<![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 t