Austerity: The History of a Dangerous Idea

August 22, 2013

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Mark Blyth. Austerity: The History of a Dangerous Idea. Oxford University Press, 2013.

Austerity has emerged as a dominant–if not the dominant–public policy response to the financial crisis and ensuing Great Recession. In Europe, leading politicians and central bankers impose austerity measures on struggling economies as a condition of receiving loans, forcing their governments to curb spending, reduce public payrolls and cut public-employee pensions. In the US, Republican lawmakers have become preoccupied with spending cuts to the exclusion of almost every other public policy besides national defense. Apparently, the economic crisis has encouraged the view that nations are out-of-control spenders who must be reined in for the good of the economy.

Mark Blyth, Professor of International Political Economy at Brown University, joins an increasing number of political scientists and economists who are questioning the rush to austerity. Is it really good economics, or is it a blend of weak economic arguments and strong political opportunism?

Blyth defines austerity as:

…a form of voluntary deflation in which the economy adjusts through the reduction of wages, prices, and public spending to restore competitiveness, which is (supposedly) best achieved by cutting the state’s budget, debts, and deficits. Doing so, its advocates believe, will inspire “business confidence” since the
government will neither be “crowding-out” the market for investment by sucking up all the available capital through the issuance of debt, nor adding to the nation’s already “too big” debt.

Blyth regards austerity as a dangerous idea for several fundamental reasons. First, there is little hard evidence that austerity policies actually work to pull countries out of economic recessions. Second, austerity is unfair to the poor, who end up paying for the financial mistakes committed by the rich in their own self-interest. Third, the argument for austerity rests on fallacious reasoning and misrepresentation of economic facts.

The main fallacy here is the “fallacy of composition,” which assumes that what is true for the parts is also true for the whole. Although an individual household can improve its economic position by cutting spending, that is less true for an entire nation or the global economy. As Keynes explained with his “paradox of thrift,” too much saving by too many people at the same time reduces consumption, discourages investment and perpetuates high unemployment.

The main misrepresentation of economic facts is the characterization of the crisis as primarily a “sovereign debt crisis” brought on by too much government spending. Blyth views it instead as “a banking crisis first and a sovereign debt crisis second.” Austerity is partly a political argument intended to shift responsibility from powerful financial interests to ordinary citizens. It has also become a kind of morality play. “Austerity is the penance–the virtuous pain after the immoral party–except it is not going to be a diet of pain that we all share. Few of us were invited to the party, but we are all being asked to pay the bill.”

In Part One of the book, Blyth sets out to explain how the private sector generated the crisis in both the United States and Europe. With regard to the US, economists have identified many contributing causes, but Blyth focuses on the four he regards as most essential:

  1. During the US housing boom, banks not only made too many risky mortgage loans, but the large investment banks relied too heavily on mortgage-backed securities as collateral for their own borrowing. When those securities lost value, there was a run on the banks in the “repo” market where businesses lend to one another. Credit dried up, and banks had to start dumping assets to maintain their liquidity and solvency.
  2. The availability of “credit default swaps,” which in effect insured banks against mortgage defaults, both encouraged banks to be more reckless in issuing mortgages and mortgage-backed securities, and spread mortgage risk to the insurers.
  3. Financial analysts grossly underestimated the probability that a large number of financial assets could lose value at the same time. They assumed that individuals acting in their own self-interest could manage risk, but what actually happened was that many self-interested actions combined to create a systemic risk too large for the private financial sector as a whole to manage.
  4. The prevailing neoliberal economic ideas celebrated the rational individual and the efficient markets that result when such individuals are free to make their own economic decisions. They did not anticipate large-scale systemic failure or support market regulations to prevent it.

In Europe too, the crisis “has almost nothing to do with states and everything to do with markets. It is a private-sector crisis that has once again become a state responsibility.” Ireland and Spain did not have excessive debts or deficits before they experienced privately funded housing bubbles. The problem in Portugal and Italy was not primarily public debt either, but low-growth, low-productivity economies. One country that did engage in excessive public borrowing and spending was Greece, where the government was trying “to increase personal income and public consumption, an understandable response to decades of instability, violence, and political polarization.” The advocates of austerity used the case of Greece to brand the entire European crisis as a “sovereign debt crisis,” with government belt-tightening the primary solution.

