is expected to slow further over the rest of the year – was nonetheless “operating within a reasonable range”, in his Tianjin speech on Wednesday Premier Li suggested again that the China’s 7.5% growth target is not a hard target, and that there may be “variations” in China’s growth relative to the target.

I think every one knows that variations will only come in one direction, and although his stated expectations are still pretty high, most analysts, correctly I think, interpreted his remarks as a warning that growth rates will drop even more. Here is how the People’s Daily described the speech:

Premier Li Keqiang on Wednesday said China can meet the major economic goals this year and policymakers will not be distracted by short-term fluctuations of individual indicators. Li downplayed the importance of some economic data from the past two months when delivering his keynote speech to the 2014 Summer Davos, which opened Wednesday in north China’s port city of Tianjin.

…China has targets of GDP growth around 7.5 percent and a consumer price index (CPI) increase of about 3.5 percent in 2014, with 10 million more urban jobs to keep the urban unemployment rate at a maximum of 4.6 percent.

Inflation is also below target. According to the National Bureau of Statistics Wednesday release, “In July, the consumer price index (CPI) went up by 2.3 percent year-on-year. Prices grew by 2.3 percent in cities and 2.1 percent in rural areas. Food prices went up by 3.6 percent, while non-food prices increased 1.6 percent. Prices of consumer goods went up by 2.2 percent and prices of services grew by 2.5 percent.”

Surprisingly, analysts continue to hail lower-than-expected CPI inflation as giving the PBoC room and encouragement to expand credit – largely I guess because this is what analysts say when US or European CPI inflation numbers are low, and although most of us haven’t thought through the differences between China and the US in the ways prices respond to monetary policy, we don’t want to seem like we don’t know what we are doing. The constraint on monetary and credit growth in China is not CPI inflation and never has been. Monetary and credit growth in China are constrained by the impact of GDP growth on balance sheets.

For me the main information coming out of CPI inflation data is that consumer demand relative to total production continues to be too weak to drive up prices, something confirmed earlier this week by the August trade numbers, which failed to suggest strong growth in domestic demand. According to Xinhua:

China’s exports in August rose 9.4 percent year-on-year to 208.5 billion U.S. dollars, with monthly trade surplus reaching an all-time high of 49.8 billion U.S. dollars, customs data showed on Monday. China’s imports continued to contract last month, with a year-on-year decrease of 2.4 percent, to 158.6 billion U.S. dollars, the General Administration of Customs said in a statement.

Trade surplus in August jumped 77.8 percent year-on-year and hit a record high again, after reaching an all-time high of 47.3 billion U.S. dollars in July, the data showed.

Although in my opinion the current 6-7% medium-term growth expectations are still far too optimistic, and will almost certainly be disappointed within one or two years, the good news is that most analysts at least recognize that the increasing risk of a “hard landing”, which they mostly seem to define as growth below 6%. The idea that during the rebalancing process Chinese growth can drop as sharply as it has for every other country that has gone through a similar rebalancing is still hard to accept, even though a little digging would make it clear that analysts underestimated the pace of slowdown during each of the previous cases too.

Still, the fact that we have been consistently surprised on the down side since 2010 has alerted most analysts to the possibility that we may continue to be surprised on the down side. A “hard landing” of growth below 6% is still considered unlikely, but no longer possible to ignore.

This worries a lot of people. A hard landing, we are told, would be devastating for the world economy because China is the world’s “growth engine”, and if it falters, growth around the world will also slow. There is also rising concern about a banking crisis within China. An economist at Oxford Economics recently told a Sydney audience that “Chinese authorities were understating the extent of bad loans on their banks’ books and faced tough choices in dealing with the potential bank failure.” In that he is certainly right, but he went on to say: “”We don’t know when there will be a China banking crisis and how it will play out but it is almost certain there will be one,”

I am not sure I agree. Insolvency doesn’t necessarily lead to crisis, as countries like Spain have made clear. It takes a collapse in liquidity to create a crisis, and if insolvent borrowers remain liquid, we are likely instead to see a long, difficult period of slow growth in which the losses are painfully ground out of the system (and always turn out to be greater than they would have been had they been recognized immediately).A banking crisis in China is always possible, and several people I respect are quite certain that there will be one, but I think that as long as Beijing implicitly or explicitly guarantees deposits, and as long as Beijing’s credibility with Chinese households is solid, and I believe it is, I think we are more likely to see many years of Japanese-style “zombie banks” than a banking crisis.

What does it mean if growth slows?

At any rate as far as I can understand, most analysts claim that if growth in China fell much below 6%, we would be likely to suffer the following:

The rest of the world would slow, perhaps sharply, as a consequence of China’s lower growth.
There would be a crisis in the Chinese financial system, which would spread to the global financial system.
Political instability would emerge in China as unemployment surges.
I think most analysts may be overestimating the adverse consequences and underestimating the probability of much lower growth. I continue to expect growth rates to fall substantially, probably by 1 percentage point a year or more for the rest of the decade, so that in the best case, during the expected period of President Xi’s administration (2013-32), growth rates are unlikely to average above 3-4%.

Higher growth rates are not impossible, of course, but to get the arithmetic to work for me it would take some fairly implausible assumptions – mainly that Beijing engineers the transfer of 2-3% of GDP every year from the state sector to the household sector – for China to achieve growth rates anywhere near 6% for the next decade. I would make two further points about the consensus:

1. Even though most analysts who now think 6% is the likely lower end of China’s growth trajectory have already had one or more Damascene conversions, they still think of rebalancing largely as a linear process. It isn’t. The longer unbalanced high growth is maintained (and high growth is always unbalanced), the sharper the reversal must ultimately be.

In the best-case orderly adjustment, growth rates will drop every year, more or less smoothly, as credit growth is constrained and investment growth drops with it. As the reforms proposed during the Third Plenum are implemented, ordinary Chinese households will benefit from direct or indirect transfers from the state sector, so that total household wealth will continue to rise more or less in line with the growth in household income during the past decade. In that case, consumption growth will remain in the 5-8% range.

As this occurs, the consumption share of GDP growth will, of course, rise over the next few years so that much slower GDP growth does not imply much slower growth in the rate at which ordinary Chinese see an improvement in their standard of living. The two biggest risks to a smooth adjustment are, first, that the Chinese elite are successfully able to prevent the implicit transfers of wealth to the household second implied by the Third Plenum reforms, and second, that the wealth effect of a collapse in real estate prices, or a high correlation between consumption growth and investment growth, result in much slower than expected consumption growth. The second risk is the focus of a recent blog posting in which JCapital’s Anne Stevenson-Yang’s more pessimistic consumption expectations are contrasted with mine, with a follow up blog posting, and while we disagree, I don’t completely dismiss the JCapital position.

A disorderly adjustment will have a different dynamic. It is likely to occur after another 2-3 years or relatively high (7-8%) GDP growth rates followed by a very ugly contraction once debt capacity is exhausted, which will occur when new loans cannot grow fast enough both to roll over existing bad loans (by which I mean loans that funded projects whose returns were insufficient to liquidate the loans) and to generate economic activity. Average growth rates in the case of a disorderly adjustment will be well under 3-4% but the adjustment will be highly discontinuous.

So if GDP growth rates are much lower than current consensus and even much lower than what most analysts would consider a “hard landing”, does this mean – especially if China’s economy is, as the New York Times called it, “the world’s main growth engine in recent years” – that the global economy is dire straits?
It depends on how China adjusts. China is not the world’s growth engine and never has been. It is simply the largest arithmetical component of growth, which is a very different thing. Whether China’s economy slows, and how quickly it does, matters to specific sectors of the global economy – positive to some and negative to others – and this will depend primarily on the evolution of China’s current account surplus. An orderly rebalancing will be good for the world on average and a disorderly one bad.

The same is true about the effect of a Chinese slowdown on social conditions. People do not generally care about GDP growth rates. They care about their own income growth relative to their expectations. Rebalancing in China means by definition that Chinese household income growth will outpace GDP growth, after many years of the opposite. A best-case orderly rebalancing should result in little change in the growth of household income, even as GDP growth drops sharply. This for example is what happened in Japan from 1990 to 2010, when GDP growth dropped close to zero but household income grew at nearly 2%.

A disorderly rebalancing, however, could result in negative growth in both GDP and household income, with the former dropping more than the latter. This, for example, is what happened in the US in the 1930-33 period – with GDP dropping by around 35% and household income dropping by around 19%. In the case of China, in other words, while elites will suffer in both scenarios, in the former case there is no reason for popular discontent.

Is China the world’s growth engine?

When analysts say that China is the world’s growth engine – something they said about Japan in the 1980s, by the way – they are implicitly assuming incorrectly the source of growth. If you multiply China’s GDP growth by its share of global GDP, you will find that Chinese growth over the last few years has comprised a larger share of global GDP growth than that of any other country. But this doesn’t mean it is the engine of growth.

An engine of growth drives growth around the rest of the world. If an economy is simply growing quickly, and especially if it is growing at the expense of other economies, it can hardly be called an engine of growth. In that case its growth actually constrains growth elsewhere.

Consider the colonial relationship between Britain and India 200 years ago. During the middle of the 18th Century and well into the beginning of the 19th Century India produced far more textiles – and usually much cheaper and of better quality – than did England, but a number of measures aimed at undermining Indian textile producers and protecting British textile producers (tariffs that almost always exceeded 50%, for example, and by 1813 were as high as 85%) meant that at some point in the first half of the 19th Century the British textile industry had become the most efficient in the world and was able largely to eliminate the Indian textile industry from global competition.

There is no question that Britain was the largest component of global GDP growth at the time (the US and Germany did not surpass Britain until the 1860s and 1870s), but it would be foolish to say, at least in the Indian context, that the UK was the “engine” of global growth. In the textile industry, its growth came at the expense mainly of India.Iam not suggesting that China’s growth relative to the rest of the world is equivalent to Britain’s growth relative to India. My point is only that a country’s contribution to global growth cannot be calculated by measuring its share of global growth.

So what contributes to growth? One of the thornier debates in economics is the debate between supply-siders, who insist that increasing production is the only way to increase growth, and the demand-siders (often Keynesians) who insist that increasing demand is the only way to increase growth, at least it is when resources are underutilized. Each statement is one side of an accounting identity, but causality does not necessarily run only in one direction. Growth can be driven primarily either by supply or by demand, depending on circumstances. When savings are in short supply, it is the latter. When not, it is the former.

To put it more explicitly, when investment is constrained by a lack of savings, the best way to generate growth is to increase investment by forcing up the domestic savings rate, in which case the world’s growth engine is likely to be the country that exports capital to investment-hungry parts of the world. Of course a net exporter of capital is by definition a country that is running a current account surplus.

In the United States during much of the 19th Century, an erratic and unstable financial system combined with the huge infrastructure needs of a rapidly expanding continental economy meant that the US was almost always in short supply of money and capital*, and so to a large extent its growth rate was constrained mainly by British liquidity. When money poured into the US from Europe, and mainly from England, investments in the US grew apace and the US economy boomed, until some event caused the taps to be turned off (the collapse in silver mining in the 1820s during Latin America’s wars of independence, for example, which was followed by the US crisis of the 1830s and, as a matter of interest to those interested in Chinese history, with the replacement of silver exports with opium to the silver-starved Qing government in China). Whereas Britain may not have been an engine of growth for 18th Century India, or at least for the Indian textile industry, it was for much of the 19th Century the world’s engine of growth because it supplied much of the capital that a savings-starved world needed to fund investment.

But when savings rates are excessive, which is often a consequence of income inequality and a high state share of GDP, as I show in one of my earlier blog posts, the problem the economy faces is insufficient demand, not insufficient savings available for investment. In fact as consumption declines with the rising savings rate, it tends to reduce the need for productive investment, so that both productive investment and consumption tend to drop.

Technically you can never have “excess” savings over investment because savings must always balance investment globally. But as I show in another blog entry, the tendency of rising income inequality to force up the savings rate beyond the needs of productive investment must necessarily be balanced by one, or a combination, of three counterbalancing events:

As the savings rate tends to rise (or, which is the same thing, as the consumption rate tends to decline) productive investment opportunities tend also to decline, so that excess savings flow into speculative and non-productive investment, including rising inventories, developing countries, risky technology ventures (which can generate huge positive externalities), real estate, stock markets, etc.
Perhaps because rising prices in speculative assets causes a strong wealth effect, ordinary households borrow against their rising wealth to increase consumption faster than their income increases, driving down their savings rate in line with the rise in savings that accompanies rising inequality.
Rising speculative investment, rising inventories, and rising debt eventually reach a limit, often followed by a crisis, after which unemployment must rise and, by reducing production faster than it reduces consumption, forces down the savings rate enough once again to maintain the balance between savings and investment.
When the world suffers from too low a level of savings to fund needed productive investment, policies that force up savings are positive for long-term growth. For similar reasons, economies with excess savings create growth abroad by exporting the excess to where it is needed. In that case the supply-side insistence on focusing policy on ways to generate additional savings does result both in more growth and in trickle-down wealth expansion.

However when savings are high enough and mobile enough that balance can only be achieved in the form of high unemployment, the world does not need more savings to fund more productive investment, as the supply-siders argue, but rather more demand, as the Keynesians insist. More sustainable demand (in the form of needed infrastructure or of higher consumption by wealthier workers) will lead to more productive investment by redeploying underutilized resources, including unemployed workers.

If there is such a thing as a global engine of growth, in the latter case, it is the country that is able (or is forced) to import the most amount of capital and export the most amount of demand (i.e. run the largest trade deficit). In that case countries with large trade surpluses that have to export excess savings do not cause growth abroad. As an aside Kenneth Austin recently published in The Journal of Post Keynesian Economics what I think is a very important paper on how capital exports affect the global economy. His paper is summarized in a recent New York Times article.

What will drive China’s contribution to global growth?

So what kind of world are we in – one with excess savings, or one with excess demand? I would be truly surprised if anyone suggested that we are in the latter world and not the former.A world of excess savings is prone to bubbles, and either debt-fueled consumption or high unemployment, and this pretty much describes the world we have been living for the past two decades. For this reason I would argue that countries that are absorbing excess savings – i.e. running current account deficits – are generating growth abroad while countries that are exporting excess savings – i.e. running current account surpluses – are weakening growth abroad.

China, in other words, is not the world’s growth engine. Behind Germany and ahead of some of the oil producers,it runs the largest current account surplus in the world, which means that it is exporting its excess savings in a world that has nowhere to put the money, and so the world must respond either with speculative asset bubbles, unproductive investment, debt-fueled consumption binges or unemployment.

This means that to assume slower growth in China will reduce growth abroad is wrong. As the growth rate of China’s economy drops, the fact that its share of global GDP growth will drop does not presage anything bad for the global economy.What matters is what happens to China’s current account surplus. As long as the world suffers from weak global demand, if China’s current account surplus declines relative to global GDP, China is adding net demand to a world that needs it. This is positive for global growth. If on the other hand China’s current account surplus rises, China will be adding more savings to a world already unable to absorb total savings productively, and the world will be worse off.

This tells us how China’s rebalancing will affect growth abroad. China’s contribution to global growth over the next decade depends on the relative pace at which savings and investment decline. If savings declines faster than investment, China’s excess savings will decline and with it its current account surplus. China in that case, will be adding net demand (or reducing negative net demand, to be more precise) to a world that needs it. If on the other hand China’s investment rate declines faster than its savings rate, its current account surplus will by definition grow, and the world economy will be worse off.

So which will it be? I think it depends on how orderly the rebalancing process will be.

1. In an orderly rebalancing, China will take steps to reduce investment growth. Instead of causing unemployment to surge, however, the reforms proposed during the Third plenum, most of which involve direct and indirect transfers from the state sector to the household sector, should keep consumption growth rates relatively high.

In order to keep the process as stable as possible and to prevent a surge in unemployment, my guess is that investment will decline more slowly than consumption will rise, so that in effect the gap between savings and investment narrows. This is just another way of saying that China’s current accounts surplus will narrow as a share of global GDP and the effect for the world will be positive (this is what occurred during Japan’s rebalancing between 1990 and 2010).

2. A disorderly rebalancing can occur in a number of different ways so it is hard to predict the impact on the current account, but the most likely outcome would be a surge in the current account surplus. Assume, for example, that a disorderly rebalancing occurs because Beijing waits so long to force through the reforms that it runs into debt capacity limits (i.e. the growth in debt cannot exceed the growth in the amount of bad debt that must continually be rolled over). In that case investment will drop quickly. At the same time unemployment will rise, which will partially reduce the savings rate, but worried Chinese households with jobs will cut back on consumption, which will increase the savings rate.

If the combination of the two causes the savings rate to rise, or to fall more slowly than the rapidly declining investment rate, the automatic corollary is a rise in the current account surplus. This would reduce demand in a world already suffering from low demand.

A slowing Chinese economy might be good or bad for the world, depending on how it affects the relationship between domestic savings and domestic investment, and this itself depends on whether Beijing drives the rebalancing process in an orderly way or is forced into a disorderly rebalancing by excess debt. My best guess is that Beijing will drive an orderly rebalancing of the Chinese economy, even as it drives growth rates down to levels that most analysts would find unexpectedly low, and this will be net positive for the global economy.

This is an abbreviated version of the newsletter that went out ten weeks ago.  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.

* To the point, where counterfeit money was often accepted as real, even though it was known to be counterfeit (Stephn Mihm, A Nation of Counterfeiters: Capitalists, Con Men, and the Making of the United States, Harvard University Press, 2009). This, by the way and for those who find this kind of think interesting, was also true in China during the late Ming Dynasty, and explains China’s huge demand for silver, which was soon to be supplied by Spanish silver discoveries in the Americas.

<![CDATA[The four stages of Chinese growth]]> From the early 1980s until now China has grown at a pace not matched since the four decades Argentina enjoyed before the First World War. In spite of some fairly goofy attempts a few years ago, however, to characterize China during this period as having followed a set of policies called the “Beijing Consensus”, these decades did not involve a unified set of policies, or a set of related polices, that Beijing implemented consistently. It is far more useful, I would argue, to think about the past 3-4 decades as consisting of four very different periods, the last of which we are, with great difficulty, just starting.

The idea of a Beijing Consensus has probably help to prevent or postpone an understanding of the vulnerabilities in the current growth model and the steps China must take to address these vulnerabilities. Among other things this confusion made China’s nearly four decades of growth seem far more exceptional than it was, and so created the very lazy belief among analysts that there are no historical precedents that can guide us in understanding the strengths and the vulnerabilities of China’s economic trajectory.

Before explaining why China’s growth trajectory can best be understood by separating out these different periods I want to re-introduce the idea of social capital, a topic about which I wrotelast year. As I use the phrase, social capital is the set of institutions – including the legal framework, the financial system, the nature of corporate governance, political practices and traditions, educational and health levels, the structure of taxes, etc. – that determine the way individuals are given incentives to create value with the tools and infrastructure that they have.

In a country with highly developed social capital, incentive structures are aligned and frictional costs reduced in such a way that agents are rewarded for innovation and productive activity. The higher the level of social capital, the more likely they are to act individually and creatively to exploit current economic conditions and infrastructure to generate productive growth.

It is a hard concept to explain precisely and to quantify, but the idea of differing levels of social capital helps explain why, for example, French entrepreneurs (not to mention Indian, Chinese, Mexican and Nigerian) are more likely to create successful tech startups in the US or the UK than at home, or why it is easier to start a business in Sidney than in Beijing, or why technological innovation is not evenly spread out among countries, even among countries at similar development levels, but rather tends to cluster in a few areas in a few countries where tech entrepreneurs seem to believe that their work is made easier and the rewards greater.

Developed countries are rich because they have higher levels of social capital than backward countries, and not, as is sometimes believed, because they have abundant capital stock. On the contrary, rather than the cause of wealth, abundant capital stock should be, but isn’t always (China may be an example), a consequence of abundant social capital. The resulting higher level of worker productivity makes it easier to justify additional infrastructure that saves the time and labor of productive workers. A high level of capital stock is a “symptom” of wealth, not a cause.

In developed countries, in other words, abundant social capital encourages residents and businesses to use available conditions and infrastructure in the most productive ways possible. Undeveloped countries, on the other hand, are poor because they do not have the often-intangible qualities that allow citizens spontaneously, and without planning, to exploit their economic and infrastructure resources most efficiently and productively.

How to become a developed country

A developing country needs to implement two sets of policies if it is to succeed in advancing to the developed stage. One set is pretty obvious. These are policies aimed at directly improving the environment under which businesses operate – by giving them the resources they need, such as good infrastructure, capital, and an educated work force.

The second set is much harder to prescribe and is aimed at improving social capital precisely so that individuals and businesses can use these resources efficiently and productively. These reforms involves creating productive incentive structures, robust and efficient legal systems with predictable enforcement, financial systems that allocate capital productively, limited political and elite interference in the wealth-creation process, limited rent seeking, clarity and ease in the ability to create businesses or otherwise create economic value for society, etc. It is perhaps worth noting that in every country, reforms that build social capital are likely to be highly idiosyncratic, and dependent on that country’s particular culture and history, which may explain why grand development theories applied uniformly to different countries never seem to work outside their country of origin.

To understand the challenges that face China today it is necessary to understand how these two sets of policies have very different political economy implications. Because the first set of policies often involves the allocation of resources from the center, it tends to receive tremendous support from a rent-capturing elite, and because these policies benefit the elite, this support tends to be self-reinforcing. The more the policies are implemented, the better for the elite, which in turn increases their power, which creates stronger support for the policies.

The second set of policies are much more difficult to implement because they often or usually require a dismantling of the distortions and frictions that create rent for the elite, thus the undermining the ability of the elite to capture a disproportionate share of the benefits of growth. A financial system that allocates capital efficiently and productively, for example, is not one that allocates capital on the basis of power or access. A fair, clear, and predictable legal system is not one in which some groups are privileged relative to others. If anyone can start a business, the benefits of monopoly or oligopoly are undermined.

The kinds of liberalizing reforms that increase social capital, consequently, are likely to be unpopular with the elites that have benefitted from their absence, unless perhaps the resulting or accompanying surge in wealth or productivity is great enough to allow elites to benefit even as their share of the benefits declines. This might be one reason why, as I discuss in my book,The Volatility Machine, that throughout modern history developing countries often seem to embark on liberalizing economic reforms only during periods of great international liquidity, when money is flowing into risky ventures like high technology, real estate, and developing countries.

While the liberalizing reforms usually undermine the ability of the elite to capture a disproportionate share of growth, in other words, because the reforms often seem to encourage massive foreign capital inflows, and these push up the price of assets largely controlled by the elite, political opposition to the reforms is weakened. If this is true, by the way, it means that attempts at implementing liberalizing reforms are successful mainly during periods of great global liquidity, and this might have implications for China, especially if over the next few years global central banks begin to withdraw the huge liquidity injections that have underpinned asset bubbles around the world.

From social capital to physical capital

With that lengthy preamble, let me return to China’s recent economic history. As I see it, the four periods that characterize China’s long growth spurt can be described this way:

1.  The first liberalizing period. In the late 1970s and early 1980s Beijing forced through a series of liberalizing reforms that I would characterize as aimed at building social capital. By eliminating laws that severely constrained the ability of Chinese to behave productively, these reforms unleashed an explosion of economic activity that generated tremendous wealth creation. It became legal, for example, for Chinese to produce and sell as individuals, not just through the relevant and usually badly managed state-controlled collectives or organizations. A limited number of farmers were allowed to keep anything they produced above some quota, and agricultural yields doubled almost immediately. If a man believed there was a shortage of bricks in his town, he could create a company to manufacture bricks, and China’s hopeless jumble of soaring brick inventories in one part of the province matched by severe brick shortages nearly everywhere else was replaced with a system in which the more efficiently you made and delivered bricks, the richer both you and the country became.

But the implementation of the reforms was not easy. It undermined a very powerful party structure (not to mention the managers of the old state-controlled brick manufacturer) that had been built up over the previous three decades around the ability of its members to constrain and direct economic activity, and so these reforms met with powerful elite resistance. It was only, I would argue, because of the credibility, prestige, and power that Deng Xiaoping and the men around him had, and the loyalty they had built within the PLA, that Beijing was able to overcome elite resistance and successfully implement the reforms. Even in the 1990s, Deng struggled with elite opposition and my understanding is that his famous 1992 Southern Tour was arranged mainly to outflank and defeat provincial opposition to continued economic liberalization.

2. The “Gershenkron” period. As Chinese productive activity swelled it soon began, however, to run into infrastructure and capacity constraints. This began the second phase of China’s astonishing growth, one characterized by the marshalling of domestic resources to fund an investment boom aimed at creating infrastructure and capacity. Like the many previous examples of investment-driven growth miracles, China embarked on a program to resolve the major constraints identified by Alexander Gershenkron in the 1950s and 1960s as constraining backward economies: a) insufficient savings to fund domestic investment needs, which had to be resolved by policies that constrained consumption growth by constraining household income growth, and b) the widespread failure of the private sector to engage in productive investment, perhaps because of legal uncertainties and their inability to capture many of the externalities associated with these investments, which could be resolved by having the state identify needed investment and controlling and allocating the savings that were generated by resolving the savings constraint.

Because China’s infrastructure was far below its ability to absorb and exploit infrastructure efficiently and productively (its social capital exceeded its physical capital, in other words), it was relatively easy for the central authorities to identify productive investment projects, and as they poured money into these projects, the result was another surge in wealth creation from the early 1990s to the early 2000s. Although all Chinese benefitted from this wealth creation, the new elite benefitted disproportionately, in large part because of the constraints imposed on the growth of household income aimed at generating higher savings. Of course over time these new elites became politically entrenched. This elite today is famously referred to (in China) as the “vested interests”.

3. Investment overshooting. But China was still an undeveloped economy with “backward” (in Gershenkron’s sense) social, legal, financial and economic institutions that sharply constrained its citizens from achieving the levels of productivity that characterize developed countries. Its social capital was still very low, in some cases perhaps even as a partial consequence of policies that had led to the earlier rapid investment-led growth by allowing elites to control access to cheap capital, land, and subsidies. As investment surged, China’s physical capital converged with its social capital (i.e. its infrastructure more or less converged to its ability to exploit this infrastructure productively), after which additional physical capital was no longer capable, or much less so, of creating real wealth.

Instead, continued rapid increases in investment directed by the controlling elites (especially at the local and municipal levels) created the illusion of rapid growth. Because this growth was backed by even faster growth in debt, however, it was ultimately unsustainable. This period began around the beginning of the last decade, I would argue, and it is the period in which we currently find ourselves.

4. The second liberalizing period. What China needs now is another set of liberalizing reforms that cause a surge in social capital such that Chinese individuals and businesses have incentives to change their behavior in ways that generate greater productive activity from the same set of assets. These must include changing the legal structure, predictably enforcing business law, changing the way capital is priced and allocated, and other factors that determined the incentives, so that Chinese are more heavily rewarded for activity that increases productivity and penalized, or at least less heavily rewarded, for rent seeking.

But because this means almost by definition undermining the very policies that allow elite rent capturing (preferential access to cheap credit, most importantly), it was always likely to be strongly resisted until debt levels got high enough to create a sense of urgency. This resistance to reform over the past 7-10 years was the origin of the “vested interests” debate.

Most of the reforms proposed during the Third Plenum and championed by President Xi Jinping and Premier Li Keqiang are liberalizing reforms aimed implicitly and even sometimes very explicitly at increasing social capital. In nearly every case – land reform, hukou reform, environmental repair, interest rate liberalization, governance reform in the process of allocating capital, market pricing and elimination of subsidies, privatization, etc – these reforms effectively transfer wealth from the state and the elites to the household sector and to small and medium enterprises. By doing so, they eliminate frictions that constrain productive behavior, but of course this comes at the cost of elite rent-seeking behavior.

The uncertain process of liberalizing reforms

Because of rapidly approaching debt constraints China cannot continue what I characterize as the set of “investment overshooting” economic polices for much longer (my instinct suggests perhaps three or four years at most). Under these policies, any growth above some level – and I would argue that GDP growth of anything above 3-4% implies almost automatically that “investment overshooting” policies are still driving growth, at least to some extent – requires an unsustainable increase in debt. Of course the longer this kind of growth continues, the greater the risk that China reaches debt capacity constraints, in which case the country faces a chaotic economic adjustment.

Beijing must therefore embark as quickly and forcefully as possible upon what I have characterized as “second liberalizing period” economic policies, which in a sense means a return to the “first liberalizing period” reform style of the 1980s. There is by the way no longer much confusion over what these policies entail. Beijing knows more or less, perhaps a little later than optimal, exactly what must be done, although the sequencing of reforms is more controversial, and the proof that it understands the relevant issues is that the Third Plenum clearly and explicitly addressed the relevant issues head on, proposing at the end exactly the kinds of policies we would have expected if China is to embark on a new set of policies aimed at driving sharp increases in social capital.

