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.”