Beneath the Surface

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Pettis’s analysis of the European debt crisis is based on the same principles as the rest of his analysis. Crises are caused by economic imbalances. These are both trade imbalances and complementary gaps between savings and investment:  “Any policy that affects the gap between savings and investment in one country must affect in an opposite way the gap between savings and investment in the rest of the world.”

In the European case, the players are on the one hand northern European countries that produce more than they consume, save more than they invest domestically, and run trade surpluses; and on the other hand the mostly southern European countries that consume more than they produce, save less than they invest domestically, and run trade deficits. As usual, Pettis discourages us from attributing the crisis to the moral superiority of the first group of countries over the second:

Confused moralizers love to praise high-savings countries (let us call them all “Germany”) for their hard work and thrift, and deride high-consuming countries (which we will call “Spain”) as lazy and too eager to spend more than they earn. The world cannot possibly rebalance, they argue, until the latter become more like the former….The high German savings rate…had very little to do with whether Germans were ethnically or culturally programmed to save—contrary to the prevailing cultural stereotype. It was largely the consequence of policies aimed at generating rapid employment growth by restraining German consumption in order to subsidize German manufacturing—usually at the expense of manufacturers elsewhere in Europe and the world.

After German reunification in the early 1990s, Germany adopted a set of policies designed to promote productivity and competitiveness and combat unemployment. It held down consumption with wage constraints and high taxes, while using tax revenue to build infrastructure. It succeeded so well that it became a large net exporter of goods and capital to other countries in Europe. But in accordance with Pettis’s inexorable economic logic, other countries had to be net importers of goods and capital, with consumption greater than production and savings less than investment.

In those respects, the relationship between Germany and Spain resembles the relationship between China and the United States. However, one of the mechanisms by which countries like Spain became so heavily indebted is different. The US and China have two different currencies, one artificially strong because of the dollar’s traditional role as the primary reserve currency of the world, and the other artificially weak because the Chinese government wants to favor exporters over consumers. That helps make Chinese exports cheap and US exports expensive. Before the financial crisis, the demand for dollar-denominated assets like US stocks, bonds and mortgage-backed securities pumped up asset prices and held down interest rates, making Americans feel richer than they were and making it easier for them to borrow.

A different currency mechanism helped create the European imbalances–the European Monetary Union! Here I found Pettis a little vague on the mechanics, but here’s how I understand it: If each country had its own currency, and each currency were valued realistically relative to the others, then countries would find it harder to become too indebted. Less competitive countries would have weaker currencies, and they couldn’t afford to import very much, or borrow without paying high interest rates. The adoption of the strong Euro–which became the world’s second most desired currency after the dollar–created an illusion of financial strength in the less competitive economies, helping them to spend more and borrow at low interest rates. They could grow their economies, although like the US they relied on growth in the nontradable goods sector that sometimes took the form of housing bubbles. Stronger economies like Germany were only too happy to export their products and their excess savings to support the high levels of spending and debt. Only after the formation of the EMU did Spain, Italy, Portugal and Greece routinely run large deficits. “German anticonsumption policies force up the German savings rates and the German trade surplus, and European monetary policies force those surpluses onto the rest of Europe.”

Pettis sees only three possible resolutions to the European crisis:

(1) a reversal of the trade imbalances, which requires that Germany stimulate demand to the extent that it runs a large trade deficit, (2) many years of high unemployment, including, soon enough, in Germany, or (3) the breakup of the euro and sovereign debt restructuring for much of peripheral Europe including, possibly, France.

The second route is the familiar idea of imposing more austerity on the debtor countries. They got themselves into this mess, so the story goes, and so they should pay down debt and reduce consumption. The problem is that the Europe’s economy depends on the consumption of the deficit countries in order to balance the frugality of the surplus countries. If everyone tries to be frugal at once, aggregate demand will collapse, causing high unemployment throughout Europe.

