Beneath the Surface

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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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In Chapter 6, “Restoring International Balance in the World,” Temin and Vines use their model of internal and external economic balance to analyze the state of the global economy in the aftermath of the recent financial crisis. The main players in their story are East Asia (especially China), the United States, and Europe (especially the 17 nations of the European Monetary Union).

Since the 1980s, more countries in East Asia have adopted a path to growth similar to that of Britain, Germany and Japan before them, the model of rapid industrialization and expansion of exports. Rather than letting their currencies float in a way that might limit exports by making them more expensive, they pegged their currencies to the dollar at a low exchange rate, making exports cheap and imports expensive. The price they paid for that was relatively low wages and consumption for their own people, even as their export-based economies took off. Rather than spending the dollars they earned from their exports to boost their own standard of living, they lent them back to us to sustain our standard of living. They saved and lent more so that Americans could borrow and spend more.

Meanwhile, as I described in the previous post, the United States became relatively less competitive in world markets. It tried to keep its economy going by living beyond its means, importing more than it exported, having government spend more than it taxed and consumers spend more than they could afford. When the financial system collapsed under the burden of excessive and increasingly risky debt, the Great Recession ensued. Although a recovery is underway, the United States may now be forced to adjust to its uncompetitive position in another way, through fiscal austerity and high unemployment. The Federal Reserve is trying to reduce unemployment by keeping interest rates low, but it may be reaching the limit of what monetary policy alone can do. The dilemma of fiscal policy is that in the long run, spending has to fall and/or taxes have to rise to reduce debt, but in the short run, either of these measures can increase unemployment. “The US position is perhaps as bad as anywhere, in that there may be too-rapid removal of the stimulus in the short run but no coherent fiscal stabilization plan for the long run.”

The global situation is complicated by the economic condition of Europe. The European Monetary Union was formed in 1999 by twelve countries, later expanded to seventeen. Having monetary unity–a common currency–without political unity turned out to be tricky. It did promote cross-border economic activity by eliminating the confusion and risk of companies having to deal with many different floating currencies. It also seemed to provide some defense against inflation, a central preoccupation of policymakers at the time. “Gradually a view grew…that other European countries could latch themselves onto Germany by forming the European Monetary System, and that by doing so they could assume the anti-inflation credibility of the Bundesbank.” Economic policy in the Eurozone would have four main components: (1) the European Central Bank would pursue inflation control as its prime objective; (2) governments would try to maintain balanced budgets, as opposed to using fiscal policy to stimulate their economies; (3) those in a position to influence wages and prices would try to control them to maintain their country’s competitiveness; and (4) interest rates would be similar among countries. Only the first of these policies–fighting inflation–turned out to be very successful.

Differences in competitiveness among European countries undermined the system, especially the difference between Germany and the GIIPS countries–Greece, Ireland, Italy, Portugal and Spain. Having a common currency turned out to be very much like being on the gold standard before the Great Depression. The less competitive countries had trouble making their exports cheaper or imports more expensive to move toward external balance. With nominal exchange rates fixed, they could only reduce real exchange rates by reducing wages and prices, which would provoke internal resistance. As in the United States, it was easier to maintain demand by running up debt, enabled by global financial institutions seeking high returns while underestimating risks. “Capital inflows enabled increased expenditures, which strengthened the boom in these countries and made inflation worse. The opposite was true in Germany. High real interest rates and outflows of capital, organized by the German banking system, meant that German savings were not used at home but flowed to the European periphery.” So just as Chinese thrift financed American spending, German thrift financed GIIPS spending.

When the global financial crisis struck, the risks inherent in this situation became apparent, leading investors to demand a substantial risk premium–a higher interest rate–to continue lending to the indebted economies:

If a country earns less than it spends for many years because it is uncompetitive, it will be out of external balance, and it will accumulate foreign debts to pay for its imports. Tax revenues will shrink, and the government’s budgetary position will become difficult. There will be political pressures on the government to spend more to counteract the loss of activity caused by the loss of competitiveness, making the fiscal position worse. Financial markets will begin to fear that the country’s government might default on its debt, and a sovereign risk premium will emerge.

The indebted countries of Europe are now turning toward austerity, as is the United States, but the European countries are having it forced upon them suddenly as a condition of financial assistance from the rest of Europe. This has led to large reductions in spending and increases in unemployment. Temin and Vines argue that stronger economies, especially Germany, need some expansion of demand in order to compensate for austerity elsewhere. Otherwise, aggregate demand will fall for Europe as a whole, contributing to global recession. Germany has the potential to become the next hegemonic power, acting for the good of other countries, but so far has not embraced that role.

