The Shifts and the Shocks (part 2)

December 17, 2014

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The second part of Martin’s Wolf’s The Shifts and the Shocks examines the deeper economic causes of the financial crisis. “This crisis was the product not just of easily fixable failings in the financial sector….It was also the product of failings of the global economic system….Moreover, both are among the consequences of fundamental shifts in the world economy.”

Wolf’s interest in looking for deeper causes sets his book apart from more superficial treatments that just blame the crisis on easy credit, foolish borrowing, and loose monetary policy by the Federal Reserve. Wolf regards these as symptoms rather than underlying causes. Returning to full employment and high economic output may be harder than most people realize, since it will require addressing some fundamental economic problems.

This part of the book is divided into two chapters: “How Finance Became Fragile” and “How the World Economy Shifted.” Again, his approach is to examine financial effects before economic causes, so the reader must follow the argument all the way through to arrive at the key conclusions.

How finance became fragile

Financial crises have been endemic to capitalism. The financial system often fluctuates between phases of boom and bust, optimism and pessimism, credit expansion and credit contraction. Wolf summarizes Hyman Minsky’s description of five stages in a financial bubble:

‘displacement’ – a trigger event, such as a new technology or falling interest rates; ‘boom’ – when asset prices start rising; ‘euphoria’ – when investors’ caution is thrown to the wind; ‘profit-taking’ – when intelligent investors start taking profits; and ‘panic’ – a period of collapsing asset prices and mass bankruptcy.

For the most recent episode of credit boom and bust, Wolf identifies five factors that contributed to financial fragility:

  • a trend toward financial liberalization and weakening of financial regulations
  • globalization of banking, lending and holdings of assets
  • financial innovations such as derivatives and shadow banking (trading of asset-backed securities)
  • leveraging (holding more debt relative to equity, magnifying returns on the upside but also losses on the downside)
  • incentive systems that rewarded risk-taking and short-term success

He also identifies three failures of policymakers:

  • underestimating the need for regulation
  • focusing monetary policy on controlling inflation, while overlooking other sources of instability
  • not intervening in the banking collapse soon enough (specifically, letting Lehman Brothers fail)

How the world economy shifted

Once again, Wolf emphasizes that despite all of these financial weaknesses, “the failure does not lie only or even mainly within the financial system or with financial regulators. The crisis had wider economic causes–and consequences.” In particular, the boom in easy credit and excessive lending depended on what Ben Bernanke called–even before the crisis–a “global savings glut.” Wolf argues that this should also be thought of as an “investment dearth,” or a problem of balancing savings and investment. The issue is sustaining economic activity by using the money not spent on consumption for investments in future production.

To a degree, investment adjusts to savings through fluctuations in interest rates. If the desire to save is greater than the desire to invest in the means of production, interest rates fall, capital becomes cheap, and balance is restored by discouraging saving (through low return) and encouraging investment (through low cost). But in an economic slump, this balancing mechanism can fail to put capital to productive use. People may choose to sit on cash, neither spending it nor buying low-interest bonds, and businesses may refrain from investing in production because the demand for products is so weak. “In brief, Mr. Bernanke’s global savings glut would be visible in a combination of two phenomena: weak economies and/or low interest rates. Today, this combination is precisely what we see in the high-income countries.”

What caused the global savings glut was primarily a shift in many emerging economies, especially China, from being net importers of capital to being net exporters of capital. Although it has been common for investors in developed countries to find investment opportunities in less developed ones, some of the latter prefer to avoid dependence on foreign capital. They choose to strengthen their economies by encouraging saving over spending, financing their own industries, emphasizing exports over domestic consumption and running trade surpluses. At the same time, some developed countries, especially Germany and Japan, were also becoming net exporters of goods and capital, partly because their aging, slow-growing populations required less investment in new infrastructure and capital equipment at home. In the words of Raghuram Rajan, “So long as large countries like Germany and Japan are structurally inclined–indeed required–to export, global supply washes around the world looking for countries that have the weakest policies or the least discipline, tempting them to spend until they simply cannot afford it and succumb to crisis.”

The largest of such countries was, of course, the United States, whose own industries were threatened by the ease with which American consumers could buy foreign goods. Making that situation worse was the strong American dollar–still the world’s most popular currency for holding cash reserves–which made American products more expensive and foreign products cheaper. However, the glut of foreign savings seeking investment opportunity brought interest rates down, discouraging saving and making it easier for Americans to buy expensive things on credit, especially housing. Investors who were reluctant to invest in faltering American manufacturing could invest in mortgage loans, including very shaky ones, which were packaged in clever ways to disguise the risks. So there was a credit boom that took multiple forms: creditor countries like China and Germany lending to debtor countries like the United States and Greece, an exploding finance industry lending to consumers within the United States, and rich investors around the world financing the US government deficit.