Pettis much prefers the first route of higher German spending, although he admits it would require “a radical change in German understanding and commitment to Europe.” But “if Germany were to stimulate domestic consumption massively by reducing income and VAT taxes, turning its trade surplus into an equally large deficit, Spain and the other deficit countries of Europe would be able to grow their way back into health and earn the euros to repay their external debt.”

If Germany cannot make the transition to a higher-consumption society, and deficit countries cannot accept a crushing burden of austerity, then the EMU may not survive. Indebted countries would then suffer a loss of buying power as they returned to their own weaker currencies. Creditors in richer countries would also be hit, since they would have trouble collecting their debts. Since both kinds of countries share the responsibility for creating the problem, Pettis sees a certain logic in both having to share the consequences:

This makes it illogical for Germans to insist that the peripheral countries have any kind of moral obligation to prevent erosion in the value of the German banks’ loan portfolios. It is like saying that they have a moral obligation to accept higher unemployment in order that Germany can reduce its own unemployment.

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Chapter 8 of Michael Pettis’s The Great Rebalancing is called “The Exorbitant Burden,” and it deals with the peculiar position of the United States in the global economy. The title is a play on the phrase “exorbitant privilege,” referring to the common belief that Americans benefit from the popularity of the dollar as the world’s dominant reserve currency. Are countries like China doing us a favor by holding so many dollar-denominated assets like Treasury bonds, “helping” us finance our deficit? Pettis thinks not: “Countries that export capital do not help the deficit countries that import capital–on the contrary, capital exports often have adverse trade and growth impacts on the recipients.”

Rich manufacturing countries like the United States have usually been net exporters of capital and tradable goods. The unusual position of the US as the world’s biggest debtor nation is an important part of the imbalances that led to the global financial crisis.

Here again, Pettis stresses the complementarity of the imbalances. “Any policy that affects the gap between savings and investment in one country must affect in an opposite way the gap between savings and investment in the rest of the world.” If countries like China hold down consumption and save even more than they invest domestically, then other countries must consume a lot and save less than they invest domestically. According to Pettis, that’s just inescapable economic logic.

But which way does the causality run? Did the US increase its reliance on foreign capital because Americans chose to consume more and save less, or did the infusion of foreign capital from countries like China induce Americans to consume more and save less? The first way of looking at it is easier to grasp, and it may also reflect a moral preference for blaming financial problems on a lack of thrift. But Pettis reasons this way:

If the imbalance had been initiated by an endogenous consumption binge in the United States, with American investments chasing insufficient and declining domestic savings, we would have expected that rising interest rates in the United States would have been required to pull in savings from abroad to be financed….In a period however also characterized by tax cuts, foolishly conceived and ruinously expansive military adventures, and rising fiscal deficits, the fact that U.S. interest rates remained broadly stable and even declined during this period of explosive growth in the current account deficit makes it hard to believe that capital inflows were driven wholly or even primarily by endogenous demand and insufficient domestic savings.

Pettis concludes that foreign underconsumption and capital exports didn’t just enable Americans to live beyond their means; they forced Americans to choose between doing so and suffering GDP decline and high unemployment.

Why would that be? First of all, the strengths of the American economy and its currency made it a prime target for foreign investors and exporters. “Only the U.S. economy and financial system are large enough, open enough, and flexible enough to accommodate large trade deficits.” When other countries exported their surplus savings here, either investment had to rise by the same amount or domestic savings had to fall. Federal Reserve Chairman Ben Bernanke spoke of a “global savings glut,” observing that net capital inflows had risen to 6% of GDP before the financial crisis. Investment did rise, but not enough, as investors had trouble finding productive uses for all that capital.

The reason why foreigners had so many dollars to invest was that they earned them by selling us their exports. China promoted exports by holding down wages and keeping their own currency weak, while their demand for dollars kept the dollar strong. That hurt American manufacturers by keeping their products more expensive on world markets.

Now recall Pettis’s fundamental accounting identities:

GDP = Consumption + Government Spending + Investment + Net Exports
Savings = Investment + Net Exports

With net exports falling farther below zero, and investment rising too slowly to absorb the available capital and offset the decline in the tradable goods sector, only a decline in savings and an increase in household and/or government spending could keep GDP from falling and unemployment from rising.

