“…not with a bang but a whimper”
by Michael Pettis, China Financial Markets
This is an expansion of the interview I gave to Doug Pancoast of Controversial Truth. The focus of the interview was a discussion of some of the topics in my books, The Great Rebalancing and Avoiding the Fall: China’s Economic Restructuring. In what follows the material in the interview is increased significantly with a lot of examples and with historical material that I find very interesting.
- I was so impressed with how fair and evenhanded you are in the books and how you try to consider the viewpoints of all sides. I try to do this in my own writing, but find that it is sorely lacking in today’s society (and indeed throughout much of history). How do you manage to stay so unbiased and so fair in a world where people are tempted to be so prejudice towards one side or another?
Thanks for saying that. To the extent that it is true I think in part it may be because my background is pretty multinational. I was born in Spain of a US father and a French mother, and I grew up in Spain, Pakistan, Peru, Haiti, and Morocco, I have sisters-in-law from Iran and Brazil, I currently live in China, and my whole career and education has been “international”. Perhaps this has forced me to break free of a very provincial attitude among economists, especially those from large countries like the US or China, that among other things prevents them from recognizing how powerful global linkages can be. Everyone knows in principle that changes in one country that affect total production or total consumption automatically require predictable obverse changes in another, but economists often still have a hard time identifying these linkages and acknowledging the direction of causality, even though they know the accounting identities around which the balance of payments is structured that require these adjustment. What is more, they almost always assume that except in the most obvious cases, like the impact of China on the price of steel in the US, events can only originate in the US, or perhaps in Europe, and then cause events elsewhere.
In fact this isn’t true. Because the US economy and its financial markets are so large and flexible, and because many other economies have large players – usually the state – whose behavior can drive deep domestic imbalances, it is often the US that responds to events driven abroad. For example after the 1997 Asian external debt crisis, a number of Asian countries began to accumulate US dollar reserves, and this accumulation accelerated in the next decade. It is purely an accounting identity that if other countries become next exporters of capital to the US, they must run current account surpluses (although not necessarily bilateral surpluses, which are in fact unlikely) and the US must run current account deficits (although not necessarily bilateral deficits, of course), and it is also purely an accounting identity that if the US runs a current account deficit, its domestic savings must be lower than its domestic investment.
Every economist knows this, or should know this, and yet to say that the surge in the US current account deficit during the decade before the 2007-8 crisis was a necessary adjustment to Asian reserve accumulation policies of the last decade is considered an extremely political statement. Some economists in the US counter this claim by arguing that the US deficit cannot be caused by Asian reserve accumulation polices because it has bilateral deficits with many countries, or, what is even more absurd, because it has a low savings rate. It is true that in principle the capital-flow imbalances could have been caused by a decision by American households to reduce their savings rates sometime around 1997, which forced someone else – the East Asians, for some reason – to raise their savings rate, but it is hard to explain why excess US demand for foreign savings, and not excess supply of foreign savings, would have been accommodated by declining, not rising, interest rates.
It seems so logical, and yet it has become such a politicized argument in which the balance or payments identities are almost never invoked. I suspect the prejudice thatonly Americans can act independently, and everyone else must respond, may exist at least in part because most economists have either studied in the US or have studied under US-trained economists, and so without realizing it have developed a US-centric view of the world that cannot posit an alternative world.
I remember reading in the early 1990s for example a very interesting book about the US “long depression” of the 1880s and 1890s that began with the September 1873 crash in the NY Stock Exchange. The book explored the roots of the crisis in the railroad boom of the 1860s and wonderfully invoked the famous attempt by Jay Gould and James Fisk to corner the gold market in 1869. There was however almost no reference to events outside the US except in describing how the New York crisis subsequently affected British banks. It seemed that for the authors, events in the US pretty much explained everything that happened in the US economy before and after the 1873 crisis.
It wasn’t until a few years later when I read Charles Kindleberger’s brilliant book, A Financial History of Western Europe, that I realized that the 1873 crisis was a global crisis, and that it didn’t even originate in the US. It actually began in May, 1873, with the collapse of the Vienna stock market, which spread to Berlin and London before it hit New York. I also learned that the roots of financial instability included the 1866 collapse of Overend, Gurny, a major London bank, and that stock markets around the world had soared shortly after Barings had financed the huge French war indemnity forced upon France after the 1870 Franco-Prussian War. One of Kindleberger’s great insights was that the recycling of massive payments, such as the French indemnity, often leads to liquidity-driven speculative frenzies in stock, bond and real estate markets.