For most of the years leading up to the financial crisis, US business remained highly profitable, and contributed to the savings glut by running large surpluses. “With rising profits and a weak desire to invest, the non-financial corporate sector became a net supplier of savings to the rest of the economy.” The only way to keep the economy humming was for households and government to absorb excess savings by running deficits. “Persuading the household sector to spend consistently more than its income is quite hard,” Wolf says, but it was managed with easy credit. I would add that getting a Republican administration to accept large deficits ought to be hard too, but it was managed with tax cuts and wars.

One additional contributor to the savings glut and credit boom was rising economic inequality. “Finally, there was a huge shift in the distribution of income inside many economies, notably including high-income countries, from wages to profits, and, within wages, from those at the middle and bottom towards the top, partly due to globalization, partly due to technology, partly due to financial liberalization, and partly due to changes in social norms, particularly corporate governance.” While those with higher incomes could afford to save more, those with lower incomes relied more on credit to sustain consumption.

In the end, the global savings glut resulted in a massive waste of economic resources, as too little capital was put to productive use. “Instead, the resources were wasted in building unneeded and unaffordable houses or in fiscal deficits caused by unfunded wars, unfunded entitlement spending and unfunded tax cuts. The capital imported by the US, in particular, was wasted on a colossal scale.”

The final post on Wolf’s book will deal with ideas for putting the global economy on a more sustainable footing.

Continued


The Shifts and the Shocks

December 15, 2014

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Martin Wolf. The Shifts and the Shocks: What we’ve learned–and have still to learn–from the financial crisis. London: Penguin, 2014.

British economic journalist Martin Wolf provides a comprehensive account of the global financial crisis and its aftermath. The story unfolds slowly and covers a lot of ground, so the reader needs to read the entire book carefully to get the full picture.

Wolf’s own policy perspective is fairly moderate. He supported much of the economic liberalization and limitation of state power under Margaret Thatcher and Ronald Reagan, but he now believes that liberalization got out of hand and became a major cause of the financial crisis. “The financial driven capitalism that emerged after the market-oriented counter-revolution has proved too much of a good thing. That is what I have learned from the crisis.” He also faults naïve economists for exaggerating the efficiency of free markets and overlooking the signs of increasing instability, thus condoning the risky behaviors that led up to the financial meltdown.

The title of the book refers to Wolf’s distinction between the underlying shifts in the global economy that made financial markets less stable, and the actual financial shocks that caused a sharp contraction of economic activity and created a need for government intervention. In organizing the book, Wolf chose to cover the shocks in Part I and the shifts in Part II. I thought that made the book’s argument harder to follow, reversing the chronological order of events and putting the financial cart before the economic horse that was pulling it. Wolf describes the financial crisis in Chapter 1, but doesn’t discuss the reasons for financial instability until Chapter 4. He only sets the scene briefly by describing four features of an ultimately unsustainable global situation: “huge balance-of-payments imbalances; a surge in house prices and house building in a number of high-income countries, notably the US; rapid growth in the scale and profitability of a liberalized financial sector; and soaring private debt in a number of high-income countries, notably the US, but also the UK and Spain.”

When investors lost confidence in the value of the loans they had made and the assets they had helped inflate, major investment banks failed and credit dried up. That forced governments to intervene, very likely bringing to an end the era of financial liberalization. The US government took over the biggest mortgage lenders, injected capital into failing businesses, lent money to banks at zero or near-zero interest rates, and held down longer-term rates by purchasing private bonds.

Post-crisis recovery and its limitations

Judging from the size of the banks that failed, the financial crisis was even worse than the crash of 1929, but the rapid policy response kept the economic situation from becoming as bad as the Great Depression. Nevertheless, the success of the recovery has been limited by the failure of government to be even more aggressive. Wolf’s verdict is that it rescued the world economy “fairly successfully, but not successfully enough, largely because the fiscal stimulus was both too small and prematurely abandoned.”

The post-crisis recovery has been weak for many reasons: Borrowers reduced borrowing and spending and turned to paying down debt. Investors also pulled back as a reaction against previous overinvestment, especially in housing that buyers couldn’t really afford. Financial institutions became more reluctant to lend, and borrowers could no longer count on inflation to increase the price of their assets while reducing the real value of their debts. The result was a general state of economic “malaise” in which low consumer demand and low investment reinforced each other.