The problem for China, of course, and as I think nearly everyone understands, is to implement these liberalizing reforms well before the country starts to bump up against its debt capacity constraints. Xi’s administration must do this against what is likely to be ferocious resistance from those who have benefitted enormously from constraints on Chinese productivity growth, and who consequently stand to lose the most from real reform.

I would argue that this is exactly what President Xi seems to be doing, and why even before he was formally in power he sought to consolidate power, undermine and frighten potential opposition, strengthen his relationship with the military, and unify the country’s policymakers behind the need for reforms. This may also be why PBoC Governor Zhou – who was among the first senior policymakers, I believe, to recognize the urgent need for China to rebalance economic growth away from the current debt-addicted model – seems to be among the key economic decision-makers.

Unless President Xi is successful in consolidating power and control over economic assets, an abundance of historical precedents suggests that he is unlikely to overcome powerful elite resistance. If he is successful – and for now I am cautiously optimistic that he will pull it off – he will be in a position to implement the urgently needed liberalizing reforms that will push China onto its next stage of sustainable productivity growth, in which case he is likely to be hailed as China’s greatest leader since Deng Xiaoping – and for many of the same reasons.

Perhaps not everyone in Beijing understands, however, that this will happen only after a difficult and probably long adjustment period, during which GDP growth rates, although not necessarily household income growth rates, must fall far more than they already have, for reasons I have discussed elsewhere. This matters to the long-term success of China’s reforms, because sharply slowing growth may revive or unify political opposition.

In fact I suspect the reason credit growth in the past year or two has not slowed nearly as sharply as it should, or as sharply as required by the economic analysis implicit in the Third Plenum reform proposals, is precisely because of the expected impact of meaningful credit constraint on GDP growth. Any attempt to rein in credit will sharply reduce GDP growth, and there is of course likely to be a positive correlation between lower growth and a stronger and more unified opposition. Xi must take steps to slow growth, but he might not yet be able to do so.

<![CDATA[Some things to consider if Spain leaves the euro]]> It might seem almost churlish to wonder what would happen if Spain were to leave the euro. The official European position is that the battle of the euro has been pretty much won, and anyone who argues otherwise will be accused of being a euro hater, an Anglo-Saxon or, even worse, a writer for theFinancial Times.

But there is more than one “battle” around the euro. While the battle of liquidity seems to have been won, the solvency and the unemployment battles (the latter of which is really a battle of unbalanced demand) have not even been addressed. Every sovereign debt crisis in modern history has been preceded by assurances that it was only a liquidity crisis, but as I see it there were three separate problems that erupted in the 2008-09 euro crisis:

  1. A liquidity crisis. After the US subprime crisis set off a more general financial crisis in the US, investors were spooked. As they looked around to see who else was vulnerable, they began to wonder about peripheral Europe and, even worse, they wondered if everyone else was wondering. Once that process begins, it is just a question of time before credit dries up for at-risk borrowers. Suddenly heavily-indebted European sovereign borrowers found themselves unable to roll over their debt.
  2. A solvency crisis. Wondering about the sustainability of peripheral European debt was not irrational. In fact debt levels for many countries had soared, even before it was obvious that these countries were on the hook for an explosion in contingent liabilities generated by bad debts in the banking system. It is not at all clear that even at current levels these countries can repay their debts without imposing tremendous pain on an electorate that might (rightly in my opinion) refuse to accept it.
  3. A demand imbalance. Policies in Germany around 2000 aimed at improving Germany’s international competiveness did so by forcing down wage growth and, with it, household consumption growth. For reasons about which I am not sure it seems that investment growth also slowed dramatically, compounding the problem of weak household consumption growth. As German domestic demand fell relative to its total production of goods and services, instead of seeing unemployment rise as German producers cut back on capacity, Germany was able to resolve its domestic demand deficiency in the form of a rising trade surplus, as excess German savings poured into peripheral Europe. These ignited an asset boom that, by making peripheral Europeans feel richer than ever,ignited a consumption boom. Germany’s domestic demand deficiency, in other words, was matched by excessive demand in peripheral Europe, but this could go on only as long as the asset boom continued on the back of rising debt. Once it ended it could only be resolved by a rise in unemployment.

Have Europe’s problems been resolved? The ECB’s resolve to do “whatever it takes” has resolved the first of these three problems, at least temporarily. The ECB has promised to supply unlimited liquidity to roll over European sovereign debts, and as long as this promise is credible, private investors are happy to step in and roll the debt over themselves. Plentiful global savings have encouraged an urgent search for yield, and the ECB’s very credible commitment did the rest. But has Europe resolved the other two crises?

Clearly the second problem, the solvency crisis, hasn’t been resolved. Debt has grown much faster than GDP in all of the heavily indebted countries of Europe, making the debt burden worse than ever, and the visible debt is almost certainly understated by contingent liabilities that might arise within the banking systems of the afflicted countries.

For now low interest rates make the debt burden seem manageable, but if debt continues to grow faster than GDP (and even if Europe is able to achieve the optimistic GDP growth targets promised by the various governments, debt will still grow faster than GDP for many more years), at some point debt levels will seem so high that further unlimited promises by the ECB will simply not seem credible. At that point investors will flee the government bonds issued by peripheral European governments.

But we probably won’t need to wait even that long. If the ECB were ever to hint at an end to low interest rates, or an end to the promise of indefinite rollovers, the debt level would quickly become unmanageable as the cost of rolling over the debt soared. Like in Japan today, high debt levels are made manageable because of low interest rates, and the hope is that at some point a resurgent economy will allow the countries like Spain to grow their way out of their debt burdens.

But here is the dilemma. Interest rates are low mainly because growth is non-existent. Should Europe start to grow, interest rates would be forced up and, depending on the maturity structure of the debt when this occurs, higher interest rates could cause financial distress costs to rise quickly enough to stifle growth. We are likely, in other words, to relearn the lesson of nearly every previous debt crisis in history –the debt burden itself prevents the kind of economic resurgence that allows highly indebted countries to grow their way out of debt. It is only when the debt has been written down to some manageable levels that afflicted countries ever begin again to grow.

The third problem, the demand imbalance, hasn’t been resolved either. In Germany there is talk of raising wages to rebalance demand. There continues to be, however, reluctance to do so because of the fear that higher wages will undermine Germany’s international competitiveness and force its economy to rely on productivity growth, of which there has been precious little in the past twenty years.

If German consumption doesn’t rise, then in principle the domestic imbalance can be resolved by a rise in German investment, but it isn’t clear how this could happen. The German private sector – not surprisingly given excess global capacity and weak global demand – seems reluctant to embark upon a domestic investment boom.

The German government also seems reluctant to invest because this would require a rise in government debt, and were perceptions of German credit to weaken, it would undermine the credibility of implicit German support for the weaker European sovereign borrowers. What makes the whole process maddeningly complex is that Germany’s creditworthiness is itself vulnerable to any perceived deterioration in the creditworthiness of peripheral European governments because German banks, who were among the main conduits for the export of German savings to peripheral Europe, are too heavily exposed to peripheral Europe.

Until we see higher German consumption or higher German investment, however, German businesses must continue to rely indirectly on demand from the rest of Europe, which must consequently continue to absorb weak German demand in the form of higher domestic unemployment.

A quick digression on bilateral trade balances

Many analysts have trouble understanding how Germany’s demand deficiency has been absorbed by peripheral Europe when much of Germany’s exports go elsewhere, to China for example. Quite a few analysts besides me – Martin Wolf, for example, or Heiner Flassbeck – have pointed out that distortions that forced up German savings relative to investment after around 2000 (and so caused Germany to swing from large trade deficits in the 1990s to among the largest trade surpluses in the world in the 2000s and through to today) were directly responsible for the collapse in savings relative to investment in peripheral Europe.

Germany’s trade surplus, in other words, required – and probably caused – the trade deficits of the rest of peripheral Europe (many of whom ran large surpluses in the 1990s). Some analysts find this hard to understand because, they point out, Germany does not run bilateral surpluses with peripheral Europe, or not anywhere near the extent of aggregate German surpluses and aggregate peripheral European deficits. This proves, they argue, that the deficits of a country like Spain, for example, have nothing to do with German surpluses, and were caused by domestic failures within those countries.

It proves no such thing. The reason has to do with the nature of global trade. Imbalances have to settle on an aggregate basis and do not need to settle bilaterally. In fact they rarely do. The key is to focus on capital flows. Remember that if Germany is a net capital exporter, it must run a trade surplus. If its capital exports cause other countries in Europe to become net importers of capital, they must run the trade deficits that correspond to Germany’s trade surplus (I am glossing over the differences between the trade and current accounts, but this does not affect the argument).

It isn’t necessary, in other words, that German run a trade surplus bilaterally with other European countries in order that German demand deficiency be resolved by the rest of Europe. The trade surpluses and deficits can occur bilaterally, but it is actually unlikely that they will. Perhaps it is easier to think in terms of the currency. Without a common currency Germany’s currency should have risen, and the currencies of other European countries dropped, given their respective trade account balances. The common currency prevented this, however, so that Germany benefitted from a weak euro while other European countries suffered from a strong euro.

In my book, The Great Rebalancing, I create a very simply four-country model (I call them the US, China, Mexico, and Brazil) in which China exports capital to the US, with Brazil and Mexico in balance, and show that China must consequently run a trade surplus, the US must run a trade deficit, but not necessarily bilaterally. There doesn’t even have to be direct trade between the two. Even if they can each trade only with Brazil and Mexico, China will still have a surplus and the US a deficit.

This confuses a lot of people who think the causes and consequences of trade imbalances must show up in bilateral trade balances, but even simple trade theory recognizes that bilateral balances almost never matter. It is the direction of capital flows that will direct the trade imbalances. This is why Germany’s net capital exports, mainly in the form of bank loans, to peripheral Europe had to result in German trade surpluses and peripheral European trade deficits, whether or not these countries even traded with each other, let alone ran trade balances that matched the capital balances.

Back to the problem of debt

How much longer is the rest of Europe willing to maintain high unemployment in order to support the German economy? On May 26 we will discover, I suspect, that at least some parts of the rest of Europe have little interest in continuing to maintain the euro if that simply means that they must suffer unemployment in order to protect Germany from its unwillingness to pay workers more.

For now the policy-making elite in peripheral Europe continues to insist that there will be absolutely no flexibility on the matter of the euro. But in the 1920s the British policy-making elite, who insisted then that there would be absolutely no flexibility on the matter of free trade, was forced to abandon its principles as high unemployment and voter revolt forced it into devaluing sterling and setting up tariffs. There is huge controversy on the sequence and causality (not surprisingly), but there is little doubt that after these occurred the British economy improved significantly and unemployment dropped. Meanwhile it was trade-surplus America that suffered mightily from the rise of global protection, not trade-deficit England.

What does this mean for the survival of the euro? Perhaps that when the policy-making elite is determined to act “responsibly” and maintain its highest principles (protect the bankers), but mainly at the expense of the working and middle classes, policymakers are eventually forced into retreat by an angry electorate. And perhaps it also means that the electorate isn’t quite as stupid about economic policymaking as the elite might think.

There are at least two things I would suggest we should consider in thinking about the future of the euro:

  1. Peripheral Europe has so far been remarkably tolerant of high unemployment, but of course the longer this goes on the lower the tolerance. If at some point opposition to the euro, or opposition to servicing the debt, becomes an obvious way to gain political support, we may see the debate about the euro move from the radical and occasionally lunatic fringe to a more respectable part of the political spectrum, in which case financial distress costs will intensify and the process of unraveling the euro will intensify.
  2. My model argues that the German imbalances are forced onto the peripheral countries in the aggregate, who together have to absorb the shortfall in German demand by increasing their unemployment. This suggests that if any country were to leave the euro, the total imbalances would rise (every time a weak country leaves the euro, the euro will strengthen) and would furthermore be concentrated among a smaller group of countries, which would then face additional pressure and weaker credibility. No matter how determined any individual country is to stay in the euro, in other words, its ability to stay may well be determined by the weakest “link”.

The May 26 votes might end up reminding us that the euro crisis isn’t over. The longer unemployment and hopelessness drag on, the greater the erosion of support for the establishment and the stronger the support for the radicals who want to abandon the euro.

By refusing to allow the introduction of any flexibility into the discussion of the long-term outlook for the euro, Brussels is forcing Europeans to choose among two absolutes: stay in the euro as it is, or break the currency union permanently. This is risky, because over time the second option becomes increasingly viable, and any movement toward to second option is self-reinforcing – which means that as long as opposition to the euro is low, the growth of opposition to the euro will be slow, but when we reach the point at which opposition to the euro is large enough to be taken seriously, the growth in opposition will accelerate.

Policymakers who think, in other words, that we do not need to discuss alternatives to the hard euro position until much later, when there is a real threat to the hard euro, are taking a huge gamble. Once we have reached that point, the risk is that we get the intellectual and institutional equivalent of a “bank run”, and policymakers will be shocked by the speed with which things fall apart. It will then be too late to introduce a more flexible position on the euro.

By the way those who advocate more flexibility on the euro are usually painted as enemies of Europe and the euro, but this is nonsense of course. In my opinion the world is better off with a united Europe (more united than now) and with a common currency, but it might very well be that the only way to achieve both is to introduce flexibility into the current system, which means, among other things, the possibility of a temporary withdrawal. Otherwise any break will be permanent.

What does withdrawal look like?

Along those lines I have been thinking about what would happen if Spain were to leave the euro. I confess I know very little about the legal and political implications about a euro exit, and although I have heard often enough that it is impossible to leave the euro, I don’t think anything such thing can be true about a sovereign nation. It may be difficult, it may be messy, and it certainly will be unpleasant, but it can happen.

But aside from legal issues, there are a number of economic and financial considerations that I base on my fifteen years of trading the sovereign debt of defaulted and restructured countries and my addiction to financial history. Here are the things I considered as being relevant to any breakup.

  1. First and most obviously if Spain leaves the euro its debt burden will soar. If Spain left the euro and returned to the peseta, the peseta will immediately fall, and as it does the peseta value of the euro-denominated debt will rise commensurately. Let us assume that when this happens Spanish external debt is 110% of GDP. In that case a 20% decline in the value of the peseta will immediately raise the debt to 137.5% of GDP and a 50% devaluation of the peseta will raise the debt to 220% of GDP.
  2. By how much will the peseta devalue? You might think this is a question about how “overvalued” the Spanish euro is (15%? 20%?), but in fact the debt burden itself determines the amount of the depreciation because of the way it forces certain types of investor behavior. In the end the amount of depreciation will have nothing to do with economists’ estimate of the amount of peseta overvaluation.

Why? Because a devaluation will the lock the country into a self-reinforcing cycle in which a devaluing currency forces up debt, which forces Spanish businesses and households to hedge by buying euros and selling pesetas, which forces down the peseta further, which causes even more hedging, and so on, so that the peseta will drop down unrestrainedly until investors believe Spanish assets are cheap enough that they begin to counteract peseta hedging by buying pesetas to acquire Spanish assets. The structure of the balance sheet, in other words, is what determines the amount of the devaluation, and countries with a great deal of external debt are likely to see their currencies fall far below any “rational” level.

If Spain were a developing country, I would argue that given its debt level the peseta would fall at least 50-70% (and so its debt burden would triple), but because it has a credible legal structure (I am assuming no radical party wins the election before a euro exit), a decline of 30-40% might be enough to set off foreign buying. My guess, in other words, is that if Spain left the euro with a center-right or center-left administration, the peseta would likely drop no more than 30-40%. This still will cause an already unbearable debt burden to become impossible, especially because interest rates will immediately rise.

  1. This, by the way highlights the importance of the political process and the speed with which Spain decides on its strategy. The longer it takes for Spain to arrive at a decision to abandon the euro, and the more bitter the fight to get there, the greater the likelihood of a radical right or left party taking power, in which case the euro might not stabilize at a 30-40% discount.
  2. There might be a way to limit the drop further. Over the longer term I think a more tightly organized Europe, with a single currency and a real fiscal center, is good for Europe and the world, and a euro exit might even be just the way to achieve this. If Spain were credibly (this means with full German support) to commit to returning to the euro within, say, five years, at a predetermined level – for example one implying a 20% depreciation over five years – Spain might be able to get most of the competitive benefits of a depreciation without giving up the benefits of monetary and economic integration. It would be a “stable” departure from and reentry to the euro.
  3. However much the devaluation, whether it is catastrophic or orderly, debt would surge. There is a foolish belief that as long as we can find a way to roll over the debt the debt burden itself does not matter, but of course it does for two reasons. First, resources must be appropriated from some part of the economy to service the debt, and second, debt creates financial distress costs that can far exceed the actual cost of the debt.

Spain must restructure its debt burden to a “reasonable” level, which means a level at which the mechanisms that create financial distress are minimal. High levels of debt, remember, force creditors, businesses, household savers, household consumers, and policymakers all to act in ways that increase balance sheet fragility and reduce growth, not because they are evil but because they are rational. For this reason countries that are perceived as having too much debt never grow until the debt burden has been resolved. It is in everyone’s interest that Spain immediately receive a significant debt haircut or else it will not return to growth and the devaluation will have been wasted. I would argue that Spanish external debt should be reduced to 60% of GDP and payments stretched out between 10-30 years.

  1. Significant debt forgiveness doesn’t mean equally significant losses for creditors. Financial distress costs are triggered by the perception of a high probability of default. Spain’s creditors, of course, will hate to see their claims on Spain sharply reduced, but this is almost certainly going to happen anyway (I don’t think Spain has much chance of “growing” its way out of its debt burden without debt forgiveness), and if done in an orderly way, it is possible to compensate creditors for at least part of the debt reduction without incurring financial distress costs.

Spain can replace debt claims with a different set of claims whose payment schedule is positively correlated with economic performance. Instruments that pay according to GDP growth, the performance of the stock market, or land prices, for example, are the right way to line up the interests of the Spanish economy with those of the creditors. These are not unprecedented – Argentina provided GDP warrants on its defaulted 2001 debt – but they are used far too little. If a devaluation plus a sharp cut in Spanish debt causes Spain’s economy to come roaring back, as it most certainly will, creditors will be paid on the basis of how well the economy does, and can eventually recover a substantial part of the value of their original claims.

This is a very important point that few understand. High fixed claims will continue to drag down the economy because they increase the probability of default, and an increase in the probability of default sets off the self-reinforcing process of financial distress, in which agents behave in ways that worsen the debt burden, and worse debt burdens create pressure for agents to exacerbate their adverse behavior. But this doesn’t happen with high variable claims that are correlated with how well the economy does (like equity in a company, which cannot create financial distress costs). These claims are high when Spain can pay and low when Spain cannot, so they do not increase default probabilities at all. For this reason they will create absolutely no financial distress costs.

  1. If Spain were to eliminate financial distress costs and lower its domestic costs by 20% with a devaluation, the economy, at least part of whose poor legal structure has been reformed under Rajoy, would almost certainly soar, clocking in growth rates of 5% or more for several years. Spain has not completely wasted the crisis. It has implemented very serious reforms, especially labor reforms, but these reforms were aimed at old distortions in the Spanish economy and had nothing to do with the current crisis, which is caused by excess debt and an uncompetitive exchange rate.

I go to Spain often to see my family (I will go there this Thursday, for example). It is incredibly frustrating to see how terribly Spaniards are suffering, especially in the south, where my family lives. To add insult to injury, Spanish suffering is being blamed on old stereotypes – their fiscal irresponsibility and their laziness – when in fact Spain was among the most fiscally responsible countries in Europe before the crisis and Spanish workers worked more hours every year than did the Germans.

Spain clearly has a lot of serious policy problems, and way too much corruption, but these problems pre-date the crisis and pre-date Spain’s joining the euro. They have nothing to do with the current crisis, which was primarily the result of a demand imbalance in Germany. As I argue in my last blog entry, both the explosion in Spanish consumption before 2008 and the surge in Spanish unemployment after are automatic consequence of a savings glut for which Spain bears no responsibility.

Spain, in other words, cannot resolve its crisis on its own. It requires concerted action by Europe, and especially by Germany, in order to bring down unemployment. Germany cannot play its role because this must involve debt forgiveness, and Germany will not be prepared to acknowledge the need for debt forgiveness until German banks are sufficiently capitalized to recognize the obvious. There are no winners here, Europe’s demand deficiency means that there will be high unemployment somewhere, but Spain can decide how to distribute the cost of adjustment by deciding whether or not to remain inflexibly within the euro.

<![CDATA[Why a savings glut does not increase savings]]> Debate about the global savings glut hypothesis is mired in confusion, a fundamental one of which is the seemingly obvious but false claim that a global savings glut must lead to higher global savings.Here, for example, is a recent piece by one of my favorite economists, Barry Eichengreen:

There is only one problem: the data show little evidence of a savings glut. Since 1980, global savings have fluctuated between 22% and 24% of world GDP, with little tendency to trend up or down.

As surprising as it might sound, global savings gluts do not result in higher global savings except under specific, often unlikely, conditions.

What is a savings glut?

There is no formal definition, but whenever market conditions or policy distortions cause the savings rate in one part of the economy to rise excessively (itself an ambiguous word), we can speak of a savings glut. There are at least two main causes of a savings glut.

  1. A rise in income inequality. We see this in Europe, the US, China, and indeed in much of the world. As wealthy households increase their share of total income, and because they tend to save a larger share of their income than do ordinary households, rising income inequality forces up the savings rate.
  1. A decline in the household share of GDP. We’ve seen this mainly in China and Germany over the past fifteen years. When countries implement policies that intentionally or unintentionally force down the household share of GDP (usually to increase their international competitiveness) they also automatically force down the consumption share of GDP. Because savings is defined as GDP minus consumption, forcing down the consumption share forces up the savings share. There are many policies and conditions that do this, and I discuss these extensively in my book, The Great Rebalancing, but the main ones are low wage growth relative to productivity, financial repression, and an undervalued currency.

Notice that in both these cases, and completely contrary to the popular narrative that praises high savings as a consequence of household thrift, and so as morally virtuous, the rise in the savings rate does not occur because ordinary households have become thriftier. In the former case household savings rise simply because the rich increase their share of total income. In the latter case national savings rise without households in the aggregate increasing their savings.

How does the economy balance?

An economy’s total production of goods and services (GDP) can be defined either from the demand side (consumption plus investment) or from the supply side (consumption plus savings). By definition, in other words, savings is always exactly equal to investment.

An economy experiencing a savings glut must maintain this balance. It is consequently just a matter of logic that a savings glut must be accompanied by a balancing adjustment – either by an increase in investment or by a reduction in savings in another part of the economy – and this adjustment must occur simultaneously. The necessary implication is that whatever causes the savings glut must also cause one or both of these balancing adjustments.

There are only two ways investment can rise and two ways savings elsewhere can drop. This means that a savings glut must result in one or more of the following, enough fully to offset the savings glut:

  1. If productive investment has been constrained by the lack of savings, productive investment will rise.
  1. Nonproductive investment can also rise. Excess savings can cause large speculative flows into real estate or other assets, perhaps even setting off asset “bubbles”. When this happens it can create additional investment outlets for excess saving in the form of projects, including most often real estate projects, whose economic value can only be justified by rising price expectations.
  1. Rising asset prices can unleash a consumption boom if it causes ordinary households to feel wealthier and so increase their consumption (the “wealth effect”). This increased consumption creates what I will call, perhaps clumsily, a “consumption glut”.
  1. If less consumption caused by the savings glut is not matched by higher investment or by a consumption glut, total demand drops, resulting in higher unemployment. Unemployed workers stop producing goods and services but do not stop consuming. Because savings is simply the gap between production and consumption, unemployment causes the savings rate to drop.

Economists almost always miss this point. A global savings glut must be accompanied by one or more of the four adjustments listed above. It can result in higher global savings if the economy rebalances in the form of higher productive or unproductive investment, or it can result in no change in the global savings rate if the economy rebalances in the form of a consumption glut or a rise in unemployment. Nothing else is possible.

The best outcome is if a savings glut is accompanied by higher productive investment. This is often referred to as “trickle down economics” when both the rich and the poor benefit from productive investment, with the rich benefitting more.

If there is a savings glut, will productive investment automatically increase? If productive investment has been constrained by low savings it will, but productive investment tends to be constrained by insufficient savings mostly in undeveloped countries. Most excess savings, however, have originated or flow into rich countries.

In rich countries there are often many productive projects that desperately await investment, but this failure to invest is driven by other factors, and usually not by the lack of savings, so that a savings glut is unlikely to lead to higher productive investment*. Former Fed Chairman (1934-48) Marriner Eccles even argued that a savings glut could reduce productive investment. “By taking purchasing power out of the hands of mass consumers,” he wrote, “the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants.”

More commonly when excess savings are high they flow into real estate and stock markets, perhaps even setting off bubbles, with overinvestment in real estate an almost inevitable consequence of rapidly rising housing prices (we saw this most obviously in peripheral Europe, the US and China). These speculative flows have another impact that allows the economy to balance savings and investment. The real estate bubble makes households feel wealthier, which encourages a consumption glut, so that between the real estate boom and the consumption glut, the savings glut is fully absorbed.

But this is temporary. When the asset bubbles burst, the resulting surge in unemployment brings down the savings rate enough again to maintain the balance between savings and investment.

Savings must balance

The point here is that a savings glut need not result in an overall rise in savings. It can just as easily cause a consumption glut elsewhere whose positive impact on total demand fully mitigates the negative impact of the savings glut. The idea however that a savings glut can simultaneously create a consumption glut seems to be one of the most difficult things for many economists to understand, perhaps because it seems at first so counterintuitive.

Of course the other way a savings glut need not result in an overall rise in savings is through higher unemployment. In fact because neither an asset bubble nor a consumption glut is sustainable, unless productive investment has been constrained by a lack of savings, the only long-term consequence of a savings glut is a rise in unemployment and no rise in total savings.

In that case there might be only two sustainable ways to address the resulting unemployment. Either the savings glut is reversed, or governments act to eliminate whatever were the previous constraints on productive investment (perhaps by liberalizing constraints to investment or even by initiating a kind of “new deal” in infrastructure investment). The third way, although not sustainable, is for another asset bubble to be inflated so as to encourage another consumption glut, which seems currently to be the preferred way of US and European governments.

Which way is the causality?

It is just a matter of logic that unless investment rises substantially, a savings glut must combine with a consumption glut or with a surge in unemployment so that there is no net increase in savings. But logic only tells us that the two must occur simultaneously. It implies no obvious direction of causality. Does a savings glut cause a consumption glut, or does the consumption glut cause the savings glut? To put it in contemporary terms:

  1. Did Chinese policies aimed at forcing up domestic savings (by forcing down the household income share of GDP) set off a consumption glut in the US, or did profligate US consumption require that Chinese savings rise to accommodate it?
  1. Did German policies aimed at restraining workers’ wages force up the German savings rate, with excess savings pouring into peripheral Europe, setting off real estate bubbles, which then set off consumption gluts, or did over-enthusiasm about the euro cause overly confident citizens of countries like Spain to embark on a consumption binge, which could only be balanced by a rise in the German savings rate?

One way of resolving these questions might be to examine the cost of capital. Pulling capital from low-savings to high savings parts of the economy might seem to require high interest rates. Pushing capital from high-savings to low-savings parts of the economy might seem to require low interest rates.

There is so much misunderstanding about the savings glut hypothesis that much of the debate has verged on the nonsensical. Unless it unleashes a truly heroic surge in investment – productive or nonproductive, although the latter can only be temporary – a savings glut must always be accompanied either by a consumption glut elsewhere or by a rise in unemployment. No other option is possible. This is why savings gluts rarely result in higher overall savings.

This is also why any serious discussion of the savings glut must eschew moralizing and must focus instead on the direction of causality. Did distortions that created a savings glut force the creation of a consumption glut, or did distortions that created a consumption glut force the creation of a savings glut? Any analysis that does not recognize that both must occur simultaneously, and so must be resolved simultaneously, cannot possibly be correct.

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* Perhaps in cases in which investment has been constrained by high interest rates, higher savings can unleash more productive investment. It may also be, although I cannot prove it, that when income inequality is low, higher savings associated with further increases in inequality can lead to more productive investment in part because interest rates might be high. In that case it would seem that when income inequality is high, higher savings associated with further increases in inequality will not lead to more productive investment.