Germany is forcing a speedy and unprecedented degree of austerity adjustment on the GIIPS. But Germany is not ensuring a correspondingly rapid expansion of demand at home. Instead, it is using its competitive position to ensure that it grows rapidly by means of an export surplus. The external surplus of Germany, caused by an overly competitive position and inadequate internal demand, is making it impossible for the GIIPS to achieve either internal or external balance.

Now let’s combine the European story with the US-China story to see the three regions in combination. The US dollar and the European euro have a floating exchange rate, and that tends to avoid persistent external imbalances where either the US or Europe is unable to pay for its exports with its imports. (According to the Swan IB/EB model, weak demand for either’s products would push down its exchange rate, making its exports more attractive.) But in relation to the Chinese renminbi, both the dollar and the Euro are too strong, damaging the competitiveness of both the United States and Europe. That gives both Europe and the United States an incentive for fiscal caution, if they want to avoid a trade deficit and excessive debt. The northern European economies, especially Germany, have exercised that caution for a long time, while the Americans are just starting to. That’s why the Western trade deficit encouraged by the East Asia trade surplus and weak currency has become largely an American problem. “Low demand in China causes a current account surplus between China and the rest of the world. But Europe’s high savings means that Europe does not run a deficit. The surplus of China is mainly maintained at the expense of the United States. This is the story of the US deficit.”

So here’s the problem: Countries that have been running deficits, notably the United States and the GIIPS countries of Europe, need to pay down debt and move toward austerity, at least gradually. But countries with surpluses, notably Germany and China, cannot maintain their frugality at the same time. If all countries try to curb spending and import less than they export, aggregate demand cannot absorb productive capacity, global output will fall, and global recession will occur. No matter how sensible austerity seems to each country considered alone, global austerity will bring them all down together. The Chinese will need to raise wages and produce more for domestic consumption. The Germans will need to save less and spend more, risking inflation, and it will also need to take the risk of lending to troubled economies so that they can hold down unemployment while they make the transition to greater competitiveness. No other country is in a better position to take those risks. During the Great Depression, Germany made a bid for hegemonic power through military conflict and lost. Now it has an opportunity to assume hegemonic power through peaceful cooperation, resulting in a win-win.

By the way, I wish the authors had given more attention to the qualitative ways of increasing competitiveness. They focus primarily on quantitative adjustments–lowering the nominal exchange rate, lowering costs of production, and so forth. But if a debtor nation can invest in new activities that can find a global market, it may be able to increase exports without just weakening its currency or cutting costs. It can move away from living on credit without moving toward too much austerity. The authors seem to share that goal, but they don’t discuss that way of achieving it.

Although they see a significant risk of continuing global recession, Temin and Vines try to end on a hopeful note. They cite the collaborative process by which the G20 financial leaders (finance ministers and central bank governors from 20 nations representing about two-thirds of the world’s population) have formulated global economic objectives and engaged in an ongoing assessment of progress toward meeting them. In 2011, the G20 Mutual Assessment Process analyzed the policies of seven countries (US, Germany, France, UK, China, Japan and India) and made recommendations similar to those of this book. The authors also report that things are moving in the right direction in China, with expansion of domestic demand, rise in the real exchange rate, and decline in the trade surplus. They remain concerned about trends in the US and Europe, however:

The pressure for austerity, reducing domestic demand, echoes the policies of the early 1930s that led to the Great Depression. And the absence of a hegemon makes it harder to come out of these troubles into anything like the golden age of economic growth that followed the Second World War. We hope that our exposition will help national leaders adopt policies that point us toward the restoration of international economic balance and prosperity.

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My previous post described the Keynesian economic models that Temin and Vines use to explain the relationships between national economies and the global economy. The title of their book represents an overarching theme in their analysis: the need for some strong country to take the lead in fostering international cooperation and global economic growth.

Countries are economic competitors for export markets, but they are also trading partners. Each country benefits by having trading partners that can afford to buy its goods and pay for them with their own exports. Economic collapse in one country hurts other countries, and assistance to a struggling country may be in the long-run best interest of all countries. Such assistance carries risk, however, since it comes with no guarantee of a reciprocal benefit to the country providing the assistance. Temin and Vines believe that the global system works best when it contains one particularly strong country that can afford to take the risk of international leadership. Using the language of world systems theory, they refer to that country as the “hegemonic power.” The authors explain this further using the game-theory concept of the “prisoner’s dilemma,” but I don’t find those details essential.