With this background, the housing bubble that played such a large role in the recent financial crisis makes sense. Here, I think Pettis misses an opportunity to connect the dots more clearly, maybe because he feels that this part of the story is already well known. While he doesn’t elaborate the point, his analysis makes clear that the housing bubble was driven by more than just foolish buyers borrowing beyond their means. The global savings glut described by Bernanke meant that too much capital was chasing too few good investment opportunities. The decline of the tradable goods sector encouraged investors to put their money into nontradable goods, especially real estate. The rapidly expanding financial industry cooperated by increasing the volume of subprime loans and packaging them in a way that disguised their investment risk. It wasn’t just borrowers chasing loans, but lenders promoting ever-shakier debt.

The bubbles in real estate and other assets, such as stock, kept the economy growing and made Americans feel wealthier than they really were. That helps explain one of the anomalies of the pre-crisis economy, that consumption remained high even though wages weren’t keeping pace with productivity gains. The ample supply of capital fed both the investors’ eagerness to lend and the consumers’ willingness to borrow and spend.

The common prescription that Americans must borrow and spend less and save more is valid, but it leaves out too much. Declines in household consumption and government spending could easily contract GDP and increase unemployment. Avoiding that requires corresponding increases in investment and net exports. Capital must flow into useful, job-creating activity, not just asset bubbles. More of the investments must be in globally desirable tradable goods. Those changes require corresponding changes in foreign economies, particularly China, as described in the previous post. They have to let wages rise, allow their currencies to appreciate against the dollar, and not export so much savings.

Neither underconsuming nor overconsuming countries will have an easy time maintaining economic growth and high employment while making their economies more sustainable. “Growth rates will jump up and down during the long landing, but the trend will be sharply down.” Pettis notes that historically, export-based economies have suffered the most in times of global contraction, so he’s a little bearish on China. On the other hand, he believes that the United States is already starting to get its house in order, and that it will be “the first major economy to emerge from the crisis.”

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The central idea of Michael Pettis’s analysis of the global economic crisis is the inescapable connection between a country’s domestic economic policies and its global position as a net exporter or importer of capital and goods. An underconsuming economy–one with savings greater than domestic investment–will export capital and goods. An undersaving economy–one with savings less than domestic investment–will import capital and goods. These two kinds of economies play complementary–but not necessarily sustainable–roles in the global economy. We may praise the first and criticize the second because we associate underconsumption with thrift and moral discipline. But from a macroeconomic perspective, “an excessively high savings rate can be just as debilitating for an economy, perhaps even more so, as an excessively low savings rate.” Either condition can distort an economy and send it down a path toward unsustainable growth.

In today’s global economy, China is the prime example of an underconsuming society. In 2010 household consumption in China was a remarkably low 34% of its GDP. That compares to consumption rates of 60-70% in the United States, most of Europe, and many developing countries. That means that China has an extraordinarily high savings rate, so high that savings exceed domestic investment even though domestic investment is also very high. And since Savings = Investment + Net Exports, as explained in the previous post, China has also been generating “what is probably the largest trade surplus as a share of global GDP in history.”

Pettis does not attribute China’s high savings rate to any cultural tradition of thrift. After all, it wasn’t too long ago that cultural commentators were comparing Chinese cultural values unfavorably to the American emphasis on hard work and thrift. He focuses instead on recent Chinese economic policies that have discouraged domestic consumption in favor of investment. Those policies have encouraged so much saving that domestic investment cannot absorb all the capital available, and that forces the country to export capital and run a trade surplus in order to sustain its growth in GDP.

Although China has carried underconsumption to an extreme, it is hardly the first country to adopt such policies:

There is nothing especially Chinese about the Chinese development model. It is mostly a souped-up version of the Asian development model, probably first articulated by Japan in the 1960s, and shares fundamental features with a number of periods of rapid growth–for example Germany during the 1930s, Brazil during the “miracle” years of the 1960s and 1970s, and the Soviet Union in the 1950s and 1960s.