Wolf also discusses “sectoral balances,” the balance of income and spending within the household, corporate, government and foreign sectors of economic activity. When US households and corporations reduced spending and started generating large surpluses, the economy required deficit spending by government to avoid protracted recession. This turned on its head the old idea that government spending crowds out private spending by borrowing money that could be put to better use by business. With the central bank lending money for practically nothing and corporations failing to invest much of it anyway, Wolf argues that “the private-sector cutbacks crowded in the fiscal deficit.” He believes that if the government had followed the advice of conservatives and slashed the deficit, that would have caused an economic depression.

Nevertheless, world economic leaders became so concerned about fiscal deficits that they pledged to cut them in half at the Toronto Summit of 2010. In the US, ideological opposition to government intervention remained strong, heightened by Republican opposition to the Obama presidency:

In the US, for both electoral and ideological reasons, the Republican Party was irrevocably opposed to the idea that the government could do anything useful about the economy except by leaving it alone, and so could not tolerate the possibility that the Obama administration might prove the opposite in the aftermath of the biggest economic crisis for eighty years. It therefore dedicated itself in Congress to preventing the administration from doing anything that might improve economic performance.

The crisis in the Eurozone

While the United States was starting to recover from the financial crisis, “the epicenter of the crisis moved inside the Eurozone, where it subsequently remained.” The contraction of credit exposed weaknesses in European national economies that had been masked by the adoption of a common currency.

When each nation has its own currency, the strength of that currency can reflect the competitiveness of its economy. Weak demand for its products on world markets will usually weaken demand for its currency, and the low buying power of its currency should keep it from buying more than it produces and trades. Investors from stronger economies can lend to weaker ones, but usually at high interest rates to reward lenders for taking more risk. The common European currency papered over these national differences and encouraged an excessive flow of goods and credit from the stronger economies, especially Germany, to the weaker economies of Southern Europe, such as Spain. The fiction that every euro was worth the same made it too easy for the Spanish, Greeks, Italians and others to borrow from German banks and buy German goods. The various economies appeared to be thriving together, but only until the end of the credit boom brought the game to an end.

The credit crunch put the poorer countries in the position of either defaulting on their debts or adopting austerity measures that threw their economies into recession:

Given their difficulty in borrowing and their lack of access to central-bank financing, the crisis-hit countries could not offset these deep recessions, indeed true depressions, with fiscal or monetary stimulus, at least without external support. That was not to be forthcoming on any significant scale. This was partly because Germany, supported by other creditor countries and the European Commission, argued that necessary structural reforms would not occur without remorseless economic pressure and, for that reason, regarded greater external support as counter-productive.

Wolf criticizes Germany for refusing to accept any responsibility for the crisis:

Germany’s focus on the alleged fiscal crimes of countries now in crisis was an effort at self-exculpation: as the Eurozone’s largest supplier of surplus capital, its private sector bore substantial responsibility for the excesses that led to the crisis. As Bagehot indicates, excess borrowing by fools would have been impossible without excess lending by fools: creditors and debtors are joined at the hip. A country that chooses to run current-account surpluses, indeed, one that has built its economy around generating improved competitiveness and increased external surpluses, has to finance the counterpart deficits and must, accordingly, bear responsibility for the wastage of funds.

Wolf thinks it is misleading to blame the European economic crisis on government deficits in particular. What the troubled economies had in common before the crisis were not government deficits but balance-of-trade deficits, which were a consequence of policies in both creditor and debtor countries. After the crisis, private spending declined, but government deficits increased due to falling tax revenues and counter-recessionary spending. Fiscal austerity alone, without any other economic reforms, is a recipe for continued recession.

Emerging economies

Emerging economies in Asia and Latin America generally grew at a faster rate both before and after the financial crisis. Most of them managed to avoid credit booms that would leave them as heavily indebted as the United States or Southern European countries. On the contrary, some of them, especially China, ran large surpluses by exporting more than they imported and investing heavily in other countries. Although this has been a successful growth strategy in the short run, Wolf questions its sustainability. Again, if countries like Germany and China run surpluses, others must run deficits; and if too many countries embrace austerity at the same time, global output must fall. Like Michael Pettis, Wolf thinks it is silly to treat austerity and lending as moral goods, while treating spending and borrowing as moral evils. At the macroeconomic level, the problem is finding a balance, for example by having creditor countries increase domestic demand and debtor countries increase their exports.

My next post will deal with the global economic shifts to which Wolf attributes the financial crisis in the first place.

Continued


The Great Rebalancing (part 4)

April 12, 2013

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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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The Great Rebalancing (part 3)

April 10, 2013

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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 Great Rebalancing (part 2)

April 9, 2013

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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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