<![CDATA[Do we understand the math behind the PPP calculations? ]]>

中国离世界第一很远 原因在坏账


世行这一结论也引发不少经济学家的批评,包括北京大学光华管理学院客座教授、卡耐基基金会高级副研究员迈克尔-佩蒂斯(Michael Pettis)等。佩蒂斯批评世行的分析结论,认为中国距离世界第一大经济体还很遥远,而且他的分析脱离了“人均GDP”这种陈词滥调,独辟蹊径。




中国GDP与美国GDP构造方式的主要差异在哪里呢?对债务的衡量。这并不是说中国计算债务的方法有所不同,而是中国的坏账(bad debt)很少被核销、债务偿还很少强迫执行、违约非常罕见,银行只是不断地对坏账进行转滚(rollover)。为什么会出现这种情况呢?佩蒂斯认为主要是因为中国的放贷者(银行以及家庭)(比如家庭购买信托产品即是一种放贷行为——编注),将大部分债务视为享有中央或地方政府直接或间接的担保,因此投资损失并未显示为损失(支出),而是通过转滚显示为资产。


然而在中国显然不是如此,很多应该被记为“支出”的项目(比如坏账损失)事实上在中国GDP中被当成“资产”来计算。对债务的不同处理方法导致资产负债表的巨大差异,因此佩蒂斯认为不应直接对两个国家的GDP进行对比。大概有多少坏账损失应该被记为支出但实际上被算作资产呢?佩蒂斯初略估算应该相当于GDP的20-30%。(新浪财经松风 编译)


Do we understand the math behind the PPP calculations?

A new PPP study complied by the World Bank has generated some pretty excited and, to some, alarming headlines about the new world order. There has been limited reference to this in the Chinese press, for reasons I will discuss later, but here is the Financial Times on the subject:

The US is on the brink of losing its status as the world’s largest economy, and is likely to slip behind China this year, sooner than widely anticipated, according to the world’s leading statistical agencies. The US has been the global leader since overtaking the UK in 1872. Most economists previously thought China would pull ahead in 2019.

…In 2005, the ICP thought China’s economy was less than half the size of the US, accounting for only 43 per cent of America’s total. Because of the new methodology – and the fact that China’s economy has grown much more quickly – the research placed China’s GDP at 87 per cent of the US in 2011. For 2011, the report says: “The US remained the world’s largest economy, but it was closely followed by China when measured using PPPs”.

With the IMF expecting China’s economy to have grown 24 per cent between 2011 and 2014 while the US is expected to expand only 7.6 per cent, China is likely to overtake the US this year. The figures revolutionise the picture of the world’s economic landscape, boosting the importance of large middle-income countries. India becomes the third-largest economy having previously been in tenth place. The size of its economy almost doubled from 19 per cent of the US in 2005 to 37 per cent in 2011.

The article explains the reason for price adjustments in comparing economies, and says: “The estimates of the real cost of living, known as purchasing power parity or PPPs, are recognised as the best way to compare the size of economies rather than using volatile exchange rates, which rarely reflect the true cost of goods and services.”

There is a lot of very interesting information in the World Bank study but this statement is largely incorrect, or at least exaggerates the way PPP is recognized. Adjusting GDP for differences in purchasing power makes a great deal of sense in certain cases, but the way it is done is so filled with problems that it is extremely difficult to find any economist who takes these measures very seriously.

The concept behind PPP is quite simple. You cannot always compare two countries in a meaningful way by comparing their GDPs at current exchange rates. Prices are different in different countries in ways that current exchange rates do not offset. This means that relative living standards are a function of more than just relative incomes.

This doesn’t mean that comparing the GDP of two countries directly at current exchange rates is useless. For example – and this is a fairly obvious mistake made in the FT article, and indeed in nearly every other article I have seen on the topic – if we are interested in the relative weight of two countries in geopolitical terms you would almost certainly want to compare their GDPs on the basis of current exchange rates. Exchange rates may be volatile, as this article notes, but a direct comparison, unadjusted for price differences, better measures the relative importance of each economy for its trade partners.

And contrary to what the article says later, the World Bank findings should not “intensify arguments about control over global international organisations such as the World Bank and IMF, which,” the article correctly notes, “ are increasingly out of line with the balance of global economic power”. While there is no question that countries like China, India and Brazil should see an increase in their representation among international bodies, it is not because the PPP measure tells us much about the relative weight of these countries.

Its usefulness lies elsewhere. The PPP adjustment attempts to measure the relative living standards between the two countries adjusting for the fact that prices are not equal at current exchange rates. A family earning $40,000 in one country, for example, will have the same nominal income but a better standard of living than a family earning $40,000 in another country if both families spend a significant portion of their income on nannies for their children, and if nannies are far cheaper in the first country than in the second.

This is really what the PPP adjustment tells us, but even here there are lots of obvious problems when we try to compare the two countries. One such problem is the assumption that both families have the same consumption baskets, which the PPP adjustment implicitly assumes. It is very unlikely that this is true for all sorts of reasons, not the least being that consumption itself is affected by relative prices. All of us are likely to adjust our consumption baskets in favor of those goods and services that are cheapest in relative terms.

In Beijing, for example, the cost of getting someone to clean your apartment is far, far lower than it is in New York. On the other hand New York has one of the most vibrant theater scenes in the world. No one would be surprised to hear, consequently, that someone currently living in Beijing is likely to have a cleaning lady come to his apartment far more often than he did when he lived in New York, and is less likely to go to the theater in Beijing than he did when he lived in New York. In that case comparing his standard of living in Beijing and New York, even assuming he had the same income in both places, can be pretty difficult.

But these are all obvious problems with the PPP measure, the kinds that are discussed in almost any undergraduate economics class. As long as we keep them in mind we can find the PPP measures to be quite useful in some circumstances, even if in our excitement over the kinds of news stories that generate headlines we interpret PPP to have geopolitical implications that are almost the opposite of reality.

Not all accounting is the same

But there is another problem with the PPP measure that is much greater, so much so that in some cases it completely invalidates PPP as having any kind of informational content. Economists love to use mathematics – perhaps it gives them a sense of legitimacy – but it is not always clear that they understand it very well, especially when it comes to working out the assumptions that are implicitly embedded in the various models that they use. We have seen especially egregious instances of bad analysis backed by lots of very confidence-inspiring data when it comes to analyzing the Chinese economy. The China PPP adjustment is another example.

Remember that the PPP adjustment is an attempt to correct for a significant distortion in direct GDP comparisons. The PPP model has two important assumptions. The first assumption, an explicit one, is that different countries assign different prices to the goods and services consumed domestically in a way that is not fully captured in the exchange rate. The PPP adjustment is an attempt to correct for this by taking the US economy as the standard, comparing prices of a specified basket of goods and services in the US with the second country (China, in this case), and adjusting China’s numbers upwards or downwards to reflect these differences.

But the second assumption, implicit but just as important, is that the US GDP numbers very broadly capture economic activity in the US in the same way that China’s GDP numbers capture economic activity in China. If this weren’t true, adjusting the two for relative prices would be a useless exercise. This isn’t an assumption, by the way, that either country’s GDP is somehow “correct”. It is only an assumption that any mistakes or biases in the US GDP numbers are the same as those in the Chinese GDP numbers, so that except for prices the two are comparable.

Here, of course, is where the PPP calculation can fall apart, and it is why the assumption should be explicitly stated. If you are comparing the US with an economy that construct GDP in a fairly similar way, Canada for example, PPP adjustments can be very illuminating because it allows you to compare like with like. But if GDP is constructed very differently than it is in the US, the second assumption is violated, in which case the PPP adjustment becomes simply another random comparison, which might or might not be better than the non-adjusted GDP numbers.

In China, it turns out, and not surprisingly, the composition of GDP is very different than it is in the US, mainly because the two countries measure debt very differently. It is not because China sets out to record debt differently – on the contrary, most people will tell you China records it in the same way the US and other countries do, and China certainly intends to. The problem is that in China bad debt is rarely recognized, repayment isn’t enforced, and default is almost non-existent. Banks simply roll bad debt over indefinitely. This makes comparisons between the two countries pretty hard. Why? It helps us to understand this if we think about the difference in the way we account for expenditures related to consumption and to investment. Normally, when you spend money on consumption, you create an expense. When you spend money on investment, you create an asset.

Let us assume that two identical companies each spend $50 on the same thing (say scientific research), but in one company the expenditure is recorded as an expense and in the other it is recorded as an asset. What would the financial statements for each company look like? The answer is pretty obvious. In the current recording period the first company would show $50 lower net profits than the second and $50 less assets and equity – remember however that there is absolutely no difference between the two companies, only in the way they record expenditures.

We should understand that this difference in accounting isn’t permanent. Over time, the second company will amortize, explicitly or implicitly, the $50 in additional assets, so that in future periods its net income will be a little lower every year, until at some point, when the expenditure (asset) is fully amortized, the two balance sheets will again look identical.

The important thing here is to recognize that if two companies (and the same is true for two countries) recognize expenditures in different ways, one as an asset and one as an expense, in the short term their financial statements will look very different but over the longer term they will converge. One of the two will report better income and asset numbers in the period during which expenses are being reported as assets, worse income and better assets numbers during the amortization period, and identical numbers thereafter.

Adjusting for debt

It turns out that the difference between the way the US and China implicitly construct GDP shows up in the way bad debts are treated, and by bad debt I mean the excess of the cost of an investment over its value. What happens if you borrow $100 to create an asset that ends up being worth only $80? The best way to treat this would be to create an $80 asset and the equivalent of a $20 expense, with the latter loss showing up as a claim against profits (for a company) or GDP (for a country).

This is effectively what we do when we write down debt in a market-based financial system. If an investor borrows $100 and invests it in an asset that creates only $80 of value, he will either default, and the debt will be liquidated, with the difference between$100 and $80 showing up as an expense (as loan loss provisions in a bank, for example), or he will write down the difference by transferring money from operating earnings or the sale of assets, with the write-down showing up as an expense.

Let’s assume that in China defaults do not happen to the same extent that they do in the US. First of all, is this a reasonable assumption? It clearly is. Except for the occasional insignificantly small one (what the Financial Times calls a “Potemkin default”), defaults are extremely rare in China, partly because much of the lending into what we usually assume are the worst projects are implicitly or explicitly guaranteed by the state or by local governments and partly because it may be politically difficult to record certain loans as problem loans.

At any rate although I don’t have numbers with me I think it is pretty safe to say that the number and value of defaults in China are a small fraction of those in the US. For this there are only two possible explanations. One is that Chinese investors are and have been far, far less likely to make bad investments than US investors (90-95% less likely if there are 10-20 times as many defaults in the US as in China relative to the sizes of their economies).

A few years ago there may have been a few very brave people who still believed this, but not too many do any more. With a comparatively short history of making investments, much more rapid credit growth in recent years, extraordinarily low interest rates compared to nominal GDP growth rates, and seemingly near-infinite amounts of moral hazard, it is implausible that Chinese investors are so far less likely to make bad investments than US investors.

That leaves the only other possible explanation, which is that bad investments are simply not recognized within the banking system to the same extent that they are in the US, and are in fact rolled over. Because even government officials and senior bankers have admitted many times that this is what happens, I think we can assume that it does. The automatic consequence, if this is true, is that a lot of what should be recorded as “expenses”, e.g. loan losses, are actually treated in China’s GDP calculations as “assets”.

This matters when we compare China’s GDP with that of the US. The two countries treat the accumulation of bad debt in very different ways (not because China intends to, but simply because it is politically difficult in China to force repayment when most of the borrowers are politically powerful), and as in the case of the first company relative to the second, this difference means that as long as China is accumulating and rolling over bad debts, China’s GDP and its assets will be significantly overstated relative to those of the US.

A rough proxy for the amount of the overstatement might be the bad debt on Chinese balance sheets net of liquidation – if we were to define “bad debt” in economic, rather than legal, terms (for example by including debt whose repayment might be considered questionable were all explicit or implicit central or local government guarantees credibly withdrawn). One ironic implication of course is that if China were to engage in an orgy of bad investment, it would get poorer (as more and more money goes to what in reality are expenses) while artificially boosting its GDP growth (as more and more expenses are recorded as assets). This seems to have been what happened in 2009-10 and thereafter.

This is almost certainly why Premier Li has insisted again and again that in spite of what must be tremendous domestic pressure China will not attempt to regain growth by another “fiscal stimulus” after the disaster of 2009-10. This will just boost GDP by creating more losses and effectively converting them into “assets”. According to an article in Friday’s Financial Times:

Premier Li Keqiang has said the government will steer clear of short-term stimulus measures to boost the economy. Li (pictured) said in an article published yesterday that pushing through deeper economic reforms was a wiser and more courageous approach than relying on government spending and borrowing to produce growth.

If the premier refuses another major fiscal stimulus in spite of rapidly slowing growth it can only be because he does not believe that all the growth generated by previous fiscal stimulus package was real, and this can only be because they generated large losses that were not recognized as losses but showed up, instead, in the form of “assets”.

This means that on a comparable basis, if you believe that China does not recognize bad debt in the same way that the US does, China’s reported GDP is likely to be overstated by the failure to recognize the difference between the cost of investment and the value created by that investment. Unless you believe that the US fails to recognize losses on investments to anywhere near the same extent, if you really want to compare the two economies more usefully you would have to do at least two adjustments: you would have to adjust China’s GDP upwards for price differentials and also adjust it downwards for unrecorded losses.

By how much would it have to be adjusted downwards? My back of the envelope calculation is that GDP may be overstated relative to US GDP by 20-30%.

Implying false precision

Is this an implausible number? Probably not. It is admittedly very rough, but it is based on what I think are reasonable assumptions about the annual amount of debt-related overstatement that is likely to have occurred in the past one or two decades. There is already substantial evidence that the Chinese banks have a long-established track record of accumulating bad debt.

China’s last banking crisis, for example, was estimated to have cost China roughly 40% of GDP, with some estimates even higher, but remember that these did not show up immediately. They were created in the late 1990s and were effectively recorded over the 2000-10 period in the form of significant transfers from the household sector (I have explained before how financial repression was the form in which the transfer took place), whose growth lagged GDP growth substantially.

Of course household income still grew very rapidly (7-9% of GDP), driven by even higher growth in GDP, but this was because of a massive increase in investment during the amortization period. Unless the ability to invest productively has sharply improved, much of the previous losses will have been amortized effectively by creating a whole new set of losses in the banking system – a large portion, in other words, was simply rolled over.

Since the huge losses generated in the 1990s, total Chinese debt has become a much larger share of GDP, the accumulation of the debt system-wide has arguably occurred in a more opaque manner, credit has grown at a far more rapid pace, and interest rates have been extraordinarily low (for long periods of times 10-15 percentage points below nominal GDP growth rates). On the other hand Chinese banks have gained an extra decade of experience in making loans and there arguably may have been a small decline in moral hazard.

The former set of circumstances should increase the risk and amount of losses in the banking system and the latter should reduce it. Either way the claim that an amount equal to 20-30% of GDP that should have been written off as loan loss expenses were instead accumulated as assets is not nearly as extreme as it might seem.

I should stop here and make a point that I am almost certain is going to be very widely misunderstood by many people who read this blog entry. My argument is not that China’s “real” GDP is 20-30% lower than its stated GDP. The whole issue of measuring GDP is incredibly complex, and it isn’t meaningful at all to say that a country’s real GDP is some quantity more or less than its stated GDP.

My point is a lot smaller and a lot more precise. China and the US compile their GDP data implicitly in very different ways, among the most notable of which is the way Chinese lenders, banks as well as households, treat a substantial portion of the debt as if it were implicitly or explicitly guaranteed by central or local government agencies. This means investment losses don’t show up as losses (expenses) because it is politically difficult to do so, and are instead rolled over and so show up as assets.

Because their economies are implicitly structured in very different ways, which create very different balance sheets, the two economies cannot be directly compared. One difference, and this of course is addressed in the PPP calculations, is that because relative prices of goods and services are different enough if you want to compare living standards you must make adjustments to average income based on differences in purchasing power.

But another difference – and this may be just as important, or even more so, then relative price differentials – is that the two countries’ balance sheets are not comparable, because of debt, and have materially different ways implicitly to recognize the gap between the cost of an investment and the value of that investment. Adjusting for this fact, I would argue, is just as important in any comparison of the two economies as adjusting for price differences.

So what is the point of all of this? Mainly that sometimes simplifying or adjusting our analyses can be useful, but we should be very aware of the assumptions, explicit and implicit, that underlie our analyses. PPP adjustments are useful when we are comparing two economies that are structurally similar and that compile GDP in ways that make them comparable.

But if we are going to compare two very dissimilar economies, France and Sudan, for example, or Brazil and North Korea, or the US and China, we have to be cautious because there are many other equally important adjustments we must make before we can usefully compare their GDPs. The PPP adjustment is an obvious example, but in these cases just adjusting on a PPP basis is a pretty random way of choosing which adjustment we are going to make.

So what? It may be a random adjustment but it is still an adjustment, right? On average, adjusting for PPP probably leaves us no worse off than not adjusting for PPP, so why would we want to oppose doing so?

Only because the adjustment can imply far more certainty than is warranted (a common mathematical mistake among non-mathematicians). We should be wary because of the implication that PPP is not just a random adjustment, and that it actually significantly improves our ability to compare any two economies. In some cases it does, but too often it cannot, and actually makes the comparison worse. While the PPP adjustment should increase our confidence in our ability to say something meaningful about the relative sizes of the US and Canada, it should not increase our confidence in our ability to say something meaningful about the relative sizes of the US and China.

By the way I should add a quick math point here that is often forgotten. If we believe that in order to make it comparable to that of the US we should adjust GDP upward by 25% to reflect the price differentials (the PPP adjustment) and then adjust it downwards by 25% to reflect the different ways of recording debt-related losses, the net is not a wash. China’s GDP is 7% smaller after the two adjustments.

Beijing opposes the PPP calculations

By the way according to a Friday article in the Financial Times Beijing has been opposed to the new World Bank calculations:

China fought for a year to undermine new data showing it is poised to usurp the US as the world’s biggest economy in 2014 based on purchasing power, according to people who helped compile the report.

The report, released this week by the International Comparison Programme under the auspices of the World Bank, included a line stating that the “National Bureau of Statistics of China has expressed reservations about some aspects of the methodology”. Beijing has declined to publish the headline number for China and the report said that the NBS “does not endorse the results as official statistics”.

The FT article says that the reason Beijing was opposed to the study was fear that “ leaders do not want exposure to the international pressure that comes with being the world’s largest economy, according to people familiar with Chinese official views on the matter.” The article then quotes Vinod Thomas, director-general of independent evaluation at the Asian Development Bank as saying: “They certainly don’t want to overstate the size of their economy. They are sensitive about that.”

I think this is probably correct but I think the FT and others may have missed the point. If GDP is indeed “overstated” by the failure to recognize bad debt, remember that this overstatement is not permanent. The difference will necessarily be amortized over the future, and the result will be that today’s overstatement will be matched by tomorrow’s understatement, and for those who receive my newsletter, I explained in the latest issue that the overstatement is only equal to the understatement if there are no financial distress costs associated with the excessive debt burden. If there are, and there almost certainly will be, tomorrow’s understatement will exceed today’s overstatement.

This means that if you look only at PPP adjustments, China runs the risk of becoming the world’s largest economy earlier than expected, only to slip back to second place over the next few years. This, I suspect, would be a political embarrassment, and it is very understandable why the current administration would not want it to happen.

<![CDATA[Economic Consequences of Income Inequality]]> A lot of things have happened in China since my last entry – in the FX markets, in the banking system, in the announcements of default, and in the continuing lowering of growth expectations – but for all the turmoil, as I see it nothing has happened that was unexpected and that has not been discussed many times on this blog. For that reason I decided to post a rather long essay (sorry) on income inequality and on how I think we can best think about the impact of income inequality on the global economy.

This is a loaded topic, and I suspect I am going to get a lot of responses claiming that my essay is totally brilliant or totally nonsensical based, mainly, on the political orientation of readers. This entry, however, is not intended to be political. Very few things in economics are good or bad in themselves, but rather can be good under certain conditions or bad under others. I want to try to tease out as logically as I can the conditions under which rising income inequality can be good or bad for the economy.

That is all I am trying to do. My logic may be faulty and my assumptions may be wrong, and I invite readers to challenge either, but none of this should be seen as moral or immoral. Income inequality may very well be one or the other for very solid social, political or even religious reasons, but I am interested here only in the logical economic outcomes of income inequality.

Digging deeper into the model I use to understand income inequality also allows me to dig deeper into the sources of global imbalances – the two are tightly interlinked – and how these imbalances have driven much of what has happened around the world in the past decade. This model rests on an understanding of how distortions in the savings rates of different countries have driven the great trade and balance-sheet distortions with which we are wrestling today, just as they have in most previous global crises, including those of the 1870s, the 1930s, and the 1970s. Rising income inequality is key to understanding this model.

It turns out that it is actually not that hard to work through at least one of the major economic consequences of rising income inequality. I would argue that from an economic point of view the income inequality discussion is mainly a discussion about savings, and when you introduce into the economy a systematic tendency to force up the savings rate, the economy must respond in what are only a limited number of ways.

As I will show, some of these responses require an unsustainable increase in debt, and so are temporary. There are, it turns out, two sustainable responses to a forced increase in the savings rate in one part of the economy. The first is an equivalent increase in productive investment (this, I think, is the heart of the supply-side “trickle down” theory). The second is an increase in unemployment.

Much of what I am going to argue is not new, and is merely a revival of the old “underconsumption” debate. Before jumping into the argument I want to start by quoting the remarkable former Fed Chairman (1932-48) Marriner Eccles, who may well have been the most subtle economist of the 20th Century, from his memoir, Beckoning Frontiers (1966):

As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth – not of existing wealth, but of wealth as it is currently produced – to provide men with buying power equal to the amount of goods and services offered by the nation’s economic machinery. Instead of achieving that kind of distribution, a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations.

But by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.

The key point here is that all other things being equal, rising income inequality forces up the savings rate. The reason for this is pretty well understood: rich people consume a smaller share of their income than do the poor. The consequence of income inequality, Eccles argued, is an imbalance between the current supply of and current demand for goods and services, and this imbalance can only be resolved by a surge in credit or, as I will show later, by rising unemployment.

Rising income inequality reduces demand. It does so in two ways. First, it directly forces down the consumption share of GDP, and second, it reduces productive investment by reducing, as Eccles says, “the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants.”

But – and here is where I will presume to add something new to the historical debate about income inequality and underconsumption – there is another very important form of rising income inequality that also forces up the savings rate in a very similar way, and this has been especially important in the past two decades. A declining household share of GDP has the same net impact as rising income inequality.

We have seen this especially in places like Germany and China during the past decade. In both countries policies were implemented which, in order to spur growth and, with it, employment, effectively transferred income from households to producers of GDP.

The main form of this transfer, in the case of Germany, was an agreement around fifteen years ago to restrain wage growth. By keeping wage growth lower than productivity and GDP growth, unit labor costs declined in Germany and German workers became more “competitive” in the international markets. This forced up the German savings rate and converted Germany’s current account from large deficits in the 1990s to the largest surpluses in the world.

In the case of China there were also restraints on wage growth relative to productivity growth – not so much a policy choice, I would argue, but a consequence of the huge number of underemployed rural workers in China – but there were at least two other very important transfers. First, China has had an undervalued currency ever since 1994, which acts as a spur to growth in the tradable goods sector by effectively taxing foreign imports (and notice, by the way, that something similar happens in Germany, which also has an “undervalued” euro in relationship to the “overvalued” euro of countries like Spain, Italy and France). This reduces the real value of household income as a share of GDP.

Second, and most importantly, interest rates in China have been severely repressed during much of this century, perhaps by as much as five to ten percentage points or more. This has acted as a huge transfer from net savers, who are the household sector for the most part, to net borrowers, who consist mainly of manufacturers, infrastructure developers, real estate developers, state-owned enterprises, and government entities.

In both cases, and this is true of other countries, especially if they have large state sectors, one of the consequences of these hidden transfers is that GDP, which is the total production of goods and services, rose faster than household income for many years, meaning that households retained a smaller and smaller share of the total amount of goods and services they produced. Of course as the total share of GDP they retained contracted, it is not a surprise that they also consumed an ever-declining share of GDP.

The squeezing of the household sector

Notice how this affects total savings. Even if German or Chinese households kept their savings rates steady (i.e. they consumed and saved the same share of their income as before), their consumption as a share of GDP had to decline in line with the household income share of GDP. Most consumption is household consumption, and so as household consumption declines as a share of GDP, total consumption also tends to decline as a share of GDP, which is just another way of saying that total savings rise as a share of GDP.

This is a point that is often missed. Rising income inequality can have the same impact on savings and consumption as a rising state or business share of GDP. In a country in which the state retains a growing share of GDP, the net impact on savings and consumption is almost identical to that of a country in which income inequality is rising. In both cases consumption tends to decline and savings to rise as a share of GDP.

This tendency for rising income inequality, or a rising state share of GDP, to force up the savings rate can be a good thing. If there is a large amount of productive investment that needs to be funded, and not enough savings to fund this investment, increasing the savings rate can cause an equivalent increase in productive investment, and this increase can create sustainable demand for new jobs. Notice that these new jobs force up the total amount of goods and services produced, so that ordinary workers will see their income increase even as income inequality increases. The rich will do very well, but the rest will do pretty well too.

But what happens if there is already enough savings to fund productive investment? In that case the impact of rising income inequality is very different. To understand why, let us assume a closed economy with a moderate amount of unemployment (until we begin interplanetary trading the world is a closed economy). We can define the total amount of goods and services produced, which we usually refer to as GDP, in two ways.

First, everything that we produce must be absorbed, and the two ways we can absorb it is either by consuming the goods and services we produce, or by investing them today for future consumption. GDP, in other words, is the sum of everything we either consume or invest, or to put it arithmetically:

GDP = Total consumption + Total investment

This is true by definition. Second, because our total income is equal by definition to the sum of all the goods and services we produce, and there are only two things we can do with our income, consume it today or save it for future consumption, GDP is also by definition the sum of savings and consumption, or, to put it arithmetically:

GDP = Total consumption + Total savings

From these two equations it is obvious that in any closed economy savings is always equal to investment. This simple truth, which is true by definition, has very powerful implications.

Let us assume now that something has happened that caused a transfer of wealth in our economy from the poor to the rich, or that caused the household share of income to drop. To make things simpler we will assume that this transfer occurred without changing GDP, so that the total amount of goods and services is unchanged, but now ordinary households retain a smaller share. This transfer of wealth must have an impact on both total savings and total consumption.

At first the impact might seem obvious. Total consumption will decline and total savings will rise. But it is not that obvious. In order to maintain the balance expressed in the two equations, mainly the requirement that savings is always exactly equal to investment, something else must happen. There are only two possible things that can maintain the balance:

  1. Investment must rise in line with the increase in savings.
  2. Savings in fact do not rise, which implies that any increase in savings caused by the transfer of wealth was matched by some other event that caused an equivalent reduction in savings.

I apologize if these sound obvious, but I want to keep the flow of the argument as logical as possible, and so I hope each step follows obviously from the prior step.

Let’s take the first condition. Will investment rise? There are, again to be terribly obvious, only three ways investment can rise.

  1. There can be an increase in productive investment.
  2. Unproductive investment can rise in the form of unwanted inventories.
  3. Other forms of unproductive investment can rise.

What causes investment to rise?

Let’s consider each of these three in turn before we consider our second possibility, that savings in fact do not rise.

1. There can be an increase in productive investment.

This is obviously the best-case scenario. The tendency to increase the savings rate is met by an increase in productive investment that exactly matches the reduction in consumption. The combination of an increase in productive investment and a reduction in consumption keeps total demand constant, so that there is no imbalance (in the aggregate, of course) between the total demand for and the total supply of goods and services produced by the economy. Because the increase in investment is productive, however, over time total goods and services will grow, and, presumably, households will be able to increase their consumption in the future.

How likely is this to be happening in the current environment? It is probably not very likely. It is hard to believe that in rich countries, like the US, there are a lot of productive investments that are neglected simply because there is an insufficient amount of savings to fund them.

I am not saying that every productive investment in the US has already been made, but just that if there are productive investments that remain unfunded, it isn’t because of insufficient savings. It might be because of political gridlock, high levels of uncertainty, or something else. Of course it could also be because interest rates are too high, in which case rising income inequality would, presumably by increasing the total amount of savings, cause interest rates to drop. In that case there might indeed be an increase in total productive investment.

But here is where we run into the problem signaled by Eccles. Because the purpose of investment today is to increase consumption tomorrow, if the increase in income inequality is expected to be permanent, the desired amount of productive investment is actually likely to decline. This is because, to quote Eccles again, lower expected consumption would reduce “the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants.”