Leading up to the crisis, the European banks engaged in some of the same reckless borrowing and lending that brought down the US economy. But in this case, they were aided and abetted by the European Monetary Union. The replacement of local currencies by the supposedly stronger euro made lending to weak economies like Greece and Italy seem safer. Interest rates fell dramatically in the peripheral countries, indicating that debts owed in euros were considered less risky. Yet the yields remained high enough to motivate European bankers to flood the periphery with cheap money. “While the Northern lenders lent to local banks, property developers, and the like, periphery consumers used this tsunami of cheap cash to buy German products, hence the current account imbalances….” The stronger core and the weaker periphery seemed to be getting rich together, the core by exporting capital and goods, and the periphery by importing them. Relative to the GDPs of European countries, European banks held financial assets far greater than those of US banks, and those assets included many of the same shaky securities that brought down US banks. Once the banks started to fail, the credit crunch hurt all the weak economies, whether they already had heavily indebted governments or not. Now many governments faced higher borrowing costs, the expense of bailing out troubled banks, and the declining tax revenues and higher social expenses resulting from a contracting economy. So what began primarily as a private banking crisis quickly became a sovereign debt crisis.

One could argue that even if the financial crisis originated in the private sector, public austerity is still required to resolve it. In Part Two of his book, Blyth examines the historical record for evidence that austerity is good economic theory or good policy.

Continued

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Macroeconomics and Moral Judgment (part 2)

July 6, 2013

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In my last post I argued that the study of economics should inform but not eliminate our individual moral judgments as citizens in a democracy. Economics shifts our attention from the virtues and vices of individuals to the strengths and weaknesses of fundamental economic policies. But that doesn’t mean we have to attribute economic events like the recent financial crisis just to impersonal economic forces. Policies are made by people, and some people have more influence on them than others.

To illustrate how a macroeconomic perspective can inform our moral stance, consider the distinction between personal saving and national saving.

Saving: the more the better?

Recently, I posted a series of investment guidelines called “Principles of Sound Investing.” The very first principle I discussed was “Live within your means,” dealing essentially with the virtues of saving. A household’s savings rate is a crucial determinant of its ability to sustain its income into the retirement years. This is partly just a matter of mathematics. By making assumptions about rates of return, longevity, and so forth, financial planners can calculate recommended savings rates, which usually come out in the range of 10-15%. But the issue also gets entangled with our ideas about how people should live. We tend to think of people who can save for tomorrow as frugal and responsible, while people who run up debt by spending beyond their means as self-indulgent and irresponsible.

Macroeconomics provides a different perspective on saving, one that focuses on national savings rates, not just household savings rates. From this perspective, saving is also a good thing, but only up to a point. Saving provides capital for investment in economic enterprises, which sustains economic production and supports future consumption. National production and national income depend in part on national saving. However, they also depend on national consumption, since producers can’t sustain or increase production if consumers aren’t buying. Too much consumption and too little saving can be a problem, but so can too much saving and too little consumption. That’s why the messages from advertisers seem at odds with our ethic of frugality: Go ahead, live it up; buy that sports car; you deserve it! Already in the 1950s, William H. Whyte was describing how the mass-consumption economy was undermining our traditional ethic of thrift.

Economists like Michael Pettis argue that underconsumption can be just as big an economic problem as overconsumption. He warns us against applying our individualistic conceptions of virtue to entire countries, seeing countries with a high ratio of savings-to-consumption like China and Germany as good, and those with a low ratio of savings-to-consumption like the United States and Greece as bad. In the global economy, the two kinds of countries are complementary, and together they have created the global imbalances that resulted in the financial crisis.

One country’s underconsumption enables and even forces another country’s overconsumption, through its export of goods and capital. A country whose citizens spend too little to absorb its productive capacity can rely on exports to keep the economy booming. But for that country to be a net exporter, generating trade surpluses, some other country must be a net importer, running up debt.

Underconsumption as a growth strategy

In addition to seeing underconsumption as a possible problem and exports as a solution, global macroeconomics can see underconsumption and exports as two sides of a conscious strategy for growing an economy. The idea is to hold consumption down, limit the production of consumer goods for the domestic market, and invest heavily in infrastructure and export industries. That’s been a common model for developing countries in Asia recently, as well as in countries like Brazil and the Soviet Union somewhat earlier.

The prime example of an underconsumption growth strategy today is the Chinese economy. Several key policies support that strategy. Employers raise wages at a slower rate than worker productivity. The central bank sets the value of the national currency low in relation to other currencies, reducing the buying power of Chinese consumers while making Chinese goods cheap on world markets. The central bank also sets interest rates very low, hurting ordinary depositors but helping producers borrow to expand production. The low interest rates are more helpful to producers than consumers, since China provides less financing for consumer expenditures.

This is one way to grow an economy, but it is not without costs. It limits the ability of the domestic population to benefit from the results of their own increasing productivity. In addition, it leads some other country to compensate by spending beyond its means, which it can’t do forever.

