Beneath the Surface

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

GDP = C + G + I + NX  (Net Exports)

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

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

GDP = C + G + S

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

S = I + NX

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

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

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

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

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

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