2. Unproductive investment can rise in the form of unwanted inventories.

This, as I understand it, is the process Keynes eventually described after his famous 1930 debate with Ralph Hawtrey. The process is quite easy to explain. As income inequality rises, total consumption tends to decline.

Because there is no equivalent increase in productive investment, the economy finds itself producing more goods and services that it can absorb, and the balance piles up as unwanted inventory, which is a form of unproductive investment. Of course manufacturers are unwilling to pile up infinite inventory levels so this process must eventually stop. Rising inventory levels, in other words, can only be a temporary counterbalance to rising income inequality.

3. Other forms of unproductive investment can rise.

The third way for investment to rise is if the additional savings are used to fund other forms of unproductive investment. Perhaps the tendency for savings to rise without an equivalent increase in productive investment forces down interest rates, with suddenly-cheap capital leading to speculative behavior. Charles Arthur Conant wrote about this extensively at the turn of the last century:

For many years there was an outlet at a high rate of return for all the savings of all the frugal persons in the great civilized countries. Frightful miscalculations were made and great losses incurred, because experience had not gauged the value or the need of new works under all conditions, but there was room for the legitimate use of all savings without loss, and in the enterprises affording an adequate return.

The conditions of the early part of the century have changed. Capital is no longer needed in the excess of the supply, but it is becoming congested. The benefits of savings have been inculcated with such effect for many decades that savings accumulate beyond new demands for capital which are legitimate, and are becoming a menace to the economic future of the great industrial countries.

Conant’s point was that “congested” capital would end up in speculative investments that were not productive – vast tracts of empty apartment buildings, or spectacular but mostly empty airports, railroad lines, super highways and other infrastructure, or increases in manufacturing capacity even in industries that are experiencing overcapacity, or perhaps in a very expensive sporting event – but would nonetheless seem profitable because of the expectation that asset prices would continue to rise. These investments, whose low productivity will result in debt rising faster than debt-servicing capacity, can go on for many years, to the point where the implicit losses would have to be recognized, but this is clearly not a sustainable solution to excess savings because it requires limitless debt capacity.

Needless to say this seems to have been a pretty good description of recent investments in places as far apart as Arizona housing tracts, Dublin apartments, extravagant but unused Spanish airports, Chinese ghost cities, or Chinese solar manufacturers. We have seen a lot of this before the global crisis of 2007-08, and the seemingly obvious conclusion it that the tendency to increase the savings rate beyond the productive needs of the economy was balanced at least in part by a surge in speculative and unproductive investments.

These three are, logically, the only three ways we can balance the tendency for an increase in savings to be matched with a corresponding increase in investment. Either productive investment rises because productive investment had been constrained by insufficient savings, or unproductive investment rises, either in the form of unwanted inventory or in another form. The first is our best-case scenario, although for the reasons I have noted it is unlikely to describe conditions today, especially in capital-rich countries like the US. The second and third ways are unsustainable because they actually destroy value by increasing debt faster than they increase debt-servicing capacity.

What prevents savings from rising?

I said however that there is a second perfectly obvious way we can maintain the balance between savings and investments even if there is a substantial wealth transfer from ordinary households (either to the rich, or to the state sector). It is possible that total savings in fact do not rise, which implies that any increase in savings caused by the transfer of wealth was matched by some other event that caused an equivalent reduction in savings.

As far as I can work out there are really only three logical ways a transfer of wealth is consistent with no change in the total savings and consumption shares of GDP.

  1. The wealthy or the state consume as much as ordinary households.
  2. Ordinary households increase their consumption rate and reduce their savings rate.
  3. Unemployment rises.

Again, let us consider each of the three so that we can list the possible outcomes.

1. The wealthy or the state consume as much as ordinary households.

Clearly this hasn’t happened and is unlikely to happen in the future. Both common sense and all historical precedent suggest that except perhaps over very, very long time periods, consumption does not rise linearly with income and households consume a far greater share of their income than the state sector can. This might not be true of income inequality between countries, by the way, but that shouldn’t matter.

2. Ordinary households increase their consumption rate and reduce their savings rate.

This, which is what happened in the United States and peripheral Europe, is one of those brutally obvious points that so many commentators and economists have failed to grasp. I think the mechanism is fairly easy to understand and has already been much discussed, for example well over 100 years ago by John Hobson who showed how rising income inequality can cause both higher savings and lower opportunities for productive investment. The difference, he argued, poured into speculative stock, bond and real estate markets or was exported abroad to finance foreign demand for home products.

As money poured into stock, bond and real estate markets, either at home or abroad, it caused these markets to soar, making everyone feel richer. The consequence was that although ordinary households saw their share of total GDP decline, rising asset prices nonetheless made them feel wealthier, and encouraged them to maintain or increase their consumption.

Higher savings generated by the rich or the state, in other words, were matched by lower savings (or rising debt, which is the same thing) among ordinary households. Of course this can only be sustained if asset prices rise forever, but assets are locked into a circular process in which rising asset prices cause rising demand and rising demand justifies higher asset prices.

It takes rising debt to combine the two processes, so it is only a question of time before we reach debt capacity constraints, in which the system has to reverse itself, which it did in the developed word as a consequence of the 2007-08 crisis. This process, in other words, is the default reaction to a forced increase in the savings rate in one part of the economy, but it is not sustainable because it requires a permanent rise in consumer debt.

3. Unemployment rises.

There is another way you can force down the savings rate, and this is by closing down factories and firing workers. As workers are fired, their income drops to zero. Their consumption, however, cannot drop to zero, and so they dip into their savings, borrow from friends and relatives, receive unemployment compensation, or otherwise find ways to maintain at least some minimum level of consumption (crime, perhaps, or remittances).

Of course savings is just GDP minus consumption, and so as their production of goods and services drops relative to their consumption, by definition the national savings rate declines. This balances out the higher savings generated by rising income inequality.

If the savings rate in one part of the economy rises, without an equivalent rise in investment the only way for the economy to balance is for savings elsewhere to decline, and this can happen either in the form of a (usually credit-backed) consumption binge, or in the form of rising unemployment. The first is unsustainable.

Once we understand this it is pretty easy to explain much of what has happened in the global economy over the past decade or two. As an aside, it may seem strange to many to think that excess savings is not a good thing. We are used to thinking of thrift as good for us, and even more thrift as better, and this belief is embedded with so much moral certainty that we react with repugnance to anyone who suggests otherwise. Bernard Mandeville’s Fable of the Bees was famously hated in the early 18th Century for suggesting that if we all saved everything we would all be destitute, and John Hobson, in his “Confessions of an Economic Heretic” tells how his teaching assignment was rejected because of

the intervention of an Economic Professor who had read my book and considered it as equivalent in rationality to an attempt to prove the flatness of the earth. How could there be any limit to the amount of useful saving when every item of saving went to increase the capital structure and the fund for paying wages? Sound economists could not fail to view with horror an argument which sought to check the source of all industrial progress.

But excess thrift is a much more serious problem than insufficient thrift. There are two reasons besides moral outrage why we get confused about the value of savings. First, and obviously, because more savings is good for individuals, we assume that it must be good for society. It shouldn’t take long to see why this is simply wrong.

Second, most economic thinking is implicitly about the US or the UK (most economic theory comes from economists trained in one or the other country). Because these countries have had a problem in the past several decades with excessive consumption and insufficient savings, we assume that these are universal problems. We want global savings to rise because we want US savings to rise, because what is good for the US must be good for the world, right?

The global imbalances

Before using this model to examine recent history I think it would be useful to summarize. If the savings rate rises in any part of a closed economic entity, like the global economy, it must be counterbalanced by at least one other change that allows the savings and investment balance to be maintained. Either the investment rate rises, in the form of productive, or unproductive, investment, or the overall savings rate does not rise because it declines in some other part of the economy.

We are left with the table below that shows the six ways that an increase in savings caused by rising income inequality or a rising state share of GDP must be counterbalanced. Each counterbalance is shown to be sustainable or unsustainable.

Counterbalance Condition Sustainability
Increase in productive investment This might happen if total desired investment had been constrained by insufficient savings Sustainable
Rising inventories If factories maintain production even as sales decline, inventories will automatically rise Not sustainable
Increase in speculative investment If there is excess capital beyond productive investment, it will flow into non-productive investments Not sustainable
Linear change in consumption If consumption rises with income, income inequality need not create a demand shortfall Sustainable but a seemingly impossible outcome
Increase in credit-financed consumption If households feel wealthier thanks to rising asset prices, they will embark on a consumption binge funded eventually by debt. Not sustainable
Increase in unemployment If production of goods and services exceeds the demand, factories will fire workers until supply and demand once again balance Sustainable

From this table the problem of income inequality is obvious. There are only two sustainable solutions to the problem of a structural increase in the savings rate. Either we must see an increase in productive investment – which is unlikely except in specific cases in which desired productive investment has been constrained by lack of capital – or we must see an increase in unemployment. Nothing else is sustainable.

There are intermediate steps, but because these require debt to grow faster than debt-servicing capacity, they can only continue until debt levels are so high that the market becomes unwilling to allow them to continue to rise. These intermediate steps are easy to understand. At first, in order to keep unemployment from rising, the excess savings can fund a surge in speculative investment or a surge in consumption, or both, with the latter kicked off by the wealth effect that is often a consequence of a surge in speculative investment.

This is exactly what seems to have happened to the global economy. As savings were force up structurally, whether because of rising income inequality or a declining household share of GDP, the system responded in ways that were sustainable (increases in productive investment) and in ways that were unsustainable (rising inventory in China, increases in speculative investment in the US, China, and Europe, and increases in credit-financed consumption in the US and southern Europe). At some point excessive debt eliminated all the unsustainable ways, and we were forced into accepting the remaining sustainable way, which is an increase in unemployment.

I should add here that this model does not tell us where the increase in unemployment must occur, but history tells us much of what we need to know. In the early stages of the adjustment unemployment usually occurs in the countries that saw the fastest increase in debt, typically the countries with excessively low savings. But as these countries begin to intervene directly or indirectly in trade, the unemployment shifts to the countries with structurally high savings rates – Germany and China, in the current case.

This shouldn’t surprise us. If the global problem is insufficient demand, countries that have excess demand (deficit countries) can increase their share of demand simply by intervening in trade. Countries with excess supply (the surplus countries) have to hope that they are allowed to continue to force their excess savings onto the rest of the world or else supply and demand cannot balance domestically.

It is easiest to see this process in Europe. Following the convention I have used before, I will simplify things by assuming that Europe consists of only two countries, Germany and Spain. Here, as I see it, is the sequence:

  1. Beginning around the turn of the century, and in order to increase German employment, German labor unions, corporations, and the government agreed voluntarily to restrain wage increases in order to make Germany more competitive in the international markets. This had a double effect. First, the household share of income declined. Second, as unit labor costs dropped, German rentiers and business owners saw their share of total income rise. The net effect was that the share of GDP retained by ordinary German households declined partly because non-households (businesses and the state) retained a growing share of total income and partly because within the household sector the rich retained a growing share.
  2. Both effects caused consumption to decline as a share of GDP, or, to put it another way, caused the German savings rate to rise (and notice this had nothing to do with rising thrift among German households). Higher German savings had to be counterbalanced, either within Germany or within Spain.
  3. They were not balanced within Germany. German investment rates did not rise to match the increase in savings (in fact I think investment actually declined), nor did consumption among ordinary German households surge. If Germany had been a closed economy, a rise in unemployment would have been, in that case, inevitable. Instead, Germany exported the excess savings to Spain, which under the conditions of the euro Spain was not able easily to reject (tariffs or currency depreciation). Because capital exports are just the obverse of a current account surplus, this meant that after spending much of the 1990s in deficit, Germany’s excess production, caused not by a surge in production but rather a decline in consumption, was resolved by the country’s running a current account surplus.
  4. This resolved Germany’s problem, but only by forcing the savings imbalance onto Spain. Because savings exceeded investment in Germany, investment had to exceed savings in Spain.This meant either that productive and unproductive investment in Spain had to increase, or that savings had to decline. Martin Wolf makes this point when he argues that the expansion in Germany’s tradable goods sector forced an equivalent contraction in Spain’s tradable goods sector, so that in order to prevent unemployment (temporarily, as it turned out) Spain had to embrace cheap capital which unleashed both a speculative investment boom and a consumption boom.
  5. And both happened. There was some increase in Spain’s productive investment, but the lowering of Germany’s unit labor costs relative to Spain made the Spanish tradable goods sector uncompetitive, reducing desired investment in the tradable goods sector. It was difficult, in other words, for productive investment in Spain to rise enough to account for the surge in German savings.
  6. As asset prices in Spain soared, thanks to the surge in capital inflows, this made Spaniards feel wealthier. There were two obvious consequences of soaring asset prices. Excessively cheap and easily available money poured into non-productive investments – apartment buildings and bloated infrastructure, for the most part. It also funded a consumption binge, and the Spanish savings rate dropped sharply.
  7. But neither of these is sustainable. The debt backing unproductive investment and soaring consumption could only continue if there was unlimited debt capacity. Clearly there was a limit to the debt, and the global crisis in 20007-08 put an end to the party.
  8. This exhausted all the ways an increase in German savings could balance save one – a rise in unemployment. Not surprisingly, unemployment soared almost immediately, but of course it did so in Spain. If Spain leaves the euro, Spanish unemployment will decline sharply, but total unemployment will not, which means that German unemployment will rise.

The Fable of the Bees

Where does this leave us? Until we see a significant downward redistribution of income in Germany we don’t have many options. If Spain were to leave the euro, this would solve its unemployment problem, but only by forcing unemployment back onto Germany.

Many analysts have argued that Spain could have done the same things over the past fifteen years that Germany did and so would not have suffered, but I hope this analysis shows why this solution – so called “austerity” – is completely wrong. If Spain has also taken steps to force up its savings rate by cutting wages, it would only force up the global savings rates even further and, with it, once debt capacity constraints were reached, unemployment – perhaps not in Spain, but elsewhere. The solution to excess savings, in other words, is not for low-saving countries to cut back on consumption. This will only increase global unemployment.

What is very clear from this analysis is that there are really only three sustainable solutions to the global crisis in demand. Either the world has to embark on a surge in productive investment, or we need to reduce the income share of the state and of the rich, or we must accept that unemployment will stay high for many more years.

The first is possible, but with so much excess manufacturing capacity and excess infrastructure in many parts of the world, and with significant debt constraints, we need to be very careful about how we do this. Certainly countries like the United States, India and Brazil lack infrastructure, but they do so largely because of political constraints, and it is unreasonable to assume that any of these countries will soon embark on an infrastructure-building boom.

Even if they do, the amount of excess savings is likely to be huge, and without a significant redistribution of income to the middle classes and the poor, it is hard to see how we can avoid high global unemployment for many more years. Because trade war is the form in which countries assign global unemployment, I would expect trade relations to continue to be very difficult over the next few years, as countries with high unemployment and low savings intervene in trade, thus forcing the savings back into countries with excess savings.

So what are the policy implications? Clearly Europe, the US, China, Japan, and the rest of the world must take steps to reduce income inequality. Just as clearly countries like China and Germany must take steps to force up the household income share of GDP (in fact polices aimed at doing this are at the heart of the Third Plenum reform proposals in China). Because it will be almost impossible to do these quickly, as a stopgap countries with productive investment opportunities must seize the initiative in a global New Deal to keep demand high as the structural distortions that force up the global savings rate are worked out.

But redistributing income downwards is easier said than done in a globalized world, especially one in which countries are competing to drive down wages. The first major economy to attempt to redistribute income will certainly see a surge in consumption, but this surge in consumption will not necessarily result in a commensurate surge in employment and growth. Much of this increased consumption will simply bleed abroad, and with it the increase in employment.

Less global trade, in other words, will create both the domestic traction and the domestic incentives to redistribute income. In a globalized world, it is much safer to “beggar down” the global economy than to raise domestic demand, and so I expect that there will continue to be downward pressure on international trade.

Until we understand this do not expect the global crisis to end anytime soon, except perhaps temporarily with a new surge in credit-fueled consumption in the US (which will cause the trade deficit to worsen) and more wasted investment in China (which, because it is financed with cheap debt, which comes at the expense of the household sector, may simply increase investment at the expense of consumption). These will only make the underlying imbalances worse. To do better we must revive the old underconsumption debate and learn again how policy distortions can force up the savings rate to dangerous levels, and we may have temporarily to reverse the course of globalization.

I will again quote Mariner Eccles, from his 1933 testimony to Congress, in which he was himself quoting with approval an unidentified economist, probably William Trufant Foster. In his testimony he said:

It is utterly impossible, as this country has demonstrated again and again, for the rich to save as much as they have been trying to save, and save anything that is worth saving. They can save idle factories and useless railroad coaches; they can save empty office buildings and closed banks; they can save paper evidences of foreign loans; but as a class they cannot save anything that is worth saving, above and beyond the amount that is made profitable by the increase of consumer buying.

It is for the interests of the well-to-do – to protect them from the results of their own folly – that we should take from them a sufficient amount of their surplus to enable consumers to consume and business to operate at a profit. This is not “soaking the rich”; it is saving the rich. Incidentally, it is the only way to assure them the serenity and security which they do not have at the present moment.


After I sent out the first version of this essay, as I expected, I got some very heated responses, nearly all of which completely ignored the argument and focused on issues that were not relevant. If you disagree with my argument, there are only three ways you can do so. You can prove that my assumptions are wrong. You can prove that my logic is faulty. Finally, you can claim that my argument is irrelevant. You would argue, in that case, that the most important benefits or costs of income inequality do not lie in the realm of economics and have to do with social, political, or religious values or with the structure of incentives in our society.

The latter are all perfectly valid points, but they are separate from my argument. To make it easier for anyone to disagree with me in a way that is relevant or consistent, I will summarize my argument as simply, as possible, listing very specifically the propositions from which I begin and the logical sequence of the argument. The only way anyone can possibly show that I am wrong is by attacking my propositions or by finding an illogical step in my reasoning. Nothing else is valid.

Before starting let me explain some of the responses I have received that were usually irrelevant. People on the “right” focus on either of the following conclusions:

a) an increase in the state share of GDP leads to unemployment, in which case they call the argument right,

b) an increase in income inequality leads to a rise in unemployment, in which case they call the argument wrong,

c) increase in income inequality leads to a rise in productive investment, in which case they call the argument right (this whole essay, remember, is exactly the same “supply-side” argument provided by Arthur Laffer).

People on the “left” focus either on the following:

d) an increase in the state share of GDP leads to unemployment, in which case they call the argument wrong,

e) an increase in income inequality leads to a rise in unemployment, in which case they call the argument right,

f) an increase in income inequality leads to a rise in productive investment, in which case they call the argument wrong.

The problem is that you cannot agree with just the part you like. Either the entire argument is true or it is false. In fact all of these conditions can be true but are likely to be more or less important under different conditions. One of the great follies of contemporary debate, it seems to me, is that certain policies are considered to be intrinsically and always wealth-enhancing, or intrinsically and always wealth-destroying, depending on your political beliefs, whereas I would argue that these policies, and in fact many others (free trade, unionization, free banking, currency regimes, state intervention, deficit financing, etc) can be wealth-enhancing under certain conditions and wealth-destroying under others. Rather than close the door to debate we should try to figure out the conditions under which they are one or the other, and guide policy according to the relevant conditions.

I start with three propositions, from which everything else follows:

  1. The rich in any economy save a greater share of their income than do the poor. This is an assumption that can be proven or disproven empirically. The fact that some countries are rich and others poor may complicate things, but this only means that income inequality inside a country matters, whereas income inequality between countries might or might not matter.
  2. In every closed economy savings is equal to investment. This is true by definition because the demand side of an economy consists of consumption and investment, while the supply side (how we allocate total production of goods and services) consists of consumption and savings. Because demand and supply always balance, savings is always equal to investment.
  3. No one has infinite debt capacity. I don’t know if this is an assumption or if it is true by definition, however no one has ever disputed it.

Here is the argument, which can only be logically true or logically false:

1. From Proposition 1, if income inequality rises, the savings rate must rise.

2. From Proposition 2, if savings in one part of the economy rises, we must see one or both of the following:

a) investment must rise, or

b) savings in another part of the economy must decline.

3. If investment rises, one or both of the following must be true:

a) productive investment rises

b) non-productive investment rises

4. If savings in another part of the economy declines, one or both of the following must be true:

a) the “non-rich” increase their consumption

b) unemployment rises.

You might question whether there are indeed only two ways for savings in another part of the economy to decline, but these are the only two ways I can think of. If there is another way, it would interesting to see how it would affect the argument.

This leaves us with the following. If income inequality rises, we must see one or more of four possible outcomes, which I list as 3a, 3b, 4a, and 4b. Unless we discover any other possible outcome, these are the only ways to balance an increase in income inequality.

Let us focus on 3a and 3b:

  1. If productive investment rises, we all get wealthier, both rich and poor (this is what the supply-siders mean by “trickle down”). The process is clearly sustainable.
  2. If non-productive investment rises, wealth declines. Once wealth declines to some limit (it could be zero but it could also be, and is likely to be, much higher than zero) the process can be maintained only by rising debt, but from Proposition 3 there is a limit to rising debt, so this process is not sustainable.

Now let us focus on 4a and 4b:

  1. If some of the non-rich increase their consumption, they eventually draw their savings down to their minimum level (which might be zero, but doesn’t have to be), at which point they have to borrow to consume. But again, from Proposition 3 there is a limit to rising debt, so this process is not sustainable.
  2. If unemployment rises, total savings decline, although because it might also cause investment to decline, unemployment might have to rise a great deal, which is what happened in countries like Spain once debt-fueled consumption and debt-fueled non-productive investment came to an end in 2008. This is, unfortunately, sustainable.

The conclusion, which I believe follows inevitably from the three initial propositions, is that a rise in income inequality can lead temporarily to an increase in non-productive investment or to an increase in debt-fueled consumption, but in both cases they are unsustainable. A rise in income inequality can also lead to a rise in productive investment or a rise in unemployment, neither of which is unsustainable (unemployment in the long run might be unsustainable, but of course this does not invalidate the argument).

This means that rising income inequality must eventually lead to more productive investment or to more unemployment. There is no other conclusion. Can this argument be attacked? Of course it can. If you disagree with any one of the three initial propositions, then even if the argument is completely logical, the conclusion may be wrong. Alternatively, if you disagree with any of the logical steps, then even if the three initial propositions are correct, the conclusion can be wrong. These, of course, are the only ways in which the conclusion can be wrong.

Inevitably some one will discover that Keynes and Krugman said many of these things, in which case the essay is the work of the devil and innocent young people should not be allowed to read it, or that it agrees with things that Laffer and Friedman have said, in which case ditto. In fact an awful lot of economists in the past 200 years and on every part of the political spectrum have agreed with some or all of this model, mainly because it is just basic economics. There should be no guilt by association here, please.

<![CDATA[Will emerging markets come back?]]> I don’t often make reference to these kinds of things in my blog, but Saturday’s terrorist attack in the Kunming train station – in which 29 innocent people were hacked to death (the toll was especially high among the elderly who were unable to run away quickly enough from the killers) – fills me with dread and dismay. This kind of brutal massacre is not about sending a message to Beijing or to the world but is rather aimed at getting the authorities to overreact so as to create hatred within the country.

I truly hope it does not succeed. There is a great deal of anger here in China but so far, I am glad to say, excluding some over-the-top responses in the internet world the authorities and Chinese people generally seem not to be overreacting. I wish there were some way that we as individuals could of respond to the Kunming train station massacre but what is among the most awful aspects of this kind of insane event is the feeling of helplessness it creates. As individuals there seems to be so little we can do either to prevent this kind of behavior or to console the victims.

And it is not just in Kunming that things seem unsettled. Recent events in the Ukraine have capped several years of social unrest, revolution, and war around the world, and these seem to have intensified since the beginning of the global crisis of 2007-08. This should not have surprised us, and we should probably brace ourselves for several more years of political uncertainty. In late 2001 I published an article with Foreign Policy discussing what I expected the world to look like following the global crisis that I, perhaps a little prematurely, was expecting imminently.

In the article I pointed out that in the past 200 years we had experienced a number of globalization cycles, driven largely by deep changes in monetary conditions, that followed a pattern regular enough to allow us to make some fairly confident predictions. We were, I argued, living towards the end of one such cycle, and when underlying liquidity conditions changed, we were likely to see the same sort of things that we had seen in previous cycles. Among these, I wrote:

Following most such market crashes, the public comes to see prevalent financial market practices as more sinister, and criticism of the excesses of bankers becomes a popular sport among politicians and the press in the advanced economies. Once capital stops flowing into the less developed, capital-hungry countries, the domestic consensus in favor of economic reform and international integration begins to disintegrate. When capital inflows no longer suffice to cover the short-term costs to the local elites and middle classes of increased international integration – including psychic costs such as feelings of wounded national pride – support for globalization quickly wanes. Populist movements, never completely dormant, become reinvigorated. Countries turn inward. Arguments in favor of protectionism suddenly start to sound appealing. Investment flows quickly become capital flight.

These predictions about what the world was going to look like in the next several years were easy to make, I argued, because they occurred so regularly. One of the predictions that I should have made, but didn’t, was that after the globalization process had been reversed we were likely to see an upsurge in war, revolution, conflict and social unrest. These, after all, were events we usually associated with the end of previous globalization cycles, but at the time I wrote the article (published less than two weeks before the 9/11 terrorist attack) it really seemed that the world had changed in some subtle but profound way and that we had become too sophisticated to engage in such disruptive behavior.

I should have known better. I have spend much of the past two decades trying to show how persistently historical patterns reemerge, and why the claim that “this time is different” is almost always wrong, and yet I believed that when it came to revolution and war perhaps this time really was a little different. International institutions were strong enough, I believed, to manage the kinds of pressures that normally emerged from a reversal of many years of globalization.

This turns out perhaps not to be the case. Watching the news on television, especially events unfolding in the Ukraine, leaves me with a sense that we haven’t figured out how to manage these pressures. The recent rout in emerging markets has left a lot of people very confused about the direction in which the global economy, and developing countries more specifically, are going, but it turns out that once again we should not have found recent events at all surprising. They are part of the globalization cycle.

There was no “decoupling”

But once again we wanted to argue that this time was different. For several years we had been hearing that the global crisis of 2007-08 marked some kind of inflection point that signaled the decoupling of developing countries from the advanced countries of North America and Europe. The argument, as I understand it, was that the developed countries of Europe and North America had got themselves caught up in a debt-fueled consumption boom, of which the crisis was the culmination and the beginning of the process of reversal.

The developing world had, according to this argument, managed to untie itself from developed-country demand and its growth was now more likely to be driven by domestic demand arising at least in part from the more favorable demographics of the developing world. The growing middle classes, especially in China and India, were emerging to become a major focus of demand, and not only were other developed countries benefiting from this new source of demand, but eventually all countries would benefit from demand generated in the developing world.

I never found this thesis very convincing and completely rejected the “decoupling” argument. As I see, it the decade before the crisis was characterized by a series of unsustainable processes driven largely by structural changes in the global economy that tended to force up savings rates globally. In my view, the 2007-08 crisis was just the first stage of the rebalancing process, in which overconsumption in the developed world was forced by rising debt to reverse itself. But of course this couldn’t happen without equivalent adjustments elsewhere. The crisis now affecting developing countries is, as I see it, simply the second stage of the global rebalancing, or the third if you think of the sub-prime crisis in the US as the first stage and the euro crisis in Europe as the second stage.

To understand the link, we need to go back to the pre-crisis period. Ever since the 2007-08 global crisis, the world has suffered from weak global demand. Demand had been strong before the crisis, but this largely reflected the credit-fueled consumption binge, combined with a huge amount of what proved to be wasteful real estate development, unleashed as a consequence of soaring stock and real estate markets that were themselves the consequences of speculative capital pouring into countries like the United States and peripheral Europe.

The crisis put an end to this. After stock and real estate markets in the United States and Europe collapsed, and once financial distress worries constrained the ability of households to borrow for additional consumption, the great consumption and real estate boom in many parts of the world also ended.

Normally slowing consumption growth should also cause slowing investment. The purpose of productive investment today, after all, is to serve consumption tomorrow, but at first this didn’t happen. Instead we saw an intensification in 2009-10 of the credit-fueled investment binge in China, as well as in developing countries that produced the hard commodities China needed. This increase in investment was supposed to offset the impact of declining consumption in the west, and it certainly had that effect. The collapse in China’s current account surplus, for example, had almost no impact on domestic employment because it was offset by an astonishing surge in domestic investment.

This is what set off talk of “decoupling”. As weaker consumption and real estate investment in Europe and the US forced down growth in global demand, it was counterbalanced by greater demand in the developing world, driven in large part by China. Not surprisingly this meant that a larger share of total demand accrued to poor countries at the expense of rich countries.