US debt in global perspective

What do the Chinese (and other net exporters) do with all the dollars they make by selling things to Americans? One thing they don’t do very much is buy our goods. If they did, the trade imbalance wouldn’t be so large. What they do a lot is lend those dollars back to us by purchasing US securities. They are net exporters of capital as well as net exporters of trade goods.

Here I’ll repeat what I said in an earlier post about international capital flows, quoting at some points from Pettis: 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.”

Today, of course, the United States is no longer a poor country, nor a developing economy with more investment opportunities than we can fund ourselves. The large infusion of foreign capital into the US economy before the crash appears to have hurt the economy more in the long run than it helped it. With our manufacturing sector in decline and our net exports falling, there wasn’t much demand for new capital to expand production, at least not enough to absorb what Ben Bernanke has called a “global savings glut.” Instead, the capital went heavily to finance consumer and government spending. Economic activity was sustained, for a time, by running up government and personal debt. Foreigners bought a lot of Treasury bonds and–more relevant to the financial crisis–mortgage backed securities. The glut of capital pushed interest rates down, encouraging investors to “reach for yield” by considering untraditional but potentially high-return investments, such as the complicated pools of mortgages assembled by Wall Street firms.

So the housing bubble was driven by much more than irresponsible buyers borrowing beyond their means. A housing boom was one way to sustain a high level of economic activity in an increasingly uncompetitive US economy. It gave investors one place to invest and households one way to get ahead. We no longer seemed as capable of making products the world wanted to buy or expanding the middle class by raising wages. But we could finance an increase in home ownership anyway by making shakier loans and packaging them so they appealed to investors.

Economic imbalances

The financial crisis resulted from unsustainable imbalances in the global economy, especially the imbalance between net importers and net exporters, debtors and creditors, high-consuming and low-consuming nations. The economies involved had their own internal imbalances. China grew its export industries at the expense of domestic consumption. In the United States, the financial services industry boomed while manufacturing languished. We financed consumption more creatively than we developed the products and workforce required for success in the twenty-first century.

Economic imbalances also developed in Europe. Germany became a net exporter and creditor, while poorer countries like Greece became net importers and debtors. The use of a strong common currency, the euro, enabled the debtor countries to buy more than they should have, just as the strong dollar enabled Americans to import so much. One difference is that in Europe, the poorer countries are usually the debtors, while in the US-China relationship, it’s the richer country that is the debtor.

One lesson to learn from all this is that it takes both creditors and debtors to create a debt crisis. Those who heap moral blame on the debtors alone are not seeing the larger picture. Furthermore, the solution cannot just be that the debtors change their behavior to emulate that of the creditors. Since the roles are complementary, changes on one side require changes on the other side. The polices and practices of creditor economies depend on those of debtor economies. If Greeks and Americans suddenly adopted the frugality of Germans and Chinese, without complementary changes on the other side, the decline of consumption would produce global economic contraction and higher unemployment.

As the United States tries to solve its problems as a debtor nation, we don’t want to undermine the high output of our own economy either. Four things drive economic activity: household consumption, government spending, investment and net exports. (Since the US is a net importer, the last part of the equation drives foreign economies instead of our own.) Living beyond our means has been a way of sustaining aggregate demand for economic goods and services, both domestically and globally. Telling households and government to spend less may sound wise and responsible, but it fails to address the larger question of how to rebuild our economy on a stronger foundation. How can we grow the economy in a more sustainable way, without relying on consumers and government to spend beyond their means and run up debt? That is the subject of my next post.

Continued

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Macroeconomics and Moral Judgment

July 6, 2013

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Many of my posts over the past year have aimed at making sense out of the Great Recession that began in 2008. Several of the books I’ve discussed here have dealt with it specifically: Alan Blinder’s After the Music Stopped, Michael Grunwald’s The New New Deal, Michael Pettis’s The Great Rebalancing, and Peter Temin & David Vines’s The Leaderless Economy. I have found the latter two works especially helpful in seeing the recession from a global macroeconomic perspective. For one thing, international capital flows helped produce the housing bubbles in the United States and other countries.

In this post I want to raise the question of how an understanding of large-scale economic relationships might affect one’s moral judgment about economic behavior. Once that we have a better idea how the recession happened, are we–or should we be–more critical of the policies and practices that led up to it? Do we see moral failures where we didn’t see them before? Do we appreciate how wide and deep the responsibility lies? Or are we so overwhelmed by the economic complexity of the whole thing that we give up trying to assign any moral responsibility at all?

Finding villains

When things go wrong in society, a natural response is to find someone to blame. During the Great Depression of the 1930s, many Americans blamed Wall Street speculators for pushing up stock prices to unsustainable levels. They also vilified Herbert Hoover for policies that made the Depression worse, and they called the shantytowns that housed the homeless and unemployed “Hoovervilles”. They celebrated Franklin Roosevelt as the hero who rescued them, making his Democratic Party the dominant political party for decades afterwards.