The United States emerged as the hegemonic power after World War II, providing extensive assistance to Europe with the Marshall Plan and bringing nations together at Bretton Woods, New Hampshire to organize a new monetary system. Many of the ideas of what needed to be done came from John Maynard Keynes, whose thinking developed partly as a reaction against what Britain had failed to do to avoid the Great Depression and the war with Germany. Britain was the world’s strongest economy until the early 20th century, but its competitive position had weakened as the United States and Germany developed new industries like steel and chemicals, and even its established industries like textiles had failed to adopt more advanced methods. Not only did Britain’s weakened economic position undermine its international leadership, but British leaders made several policy blunders that contributed to the Depression, as Keynes saw it. Britain helped cripple the German economy and weaken its democracy by imposing crushing reparations after World War I, and it hurt itself by remaining on the gold standard throughout the 1920s. Fixing the value of the pound at too high a price in gold encouraged people to cash in pounds for gold or other currencies, leading Britain to defend the pound by keeping interest rates too high (trying to reward holders of pounds with a high return). These are contractionary policies that weaken aggregate demand and raise unemployment. (Recall that in the IS/LM model, the higher the interest rate, the lower the level of production at which demand balances supply; and in the IB/EB model, the higher the real exchange rate, the lower the level of domestic demand at which imports will balance exports.) At the onset of the Depression, Herbert Hoover was making the same mistakes in the US, maintaining the gold standard and raising interest rates. By the early 1930s, both countries had ended the gold standard and adopted more expansionary fiscal policies. Temin and Vines consider the Great Depression an “end-of-regime crisis” which brought Britain’s hegemonic power to an end and passed the mantle of leadership to the United States.

By the Bretton Woods meeting in 1944, Keynes had formulated the economic policies he believed necessary for postwar prosperity.

Keynes aimed to establish a policy framework in which individual countries like Britain would be able to promote high levels of employment and output by means of demand-management policies, mainly in the form of fiscal policy. This would, it was hoped, avert slumps in growth and would prevent the reemergence of the kind of global depression that had occurred in the 1930s. Each country would pursue internal balance.

But Keynes saw that such policies would need global support, because they would have to be reconciled with the need for each country to be sufficiently competitive. That is, each country would need to be able to export enough to pay for the imports that would be purchased at full employment.

The specific policies he recommended included management of domestic demand to maintain full employment, pegged but adjustable exchange rates to maintain the balance-of-payments between countries, reductions in tariffs to increase free trade, and international lending to foster economic development. He foresaw international institutions such as the International Monetary Fund, The World Bank and the World Trade Organization. The Bretton Woods agreement set up a system of exchange rates along the lines Keynes recommended:

The IMF oversaw a global system of pegged-but-adjustable exchange rates. A deficit country was declared to be in “fundamental disequilibrium” if it wished to import more at full employment than it was able to cover from its exports. Exchange-rate pegs were not to be adjusted (unless there was a fundamental disequilibrium) to prevent countries from stealing jobs from one another by beggar-thy-neighbor devaluations. But deficit countries in fundamental disequilibria were required to adjust their exchange rates. Lending from the IMF was available to cover liquidity problems during the adjustment period. Surplus countries in fundamental disequilibrium—that is to say, countries exporting more than the amount required to pay for what would be imported at full employment—were also required to adjust.

Under this system, a country whose exports were in much less demand than its imports could restore balance by lowering its exchange rate, making its exports cheaper and its imports more expensive. Anchoring the system of adjustable exchange rates was the stable US dollar, which once again was given a fixed price in gold. This made the dollar the world’s strongest currency, but that was okay as long as the United States was clearly the world’s strongest economy. The system worked well from 1945 until 1971, helping to make that period “the most remarkable period of economic expansion that the world had ever known.”