Decoupling in the 1970s

But the process was not sustainable. In China well before the crisis we were already experiencing the problem of excess investment in manufacturing capacity, real estate and infrastructure. In developing countries like Brazil this was matched by investment in hard-commodity production based on unrealistic growth assumptions in China. Weaker demand in the rich countries, especially weaker consumption, should have reduced whatever the optimal amount of global investment might have been, especially as we already suffered from excess capacity. To put it schematically:

  1. Before the crisis the world had already over-invested in real estate and manufacturing capacity based on unrealistic expectations of consumption growth.
  2. The global crisis forced consumption growth to drop. This should have meant that if investment levels were too high before the crisis, they were even more so after the crisis.
  3. Instead of cutting back on investment, however, the developing world reacted to the drop in rich-country demand by significantly increasing investment, driven at least in part by worries that the consumption adjustment in Europe and the US would cause a collapse in export growth which would itself force unemployment up to dangerous levels.

Clearly this wasn’t sustainable, and not surprisingly soaring debt is now forcing this investment surge to end. As a result, we are now going to experience the full impact of slower consumption growth in the rich countries, but instead of this being mitigated by higher investment growth in the developing countries, it will now be reinforced by slower investment growth in the developing world. Over the next few years demand will revive slowly in the US, not at all in Europe, and it will weaken in the developing world.

We’ve seen this movie before. In the mid-1970s the US and Europe were mired in recession as loose monetary policy in the 1960s, soaring oil prices, and many years of US spending on both the Great Society and the Vietnam War forced the US into an ugly adjustment. Instead of succumbing to reduced global demand, however, developing countries, flush with cheap capital driven by international banks eager to recycle burgeoning petrodollar deposits, intensified a developing-country investment binge that had already driven a decade of high growth for many countries. While the West suffered, they continued to grow, and for perhaps the first time in modern history excited bankers and businessmen spoke ecstatically about the decoupling of the developing world from growth problems in the US and Europe.

But the end result should have been predictable. Developing-country debt levels soared throughout the late 1970s, and once the Fed, concerned with US inflation, turned off the liquidity tap, excessive debt forced much of the developing world, and all of Latin America, into a “lost decade” of low growth, high unemployment, political turmoil and financial distress. In the 1970s of course the big capital push behind the surge in investment was driven by soaring savings in the Middle East, as oil revenues rose much faster than the ability of Middle-Easterners to increase consumption. Today the big capital push is driven by soaring savings in China, as structural constraints cause China’s production of goods and services to rise much faster than China’s ability to consume them.

The result is that over the next few years global demand will be even weaker than it has been since the crisis. Consumers in North America, peripheral Europe, and the newly rich middle classes around the world are still cutting back on consumption to pay down debt. Investors in China, Latin America and Asia are finally responding to overcapacity and soaring debt by themselves cutting back on investment. But if we all cut back our spending to service our debts, paradoxically, our debt burdens will only rise, and the great danger is that rising debt burdens will force us to cut back even more, thus making the debt burden worse (and, by the way, forcing at least some countries, in both the developing world and in Europe, to default).

Nothing fundamental has changed. Demand is weak because the global economy suffers from excessively strong structural tendencies to force up global savings, or, which is the same thing, to force down global consumption. Lower future consumption makes investment today less profitable, so that consumption and investment, which together comprise total demand, are likely to stagnate for many more years.

Squeezing out median households

Two processes bear most of the blame for weak demand. First, because the rich consume less of their income than do the poor, rising income inequality in countries like the US – and indeed in much of the world – automatically force up savings rates. Second, policies that forced down the household income share of GDP, most noticeably in countries like China and Germany, had the unintended consequence of also forcing down the household consumption share of GDP. This income imbalance automatically forced up savings rates in these countries to unprecedented levels.

For many years the excess savings of the rich and of countries with income imbalances, in the form of capital exports in the latter case, funded a consumption binge among the global middle classes, especially in the US and peripheral Europe, letting us pretend that there was not a problem of excess savings. The 2007-08 crisis, however, put an end to what was anyway an unsustainable process.

It is worth remembering that a structural tendency to force up the savings rate can be temporarily sidestepped by a credit-fueled consumption binge or by a surge in non-productive investment, both of which happened around the world in the past decade and more, but ultimately neither is sustainable. As I will show in my next blog entry in two weeks, in a closed economy, and the world is a closed economy, there are only two sustainable consequences of forcing up the savings rate. Either there must be a commensurate increase in productive investment, or there must be a rise in global unemployment.

These are the two paths the world faces today. As the developing world cuts back on wasted investment spending, the world’s excess manufacturing capacity and weak consumption growth means that the only way to increase productive investment is for countries that are seriously underinvested in infrastructure – most obviously the US but also India and other countries that have neglected domestic investment – to embark on a global New Deal.

Otherwise the world has no choice but to accept high unemployment for many more years until countries like the US redistribute income downwards and countries like China increase the household share of GDP, neither of which is likely to be politically easy. But until ordinary households around the world regain the share of global GDP that they lost in the past two decades, the world will continue to face the same choices: an unsustainable increase in debt, an increase in productive investment, or higher global unemployment, that latter of which will be distributed through trade conflict.

Emerging markets may well rebound strongly in the coming months, but any rebound will face the same ugly arithmetic. Ordinary households in too many countries have seen their share of total GDP plunge. Until it rebounds, the global imbalances will only remain in place, and without a global New Deal, the only alternative to weak demand will be soaring debt. Add to this continued political uncertainty, not just in the developing world but also in peripheral Europe, and it is clear that we should expect developing country woes only to get worse over the next two to three years.

This is an abbreviated version of the newsletter that went out three weeks ago. 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.

<![CDATA[What do Bank Share Prices Tell Us About Growth?]]> Tom Holland had an interesting piece in the South China Morning Post three weeks ago in which he discusses the low valuations of Chinese banks. About a decade ago, if I remember correctly, Chinese banks were trading between three and four times book. Those valuations have dropped considerably since then:

On Monday, the weighted average price-book value ratio for the 10 Chinese banks listed in Hong Kong fell to just 0.98. In other words, as an investor you would have been able to buy shares in Chinese banks for less than the cash you would have received – in theory – if the companies were wound up the following day and the residual value returned to shareholders. That’s a highly unusual state of affairs, especially in a rapidly developing economy like China’s where banks have traditionally been regarded as a geared play on future growth.

Holland goes on the argue that this has important implications about the quality of the banking balance sheets:

Some observers argue that the current abnormally low valuation of China’s banks is an aberration which represents a great buying opportunity. There is, however, another interpretation.

Imagine that the market has got the pricing of Chinese bank shares about right. That would imply the value at which they are carrying assets on their books is far too high. Or, to put it another way, the proportion of non-performing loans on the balance sheets of China’s commercial banks is a lot greater than they are admitting. A very rough back of an envelope calculation suggests how high the true level of bad loans might be.

If the long-term price-book ratio were an accurate representation, it would imply the real value of bank net assets should be some 40 per cent below their declared level.

While Holland is right to suggest that there are a lot of loans on the balance sheets of Chinese banks that should be, but aren’t, classified as NPLs, and that these NPLs should reduce the market value of bank shares, I think we need to think very differently about the informational content of share prices, especially for banks.

About six years ago, on October 26, 2006, ICBC completed its deal-of-the-year IPO, which, at $21.9 billion, was the largest IPO ever completed. In an article the next day, CFRI described the event like this:

Shares in Industrial & Commercial Bank of China (1398.HK), which is raising up to US$21.9 billion in the world’s largest IPO, rose as much as 18 percent in their Hong Kong debut on Friday after its stock sale generated huge investor demand.

…ICBC’s IPO values the lender at 2.23 times its forecast book value. By comparison, No. 2 mainland lender Bank of China trades at 2.35 times 2006 book, No. 3 China Construction Bank trades at 2.66, and No. 5 Bank of Communications trades at 3.04 times book.

Two weeks after the IPO was completed, while the market was still buzzing with excitement, the Far Eastern Economic Review published the following article of mine in its January/February 2007 issue:

Buying Into China’s Volatility

In November during a banking conference in Beijing, a senior manager from Bank of China noted humorously that his bank, whose recent IPO had been priced at just over three times book value and had since traded up to 3.4 times, had a significantly higher valuation than the conference’s host, HSBC, which was trading at roughly 2.1 times book value. Critics of China’s banking reform who continue to complain about bad loans, he suggested, might be missing the point. The market’s assessment was clear: Chinese banks are healthy enough for markets to assign very high values to their shares.

At first glance his suggestion seems reasonable. Share prices have informational content, after all, and market valuations must reflect real investor perceptions. Two weeks earlier the biggest public offering in history, the $22 billion IPO by the Industrial and Commercial Bank of China (ICBC), had been by almost any standard a success. Not only was the offering oversubscribed approximately 50 times, but immediately after its launch its share price surged 15%. Like other wildly successful recent Chinese bank IPOs, including those of the China Construction Bank and Bank of China, the ICBC transaction seemed to confirm that international stock markets love Chinese banks.

Markets process many kinds of information, however, and because shares in Chinese banks and shares in global banks represent different kinds of claims, it is a mistake to assume that their informational content is the same. On the contrary, whereas the share price performance of Citibank or HSBC may say a great deal about investors’ assessment of their loan and earnings quality, it says something very different in the case of Chinese banks.

This is because shares of companies with dramatically different levels of solvency trade on very different types of information, and while there have certainly been improvements in lending practices in recent years, Chinese banks have a long way to go before they are healthy and can be considered prudently managed. If nonperforming loans and other assets were valued correctly, these banks would be technically insolvent. In a November 2006 report, Fitch Ratings estimated the total amount of nonperforming loans in the system, and calculated, assuming a 30% recovery rate on nonperforming loans (though on average the recovery rate for Chinese banks has been closer to 20%), total unrealized losses in the banking system to be roughly $250 billion, which exceeds total capital and reserves by more than one-third.

This figure does not include estimates made for the rapid loan expansion of the past two years, with loans growing 10.2% in just the first half of 2006. Most analysts believe this breakneck growth will result in a surge in new nonperforming loans. Fitch’s figures also do not include another $300 billion in loan carve-outs by asset management companies, who paid for the loans with low-coupon bonds which, if marked to market, would involve a further write-down of 10-15%. After taking into account these adjustments, liabilities materially exceed the true value of assets for every major bank in China.

Optionality in Equity Prices

Because they are technically insolvent, the informational content of share prices for Chinese banks is different than for solvent global banks. High valuations normally indicate expectations of low volatility and smooth sailing ahead, but share prices can measure a number of things, and in fact under certain circumstances rising share prices may indicate more, not less, expected volatility. This is the case for Chinese banks, whose market valuations reflect a very strong component of optionality in the share price.

One useful way of understanding the valuation of equity shares is by comparing them to call options and decomposing their value. As is widely recognized, equity has a relationship to the operating assets of a company that is similar to the relationship between a call option and its underlying asset. Options are defined in part by their strike price. In the case of equity, the corresponding strike price is equal to the total liabilities of the company. This is because equity holders “own” whatever is left after all liabilities have been paid, just as owners of call options “own” the value of an asset above the strike price.

A call option has intrinsic value when the value of the underlying asset exceeds the strike price. Similarly, when a company is solvent—i.e. the market value of a company’s assets exceeds its liabilities—the company’s shares have intrinsic value equal to the difference between the two. If all assets and liabilities were recorded at their true market value, intrinsic value would be equal to a company’s book value. Since this is almost never the case, intrinsic value can be significantly more or less than book value. Only solvent companies have intrinsic value, and the greater the value of assets relative to liabilities, the more intrinsic value there is in the share price. For highly solvent companies, intrinsic value comprises by far the largest component of share price.

But intrinsic value does not fully explain share price. In the same way that the value of a call option must always exceed its intrinsic value, the value of a share is also always greater than its intrinsic value. The most important reason for this is that equity shareholders have limited exposure to a drop in asset value and unlimited exposure to an increase. This “extra” value over the intrinsic value, called time value, measures the expected volatility in the value of a company’s assets. Time value increases when expected volatility rises. The greater the reasonable range of possible outcomes for future asset values, the greater the time value. If there is a very high probability the value of the asset will soar, even if there is an equally high probability it will collapse, the limited exposure to a collapse combined with unlimited exposure to soaring values will ensure a very high time value.

A company’s share price, like the price of an option, is the sum of the intrinsic value and the time value. The ratio between the two varies as a function of solvency. Time value accounts for 100% of the share price of an insolvent company. However, for a solvent company, time value accounts for a steadily declining percentage of the share price as the value of assets rises relative to liabilities.

Solvent v. Insolvent

The sensitivity of the share price to changes in asset value increases as the value of a company’s assets rises relative to its liabilities. For an insolvent company this sensitivity is low, which is another way of saying that changes in the value of underlying assets have only a small impact on the share price of an insolvent company. For solvent companies, it is the opposite. Changes in equity value of these companies are highly sensitive to changes in asset value, and as market valuations of the company’s assets rise or fall, there will be a significant impact on the value of the company’s shares.

In the case of high intrinsic value companies, the main driver of changes in the share price is likely to be changes in investors’ assessment of asset values, which directly affects intrinsic value. Because companies are likely to have a wide mix of assets, on average the total value of these assets is not likely to vary very much since they may be largely uncorrelated. This is also true of well-managed banks, whose loans are highly diversified by industry and region. Generally for companies in the same industry, the greater the intrinsic value the less volatile share prices tend to be.

Sometimes shares have very little or no intrinsic value. The share price of new Internet companies, for example, consists almost entirely of time value since these companies have low intrinsic value. In spite of their lack of assets, however, Internet companies often receive high valuations. This may seem paradoxical at first, because we normally associate high valuations with low volatility, but Internet companies are valuable precisely because their future outlook is so uncertain—ranging from quick bankruptcy to massive future profitability.

Companies that are insolvent or nearly insolvent also have little to no intrinsic value. Their liabilities are not much less, and sometimes greater, than the value of their assets. Like Internet companies, the value of their shares consists only, or mostly, of time value. Nonetheless if the value of the underlying asset is very volatile, the shares of the insolvent company, like call options and Internet shares, can still be valuable. Their value consists not of net assets, but of the possibility that the company will generate very high revenues, or its assets rise sharply in value, at some future point.

This implies, conversely, that changes in the value of the underlying assets have only a minimal impact on the share price (until the value of assets has risen enough to approach or exceed liabilities). Share prices for insolvent companies are likely to rise or fall primarily because of changes in expected volatility, and because expected volatility can change often and dramatically, it is normal for their shares to rise and fall in price much more sharply than shares in general.

Chinese bank shares typify this kind of behavior. Their shares have no intrinsic value because their liabilities exceed the value of their assets. However even though investors may agree that Chinese banks are insolvent, they may still believe that the shares of these banks, like shares in Internet start-ups, are valuable. This is because in valuing these shares, the value of the underlying assets is much less important than the expected volatility of those assets.

The value of the Chinese banking franchise is closely tied to long-term economic growth in China. No matter how pessimistic he may be about the total amount of nonperforming loans, any investor who believes that China’s economic outlook is extremely volatile will place a high value on a call option giving him access to this volatility. Precisely because their shares have no intrinsic value, large Chinese banks are among the best assets with which to make pure bets on the volatility and growth of the underlying economy, and because China is undergoing radical reform this makes bank shares valuable even if the banks are in poor shape. As long as China’s economy lurches forward, and as long as expected GDP growth in the foreseeable future is very high, bank share prices will hold up or even strengthen. But when the economy shows danger signs, or when expected GDP growth is revised substantially downward, bank shares will suffer disproportionately.

This is not the first time markets have placed high values on the shares of insolvent banks. Large developing countries in the process of rapid reform and change are almost always likely to see extremely high values placed on their bank shares, even when (and this is often the case) the banks’ loan portfolios are doubtful. One recent example is the case of Mexico in 1990-92 when it privatized 18 state-owned commercial banks—the entire banking system—as part of a process of reform that promised to change the Mexican economic and political landscapes dramatically.

At the time Mexico was just emerging from nearly a decade of crisis, and as in China today, reform in Mexico created both great uncertainty and great optimism. After years of government mismanagement Mexico’s outlook seemed filled with great potential, although the reform experiment was also fraught with risk. With such high volatility around expected future GDP growth, investors placed an extremely high value on ways to access Mexican economic volatility, in the same way that investors would expect to pay a lot for an option on a very volatile asset.

They showed how much they were willing to pay when the banks were privatized. The prices at which the 18 banks were sold stunned even the government agencies responsible for the sales. Mexican banks, whose loan portfolios were doubtful at best and who were in nearly every case technically insolvent, sold for an average of more than three times book value—all the more remarkable given that global interest rates were much higher than they are today. Valuation criteria for the banks exceeded those of several of the largest banks in the world. After it was privatized Mexico’s largest bank, Banamex, had a price to book value ratio nearly twice that of Citibank, Mexico’s largest creditor.

Unstable Valuations

Not surprisingly, the very high valuations placed on Mexican banks by Mexican and foreign investors were extremely unstable. As the first positive impacts of reform were felt, valuations rose even higher, but this was not to last. The Mexican crisis of 1994 saw bank share prices totter and then collapse, and for the next few years as the outlook for Mexico’s economy shifted, their share prices fluctuated violently.

By 1998, Banamex was trading at little more than half of book value as the impact of the Mexican and Asian crises slowed Mexico’s growth prospects. Not surprisingly, there was also a surge in nonperforming loans. By the late 1990s Mexican authorities were so concerned about the poor performance of the banks that they permitted and encouraged sales to better-capitalized foreigners, and today most major Mexican banks are foreign-owned. Citibank purchased Banamex in 2001.

There is an important lesson to be learned from the experiences of other developing countries undergoing reform. The success of the Chinese bank IPOs should not be seen as a referendum on the health of the banking system or on the process of banking reforms. As was the case in Mexico and in other developing countries going through dramatic reform, the success of the IPOs reflects primarily investor willingness to speculate on a very volatile set of outcomes. High expected volatility can lead to high option prices and high share prices, but just as already high share prices can soar at any good news about the economy, they will drop drastically at any bad news.

This has implications for bank regulators. For years economists have argued that China’s banking regulators need a more effective monitoring system. Although China’s regulatory bodies are filled with capable managers, the problems in the Chinese banking system are too deep to be easily managed and often involve political sensitivities that make it difficult to identify and resolve problems. It was thought that these issues might be partially resolved by the IPOs. One of the functions of a securities market, after all, is to provide clear signals about market perceptions of risk and value, and these market perceptions could be harnessed by Chinese regulators. By publicly listing the large Chinese banks in the international markets, regulators hoped to enlist the aid of thousands of sophisticated investors from around the world to assess and judge the operating performance of these banks.

It is not clear, however, that changes in bank share prices will in fact have much signaling value to regulators. Soaring prices do not indicate that investors are satisfied with the pace of reform or the resolution of nonperforming loans in the banking sector. They indicate that investors are betting on continued rapid GDP growth. If and when China enters into what investors think is a material slowdown in expected long-term growth, bank share prices will fall sharply even if bank loan portfolios are improving.

It will not be until the banks gain comfortable levels of solvency that the informational content of their share price behavior will resemble that of their developing-country peers. But for now, by avidly purchasing shares in Chinese bank IPOs, the market is not saying that it has evaluated the Chinese banking system and found it satisfactory. It is saying something very different—that Chinese bank shares represent a good way to speculate on Chinese economic volatility. Optimists, like me, may believe that in the long run this will turn out to be a good bet, but for now no one should take much comfort in recent price performance. The Chinese banking system is still a mess, and it will be years before we can decide otherwise. It will also be years before changes in share prices tell us much about the fundamental health of the banks.


The main point of the article is that owning shares in a bank is the functional equivalent of owning a call option on the bank’s future operational earnings, and if the share price contains little intrinsic value (i.e. the value of its assets does not exceed the value of its liabilities by a large margin, and may even be less than the value of liabilities), by definition most of its value consists of time value, and so is extremely sensitive to changes in expectations. This means at least two things.

  1. As expected volatility declines, the value of the shares should decline too, because time value is positive correlated with expected volatility. At first this may seem strange. Normally, when expected volatility declines, share prices rise, but this is because reductions in volatility increase the value of assets. In a company with significant intrinsic value, in other words, a decline in expected volatility can increase intrinsic value by more than it reduces time value. In a company with no intrinsic value, of course, the only impact of lower expected volatility is to reduce time value.
  2. As growth expectations decline, the value of the shares should decline very sharply. To put it in option terms, as expected growth declines, the forward value of assets declines with it, so that the “strike price” of the implicit option declines relative to the asset price, putting it more out of the money.

This is why back in 2006-07 I expected a rapid decline in the price of bank stocks relative to book value. As China began increasingly running into the limits of the current growth model, I assumed, growth would decline sharply, and over time the consensus would also drop, bringing down with it the volatility of growth expectations.

How far down can prices go? As the Mexican bank example showed (full disclosure: I was a senior member of the team at First Boston that advised the Mexican government in 1990-93 on the privatization of the banking system), even when prices have dropped from 3-4 times book down to book, they can still drop a lot more. Banamex, remember, was trading at half of book before it was purchased. If you believe that growth rates have further to drop, and that this drop has not been factored into the consensus, the option framework for evaluating stock prices suggest that we haven’t bottomed out yet in bank shares.

For those who are interested in thinking more about how the option framework can clarify thinking about bank share prices, after the piece above was published the Far Eastern Economic Review asked me to follow up with a piece evaluating the rumored purchase by the Bank of China of a US consumer finance company. Here is what I wrote:

Should Chinese Banks Acquire Banks Abroad?

In an article for the January/February 2007 issue of the Far Eastern Economic Review (“Buying into China’s Volatility”) I used an option framework to explain and predict the behavior of investors in China’s bank IPOs. Share prices of insolvent or nearly insolvent banks consist almost entirely of what option traders call time value, with little to no intrinsic value. The option framework predicts that in such a case investor perceptions of the quality of management or of levels of non-performing loans will have little impact on the share price performance of Chinese banks. Instead this will primarily reflect investor perceptions of changes in China’s underlying economic volatility.

Since the article was published, there have been reports suggesting that the Bank of China is considering acquiring a consumer finance company in the US. The reported acquisition size is fairly small – reported to be about $2 billion – so it is unlikely to have much impact on the value of the buyer. It is worth pointing out however that the option framework makes two powerful, and perhaps surprising, predictions: first, that the acquisition of a foreign financial institution is likely to have a significantly negative impact on the combined banks’ share prices; and second, that the largest shareholder, because of its multiple roles, will have a strong incentive nonetheless to encourage foreign acquisitions.

There are many good reasons why a Chinese bank may want to acquire a foreign bank. It may want to diversify its loan portfolio, to serve its Chinese customers abroad, to gain experience and technology, or simply to make a long-term bet in another market. At the time of the acquisition, however, the main effect on the value of the bank’s share price will be the impact of diversification – a Chinese bank with operations in the US will have a more diversified loan portfolio and earnings stream. Diversification reduces volatility, and so usually increases a company’s enterprise value. Since the intrinsic value in share prices consists of the difference between enterprise value and total liabilities, if enterprise value rises, the intrinsic value component of the share price must also rise. Normally we would expect that this would cause the combined market value of the merged companies also to rise.

But this is not always the case. A reduction in volatility may increase intrinsic value, but it always reduces time value (share prices always consist of more that just intrinsic value, and this excess is called time value). What actually happens to share prices depends on which effect is greater. When the share price of the acquirer has high intrinsic value – i.e. the company is highly solvent and the value of its assets comfortably exceeds the value of its liabilities – it will typically have low time value, and the positive impact on intrinsic value will exceed the negative impact on time value. This will cause the combined share price to rise.

However when the share price of the acquirer has low intrinsic value and high time value – i.e. it is in a highly volatile business and has few real assets, like an internet company, or its liabilities approach or exceed its assets, like an insolvent bank – the impact of an increase in intrinsic value can be much less than the reduction in time value. In that case an acquisition will cause the combined share price to drop.

This is true not just for insolvent banks but for any company whose share price consists mostly or wholly of time value. For example when AOL and Time Warner announced in January 2000 that they would merge to create a media super-company, the first excited response of the stock market was to run up the combined value of the two firms by over 10%. Within days, however, as investors began to understand the implications of the merger, market sentiment changed and the combined value of the two firms dropped to 5% below the pre-announcement levels – during a period in which the relevant market index rose nearly 10%. Mergers involving start-up internet companies have almost always resulted in declining market prices for exactly this reason.

For Chinese banks, like for internet startups, any large acquisition will almost certainly result in a lower combined share price once the implications to investors are digested. The negative impact on the Chinese bank’s time value will exceed the positive impact on its intrinsic value, or to put it another way, more than 100% of the increase in enterprise value will go to the bank’s creditors, who benefit from more stable and diversified earnings. Equity investors, unlike creditors, place a high value on Chinese banks precisely because China’s economic future is so uncertain.

Any reduction in the volatility around future expectations will reduce their value to equity investors. Chinese banks currently have much higher price-to-book ratios than highly solvent global banks, and this high ratio reflects the high component of optionality (time value) in their share price. By sharply reducing time value a large foreign acquisition will effectively drive the price-to-book ratio lower, and so reduce the combined market value of the two banks.

But this doesn’t this mean that a rational Chinese bank will never engage in a foreign acquisition. On the contrary, it makes sense for state- controlled Chinese banks to make foreign acquisitions because the main shareholder, the government of China, has a much more complex incentive structure than do other shareholders. As a shareholder, of course, the government would like to see rising share prices, and to that extent it should not encourage foreign acquisitions. However the government’s position is not so simple. In addition to its role as shareholder, the government has at least two other important roles. First, it guarantees the bank’s depositors, so it effectively absorbs any improvement or deterioration in the bank’s creditworthiness. Second, it regulates the banks as part of its overall responsibility for the health of the banking system.

It turns out that both roles involve optionality. Creditors and regulators are effectively short put options on the enterprise value of the company because their exposure to increases in enterprise value is limited, while their exposure to declines is unlimited. Because they have differing incentive structures, their objectives differ. This is just a variation on what is known as the agency problem in corporate finance, in which managers (whose incentives, incidentally, are very similar to those of creditors) have goals that often conflict with those of shareholders.

Because the government in its role as guarantor and regulator is effectively short a put option on the enterprise value of the bank, this creates a strong incentive to minimize volatility – lower volatility increases enterprise value, and so reduces the intrinsic value of the put option (the value of a put option always decreases as enterprise value rises), while lower volatility always reduces time value. Along with being long a call option as a shareholder, the government is short a put option as guarantor and regulator, and as such it unambiguously benefits from any reduction in volatility. In this case the option framework simply makes explicit what we intuitively know: unlike shareholders, creditors and regulators worry far more about downside risk than about upside profits.

What the framework adds to the analysis is that for nearly insolvent banks, the interests of creditors and regulators are diametrically opposed to those of shareholders. Since its interests as guarantor and regulator almost certainly exceed its interest as shareholder, the government has a strong incentive to encourage behavior which may hurt shareholders in general but will benefit the government and all other creditors. China’s state-controlled banks are likely, in other words, to behave in ways that benefit managers, regulators and creditors at the expense of shareholders because its largest shareholder has a very complex incentive structure.

China’s government is not the only government whose interest may conflict with that of bank shareholders – this always happens in the case of banks with questionable loan portfolios whose deposits are implicitly or explicitly guaranteed, as the S&L crisis in the US during the 1970s and 1980s demonstrates. But because of the government’s mixed role as guarantor, regulator, and principle shareholder, it is important that investors understand that although their long-term interests may be similar to that of the government – a rapidly growing economy which translates into an increasingly valuable banking franchise – in the short term incentives are aligned in very different ways.

This is an abbreviated version of the newsletter that went out three weeks ago. 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.

<![CDATA[The Impact of Reform on Growth]]> I got a lot of feedback from my January 5 blog entry because of my argument that the implementation of the reforms proposed in the Third Plenum all but guarantees that growth rates in China will slow down. For that reason I thought it might make sense for me to explain a little more carefully why I think this must happen, and why I think that we can almost judge how successfully the reforms are implemented by how quickly growth slows.

The first point to recognize is that when a country’s growth has been driven by wasteful investment, GDP growth will exceed real economic wealth creation, productivity will be overstated, and debt will rise faster than debt servicing capacity. Why? Because in China we record growth in terms of the cost of inputs, not in terms of the value of the outputs, and so if the cost of inputs exceeds the value of outputs, we will overstate the real value of economic activity.

Now of course this happens elsewhere too, but there is an automatic mechanism for writing down this excess. This mechanism is usually the recognition of bad debt. Companies that invest poorly go bankrupt, and the value of their loans is written off. This writing off of bad loans shows up as a correction to the overstatement of growth and productivity.