Our Great Recession struck a much more polarized society, making it much harder to agree on villains and heroes. A popular conservative response has been to blame homeowners who borrowed more than they could repay, along with those in government who wanted to help them. When the Obama administration proposed assistance for people who were in danger of losing their homes, CNBC reporter Rick Santelli delivered an angry rant from the floor of the Chicago Mercantile Exchange, saying that the proposal would “subsidize losers’ mortgages.” This was a variation on an old theme in American conservatism: the economically successful are the virtuous ones, and it’s the losers whose irresponsible behavior is the problem. (To be fair, many conservatives also opposed helping the big banks, but in the end, the “too big to fail” argument carried the day there.)

Progressives tend to find their villains near the top of the economic pyramid. Teddy Roosevelt attacked the “malefactors of great wealth,” describing a battle “to determine who shall rule this free country—the people through their governmental agents, or a few ruthless and domineering men whose wealth makes them peculiarly formidable because they hide behind the breastworks of corporate organization.” The Occupy Wall Street movement has focused its attack on the richest 1% of the population, and especially Wall Street bankers. More specifically, many observers blame the Great Recession on:

  • Subprime lenders: In order to make more loans, lenders lowered their lending standards and made more subprime loans–loans with less favorable terms for people with shakier credit. They moved away from the traditional 30-year fixed-rate mortgage and heavily promoted more confusing arrangements like adjustable-rate mortgages with temporarily low “teaser rates.” They became less concerned about defaults because they increasingly sold off their mortgages to financial firms that packaged them for sale to other investors.
  • Investment bankers: Wall Street firms bought mortgages and repackaged them as complicated Collateralized Debt Obligations (CDOs). These pools of mortgages were divided into slices called “tranches,” with varying degrees of risk. In theory, at least some of the tranches were supposed to be extremely safe; in practice, even the safest ones were riskier than they were cracked up to be.
  • Rating agencies: Since the securities rating agencies were paid by the banks whose securities they rated, they had little incentive to be critical. Previously exclusive AAA ratings went to too many risky securities that ultimately collapsed.
  • Regulators: Both Congress and regulatory agencies such as the SEC and Federal Reserve acquiesced to financial lobbyists and resisted calls for regulatory reform to deal with the increasingly risky financial practices. In particular, they exempted derivative securities (those like CDOs that derive their value from other securities) from regulation.

Economics and moral engagement

An economic understanding of how the housing bubble grew and then burst can help focus our moral outrage on the most responsible players. On the other hand, it could also muddy the ethical waters. After all, economics in general–and macroeconomics in particular–isn’t about personal moral decisions. It’s about impersonal economic forces like supply and demand and interest rates and global capital flows. Maybe subprime lenders and investment bankers were just responding rationally to market conditions, doing what they needed to do to make a profit. One could argue that individuals are just cogs in some gigantic economic machine, and bad things like severe recessions just happen from time to time. Maybe we should react to them the same as we react to hurricanes–we don’t like them but we can’t blame anyone for them. In other words, maybe the effect of economics is to substitute analytic detachment for moral engagement.

And yet, complete moral disengagement certainly doesn’t work, even for climate events. They are coming to be seen as partly a result of human activity, for which we need to take some responsibility. And that should be even more true for the economy, which is, after all, a human creation.

A less extreme argument for moral disengagement is that someone must take responsibility for good economic policy, but ordinary citizens lack the expertise to do so. They should leave it to the experts. The job of keeping the economic machine humming along is a job for economists and others with technical skills. This is an appealing argument. Many people seem willing to put a relatively small number of people in charge of social institutions, as long as they are selected on the basis of merit. However, Chris Hayes’s book Twilight of the Elites tries to show that even a hierarchy originally based on merit has a tendency to become self-serving and detrimental to democracy. In the aftermath of the financial crisis, economists themselves got some criticism for being too cozy with powerful financial firms, having too rosy a view of the economy, and completely missing the impending disaster.

Call me a liberal, but I think that an informed and morally engaged citizenry is essential to a democratic society. The average citizen cannot be an expert on the details of every policy issue. But each citizen can try to tell the difference between policies that serve the broad public good and those that serve some narrower interest.

Macroeconomics does not have to make ordinary people disengaged, resigned or fatalistic about economic events. What it can do is inform and shape their moral judgments, so they have a clearer and more realistic idea about what is right or wrong about economic policies and practices. It can shift the focus from a few obvious players in an economic drama to the more fundamental economic choices that societies make. That’s what I’ll be trying to illustrate as I discuss the global macroeconomics of the Great Recession in the following two posts.

Continued

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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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