Countries that adopt such a model make a decision to base their growth on heavy investments in infrastructure and manufacturing capacity, while limiting the production and consumption of consumer goods for the domestic market. Pettis describes three kinds of policies that support this model:

• Wage constraint: Wages are not allowed to rise as fast as worker productivity. The workers’ share of the national product declines, allowing more of GDP to be saved and reinvested rather than consumed.
• Undervalued currency: The central bank sets the value of the national currency low in relation to other currencies. This weakens the buying power of consumers, while helping manufacturers compete in global markets.
• Financial repression: The central bank sets interest rates very low, hurting ordinary depositors but helping producers borrow in order to build infrastructure and expand production. Ordinary Chinese benefit less from low interest rates than Americans do, since China has little financing for consumer expenditures.

Although these policies seem harsh for ordinary workers and their households, they have generated spectacular growth in GDP. That means that national income has risen very fast. Although the share of GDP going into household consumption is low, absolute household income and consumption can still rise. Households are better off than they were before, although still disadvantaged by world standards. This leads many economists to see China as a great success story.

From his long-term, global perspective, Pettis emphasizes the down side. He sees the extraordinarily low consumption rate and the very high trade surplus as signs of “very distorted and unsustainable domestic policies, the reversal of which will be fraught with difficulty.” He believes that this underconsumption model of growth is bumping up against two fundamental constraints. These correspond to the two factors needed to balance the economic equation when consumption is low and savings are high: investment and net exports.

• Constraint on investment: If economic policies keep providing cheap capital for capital projects while also discouraging consumption, the danger is that fewer and fewer of those projects will add real value to infrastructure or manufacturing capacity. They may actually destroy national wealth by wasting it on useless or environmentally damaging boondoggles.
• Constraint on trade surplus: China’s massive underconsumption and trade surplus require other countries, especially the US, to overconsume and run up debt. Even before the 2008 financial crisis, other countries were having trouble absorbing China’s surplus, and greater austerity since the crisis is making it even less likely that they will do so.

Part of the “Great Rebalancing” Pettis recommends and expects is that China will have to reverse the policies that have encouraged savings and investment at the expense of domestic consumption. It will need to “raise wages, interest rates, and the value of the currency in order to reverse the flow of wealth from the household sector to the state and corporate sector.” The Chinese would then consume more and export less. This is easier said than done, however, because the economy is very dependent on capital projects and exports for its GDP growth and employment. “Almost certainly it will adjust with much lower growth rates driven by a collapse in investment growth.”

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Michael Pettis. The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy. Princeton: Princeton University Press, 2013

Economist Michael Pettis makes sense of the global financial crisis by applying a powerful macroeconomic theory. Like Peter Temin and David Vines in The Leaderless Economy, he emphasizes the role of global trade imbalances, saying:

There is nothing unique, unexpected, or even surprising about the recent global crisis. It was simply the necessary and chaotic adjustment after many years of policy distortions that forced large and persistent capital imbalances. The main imbalances of recent years were the very large trade surpluses during the past decade of China, Germany, and Japan and the very large trade deficits of the United States and peripheral Europe.

American developments like financial deregulation and derivative speculation may have played a role, but Pettis believes that the crisis requires an analysis of international economic relationships. Although Pettis, like Temin and Vines, focuses on trade imbalances, Pettis’s explanation strikes me as much more parsimonious and easier to follow.

One theme running through the book is what Pettis calls the “inanity of moralizing.” Because thrift is often seen as an individual virtue and a positive cultural value, many observers attribute economic problems in the United States or southern Europe to excess spending and insufficient saving. They associate debt with moral failing, whether of an individual, a government, or a nation. Pettis maintains that the consumption and savings rates of an economy “are determined largely not by the thriftiness of its citizens but by policies at home and among trade partners.” Yes, a country can suffer from too much consumption and too little saving, but it can also suffer from too little consumption and too much saving. Not only do both conditions exist, as a result of different policies, but in the global economy, they are complementary. Responsibility lies as much with the lender nations as the debtor nations.