In a system in which bad debt isn’t written down, the losses are simply hidden and rolled over. Of course after many years they are effectively written down, but this happens indirectly. In order to service the loans there is an explicit or hidden transfer from some other part of the economy to cover the full extent of the losses, so that future growth is reduced by the amount of the transfer.

Over long periods of time, in other words, real economic value and recorded economic value is the same, but over shorter periods of time they can differ enormously. If a country fails to record bad debt, its growth today will be overstated by that amount, but its future growth over the longer term will be understated by the same amount.

I think most of us agree that a significant share of the loans in the Chinese banking system would be considered, from an economic point of view, as bad loans. They were made to support investments the true economic value of whose outputs are less than the cost of the inputs. Because many of these loans are implicitly guaranteed, it may make prefect legal sense for the banks to treat these as performing, but this does not change the fact that the loans are uneconomic.

I would argue that China’s GDP is overstated by the value of these hidden losses, and over time these losses will be worked out. As long as bad loans (as I am defining them here) are increasing, it is pretty safe to assume that the gap between China’s real economic output and its recorded output is also increasing. This has been the problem with China’s growth of the last several years.

Beijing’s response is the economic reforms proposed during the Third Plenum, aimed at unlocking greater productivity potential in the Chinese economy and returning the country to a sustainable growth path. They will do this by improving the capital allocation process, so that capital will be diverted from SOEs, real estate developers, local governments and other inefficient users of capital, to SMEs, the agricultural sector, and more efficient users of capital. They will also eliminate constraints that prevent more productive use of resources, including weak legal enforcement of business claims, better protection of managerial and technological innovation, educational improvements, and so on.

The implementation of these reforms is not certain. There is likely to be tremendous political opposition for all the reasons I have discussed in the past three newsletters. But, even assuming they are forcefully implemented, the higher productivity resulting from the reforms will not lead to higher reported GDP growth. This is one of the great recent myths that, to me, make no sense at all. The higher productivity will not even allow China’s economy to continue growing at current rates. On the contrary, successful implementation of the reforms will cause GDP growth rates to drop sharply.

There are at least four reasons to expect healthier but slower GDP growth over the rest of this decade if the reforms are implemented.

1.  Leverage boosts growth and deleverage reduces it. By now nearly everyone understands that China is over-reliant on credit to generate growth. Much new borrowing is needed simply to prevent borrowers from defaulting on existing loans, so that new lending can be divided into two buckets.

One bucket consists of loans made to roll over the debt of borrowers who do not generate sufficient cashflow from the investments that their original loans funded. The loans in this bucket, of course, do not create additional economic activity, but as debt rises, financial distress costs rise with them (most financial distress costs, as is well understood in corporate finance theory, are a consequence of the way rising debt changes the incentive structures of the various stakeholders and so distorts their behavior in non-economic ways). Of course any disruption in lending would cause a surge in defaults.

The second bucket consists of loans that fund new expenditures. These expenditures, of course, generate economic activity, but if they fund consumption, or if they fund investments the value of whose output is less than the cost of the inputs, they incur additional losses that must ultimately be rolled over by loans that belong in the first bucket. Any reduction in loan growth, in other words, is positive in the long term for Chinese wealth creation, but in the short term will either force the recognition of earlier losses or will reduce economic activity.

Beijing has attempted since 2009-10 to rein in credit growth, but each time credit growth has decelerated, GDP growth rates – as we would expect – dropped so sharply that Beijing was quickly forced to relent. Because growth is more dependent than ever on credit, as Beijing finally acts to rein in credit growth decisively, GDP growth will drop sharply.

2.  Hidden transfers will be reduced. As I have discussed many times the investment-led model encourages investment by transfers – hidden or explicit – from the household sector to subsidize investment. In the Japanese version of this model, which very broadly is the version China and the Asian Tigers pursued, the main form of these transfers is the undervalued currency, low wage growth (relative to productivity growth) and, most of all, financial repression.

Because these transfers no longer create net value on the investment side (China overinvests in infrastructure and has excess capacity in a broad range of manufacturing sectors), and the extent of the transfers are at the heart of China’s very low consumption level, the proposed reforms will act to reverse the mechanisms that goosed growth by transferring resources from the household sector to subsidize manufacturing, infrastructure building, and real estate development. These mechanisms put downward pressure on household income even as they subsidized manufacturing and investment and led directly both to higher growth rates and to the investment and consumption imbalances from which China suffers and which it plans to reverse.

It should be clear that as Beijing reverses policies that once acted to increase growth, the result must be slower growth. It is hard to estimate the amount by which growth will decline once all the transfers are eliminated, but when one considers that the total amount of transfers to SOE’s during this century may exceed the aggregate profitability of the SOE sector by as much as five to ten times, it is pretty clear that their impact is likely to be substantial.

3.  Excess capacity will be resolved. Beijing recognizes that cheap credit and limited accountability have created excess capacity in industry and real estate. Why build so much excess capacity? Local governments have supported this build-up of capacity to boost growth and, with it, revenues and local employment, and because capital was essentially free (its real cost may have even been negative for much of this century) and because most projects are implicitly or explicitly guaranteed by local and central governments, there seemed to be no cost, and plenty of benefit, simply to pile on capacity.

As Beijing acts to wring out excess capacity, we will inevitably see a reversal of the earlier growth impact. If building capacity generates economic activity (and it must have, or else why do it), closing down excess capacity must become a drag on growth.

4.  Losses will be recognized. As I discuss above, because many years of overinvestment have left a large amount of unrecognized bad debt on bank balance sheets, China’s GDP growth has been overstated by the amount of the unrecognized losses. Over the next decade as Beijing cleans up its financial system, this bad debt will either be explicitly recognized or, more likely, implicitly written off over the remaining life of the loan. Either way, as the losses are recognized, growth over the next several years will automatically be understated by the amount previously overstated.

These reforms, and others – like attempts to protect the environment – will ensure that even as China’s real economic productivity improves, its GDP growth numbers will drop as the reforms are implemented. For now most commentators argue that by increasing productivity, real reform will ensure a soft landing of GDP growth rates of 7-8 percent during the rest of President Xi Jinping’s administration. A growing minority worries, however, that rapidly rising debt will force China into a hard landing.

GDP growth is an inverse proxy for reform

Although rising debt increases the probability of a hard landing, for now I expect neither outcome. More likely, I believe, is a “long landing”, during which growth rates will drop by roughly one to two percentage points every year for the rest of this decade. Implementing reforms will protect China from a hard landing. It will however force much lower, albeit healthier, growth rates.

In order to understand China’s growth prospects I think we must recognize that while a growth model can deliver healthy growth for many years, this growth can itself transform conditions to the point where the model is no longer able to deliver. At that point the economy must adjust to a new, more appropriate growth model.

The Chinese growth model is a version – in probably its most extreme form – of the investment-led growth model described by Alexander Gershenkron fifty years ago. To simplify tremendously, growth in “backward” economies is supported by policies that subsidize investment while suppressing consumption (usually by constraining household income growth). These “backward” economies are ones in which the level of capital stock is much lower than the country’s social and institutional ability to absorb investment efficiently.

Early on, many years of high investment allowed China to catch up. Once it did, however, continuing to invest in the same way and to the same degree was no longer wealth enhancing. At this point the economy needed institutional and social reforms to continue growing. The political logic of the system, however, forced, as it almost always does, continued high investment growth and, with it, increasing investment misallocation.

With this almost by definition debt began to rise faster than debt servicing capacity. This, clearly, was unsustainable, but of course it can go on for many years. It was as long ago as 2007 that former Premier Wen described the Chinese economy as “unsteady, unbalanced, uncoordinated and unsustainable”, but it proved politically very difficult for Beijing to implement the reforms his advisors suggested, and so the distortions associated with the growth model continued.

Debt surged even as the consumption imbalance deteriorated until late 2011. We have only seen in 2012-13 the beginning of any partial rebalancing, although during this time there has been at best only a deceleration in the growth rate of credit.

And yet the minimal amount of rebalancing that has occurred in the past three years has already lopped three percentage points off China’s GDP growth rate, just as we predicted. China still has a long way to go to rebalance its economy. By my calculations consumption growth must outpace GDP growth by 3-4 percentage points every year for at least a decade just to allow China to raise the household consumption share of GDP to a still-low 50 percent.

The proposed reforms will certainly unleash greater productivity, but they will also eliminate the very mechanisms that had previously turbo-charged economic activity and which showed up in the form of higher reported GDP growth rates. They will cause a sharp deceleration in economic activity even though growth will be more productive than in the past. The fact that growth rates have dropped by almost a third even before the reforms were implemented suggests to me just how much further they must drop.


This is an abbreviated version of the newsletter that went out three weeks ago.  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.

<![CDATA[Will the Reforms Speed Growth in China?]]> 【中文导读】


Although still vague on the specifics, China’s Third Plenum November partially clarified the nature of the reforms that Beijing is proposing for China over the coming year. Of course very little was said in any of the related releases about the difficulties, of which the most important are likely to be political, in implementing these reforms, nor did we hear – not unsurprisingly, I think – much about what specific steps Beijing will take to address these difficulties. What has been surprising to me is that many analysts – some of whom, but not all, recognize how difficult implementation is likely to be – expect that the reforms will unleash such a burst of productivity that growth rates in China will be maintained or even raised from the current GDP growth target of 7.5%.

This, I think, is extremely implausible. Much of what I have written in recent months concerns the difficulty Beijing will face in switching from one growth model, in which rapid growth disproportionately benefits the elite at the expense of ordinary households, to its alternative, in which much slower growth will disproportionately benefit ordinary households at the expense of the elite. This remains, in my opinion, a key consideration in evaluating prospects over the next few years, but however successfully the reforms are executed, I am convinced that analysts who predict that we are about to embark on a decade of 7-8 % growth both misunderstand the nature of China’s transformation and ignore the history of previous similar growth miracles.

It is almost impossible – in my opinion – that GDP growth rates over the rest of this decade remain at or close to current levels. I suspect that when growth rates drop, as they must, those who claimed that current growth rates would be maintained will argue that the reason their prediction was wrong was Beijing’s failure to implement the reforms correctly. While this may help save face, it is, in my opinion, profoundly incorrect. On the contrary, I would argue that if China’s GDP continues to grow annually at above 7% in 2014 and 2015, this will be precisely because Beijing did not implement the reforms. Successful execution of the reforms, in other words, is exactly why growth rates will fall sharply.

To explain why, I want to list three of the thoughts I came away with from the general reaction to the Plenum. First, while many analysts hailed the reforms proposed during the Plenum as extraordinarily “bold” and “innovative”, in fact Chinese economists have been debating these very reforms for a long time – even before March 2007, when then-Premier Wen Jiabao famously described China’s economy as “unsteady, unbalanced, uncoordinated and unsustainable.”

Most economists now recognize that in recent years too much of China’s massive investment spending has been wasted on projects with negative real returns – as happened in the late stages for every country that followed a similar growth model. Debt, consequently, is high and is growing much faster than China’s debt-servicing capacity. This is clearly unsustainable. Once China reaches debt capacity constraints, like nearly all of its predecessors did after many years of high growth, the country runs the risk of a sudden and disorderly disruption in growth.

To resolve this problem China must implement reforms that increase investment efficiency. This includes diverting resources from the state sector to small and medium businesses. Beijing must also increase the consumption share of demand, which requires above all an increase in the household share of GDP.

Boiled down to their essentials, the economic reforms proposed during the Third Plenum would do just that – by reforming the currency and interest rate regimes, changing the allocation of credit in the financial system, spurring innovation, reforming land ownership and residency requirements, imposing stronger rule of law, and perhaps even partially distributing state assets to households. There is nothing surprising or unexpected about any of these proposals.

The second thought I came away with from the consensus reaction to the Plenum is, as I have said many times before, that historical precedents suggest that the greatest challenge facing Beijing is not in identifying the right set of reforms but rather in implementing them. The reforms are relatively easy to prescribe, but political opposition to the reforms is likely to be very strong. To see why, we must understand how the alignment between the interests of the economic elite and the needs of the economy will change.

In the early 1980s, after many decades of war and economic mismanagement, China’s capital stock was far below its institutional and social ability to absorb investment productively. China urgently needed much higher levels of investment. Following the experiences of a number of “growth miracle” countries – and employing policies proposed by economist Alexander Gerschenkron fifty years ago – China put into place policies that did just that.

These policies, among the most important of which was the repression of interest rates, all worked in the same way. They diverted resources from the household sector, whose wealth nonetheless grew rapidly as rural migrants flocked to new jobs in the cities, into investment in infrastructure and manufacturing capacity, much of which was directed or controlled by the state and the economic elite.

While this resulted in at least two decades of solid and healthy growth, the state sector and the economic elite benefitted disproportionately from the combination of rapid growth and implicit transfers from the household sector. In fact the GDP share retained by ordinary Chinese households shrank dramatically over the past three decades, while the share retained by the state grew commensurately, of course, and income inequality widened. This has nearly always been the case in the early stages of the investment-led growth model – the state and the elite benefit disproportionately.

Now that soaring debt is forcing China to abandon the model, the relative distribution of economic benefits must be reversed. Ordinary Chinese households must retain a growing share of future economic growth, while the state and the economic elite must, almost by definition, retain a shrinking share. This is ultimately what it means to rebalance the economy and – as happened in other countries that followed this growth model – this is why the reforms are likely to be politically difficult. After thirty years in which the interests of the elite were positively aligned with the interests of the country, the reforms now imply a negative alignment of their interests.

How much growth can we expect?

My third thought, and this is the most important point, is about the pace of post-reform growth. Many economists believe that a successful implementation of reforms must guarantee growth of 7% or more during the rest of this decade, but this probably represents the greatest piece of confusion about China’s adjustment. Here is my Carnegie Endowment colleague, Yukon Huang, with one of the more optimistic predictions:

Despite the vagueness of the communique, the “decision” provided a comprehensive reform programme that, if acted upon, will absorb the energies of this generation of senior leaders and beyond. Ironically, rigorous implementation of these reforms will alter market incentives so that annual gross domestic product growth in the coming years could rise to 8-plus per cent even as the recent Central Economic Work Conference debated whether to lower the official target to 7 per cent to reinforce that quality now matters more than quantity.

Although not many other analysts are predicting growth rates above 8%, certainly there are widespread expectations that if the reforms are implemented growth will remain above 7%. Arthur Kroeber from Dragonomics in a Foreign Policy article expects that the reform program “is likely to be effective in sustaining the nation’s economic growth” while the Financial Times cites one analyst as suggesting that growth will stay in the 7-8% range:

However, data released on Tuesday confirmed that Chinese growth momentum remains robust, with investment slowing but retail sales picking up. The economy is believed to be growing roughly on par with the 7.8 per cent year-on-year pace it notched up in the third quarter.

This has put Lu Ting, an economist with Bank of America Merrill Lynch, in the camp that believes there need not be a trade-off between growth and reforms. “Reforms can also support growth, especially those reforms that make growth more efficient. So I don’t understand why people think reforms have to be negative for growth,” he said.

There are however at least three very strong reasons, I think, to argue that as the reforms are implemented, growth rates must drop sharply.

1. Growth rates underpinned by tremendous credit expansion, which acts to increase demand, are unlikely to be maintained in a period of relative deleveraging, during which demand is reduced.

It is widely acknowledged that perhaps the most important reason to change the Chinese growth model is its excessive reliance on debt to generate growth. Debt has soared in recent years, to the point where many economists simply look at credit growth in the current quarter in order to determine what GDP growth over the next few quarters are likely to be.

But as China deleverages, growth in demand must drop sharply. After all if economic growth over the past several years has been goosed by rapid credit expansion, deleveraging must have the opposite effect. It is strange that economists who acknowledge that the current growth model is overly dependent on debt have failed to understand that its reversal will have the opposite impact. If it did not, it is hard to explain why anyone would consider debt to be a problem in the first place.

2. The failure by Chinese banks to recognize misallocated investment must overstate past GDP growth, in the same way that this overstatement must be reversed in the future, either because the bad debt is explicitly recognized, or because it is implicitly written down over the debt repayment period.

If China currently has wasted significant amounts of investment spending, it is clear that much of the accompanying bad debt has not been written down correctly. Bad loans are almost non-existent in the banking system – that is they have not been recognized in the form of reserves or write-downs – and there have been no significant bankruptcies.

There may be good reasons for this. If a loan has been made to fund a project whose economic value is less than the economic cost of the investment, economists should treat it as a bad loan whose negative present value must be written down. However if the lending bank believes that the government implicitly or explicitly backs the loan, the bank does not need to write it down.

But while the bad loan might not represent a loss to the bank, it does represent a loss to the country, and the amount of that loss should be deducted before the country’s GDP is calculated. If Chinese banks have not correctly written down the bad debt, however, past GDP growth must be overstated by an amount equal to all the bad loans that have not been written down – a fairly large number that may amount to as much as 20-30% of GDP.

But the failure to recognize the loss does not mean that the loss does not exist. The losses implicit in the bad loans must (and will) be written down over the future, either explicitly, in which case they will result in a direct deduction to GDP growth, or implicitly, in which case they will require implicit and hidden transfers from one part of the economy or another (usually the household sector) to cover the gap between the “real” cost of capital and the nominal (subsidized) cost of capital. This transfer must reduce future growth.

The point here is that if credit is a problem in China – something no one doubts – it must be a problem because of wasted investment that has yet to be recognized, otherwise it would have resulted in negative GDP growth today. Failure to recognize the investment losses will, of course, artificially boost GDP growth today, but it must also artificially reduce GDP growth tomorrow as the recognition of those losses is simply postponed, not eliminated. The failure of many economists to recognize that wasted investment has a cost – even as they recognize that investment has been wasted – has caused them both to misunderstand the relationship between wealth creation and GDP and to understate the future impact of this overstated GDP.

Debt matters, and the only time it can be safely ignored is when debt levels are so low, and the borrower is so credible, that it creates no financial distress costs and has a negligible impact on demand. Neither condition applies in China, and so any prediction that ignores debt is likely to be hopelessly muddled. In fact I would like to propose a simple rule. Any model that predicts China’s future GDP growth must include, if it is to be valid, a variable that reflects estimates of the amount of hidden losses buried in the banks’ balance sheets. If it does not, it cannot possibly be a valid model to describe China’s economy, and its predictions are useless.

3. The same mechanisms that forced up China’s growth rates created China’s imbalances, and reversing the latter means also reversing the former.

China’s astonishing growth during the past three decades is partly the result of a system that subsidized growth with hidden transfers from the household sector. These transfers are at the root of the current imbalances, and once reversed, so that China can rebalance its economy towards healthier and more sustainable sources of demand, the very processes that turbocharged growth will no longer do so.

If growth has been healthy and sustainable, in other words, there would be no need for Beijing to change its growth model – in fact it would be foolish to do so. If growth has not been healthy and sustainable, this is almost certainly because it has been artificially propped up, and if the reforms are aimed at unwinding the mechanisms that artificially propped up growth, then subsequent growth rates must be substantially lower.

Low interest rates, low wages, an undervalued currency, nearly unlimited access to credit for state-owned enterprises, a relaxed attitude to environmental degradation, and other related conditions were both the source of China’s ferocious growth as well as of China’s unprecedented economic imbalances. Reversing these conditions will rebalance the economy, but will do so while lowering growth in the obverse way that these conditions had accelerated growth.

One of the most obvious places in which to see this is in excess capacity in a wide range of businesses. It is clear that Beijing recognizes the problem of excess capacity. Here is Xinhua on the subject:

Tackling excess capacity will be one of the top tasks on China’s economic agenda in 2014, as the issue becomes a major challenge to maintaining the pace and quality of economic growth. “The Chinese economy still faces downward pressure next year,” the Central Economic Work Conference pointed out on Friday, citing the capacity issue weighing down some sectors as one of the major challenges facing the world’s second-largest economy.

It should be obvious that building excess manufacturing capacity, like building up inventory, is a way of propping up growth numbers today at the expense of tomorrow’s growth numbers. Closing down excess manufacturing capacity must be negative for growth in the same way that building it was positive.

These three conditions, which are the automatic consequences of the reform process – deleveraging, writing down unrecognized investment losses, and reversing policies that goosed growth rates – must lead to much slower growth. In theory these conditions can be counterbalanced by an explosion in productivity unleashed by the reforms. When analysts claim that growth rates will not slow if the reforms are implemented, this must be implicitly what they mean.

But this is unlikely to be the case. For the net impact of the reforms on growth to leave China’s GDP growth unchanged, or even to accelerate, the amount of productivity that must be unleashed by the reforms is implausibly, even extraordinarily, high. What is more, the positive impact on productivity must emerge almost immediately. Longer-term productivity improvements – for example those generated by education, land, and hukou reforms, or reforms to the one-child policy, or a speedier and more efficient urbanization process – do not count.

I am so convinced that the implementing of these reforms must result in slower growth – if only because it is impossible to find a single relevant case in history in which the adjustment following a growth miracle did not include an unexpectedly sharp slowdown in growth – that I would propose that we can judge the forceful implementation of the reforms inversely with GDP growth. If China is able to impose an orderly adjustment quickly, its GDP growth rate will slow substantially for several years.

GDP growth rates of 7% or more, on the other hand, will suggest that credit is still rising too quickly and that China has otherwise been unable to implement the reforms, in which case China is likely to reach debt capacity constraints more quickly. Growth of 7% for the next few years, in other words, is almost prima facie evidence that China is not adjusting.

I wish my readers a great 2014. This year promises to be an exciting and unsettling one. Stay tuned.
This is an abbreviated version of the newsletter that went out nearly four weeks ago. 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.



  而Avoid the Fall的作者、经济学家Michael Pettis认为,这极不现实。中国现在正面临经济转型。现在的经济模式是以牺牲平常百姓的利益为代价,让精英阶层大举获利。而转型之后,中国将牺牲精英阶级的利益,让普通民众获得更多的财富。在转型的过程中,经济增速将会减缓。










  1. 目前中国经济增长由庞大的信贷扩张所支撑。尽管信贷的扩张能够提升需求,但是在去杠杆的时代将难以维系。这意味着需求将会减弱。


  3. 帮助中国增长的机制也导致了中国经济的不平衡,要改变不平衡的局面,就一定要改变增长机制,而这会影响增长。



<![CDATA[Monetary Policy Under Financial Repression]]> Following Paul Krugman’s lead I guess I can refer to this post as being “wonkish”. Much of it is based on my recent book Avoiding the Fall (Carnegie Endowment, September 2013).

In order to understand much of what is happening in China I believe it is crucially important to understand how financial systems operate under condition of financial repression. Because most of what we know about economics is derived from economists whose operating environment is the classical “anglo-saxon” economies (I stress “classical” because for much of the 19th Century, operating under the so-called “American System”, the US itself was not, in my opinion, a classic anglo-saxon economy), there is a tendency to assume that what happens in those economies is somehow the default position in economics, and this not only causes us to underrate important economists that don’t follow this tradition, like the German Freidrich List or the American Albert O. Hirschman, but it also leads us into mistaken assumptions, like the belief that higher interest rates lead automatically to higher savings rates.

We do know some things about financial repression. Two of the first important texts to discuss financial repression comprehensively are Edward S. Shaw, Financial Deepening in Economic Development and Ronald I. McKinnon, Money and Capital in Economic Development. There is, however, a lot more to it than what is generally known, and even this is largely ignored by most economists. It seems to me that many of the mistakes we make when we think about the relationship between cause and effect, for example the impact of monetary policy on China’s economy, arise because we assume that relationships that hold in the US economy are universal and must hold in the Chinese economy too. So to return to the assumption that higher interest rates must lead to higher savings rates, I would argue that this is true mainly under two unstated assumptions, neither of which holds for China.

First, higher interest rates must must have a negative wealth effect, which they mostly do in the US. In China however the wealth effect is positive. Second, changes in interest rates should have a minimal impact on the household share of GDP. In the US, where there is a wide variety of alternative investments and where interest rates move broadly in line with changes in inflation, this may be true, but in China where most households have few alternatives to bank deposits, and where interest rates are set independently of changes in inflation, this isn’t true.

In fact distortions in domestic interest rates may be the single most important explanation of why the household share of GDP has plummeted in China, especially over the decade ending around 2010-11. So while higher interest rates in the US are typically (although certainly not always) associated with increases in the savings rate, in China they are typically associated with reductions in the national savings rate. There should be nothing mysterious about these opposite reactions to higher interest rates – both are fully explainable with our current economic tools as long as we are clear about the assumptions, often hidden, that we make. And notice that I refer to “national” savings rates, not “household” savings rates, which are commonly confused because in the anglo-saxon economies changes in the national savings rates closely follow changes in the household savings rate, whereas in China they do not.

To understand the Chinese economy we must understand how financial repression changes the relationships between variables, many of which we implicitly and incorrectly assume are fixed and permanent. Financial repression, in other words, is not only at the heart of both China’s rapid growth and China’s economic imbalances, but it also explains a number of otherwise puzzling aspects of the Chinese development model. A repressed financial system will seem to operate in a fundamentally different way than a market-based (“anglo-saxon”) financial system, but in fact the principles under which it operates can be explained using what we already know about the operations of monetary policy in a market-based financial system.

One of the apparent puzzles about China’s growth trajectory, especially in the past decade, is the seeming disconnect between rapid monetary growth and relatively stable domestic inflation. It is well known in economic theory that countries that have open capital accounts are forced to choose between managing domestic monetary policy and managing the currency regime. When a central bank chooses to intervene in the currency to maintain a desired exchange level, the amount of money it creates domestically is largely a function of the need to monetize net inflows or outflows. On the other hand if it chooses to manage the domestic money supply, the supply and demand for that currency in the international markets will determine the value of the currency.

In China’s case the capital account is technically closed, so in principle Beijing should be able to manage both the value of the currency and the amount of domestic liquidity. In reality, however, there are two significant limits to the country’s ability to maintain closed capital accounts. First, and most obviously, the capital account is the obverse of the current account, and any country with the volume of exports and imports that China runs necessarily will see significant activity in the capital account, especially if, as widely believed, Chinese nationals evade capital controls by over- and under-invoicing exports and imports. What is more, although much of the trade-related capital inflow and outflow is controlled by the central bank, an increasing share of capital flows occurs outside the central bank.

Second, China has extensive trading borders, a great deal of local corruption, and a long history both of capital control and capital control evasion. Throughout history countries with large trading borders, a long history of capital controls, and wide-scale corruption have rarely been able to control capital flows as these factors undermine the ability of financial authorities to manage them, and China is not an exception. In fact during the past decade by most accounts China has experienced significant amounts of both speculative inflows and capital flight, measuring probably in the hundreds of billions of dollars, neither of which is compatible with strict enforcement of capital controls.

For all practical purposes, in other words, and in spite of formal capital flow restrictions, China is also forced to a greater or lesser extent to choose between managing its currency regime and managing domestic money creation. Clearly it has chosen to manage the currency regime, and the enormous changes in central bank reserves, which at over $3 trillion are the largest hoard of central bank reserves ever amassed by a single county, are a testament to that.

Monetary expansion and inflation

Monetary policy from the point of view of the balance of payments is pretty clearly a consequence of the central bank’s need to monetize an enormous amount of net inflows. China’s current account surplus began surging around 2003-04 to levels that are almost unprecedented in history, with the country at its peak running a current account surplus of up to 10 per cent of China’s GDP, giving it, with the surplus equal to just over 1 percent of global GDP, one of the highest current account surpluses as a share of global GDP ever recorded.

The impact of the current account surplus on capital flows tended to reinforce monetary creation in at least two ways. As money poured into the country as a consequence both of its current account surplus and its net surplus on the capital account (among other things China is been the largest recipient of foreign direct investment in the world), it helped ignite a credit-fueled asset boom, especially in the real estate sector, that encouraged additional speculative inflows looking to take advantage of soaring prices.

In addition the massive current account surplus fueled speculation about the trajectory of the renminbi. As investors expected the value of the renminbi to rise as it adjusted to current account inflows, even more speculative inflows poured into the country seeking to benefit from any appreciation. The result was that until late 2011 substantial net capital inflows, added to the already very high current account surplus, drove up central bank purchases to extraordinary levels.

As a share of global GDP the only comparable hoard of foreign currency reserves occurred in the United Sates in the late 1920s, a period distorted by the destruction of much of Europe’s manufacturing capacity in World War 1 and by the impact political uncertainty in Europe had in driving capital to the relative safety of the United States. During this time, when the US experienced both massive current account surpluses as well as massive private capital account surpluses that generated its huge central-bank reserve hoard, the US share of global GDP was roughly three to four times the current Chinese share, which gives a sense of just how extraordinary the Chinese accumulation of reserves has been.