In the late 20th century, it was the United States that became the faltering hegemonic power. The story is in some ways similar to Britain’s earlier story, involving a combination of declining global competitiveness and domestic policy blunders. The country’s competitive position after World War II was exceptionally strong, since it was producing over one-fourth of all the goods and services in the world. Challenges were inevitable sooner or later, especially from European recovery and Asian development. The transition to a less dominant economic position was complicated by the expansionary fiscal policies of the Johnson administration, especially the failure to raise taxes to pay for the unpopular Vietnam War. With the economy already operating at high capacity, the additional fiscal stimulus pumped up consumer demand, generating both inflation and an excess of imports over exports. The combination of the dollar’s fixed price in gold but declining buying power threatened a run on the dollar, which the Nixon administration avoided by taking the US off the gold standard and letting the dollar float like other currencies. “The resulting devaluation corrected the external imbalance, but it made the internal balance worse by intensifying American inflation.” “Supply shocks” such as the higher price of oil contributed as well. President Carter’s new Federal Reserve Chairman, Paul Volcker, adopted a monetary policy so strict that it not only brought down inflation, but threw the economy into recession. When it recovered in the 1980s and after, it seemed for a time that internal equilibrium had been re-established, and by 2000 economists were speaking favorably of the “Great Moderation.” What was overlooked by many was that a worsening external imbalance was enabling the internal balance. Americans were increasingly living beyond their means, exporting too little, importing too much, and sustaining domestic consumption by accumulating government and household debt.

Why wasn’t the US trade deficit mitigated by a decline in the value of the dollar, which is what’s supposed to happen in a system of floating exchange rates? The main reason is that other countries, especially China and other East Asian countries, prevented that in order to protect their export-led economies. Instead of letting their currencies float upward, they pegged exchange rates at a level that kept their currencies cheap and the dollar strong. Then they took many of the dollars they earned with their exports and lent them back to the US, making us the world’s biggest debtor.  This arrangement made imports to the US cheap and exports more expensive, hurting US manufacturing on world markets. It also encouraged borrowing and spending by Americans enabled by saving and lending by foreigners. Our economy could remain strong only if government and consumer spending were high enough to compensate for the lack of foreign demand for our products. The Reagan-Bush reductions in taxes and increases in military spending helped fuel domestic demand, as did looser monetary policy by the Federal Reserve under Alan Greenspan, especially after 2001. Remarkably, foreign countries continued to finance our deficits even as lower interest rates diminished their returns.

At the same time, the distribution of American income was changing, with more going to the richest 1% and less to the bottom 80%.  (This is partly a result of globalization too, because of the loss or outsourcing of good manufacturing jobs.) After-tax income was becoming even more skewed, since the Reagan and Bush tax cuts were directed especially at the wealthy. The wealthy had more money to lend, while the less wealthy had more reason to borrow in order to achieve their financial goals, such as home ownership. With interest rates low, investors had an incentive to seek higher returns in riskier investments, such as sub-prime loans and the even riskier derivative securities based on those loans. While the manufacturing sector declined, the financial sector boomed, and financial institutions created new instruments like collateralized mortgage obligations, pools of mortgages that offered high returns while disguising risks. Rating agencies overrated these instruments by assuming that they were diversified enough to minimize risk, overlooking the possibility that a general decline in home prices or incomes would cause many borrowers to default simultaneously. Under-regulation of the financial industry, including a refusal to regulate derivative securities at all, made it even easier to engage in risky behavior.

In short, the choices the United States made in the face of its declining international strength were crucial. The tax cuts, financial deregulation, and choice of a low level of interest rates— instead of ensuring that the dollar devalued— are fundamental to our story. They left the United States in internal balance but with an external imbalance. The United States encouraged expenditure through financial deregulation and a low level of interest rates. This unhappy combination caused the financial bubble, which led in turn to the crash.

The internal balance in which demand absorbed productive capacity turned out to be unsustainable, since it depended ultimately on spending in excess of income by government, by consumers, and by the country as a whole. The bubble had to burst when prices fell in the overheated housing market, borrowers began defaulting on loans that were larger than their homes were worth, investors began panic-selling the overvalued mortgage-backed securities, and large investment banks failed when they were caught holding too many toxic assets themselves.

Temin and Vines regard the recent global financial crisis as another “end-of-regime crisis,” this time marking the end of American hegemonic power and global leadership.

How do we know that this is the end? We know because of the lack of leadership from the United States to revolve the crisis. The United States turned belligerent after the suicide attacks on September 11, 2001, echoing the frustrated policies of Germany between the world wars and leaving the world economy leaderless. The United States set the example for bank bail-outs during the crisis itself, but then vanished as a world leader….The country has become part of the problem rather than a leader orchestrating the search for a solution to it.

Continued