The book’s entire argument is based on three fundamental principles that Pettis calls “accounting identities.” He prefers to present these verbally rather than in equation form, using sentences like this: “For every country, the difference between total domestic savings and total domestic investment is equal to the net amount of capital imported or exported, and so is also equal to the current account surplus or deficit.” I found myself using simple equations to drive home the logic of his position, so I’ll share them here.

To start most simply, imagine a “closed” economy with no foreign trade. Recall the standard economics equation:

GDP = C + G + I  (Gross Domestic Product = Consumption + Government spending + Investment)

Pettis says that since “everything a country produces must be either consumed or saved…a country’s savings can be defined simply as its GDP less total household and other consumption.” That gives us the equation:

S = GDP – (C + G),  from which it follows that:
GDP = C + G + S,  and when combined with the first equation above:
S = I

In other words, a closed economy is in balance when whatever not spent on household or government consumption is saved, and all such savings are invested in future consumption.

Starting from such a balanced situation, suppose that the population should suddenly become more thrifty, reducing consumption and increasing savings. People decide to stop buying as many new cars and keep their old cars longer. In order to keep GDP from falling, which would increase unemployment and reduce incomes, investment must rise to compensate for the decline in consumption (first equation above). But why should investment rise? Who will invest in new automobile plants if sales of new cars are falling?

That is why underconsumption is a classic problem in macroeconomics, while it is usually not a problem at the individual level. One reason often given for underconsumption is too much income inequality, leaving the majority of households without the means to consume very much. (Richer households don’t take up the slack because they save so much–How many cars can a billionaire buy?) And one consequence of underconsumption is too many savings chasing too few good investment opportunities, leading to excessive speculation and dubious investment schemes that go bust.

Now consider an open economy that can import or export capital and goods. Now the first equation becomes:

GDP = C + G + I + NX  (Net Exports)

“Everything a country produces it must consume domestically, invest domestically, or export.”

But the portion of GDP not consumed by households or government is still savings:

GDP = C + G + S

So it follows that S in the second equation must be equivalent to (I + NX) in the first:

S = I + NX

This last proposition, which may not be intuitive, is at the heart of Pettis’s analysis of the global economy. It means that a country must have a trade surplus when it has an excess of savings over domestic investment (think China), and it must have a trade deficit when it has an excess of investment over savings (think USA).

Pettis bases his theory partly on the work of John Hobson, who over a century ago described a relationship between imperialist trade policies and domestic underconsumption. A country with excessive inequality, underconsumption, and excess saving relative to domestic investment could export its excess savings by investing in a colony. The money that flowed out of the mother country came back when it was used to purchase the mother country’s goods.

Pettis’s first accounting principle is that every dollar (or any national currency) that enters another country must come back again, so exporting capital is equivalent to importing demand to support domestic GDP and employment. A capital surplus and a trade surplus are essentially the same thing.

Under some conditions, a capital or trade imbalance can be useful for the deficit country as well as the surplus country. For much of the nineteenth century, the United States depended on foreign capital–especially British and Dutch–because investment opportunities in its growing economy were actually greater than domestic savings could fund. But that didn’t hurt the country because “the wealth generated by foreign-funded investment was more than enough to repay the foreign debt and equity obligations.” Poor countries can also benefit by relying on foreign capital for a time. “For countries that lack technology, that have weak business and management institutions, or that suffer from low levels of social capital, foreign investment can bring with it the technology and management skills that allow the economy to grow faster than its foreign debt and equity obligations.”

Obviously, Pettis does not regard the imbalances that are involved in the recent global crisis as similarly benign. He believes that the policies supporting these imbalances distorted the economies of the countries involved–creditors and debtors alike–and created unsustainable forms of growth. How these imbalances came to exist and what role they have played in the crisis will be topics for the next posts.

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