With so much money pouring into the country, the People’s Bank of China was forced regularly to monetize an amount equal to a substantial share of its existing money base. Normally central banks would try to sterilize this money creation, and the People’s Bank of China did try to mop it up, but most measures of money nonetheless continued to increase rapidly, and there is anyway a real question about the effectiveness of sterilization with highly liquid and credible instruments that are already a close substitute for money. The tools used to sterilize inflows, mainly short term bills issued by the central bank, are themselves forms of money, and the more extensively they are employed, the more liquid they become and hence the more “money-like.”

The alternative to a real and effective sterilization is for the Chinese economy to adjust in the form of a surge in inflation. As the money supply grows in response to China’s current account surplus and net capital inflows, it should cause prices and wages to surge, forcing a real appreciation in the currency, until both China’s current account surplus and net capital account inflows wither away.

This is of course the classic currency adjustment mechanism under the gold standard. As reserves soared in China, money creation soared along with it. Rapid money creation should have resulted in a rapid rise in domestic wages and prices as demand for goods and services outstripped supply. Rising domestic prices should have in turn undermined Chinese exports, encouraged imports, and reversed capital inflows.

But this didn’t happen. In fact during the past decade, price inflation in goods and services in China has been fairly moderate, and usually driven exogenously (crop failures, high commodity prices, etc.) and wages actually grew more slowly than productivity. China’s export competitiveness not only was not eroded by domestic money creation, as it would have been under the classical adjustment mechanism, but it also had, by some measures, even increased during this period. There have been periods during which inflation seemed about to take off, but these periods tended to be short-lived and were always followed by sharp declines in inflation.

At first this might seem to imply that sterilization was indeed effective in preventing money creation in China from getting out of hand. By selling central bank bills, transacting in the repo market, and raising minimum reserve requirements aggressively (to around 20 percent, compared to the 5-10 percent that is more common in developing countries), the central bank seems to have been successful in mopping up the money created by the monetization of current and capital account in flows and so protecting the Chinese economy from the normal consequence of maintaining an undervalued currency.

What happened, however, in fact was very different. Generally speaking, there have been a number of countries besides China that have managed for long periods to combine tremendous capital and current account inflows, rapid growth in foreign currency reserves, and low inflation – for example Japan in the 1980s. In nearly every case these countries also had severely repressed financial systems.

What’s more, although it was hard to find in China and other similar countries the normal evidence of rapid money creation in changes in consumer prices, other parts of the economy acted in ways that seemed consistent with rapid money creation. Credit, both inside and outside the formal banking system, grew astonishingly quickly and, as usually occurs under conditions of too-rapid credit growth, credit standards deteriorated. The stock and real estate markets experienced bubble-like behavior. Producer prices rose rapidly. Global commodity prices, spurred largely by soaring Chinese demand, also soared.

Bifurcated Monetary Expansion

So was Chinese monetary expansion excessive or not, or to put it differently, why is it that what seemed by most measures to be an extraordinary surge in money creation did not also result in significant wage and consumer price inflation? The answer, I will argue, has to do with the nature of money growth in financially repressed economies. Because the Chinese financial system is so severely repressed, money growth in China cannot be compared to money growth in a market-based financial system. Monetary growth is effectively bifurcated and affects producers and consumers in very different ways.

What does it mean to say that monetary growth was bifurcated? By this all I mean is that nominal money growth showed up as different rates of money growth for different parts of the economy. More specifically the rate of monetary growth for producers exceeded the rate of monetary growth for consumers, and this becomes clear by measuring the monetary impact on different sectors within the economy of monetary expansion under financial repression.

Countries with significant financial repression can experience periods of rapid monetary expansion with results that do not conform to normal expectations precisely because of this bifurcation in the monetary impact of credit creation. On the production side of the economy it is easy to see in China over the past decade what looked like the consequence of rapid monetary expansion – rapid growth in credit, rising productive capacity, surging production of manufacturing goods], asset bubbles, etc.

On the demand side of the economy, however, and especially considering household consumption, one gets a very different view – monetary expansion seemed to have been very subdued. Household consumption typically grew much more slowly than GDP and its share of GDP declined steadily. Consumer price inflation also tended to be low or moderate even in the face of what seemed like rapid monetary expansion.

So had there been too-rapid monetary expansion in China during the past decade or not? Why do some sectors seem to indicate that there has been, and other sectors that there hasn’t? The answer depends, it turns out, on which economic sector we examine, and whether that sector was a net borrower or a net lender. We will see that financial repression can create a bifurcation in monetary expansion when

a) net savers and net borrowers are two very distinct groups, in this case the former being households and the latter being producers of goods and infrastructure, including manufacturers, governments, real estate developers and infrastructure investors;

b) the bulk of savings consists of deposits in the banking system and the bulk of corporate financing consists of bank lending or other forms of bank financing.

The experience of China (and other financially repressed economies) suggests out that when interest rates are set artificially low in such a financial system, any given nominal expansion in money supply creates a lower real expansion in money on the consumption side and a higher real expansion in money on the production side. The consequence may be rapid GDP growth, a surge in investment and low inflation for many years, but it also leads to sharply unbalanced growth in which the role of domestic demand as a driver of growth shrinks.

To see why, assume a country in which the “natural” nominal interest rate is 5% for all maturities. For the sake of simplicity we will assume that deposit and lending rates are the same, and that the marginal reserve requirement is constant, although these assumptions do not affect our final conclusions in any significant way.

Now let us assume that there are immediately two transactions. First, a saver deposits $100 dollars in the bank for one year at 5 percent and the $100 dollars are immediately lent out to a borrower for one year at 5 percent. One year from now the borrower will repay $105 and the saver will receive $105.

Second, we assume that another saver deposits $97 for one year at 5% and the money is immediately lent out to a borrower for one year at 5%. For the sake of simplicity we will round off the pennies and assume that in the second case the borrower repays one year later and the depositor receives one year later $102.

It is clear that the because of the first transaction the money supply has increased by $100, and the depositor will receive and the borrower will repay $105 in one year. It is also clear that because of the second transaction the money supply has increased by $97, and the depositor will receive and the borrower will repay $102 in one year.

But now let us posit that the central bank decides suddenly and arbitrarily to reduce both the lending and deposit rate to 2%. This has nothing to do with a change in inflationary expectations or the real demand for money – it is simply driven by other domestic considerations.

Following the decision a third, less fortunate saver decides to deposit $100 for one year at 2% and this $100 is immediately lent to a lucky borrower for one year at 2%. Which of the first two transactions is closer in its monetary impact to the third transaction?

From the depositor’s point of view the present value of $102 one year from now is only $97 (for simplicity I am rounding off adjustments to the nearest dollar). Although the nominal amount of his deposit is $100, just like that of the first depositor, the real value of his deposit is really only $97, just like that of the second depositor. If we define money so as to include deposits, did the money supply rise by $97 or $100?

On a comparable basis it is pretty clear that the third depositor’s position, after interest rates were artificially lowered, is no different than that of the second depositor who deposited $97. Nominally the value of his deposit is the same as that of the first depositor, or $100, but his wealth is the same as that of the second depositor, or $97. Since it is real wealth, and not nominal deposits, that ultimately matters to the depositor, and which will affect his consumption and savings decisions, the third depositor is likely to behave over the long run as if he were in the position of the second depositor.

Because in this case a $100 deposit results in a $97 increase in the real value of deposits, in other words, it turns out that the nominal growth in money as measured by deposits overstates the real growth. Under financial repression a $100 transfer from the household to the bank in the form of a $100 bank deposit results in a smaller real deposit than under conditions of no financial repression.

Transfers change the monetary impact

If financial repression distorts the balance sheet of the depositor, what does it do to the balance sheet of the borrower? For the third borrower, who in our example borrowed under conditions of repressed interest rates, the transaction is the mirror opposite of the depositor’s transaction. The third depositor effectively had $3 “confiscated” from his assets in the form of an arbitrary reduction in the deposit rate. This $3 is transferred automatically to the borrower, so that the third borrower’s liability more closely resembles that of the second bower, even though he receives upfront the same $100 that the first borrower receives.

The nominal increase in money as measured by loans, in other words, understates the real increase. The third borrower receives both the $100 loan as well as a $3 “gift’ in the form of partial forgiveness of his debt. His purchasing power has gone up not by $100 but rather by $103, even as the purchasing power of the third depositor has only gone up by $97.

Depositors in a financially repressed system may make the same initial deposits as depositors in a non-financially repressed system, and borrowers in a financially repressed system may receive the same initial disbursements as borrowers in a non-financially repressed system, but their resulting balance sheets are very different. Wealth is effectively transferred from the depositor to the borrower under financial repression and so the purchasing power of the former is reduced relative to the nominal size of the deposit while the purchasing power of the latter is increased relative to the nominal size of the loan.

This transfer modifies the monetary impact on each of them and the effect is cumulative. Assume in the above example that the money supply consists entirely of $100 nominal of one-year deposits matched with $100 nominal of one-year loans. If in any given year the money supply (loans and deposits) is increased by $20, or 20%, the impact on deposits and loans is very different. In effect the real value of deposits will have risen that year by only $2 (with $18 effectively transferred to borrowers), whereas the value of loans will have increased by $38. An increase in nominal money of 20% in other words, is associated with a 2% real increase in deposits and a 38% real increase in loans.

This is what it means to say that financial repression creates a bifurcation of monetary growth. For households, and net depositors more generally, real monetary expansion is in effect much lower than nominal monetary expansion because of the implicit financial repression “tax”, and so consumption growth and consumer-price inflation will seem abnormally low. For manufacturers, real estate developers, infrastructure investors and other net borrowers, real monetary expansion is in effect much greater than nominal monetary expansion because of an implicit financial repression “subsidy”, and so asset inflation and capacity growth seem abnormally high.

Perhaps one way of thinking about it is to consider how to make a comparable impact in a market system. Imagine if somehow the US were to enact a law whose result was that every time the Fed expanded the money supply, a one-off tax was imposed on households, the proceeds of which were transferred to corporate borrowers. In that case monetary expansion would be much less likely to cause an increase in demand for consumer products, and so would create much less consumer price inflation, and much more likely to cause a surge in production.

This effective “tax” suggests that in a financially repressed system, it is normal that the impact of nominal monetary expansion will seem much greater in one sector of the economy than in another, with the differencing reflecting the net lending or net borrowing position of that sector. The impact of monetary expansion on the behavior of the saver is much lower than it is in a market-based financial system, all other things being the same. The impact of monetary expansion on the behavior of the borrower is much higher than it is in a market-based financial system, all other things being the same.

Under these conditions it is consequently not surprising that the economy can seem to be operating under conflicting monetary systems. Consumption behaves as it would in an economy with much lower monetary growth, and production and asset prices behave as they would in an economy with much higher monetary growth.

I will leave it to an ambitious doctoral student to work out the full monetary implications of financial repression and to formalize a model of monetary growth under financial repression, but it is worth noting that there are several other real implications of this bifurcation in monetary policy, all of which seem to apply to the Chinese economy:

a) Financial repression creates in effect a two-speed economy. There will normally be a growing imbalance between the net saving and net borrowing sides of the economy, and the latter should grow much more quickly than the former.

b) By subsidizing the production side of the economy and penalizing the consumption side of the economy, financial repression must always force up the domestic savings rate. This may seem at first counterintuitive because, as I discussed at the beginning of this entry, we normally associated lower interest rates with lower savings, but it is an automatic consequence of the very different wealth effect that changes in interest rates have on market-based financial systems and financially repressed financial systems. Savings, after all, are simply the difference between consumption and production, and any process that forces production to grow more quickly than consumption automatically forces up the savings rate.

Financially repressed systems with artificially low interest rates tend historically to have much higher national savings rates than market systems, and also much higher savings rates than financial systems in which interest rates are abnormally high, but oddly enough the higher savings rates are almost always ascribed to cultural preferences. Rather than explain differential savings rates by cultural factors, it seems far more promising to explain them as consequences of financial repression.

c) To rebalance the two sides of the economy either policymakers must eliminate, or even reverse, the transfer created by financial repression (i.e. either nominal interest rates must rise or GDP growth must drop) or they must implement another mechanism that directly transfers wealth from net borrowers to net lenders.

d) The more interest rates are repressed, the harder it is for consumption growth to keep up with production growth because monetary policy driving consumption is effectively much “tighter” than monetary policy driving production.

e) Consumer price inflation is not the appropriate measure by which to gauge domestic monetary conditions.

f) Hikes and reductions in interest rates are not expansionary or contractionary in the way we might expect in an open financial system. A hike in interest rates may act to contract investment, but contrary to conventional wisdom it actually expands consumption because it reduces the wealth transfer from the saver to the borrower. This allows the saver to increase consumption.

g) For the same reason consumer price inflation in a financially repressed system can be self-correcting. If inflation rises, but interest rates do not, the bifurcation of monetary growth will increase because the difference between the “correct” interest rate and the nominal rate increases. In that case any given nominal monetary expansion is accompanied by an even lower (or negative) real expansion from the point of view of consumers as net savers. By lowering the real cost of credit for borrowers, it can expand production. Increasing production while reducing consumption, of course, outs downward pressure on prices.

h) Monetary expansion accelerates investment and asset price inflation. If inflation rises, but interest rates do not, any given nominal monetary expansion is accompanied by an even greater real expansion for net borrowers.

i) This may be why in financially repressed economies regulators often resort to formal or informal loan quotas. Without loan quotas, monetary expansion for borrowers may far exceed the needs of the economy, even as monetary expansion for depositors is too tight.

j) As long as the rest of the world can accommodate the consequent excess of production over consumption, the bifurcation in monetary policy will not seem to be a problem, but once the world cannot accommodate it, the bifurcation of monetary expansion will create deflationary pressures.

k) As long as the rapid increase in monetary expansion for borrowers does not result in a misallocation of capital, the bifurcation in monetary policy will not seem to be a problem, but once rapid money expansion leads to increasingly wasted investment, as it eventually always must, the bifurcation of monetary expansion will create asset inflation and an unsustainable increase in debt (as debt rises faster than debt servicing capacity).

l) Deflation or disinflation partially or wholly resolves the bifurcation by forcing real interest rates towards their “correct” level (because real deposit and lending rates rise in a deflationary environment in there is no change in the nominal interest rate). Under deflation we would expect to see the gap between consumption growth and GDP growth narrow, or even reverse.

m) Slower GDP growth partially or wholly resolves the bifurcation by forcing real interest rates towards their “correct” level (in a market system nominal interest rates move naturally in line with nominal GDP growth). Under conditions of much slower GDP growth we would expect to see the gap between consumption growth and GDP growth narrow, or even reverse. This, for example, is what happened in Japan after 1990.

n) Disintermediation of the banking system, to the extent that it reduces the impact of financial repression, may create an unexpected burst in consumer price inflation. This is less true to the extent that, like in China, disintermediation is limited to the rich, since the consumption impact of higher income on the rich is limited.

Asset price inflation

To summarize, in a financially repressed system in which consumers tend to be net savers and producers net borrowers, consumers and producers experience very different monetary impacts of the same underlying monetary conditions. The latter exist in an environment in which the impact of monetary growth is much faster than do the former.

There are two problems, then, which must arise when a financial repressed system experiences long periods of rapid money growth. First, as growth in production systematically exceeds growth in consumption, absent exponential growth in investment a growing trade surplus is necessary to resolve the growing imbalance. Once there are constraints on the ability of the trade surplus to continue growing – for example the global financial crisis has caused a collapse in the ability of the rest of the world to absorb China’s rising trade surplus – the only way to prevent a collapse in growth is to increase investment even more.

But if investment is being misallocated this simply exacerbates the second problem. Rapid monetary expansion, exacerbated by the bifurcation created by financial repression, has a tendency to result in capital misallocation and asset price inflation because it accelerates monetary growth. If the response by policymakers to a contraction in the world’s ability to absorb rising trade surpluses is to engineer a further increase in investment, we would expect debt to surge, more investment to be wasted, and for the debt consequently to become unsustainable much more quickly.

This seems to be exactly what happened in China during the 2008-09 global crisis. Before the crisis, debt was already rising at an unsustainable pace thanks to many years of the combination of rapid monetary growth and monetary policy bifurcation. China’s trade surplus also soared as production was forced to rise much more quickly than consumption.

The crisis caused a collapse in China’s trade surplus. In order to limit the impact on Chinese growth, Beijing engineered an extraordinary increase in domestic investment. What is more, Beijing increased both the total amount of loans and deposits outstanding while lowering even further the real interest rate. The net impact was to increase the financial repression tax on households – a tax which when directly to subsidizing borrowers.

This certainly resolved the problem of a sharp decline in growth caused by a collapse in the trade surplus, but it did so by exacerbating the investment bubble and accelerating the rate at which the growth in debt exceeded the growth in debt servicing capacity. It also worsened the consumption imbalance. It is probably not a coincidence that it was only in 2010 that most analysts belatedly recognized the problem of soaring debt in China – probably at the instigation of a report by Victor Shih, then a professor of political economy at Northwestern University and until then one of only a handful of China skeptics, on the surge in local and municipal debt.

As Chinese growth rates stayed high even in the midst of the worst global economy in 70 years – a fact that was a necessary consequence of the combination of increasing financial repression and a surge in monetary growth – there were always likely to be two factors that would undermine growth. First, if the pace of monetary expansion slowed, and second, if the financial repression tax declined.

What does it mean to say that the financial repression tax declines? This doesn’t simply mean that interest rates rise, but rather that interest rates rise relative to GDP growth. In a market-based system, over long periods of time nominal interest rates are broadly in line with nominal GDP growth rates. This means that savers and borrowers fairly distribute the returns on growth in proportion to the amount of risk they take. Of course if interest rates are artificially low, savers receive a disproportionately lower share and investors a disproportionately higher share of the benefits of growth.

The greater the difference between nominal lending rates and the nominal GDP growth rate the greater the financial repression tax. In China during the first decade of this century nominal GDP growth rates have been 16-20%, depending on which period you measure and what assumptions you make about GDP growth, while nominal interest rates have been roughly 6-7%. This gives some idea of the extent of the financial repression tax, although even this understates its extent because the spread between the lending rate and the deposit rate is set artificially high, thus lowering even more the returns to depositors (an additional tax is effectively levied on depositors to recapitalize the banks).

The important point is that beginning sometime in late 2011, both conditions were in place. As debt continued to rise in China and as slowing growth eroded China’s trade surplus, there is evidence that beginning in 2010 capital flight from China began to surge, while beginning some time in the fourth quarter of 2011 speculative inflows into the renminbi began drying up. The combination turned China’s position from running net capital inflows to running net capital outflows (excluding changes in central bank reserves, which by definition balance out total flows to zero).

As a result, in late 2011 and 2012 we witnessed for the first time China’s reserves rise by less than the already-much-lower current account surplus. By the middle of the year, net capital outflows actually exceeded the current account surplus (reserves, in other words, declined in spite of a current account surplus).

As Chinese money creation slowed, exacerbated by monetary bifurcation, Chinese growth slowed along with it. This had the impact of reducing the financial repression tax (the difference between nominal GDP growth and nominal interest rates narrowed). The consequence was predictable. GDP growth slowed far more quickly in 2012 than even the pessimists had expected.

This is part of the self-reinforcing tendencies that financial repression creates for an economy. Rapid growth increases the financial repression tax, which tends to create even more rapid growth by reducing the real cost of capital. Slowing growth reduces the financial repression tax, which slows growth even further. These self-reinforcing tendencies imbedded in the national capital structure are typical of developing countries and one of their great sources of economic volatility – one that tends to undermine long-term growth.

This is an abbreviated version of a chapter of my recent book (Avoiding the Fall) which itself came out of one of my newsletter several years ago. 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.

<![CDATA[The Politics of Adjustment]]> The past two years have seen a surprising amount of turmoil at the highest levels of the Chinese political establishment. We have seen political alliances re-shuffled, powerful business and political leaders arrested, factional disputes magnified, and an explosion of rumors of more to come. After twenty years of what seemed, on the surface at least, remarkable cohesion within China’s political elite, events of the past two years have come as a great surprise to many.

And yet the historical precedents suggest that none of this should have surprised us. After nearly thirty years of spectacular economic growth and impressive social and political advances, China has probably exhausted the growth model that had once served it so well. It now suffers from many of the internal imbalances that were the near-automatic and easily predictable consequences of the policies associated with the growth model it had pursued, and policymakers in Beijing are very aware of the urgent need to adopt a new set of policies that will allow China both to rebalance the economy so as to protect itself from the consequences of soaring debt and to lay the foundations for another thirty years of solid economic growth and social and political advancement.

China is not the first country to have experienced a long period of miraculous growth. But, as University of Chicago’s Robert Aliber implied in his Warholian quip about growth miracles (“in the future every country will grow rapidly for fifteen years”), the most difficult part of growth miracles has not been the growth miracle itself but rather the subsequent adjustment. Consider the most notable examples of growth miracles: the United States in the 1920s, Germany in the 1930s, the Soviet Union from the late 1940s to the early 1960s, Brazil from the late 1950s to the late 1970s, Japan in the 1980s, and many others.

In every one of these cases, and in many more involving smaller economies, economic growth powered ahead at astonishing rates (relative to the rest of the world in depression in the case of Germany) on the back of investment programs usually, but not always, centrally directed and turbo-charged by institutional distortions that forced up domestic savings rates to levels high enough not only to fund massive domestic investment (and, in many cases, extensive military expenditures) but also to export abroad, which of course is the converse of running large trade surpluses. In each case, too, growth for many years seemed almost unstoppable, to the point where, in the case of the Soviet Union by the early 1960s and Japan by the late 1980s, there was a near-unanimous consensus that it was just a matter of years, or one or two decades at most, before either country would overtake the United States as the world’s leading economic and even technological power.

There is, in other words, plenty of historical context within which to place China’s spectacular achievement, and it is clear from this context that the most difficult part of the process has always been the subsequent adjustment, during which time the imbalances generated by the spectacular growth were addressed and resolved. But they were not always resolved successfully.

In some cases, for example that of the United States and perhaps Brazil and South Korea, the adjustment was brutally difficult but the institutions that evolved during the adjustment period laid the groundwork for many more years of growth and stability (and a shift from military authoritarianism to a robust democracy in the latter two cases). In other cases, for example that of the Soviet Union, the adjustment period was long and protracted, and perhaps because during the adjustment period the country was unable to develop the right set of institutional reforms, it eventually collapsed into the kind of chaos from which it is still struggling to emerge. In still other cases, for example Japan, the adjustment seemed to leave the country locked into stagnation.

Three generalizations

Of course the differences in the ways each country experienced both the growth miracle and the subsequent adjustment make it very hard, and risky, to generalize, but it seems reasonably safe to make three assertions about the adjustment process. First, the investment-led growth miracle always culminated in a period during which debt began to grow at an unsustainable pace, and in every case the miracle was brought to a halt either because of a debt crisis or, most obviously in the cases of Japan and the Soviet Union, because extraordinarily high debt levels locked the country into a long period of stagnant growth during which the financial system struggled to bring debt levels under control.

Second, in every single case even the greatest of skeptics arguing against the sustainability of the growth miracle ended up wildly underestimating the difficulty of the subsequent adjustment. Had those who were most skeptical about the Japanese growth miracle been told in 1990 that Japan faced twenty years of growth under 1 percent, even they would not have believed it. Had any economist who questioned the sustainability of the Soviet economy been told in 1970 that within twenty years the Soviet economy would have collapsed, and with it the state itself, it is unlikely that he would have taken the claim seriously. Even the most pessimistic of Americans in 1929 or Brazilians in 1980 would not have included in their bearish forecasts the possibility that their countries would experience a decade of negative growth. In retrospect the adjustment period would be described as a middle-income trap, a debt trap, or any of a dozen other traps, but it’s virulence would have always come as a shock.

Third, the adjustment period was never just a period of difficult economic adjustment. It was also always a period of tremendous political difficulty, fractious political disputes and, more often than not, a period of radical political transformation. In fact excluding a few, very unique cases (Singapore, for example, whose small size and external orientation gave it a flexibility impossible in a larger country), the adjustment that followed a long period of miraculous growth has always been even more striking as a period of political change than as a period of economic change.

And it is not hard to see why this should be the case. It is a commonplace among historians, almost a truism, that when a country’s governance is structured in such a way that incentives for the political elite are aligned with the economic interests of the country, the country is likely to grow rapidly and in a healthy way. When they are misaligned, there are likely to be significant strains and pressures that resolve themselves through the political system.

How does this apply to China? In the early 1980s when China’s reforms began, the country was seriously underinvested and urgently needed to improve its infrastructure, its manufacturing capacity, and housing and education. As the country’s farsighted leaders engaged in a massive program of investment, there were many opportunities for the state and for the political and economic elite to benefit directly from transforming the country’s capital stock from one of the weakest in the world to one of the best. Among the consequences was that while the lives of ordinary Chinese improved at a pace perhaps unmatched in human history, the share of China’s GDP retained by the state sector and the political elite actually increased for thirty years as they benefited disproportionately from Chinese growth. China produced more billionaires more quickly than anyone in history.

But every country that has experienced a growth miracle has also developed imbalances that had to be reversed, and the adjustment process is simply the process by which these imbalances are reversed. China is no exception. In order to rebalance the Chinese economy we must move from a period during which the elite received a disproportionate share of growing Chinese wealth to one in which ordinary households and small businesses receive a disproportionate share. After thirty years during which Chinese households retained an ever smaller share of the rapidly growing Chinese economy, doing nonetheless very well in the process, we must shift to a period during which ordinary Chinese households receive an ever rising share of a more slowly growing Chinese economy, in fact this is almost the very definition of rebalancing in the Chinese context.

China’s economic adjustment necessarily involves, in other words, a sharp reduction in the rate at which the state and the political elite have been able to grow their assets during the past thirty years, and perhaps even an overall decline. It also requires significant changes in the ways in which the financial system funds economic activity, an increase in the role of small businesses and the service industry, a very different legal framework, and a number of institutional changes that represent a sharp break from the recent past.

Aligning incentives

None of these changes will be easy, and these changes will be all the harder to make by the fact that there must also be, as a necessary part of what it means for China to rebalance, a sharp reduction in the amount of assets and resources to be distributed among the various state and elite players. China’s old economic model, which rewarded both the country and the elite very handsomely, must now be transformed into a model that will reward the country, but at least partially at the expense of the elite. This was the challenge faced by every country as it adjusted from it’s period of rapid, investment-led growth, and it has always been a politically challenging process, whether that process involved the bitter political upheavals and the redistribution of wealth from the rich to the poor forced onto the United Sates by President Roosevelt’s reforms in the 1930s, or the Brazilian rejection of it’s military rulers in the 1980s as they painfully but surely built a robust democracy.

The historical precedents are fairly clear. Every country that has emerged from many years of “miraculous” investment-led growth has either embarked willingly, or been forced by debt, into an adjustment process that turned out to be economically far more painful than anyone had expected. In every case among the greatest challenges has been a very fractious and difficult political environment. China is now beginning it’s own adjustment process and we should be prepared for both tougher economic conditions and a more difficult political environment.

History has a lot to teach us about this process, and it has a lot to teach us about which countries were able to manage the difficult adjustment in ways that created a basis for long term success and which countries were not able to do so. China’s leaders have already demonstrated sufficient foresight and ability to have managed the growth period successfully, and we have every reason to hope that they will manage the adjustment process equally well. But there should be little doubt that thirty years of astonishing growth was the relatively easier part, and that President Xi Jinping and Premier Li Keqiang face a greater challenge than that faced by their predecessors. And there should also be little doubt that the recent political turmoil in China is not an accident. History makes it very clear that the next ten years will be a political challenge for China even more than it will be an economic one.

And how will things evolve politically in China? Of course it is a little foolhardy to make predictions, but work that I have already cited many times before by Daron Acemoglu and James Robinson suggest that most cases of successful adjustment have occurred either in countries with highly competitive political structures (democracies, for example) or in countries with highly centralized decision-making (China under Deng Xiaoping, perhaps). Authoritarian countries in which political decision-making is widely dispersed, like China today, have historically found it difficult to make a successful transition.

So which way should China move? There is a widespread belief that only political reforms that impose rule of law and democratize the political decision-making process will allow China to reform successfully. For example a recent editorial in the Financial Times argues:

Much of this is difficult, for one important reason. It requires the Communist party to loosen its grip. Yet it has little choice. Unless meaningful reform can be implemented, the chances of China’s economy running out of steam are high.

This may be true, but it also may be true that a successful adjustment in China actually requires that China move temporarily “backwards” towards greater centralization of power and a tighter grip on decision-making by President Xi and his allies. After all it took Deng Xiaoping to unleash the radical reforms of the 1980s, and it is an open question as to whether he would have been able to do so had political power in China been as dispersed in the 1980s as it is today. In that sense what seems like an attempt by President Xi to consolidate power more tightly within a small group is perhaps not a step “backwards” in political liberalization but more of a temporary retreat in order to ensure a successful adjustment, which itself might be a precondition to further political liberalization some time in the future.

This is an abbreviated version of the newsletter that went out six weeks ago. 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.

<![CDATA[When are Markets “Rational”?]]> Last month’s award of the Nobel Price in economics set off a great deal of chortling because one of the three recipients, Eugene Fama, received the award for saying that markets are efficient at capital allocation and another, Robert Schiller, received the award for saying they are not. Typical is this response by John Kay:

The Royal Swedish Academy of Sciences continues to astonish the public when awarding the Nobel Memorial Prize in Economics. In 2011 it celebrated the success of recent research in promoting macroeconomic stability. This year it pays tribute to the capacity of economists to predict the long-run movement of asset prices.

People with knowledge of financial economics may be further surprised that this year Eugene Fama and Robert Shiller are both recipients. Prof Fama made his name by developing the efficient market hypothesis, long the cornerstone of finance theory. Prof Shiller is the most prominent critic of that hypothesis. It is like awarding the physics prize jointly to Ptolemy for his theory that the Earth is the centre of the universe, and to Copernicus for showing it is not.

To me, much of the argument about whether or not markets are efficient misses the point. There are conditions, it seems, under which markets seem to do a great job of managing risk, keeping the cost of capital reasonable, and allocating capital to its most productive use, and there are times when clearly this does not happen. The interesting question, in that case, becomes what are the conditions under which the former seems to occur.

I wrote about this most recently in my most recent book about China, Avoiding the Fall, and I think it might be useful to recap that argument. I argued in the book (based on some articles I published in 2004-05) that an “efficient” market is one that has an efficient mix of investment strategies. Without this efficient mix, the market itself fails in its ability to allocate capital productively at reasonable costs.

Investors make buy and sell decisions for a wide variety of reasons, and when there is a good balance in the structure of their decision-making, financial markets are stable and efficient. But there are times in which investment is heavily tilted toward a particular type of decision, and this can undermine the functioning of the markets.

To see why this is so, it is necessary to understand how and why investors make decisions. An efficient and well-balanced market is composed primarily of three types of investment strategies—fundamental investment, relative value investment, and speculation—each of which plays an important role in creating and fostering an efficient market.

  • Fundamental investment, also called value investment, involves buying assets in order to earn the economic value generated over the life of the investment. When investors attempt to project and assess the long-term cash flows generated by an asset, to discount those cash flows at some rate that acknowledges the riskiness of those projections, and to determine what an appropriate price is, they are acting as fundamental investors.
  • Relative value investing, which includes arbitrage, involves exploiting pricing inefficiencies to make low-risk profits. Relative value investors may not have a clear idea of the fundamental value of an asset, but this doesn’t matter to them. They hope to compare assets and determine whether one asset is over- or underpriced relative to another, and if so, to profit from an eventual convergence in prices.
  • Speculation is actually a group of related investment strategies that take advantage of information that will have an immediate effect on prices by causing short-term changes in supply or demand factors that may affect an asset’s price in the hours, days, or weeks to come. These changes may be only temporarily and may eventually reverse themselves, but by trading quickly, speculators can profit from short-term expected price changes.

Each of these investment strategies plays a different and necessary role in ensuring that a well-functioning market is able keep the cost of capital low, absorb financial risks, and allocate capital efficiently to its more productive use. A well-balanced market is relatively stable and allocates capital in an efficient way that maximizes long-term economic growth.

Each of the investment strategies also requires very different types of information, or interprets the same information in different ways. Speculators are often “trend” traders, or trade against information that can have a short-term impact on supply or demand factors. They typically look for many opportunities to make small profits. When speculators buy in rising markets or sell in falling ones—either because they are trend traders or because the types of leverage and the instruments they use force them to do so—their behavior, by reinforcing price movements, adds volatility to market prices.

Different Investors Make Markets Efficient

Value investors typically do the opposite. They tend to have fairly stable target price ranges based on their evaluations of long-term cash flows discounted at an appropriate rate. When an asset trades below the target price range, they buy; when it trades above the target price range, they sell.

This brings stability to market prices. For example, when higher-than-expected GDP growth rates are announced, a speculator may expect a subsequent rise in short-term interest rates. If a significant number of investors have borrowed money to purchase securities, the rise in short-term rates will raise the cost of their investment and so may induce them to sell, which would cause an immediate but temporary drop in the market. As speculators quickly sell stocks ahead of them to take advantage of this expected selling, their activity itself can force prices to drop. Declining prices put additional pressure on those investors who have borrowed money to purchase stocks, and they sell even more. In this way, the decline in prices can become self-reinforcing.

Value investors, however, play a stabilizing role. The announcement of good GDP growth rates may cause them to expect corporate profits to increase in the long term, and so they increase their target price range for stocks. As speculators push the price of stocks down, value investors become increasingly interested in buying until their net purchases begin to stabilize the market and eventually reverse the decline.

Relative value investors or traders play a different role. Like speculators, they tend not to have long-term views of prices. However, when any particular asset is trading too high (low) relative to other equivalent risks in the market, they sell (buy) the asset and hedge the risk by buying (selling) equivalent securities.

A well-functioning market requires all three types of investors for socially useful projects to have access to appropriately-priced capital.

  • Value investors allocate capital to its most productive use.
  • Speculators, because they trade frequently, provide the liquidity and trading volume that allows value investors and relative value traders to execute their trades cheaply. They also ensure that information is disseminated quickly.
  • Relative value trading forces pricing consistency and improves the information value of market prices, which allows value investors to judge and interpret market information with confidence. It also increases market liquidity by combining several different, related assets into a single market. When buying of one asset forces its price to rise relative to that of other related assets, for example, relative value traders will sell that asset and buy the related assets, thus spreading the buying throughout the market to related assets. It is because of relative value strategies that we can speak of a unified market for different assets.

Without a good balance of all three types of investment strategies, financial systems lose their flexibility, the cost of capital is likely to be distorted, and the markets become inefficient at allocating capital. This is the case, for example, in a market dominated by speculators. Speculators focus largely on variables that may affect short-term demand or supply for the asset, such as changes in interest rates, political and regulatory announcements, or insider behavior.

They ignore information like growth expectations or new product development whose impact tends to reveal itself only over long periods of time. In a market dominated by speculators, prices can rise very high or drop very low on information that may have little to do with economic value and a lot to do with short-term, non-economic behavior.

Value investors keep markets stable and focused on profitability and growth. For value investors, short-term, non-economic variables are not an important or useful type of information. They are more confident of their ability to discount economic variables that develop and affect cash flows over the long term. Furthermore, because the present value of future cash flows is highly susceptible to the discount rate used, these investors tend to spend a lot of effort on developing appropriate discount rates. However, a market consisting of only value investors is likely to be illiquid and pricing-inconsistent. This would cause an increase in the required discount rate, thus raising the cost of capital for borrowers.

Because each type of investor is looking at different information, and sometimes analyzing the same information differently, investors pass different types of risk back and forth among themselves, and their interaction ensures that a market functions smoothly and provides its main social benefits. Value investors channel capital to the most productive areas by seeking long-term earning potential, and speculators and arbitrage traders keep the cost of capital low by providing liquidity and clear pricing signals.

Where Are the Value Investors?

Not all markets have an optimal mix of investment strategies. China, for example, does not have a well-balanced investor base. There is almost no arbitrage trading because this requires low transaction costs, credible data, and the legal ability to short securities. None of these is easily available in China.

There are also very few value investors in China because most of the tools they require, including good macro data, good financial statements, a clear corporate governance framework, and predictable government behavior, are missing. As a result, the vast majority of investors in China tend to be speculators. One consequence of this is that local markets often do a poor job of rewarding companies for decisions that add economic value over the medium or long term. Another consequence is that Chinese markets are very volatile.

Why are there so few value investors in China and so many speculators? Some experts argue that this is because of the lack of investors with long-term investment horizons, such as pension funds, that need to invest money today for cash flow needs far off in the future. Others argue that very few Chinese investors have the credit skills or the sophisticated analytical and risk-management techniques necessary to make long-term investment decisions. If these arguments are true, increasing the participation of experienced foreign pension funds, insurance companies, and long-term investment funds in the domestic markets, as Beijing has done with its QFII program, is certainly seems like a good way to make capital markets more efficient.

But the issue is more complex than that. China, after all, already has natural long-term investors. These include insurance companies, pension funds, and, most important, a very large and remarkably patient potential investor base in its tens of millions of individual and family savers, most of whom save for the long term. China also has a lot of professionals who have trained at the leading U.S. and UK universities and financial institutions, and they are more than qualified to understand credit risk and portfolio techniques. So why aren’t Chinese investors stepping in to fill the role provided by their counterparts in the United States and other rich countries?

The answer lies in what kind of information can be gathered in the Chinese markets and how the discount rates used by investors to value this information are determined. If we broadly divide information into “fundamental” information, which is useful for making long-term value decisions, and “technical” information, which refers to short-term supply and demand factors, it is easy to see that the Chinese markets provide a lot of the latter and almost none of the former. The ability to make fundamental value decisions requires a great deal of confidence in the quality of economic data and in the predictability of corporate behavior, but in China today there is little such confidence.

How to develop the investor base

Furthermore, regulated interest rates and pricing inefficiencies make it nearly impossible to develop good discount rates. Finally, a very weak corporate governance framework makes it extremely difficult for investors to understand the incentive structure for managers and to be confident that managers are working to optimize enterprise or market value.

And yet, when it comes to technical information useful to speculators, China is too well endowed. Insider activity is very common in China, even when it is illegal. Corporate governance and ownership structures are opaque, which can cause sharp and unexpected fluctuations in corporate behavior. Markets are illiquid and fragmented, so determined traders can easily cause large price movements. In addition, the single most important player in the market, the government, is able—and very likely—to behave in ways that are not subject to economic analysis.

This has a very damaging effect on undermining value investment and strengthening speculation. In the first place, unpredictable government intervention causes discount rates to rise, because value investors must incorporate additional uncertainty of a type they have difficulty evaluating.

Second, it puts a high value on research directed at predicting and exploiting short-term government behavior, and thereby increases the profitability of speculators at the expense of other types of investors. Even credit decisions must become speculative, because when bankruptcy is a political decision and not an economic outcome, lending decisions are driven not by considerations of economic value but by political calculations.

China is attempting to improve the quality of financial information in order to encourage long-term investing, and it is trying to make markets less fragmented and more liquid. But although these are important steps, they are not enough. Value investors need not just good economic and financial information, but also a predictable framework in which to derive reasonable discount rates. And here China has a problem.

There are several factors, besides the poor quality of information, that cause discount rates to be very high. These include market manipulation, insider behavior, opaque ownership and control structures, and the lack of a clear regulatory framework that limits the ability of the government to affect economic decisions in the long run. This forces investors to incorporate too much additional uncertainty into their discount rates.

Chinese value investors, consequently, use high discount rates to account for high levels of uncertainty. Some of this uncertainty represents normal business uncertainty. This is a necessary component of an economically efficient discount rate, since all projects have to be judged not just on their expected return but also on the riskiness of the outcome. But Chinese investors must incorporate two other, economically inefficient, sources of uncertainty. The first is the uncertainty surrounding the quality of economic and financial statement information. The second is the large variety of non-economic factors that can influence prices.

This is the crucial point. It is not just that it is hard to get good economic and financial information in China. The problem is that even when information is available, the variety of non-economic factors that affect value force the appropriate discount rate so high that value investors are priced out of the market.

Speculators, however, are much more confident about the value of the information they use. Furthermore, because their investment horizon tends to be very short, they can largely ignore the impact of high implicit discount rates. As a result, it is their behavior that drives the whole market. One consequence is that capital markets in China tend to respond to a very large variety of non-economic information and rarely, if ever, respond to estimates of economic value.

During the past decade, Beijing was betting that increasing foreign participation in the domestic markets would improve the functioning of the capital markets by reducing the bad habits of speculation and increasing the good habits of value investing and arbitrage. But it has become pretty clear that this faith was misplaced: the market is as speculative and inefficient as ever. This should not have been a surprise. The combination of very weak fundamental information and structural tendencies in the market—such as heavy-handed government interventions and market manipulation—reward speculative trading and undermine value investing. This forces all investors to focus on short-term technical information and to behave speculatively. In China even Warren Buffett would speculate.

Investors in Chinese markets must be speculators if they expect to be profitable. As long as this is the case, investors will not behave in a way that promotes the most productive capital allocation mechanism in the market, and such efforts as bringing in foreigners will have no meaningful impact.

What China must do is something radically different. It must downgrade the importance of speculative trading by reducing the impact of non-economic behavior from government agencies, manipulators, and insiders. It must improve corporate transparency. It must continue efforts to raise the quality of both corporate reporting and national economic data. Finally, it must deregulate interest rates and open up local markets to permit arbitragers to enforce pricing consistency and to allow better estimates of appropriate discount rates.

If done correctly, these changes would be enough to spur a major transformation in the way Chinese investors behave by permitting them to make long-term investment decisions. It would reduce the profitability of speculative trading and increase the profitability of arbitrage and value investing, and so encourage a better mix of investors. If China follows this path, it would spontaneously develop the domestic investors that channel capital to the most productive enterprise. Until then, China’s capital markets, like those of many countries in Latin America and Asia, will be poor at allocating capital.

When efficient markets become inefficient

But this is not just an issue for China. In the US there have been times when markets seemed efficient and rational, and times when they clearly were not. Of course this cannot be explained by the disappearance of the tools needed by value investors – for example the market for internet stocks seemed rational in the early 1990s and clearly became irrational by the late 1990s, but this did not occur, I would argue, because fundamental investors were suddenly deprived of their analytical tools.

What happened instead, I would argue, is that conditions that led to a too-rapid expansion of liquidity at excessively low interest rates changed the environment in which fundamental investors could operate. As excess liquidity forced up asset prices, the likes of Warren Buffet found themselves unable to justify buying assets and so they dropped out of the market. As they did, the mix of investment strategies shifted until the market became dominated by speculators, and when this happened what drove prices was no longer the capital allocation decision of value investors but rather than short-term expectations of changes in demand and supply factors that characterize a highly speculative market.

This, I would argue, made the US stock market of the late 1990s (and perhaps today, too) “irrational”, not because they are fundamentally irrational or inefficient but rather because they can only function efficiently with the right mix of investment strategies. When the mix was altered – and this can happen when liquidity is too abundant, or when a sudden shock undermines the confidence value investors have in their ability to analyze data, or when a political event cause uncertainty to rise so high that value investors are priced out of the market, or for a number of other reasons – the markets stopped functioning as they should.

Perhaps what I am saying is intuitively obvious to most traders or investors, but it seems to me that it suggests that the argument about whether markets are efficient or not misses the point. There are certain conditions under which markets are efficient because the tools needed for each of the various investment strategies are widely available and ate credible. When those conditions are not met, because the tools are not available, or when they are temporarily overwhelmed by exogenous events, perhaps because the credibility of those tools are temporarily undermined, or when excess liquidity causes fundamental investors to drop out, markets cannot be efficient.

This is an abbreviated version of the newsletter that went out three weeks ago. 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.

<![CDATA[Will Debt Derail Abenomics?]]> It seems to me that one of the automatic, if not always intended, consequences of Abenomics is to force up Japan’s current account surplus, and in fact to force it up substantially. This will have to do at least in part with deciding how to manage the country’s enormous government debt burden, which easily exceeds 200% of the country’s GDP.

If I am right, this should create two concerns. First, in a world struggling with insufficient demand and excess capacity, and in which the growth strategies of too many countries implicitly involve a significant increase in exports relative to imports, a major increase in Japan’s current account surplus could easily derail growth recovery elsewhere. The US for example has to worry that policies aimed at increasing domestic demand don’t simply result in rising debt as US demand bleeds out through the current account, while both China and Europe need strong external sectors to make their own difficult domestic adjustments less painful.

Second, it is not obvious that the world will be able to absorb a significant increase in the Japanese exports, and if Abenomics implicitly forces up the Japanese savings rate relative to investment (which is all that we mean when we say that economic policies force up current account surpluses), these policies can resolve themselves either in the form of high growth and soaring exports, or much lower growth and slowing imports. The former implies that Abenomics will be successful, while the latter that it will fail. It is not obvious, in other words, that Abenomics can succeed in a world of weak demand, and its failure is likely to make Japan’s domestic imbalances worse, not better.

It may seem a little quixotic to worry about a surging Japanese current account surplus just now when in fact Japan’s external balance has declined substantially and is surprising analysts on the downside. According to an article in last week’s Financial Times:

Japan’s current account balance plummeted by nearly two-thirds in August from a year ago, surprising forecasters that had assumed it would grow nearly a fifth. The current account is a broad measure of trade. A fall indicates Japan is receiving less income from overseas investments, despite help from the falling yen.

The current account surplus fell nearly 64 per cent in August, versus forecasts expecting an 18 per cent gain. The unadjusted balance in the month was Y161.5bn, against forecasts at Y520bn and down from Y577.3bn in July. Within the data, trade of goods and services was in deficit of more than Y1tn for a second consecutive month, while income fell to Y1.253tn from Y1.794tn a month before.

My concern, however, is unlikely to be played out over the next few quarters but rather over the next few years as Abenomics is implemented, and so Japan’s external position in the immediate future doesn’t matter. What matters, I think, is that in order to generate growth Tokyo is planning to implement polices aimed at raising both inflation and real GDP, and these policies are likely to force up the national savings rate relative to investment.

What is more, to the extent that these policies are successful in generating higher nominal GDP growth, they create a problem for Tokyo in how it decides to set domestic interest rates. Japan has never really resolved the overinvestment orgy of the 1980s. Instead of writing down bad debt it effectively transferred much of it to the government balance sheet, and now this huge debt burden is itself becoming, I think, a constraint on the success of policies designed by Tokyo to spur growth.

Before addressing the debt constraint, let me start by listing the reasons why I think Abenomics is likely to affect the trade surplus. First is the impact of Abenomics on pushing down the value of the yen. As I discuss in the first two chapters of my January book, The Great Rebalancing, currency depreciation does not affect the trade balance directly by changing relative prices. It does so indirectly by changing the relationship between savings and investment (the difference between the two being the current account balance). A depreciating currency reduces the real value of household income by acting effectively as a consumption tax on imported items. This also reduces the real value of household consumption.

The proceeds of this tax are used implicitly to subsidize the tradable goods sector, which effectively increases production in that sector. Of course as production rises relative to consumption, the difference between the two – the national savings rate – must also rise.

This means that as the yen depreciates, the consequence is likely to be an increase in the Japanese savings rate. If there is no commensurate increase in investment (and I assume that with excess capacity Japan does not need to increase investment much in order to produce higher output), Japan’s current account surplus must automatically rise. In the near term the investment rate is likely to rise, largely in response to greater confidence, but over the longer term downward pressure on the consumption share of GDP (which is the likely consequence of downward pressure on the household income share) will also put downward pressure on investment growth.

Savings is the obverse of consumption

But it doesn’t end there. Japan seems to be taking other steps to force up its domestic savings rate. Here is last Tuesday’s Financial Times:

Shinzo Abe, Japan’s prime minister, pledged to press ahead with the first increase in sales tax for over 15 years despite objections from some of his closest advisers, gambling that measures to address the country’s massive debts would not hinder his attempts to jump-start the economy.

Mr Abe said on Tuesday he would couple the consumption tax hike with roughly Y5tn in new public works spending, cash grants and other stimulus in order to blunt any negative impact on the economy.

…The plan to increase the tax from 5 to 8 per cent next April had been approved by a previous government with the support of Mr Abe’s Liberal Democratic Party. But it was opposed by economists who had helped the premier draft his Abenomics strategy, as well as by some LDP politicians. The last time Japan increased the levy, in 1997, a deep recession followed that shook the party’s grip on power.

The increase in the consumption tax, part of the proceeds of which will be used to increase infrastructure investment, will accomplish many of the same results as the deprecation of the yen. A consumption tax, like a tariff, is effectively a kind of back-door currency devaluation, with a slightly different mix of losers among the household sector and winners among the producing sector.

By boosting production and reducing consumption, however, it automatically forces up the national savings rate in the same way as does currency depreciation. Even if 100% of the proceeds of the tax were used to fund increased infrastructure investment (and the article suggests that part, but not all, of the consumption taxes will be directed towards higher investment), because at least some of the investment spending will go to workers in the form of wages, who will save part of those wages, the net result will be that total savings will rise faster than total investment. Once again this must force up Japan’s current account surplus even further.

So far this all looks like an attempt by Abe to increase Japanese competitiveness and so increase its total share of global demand, but not by increasing Japanese productivity, which is the high road to growth, but rather by reducing the real Japanese household income share of what is produced. Japan (like Germany and China have done over the past decade) is attempting to increase employment by reducing wages, and this means that its workers will be able to purchase a declining share of what they produce. This effectively means Japan will be growing at the expense of its trading partners. As the Japanese become less able to consume all they produce, the excess must be exported abroad.

If the world were in ruddy good health, we might not worry too much about policies aimed at Japan’s pulling itself out of the mess created in the 1980s, but with the whole world struggling with weak demand and with country after country trying to reduce domestic unemployment by selling more abroad – effectively exporting unemployment (with Germany in particular hoping to resolve the European crisis not by increasing its net domestic demand, as it should, but rather by forcing German surpluses outside Europe) – there is a real question in my mind as to how successful the Japanese program of Abenomics is likely to be if it implicitly requires a burgeoning trade surplus.

Remember that if one country increases its savings rate, unless there is a net increase in global investment there must be a commensurate reduction in the savings rate of the rest of the world so that savings and investment always balance globally. There are broadly speaking two ways this can happen. In the pre-crisis days this reduction in the savings rate of the rest of the world occurred mainly in the form of soaring consumption fueled by credit, and in this way unemployment stayed low. Since the crisis – which because of the negative wealth effect saw credit-fueled consumption drop – foreign savings have been reduced by a rise in foreign unemployment

This means that if Japan forces up its savings rate, and assuming that we are unlikely to return in the next few years to a credit-fueled consumption binge, the only way the world can respond to a structural forcing up of the Japanese savings rate is either by higher unemployment outside Japan or, if Japan’s trade partners take steps to protect themselves from higher Japanese trade surpluses, higher unemployment inside Japan.

The debt-servicing cost of nominal GDP growth

But there is more, perhaps much more. Japan is struggling with an enormous debt burden, and perhaps this explains why Tokyo is so eager to engage in policies that force up the Japanese savings rate. As long as more than 100% of Japanese borrowing is funded by domestic savings (if Japan runs a current account surplus is must be a net exporter, not importer, of capital), it doesn’t have to rely on fickle foreigners, who might not be satisfied with coupons close to zero, to fund its enormous debt burden.

But the debt burden creates its own very dangerous source of trade instability. To understand why, we need to consider what happens to interest rates in Japan if nominal growth rates rise.

In Japan interest rates are currently very low, close to zero. With total government debt amounting to more than twice the country’s GDP – which puts it among the most heavily indebted governments in the world – it is not hard to see how low nominal interest rates benefit Japan. With interest rates close to zero, there is very little cashflow pressure on the government from servicing its debt.

Some people might argue that nominal interest rates do not matter. We should be looking at real interest rates, they would argue, and with Japan’s having experienced deflation for much of the past two decades, real interest rates in Japan are high and the nominal rate is largely irrelevant.

This is true, real interest rates do matter, but it doesn’t mean that nominal interest rates do not. In fact both real and nominal interest rates matter, albeit for different reasons. Real rates matter for all the obvious reasons – they represent the real cost to the borrower in terms of a transfer of resources from the borrower to the lender. But nominal rates also matter because they effectively determine the implicit amortization schedule of principal payments.

When the nominal rate is zero or close to zero in a deflationary environment, in other words, interest is effectively capitalized in real terms. In fact whenever the real rate exceeds the nominal rate, as it has in Japan for much of the past two decades, the cashflow cost of servicing the debt is lower than the real cost, and the difference is effectively converted into real principal and deferred. In real terms, in other words, Japanese debt is growing by the difference between the real rate and the nominal rate, and this effectively represents a reduction in the cashflow cost of servicing its debt.

When nominal interest rates are positive and higher than the real rate, however, there is effectively an acceleration of real principal payments. This means that as long as nominal rates are very low, the real cost of servicing the debt is low and the principal payments are postponed, with some of the interest even being capitalized. As nominal rates rise, however, the real cost of servicing the debt during each payment period consists of interest plus some real principal.

This is just a long, perhaps pedantic, way of pointing out that even if the real interest rate in Japan declines, debt servicing is likely to be much more difficult as the nominal rate rises. Japan might be paying a lower real rate, but it is also implicitly paying down principle, instead of capitalizing it. Tokyo would need a significant increase in revenues, or a significant decrease in expenditures, to cover the cost.

So what would force Japan to raise its nominal interest rate? In principle the nominal interest rate should be more or less in line with the nominal GDP growth rate. If it is higher, growth generated by investing capital is disproportionately retained by net savers (including mainly the household sector). There is, in other words, a hidden transfer of resources from net borrowers to net savers.

If the nominal lending rate is lower than the nominal GDP growth rate, as is the case in China today and Japan during the 1980s, the opposite occurs. There is a hidden transfer from net savers to net borrowers, and because net savers are mainly the household sector, this will put downward pressure on the household share of income even as it gooses investment growth. This hidden transfer has been at the heart of the rapid economic growth that typically occurs in financially repressed economies during the earlier stages, and is also at the heart of the investment misallocation process that typically occurs during the later stages. We have seen this very clearly in China.

Will Tokyo raise interest rates?

Japan is trying to generate both positive inflation and real GDP growth, so that it is trying urgently to raise the growth rate of nominal GDP. What happens if and when it is successful? For example let us assume that Japan’s GDP is able to grow nominally by 4-5% a year – what will happen to the nominal Japanese interest rate?

Tokyo can either raise interest rates in line with nominal GDP growth rates or it can keep them repressed. In the former case, debt-servicing costs would soar, ultimately to 8% of GDP or more. This would create a problem for Tokyo in its ability to service its tremendous debt burden. It would need a primary surplus of around 8% of GDP just to keep debt levels constant, and it is hard to imagine how such a huge surplus would be consistent with nominal GDP growth rates of 4-5%.

If it were to raise income taxes it would create a huge burden for the household sector and almost certainly force up the national savings rate by forcing down the household share of GDP. Remember that during the 1980s Japan, like China today, generated rapid growth in part through financial repression, and one of the consequences of that rapid growth was an extraordinarily high savings rate along with a huge current account surplus, both of which were ultimately unsustainable. Japan has spent much of the past twenty years rebalancing GDP back in favor of the household sector, and to reverse this process may provide relief in the short term, but it is hard to see how I can be helpful in the medium term.

On the other hand if, in order to make its debt burden manageable Tokyo represses interest rates to well below the nominal GDP growth rate, it is effectively transferring a significant share of GDP from the household sector to the government in the form of the hidden financial repression tax. This is what Japan was doing in the 1980s, with all of the now-obvious consequences.

Japan’s enormous debt burden was manageable as long as GDP growth rates were close to zero because this allowed both for the country to rebalance its economy and for Tokyo to make the negligible debt servicing payments even as it was effectively capitalizing part of its debt servicing cost. If Japan starts to grow, however, it can no longer do so. Unless it is willing to privatize assets and pay down the debt, or to impose very heavy taxes of the business sector, one way or the other it will either face serious debt constraints or it will begin to rebalance the economy once again away from consumption.

As this happens Japan’s saving rate will inexorably creep up, and unless investment can grow just as consistently, Japan will require ever larger current account surpluses in order to resolve the excess of its production over its domestic demand. If it has trouble running large current account surpluses, as I expect in a world struggling with too much capacity and too little demand, Abenomics is likely to fail in the medium term.

Perhaps all I am saying with this analysis is that debt matters, even if it is possible to pretend for many years that it doesn’t (and this pretense was made possible by the implicit capitalization of debt-servicing costs). Japan never really wrote down all or even most of its investment misallocation of the 1980s and simply rolled it forward in the form of rising government debt. For a long time it was able to service this growing debt burden by keeping interest rates very low as a response to very slow growth and by effectively capitalizing interest payments, but if Abenomics is “successful”, ironically, it will no longer be able to play this game. Unless Japan moves quickly to pay down debt, perhaps by privatizing government assets, Abenomics, in that case, will be derailed by its own success.

This is an abbreviated version of the newsletter that went out three weeks ago. 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.