Given this history, how could anyone possibly write a serious book about the US crisis of 1873 without writing at least as much about events in Europe as about events in the US? It didn’t make sense, and yet economists and economic historians do similar things all the time – they explain events in one country by referring largely to antecedents in that country. Take the Opium War in China. The standard narrative is quite straightforward. For centuries, we are told, China produced goods that Europeans wanted – tea, silk, pottery – but Europeans produced nothing China wanted, so China ran a trade surplus and accumulated reserves in the form of silver. At some point however the English discovered that it was more profitable to export Indian opium to China, which they did, and the Chinese were so furious at the poisoning of their people that they tried to prohibit it, which led to war.
But aside from the fact that it would have been impossible for China to run a trade surplus for so long, especially when the concept of reserves did not exist, the real story is a lot more interesting and complicated than that. Beginning in the late Ming Dynasty the Chinese economy was in poor shape and its monetary system was contracting relative to the growth in population, which was made all the worse because rising silver prices caused hoarding and hoarding caused rising silver prices. As a silver-based economy, among other things China desperately needed silver to re-monetize.
At first the Chinese imported silver from Japan, but eventually the Japanese forbade further exports. Around this time the Spanish began discovering silver in the Americas, and within a century were extracting huge amounts. As the price of silver in Europe plummeted relative to gold and other products, Europe discovered that they had something that the Chinese desperately wanted and which they valued far more than did the Europeans. China’s trade surplus in other words was not a trade surplus at all. There was balanced trade between Europe and China in which both sides got what they wanted.
In the 1810s Latin Americans began their wars of independence against Spain, one consequence of which was a collapse in silver production and a surge in European silver prices. When this happened England could no longer afford to exchange tea for silver, so they switched to opium, which they obtained from India at least partly in exchange for textiles, having pretty much demolished the more efficient Indian textile industry in the 18th Century. This loss of silver imports put enormous pressure on the Qing treasury and led ultimately to the sequence about which we are so familiar.
The point is that you cannot really write about the origins of the Opium War without including the very important role of the Latin American wars of independence, and yet few historians do. These kinds of sometimes-surprising global links are even more important today. Brazil and Australia had booming economies during this century, for example, but how many people know the role of artificially low Chinese interest rates in creating the boom? It is not a coincidence that the boom in both countries has ended just as the amount of interest rate repression in China has almost disappeared. It had to happen.
It is possible for Spanish economists, to take another fairly obvious example, to engage in a furious and highly politicized debate about the domestic policy distortions that “caused” the country’s savings deficit that exploded shortly after it joined the euro (one side blames lazy workers for high wages and the other side blames greedy bankers for dumb lending) without acknowledging that both high wages and risky lending might be, and in this case certainly are, the consequence of policies in Europe which the Spanish economy was unable to absorb in any other way. You cannot talk about savings distortions in one country without discussing the opposite distortions in another, and yet economists do it all the time. They usually prefer to base their explanations on an attack on their ideological enemies or a defense of their ideological friends than on the very obvious arithmetic of the balance of payments.
Economists also too easily enjoy the pleasure of moralizing. It should be very easy, to take yet another example, to understand why China has the highest savings rate in the world. Most economists don’t. Instead they refer knowingly to Chinese household frugality, based on Confucian values, even though Chinese household savings are pretty normal and the increase in household savings is a very small part of the total increase in savings (probably because in the US total savings are importantly a function of household savings, so everyone assumes this must be true everywhere).
China’s extraordinarily high savings rate is almost wholly explained by the transfer mechanisms that subsidized rapid growth over the past two decades, leaving Chinese households with the lowest share of GDP in the world, and perhaps the lowest ever recorded for a large economy. Arithmetic, not to mention historical precedents, can easily explain why these transfers, which during this century amounted to as much as 5-8 percent of GDP annually, would drive down the household consumption share of GDP by driving down the household income share, and of course high savings are simply the obverse of low consumption.
The preference of economists, not to mention other kinds of experts, to attribute China’s high savings rates to Confucian values is all the more strange when we remember that just fifty years ago East Asian countries tended to have very low savings rates, and moralizing economists then had no trouble blaming Asia’s seemingly intractable poverty and low savings on Confucian values, which for much of Chinese history had been criticized for encouraging laziness and spendthrift habits. Economists want eagerly to assign virtue or vice, but sometimes it is easier simply to stick with arithmetic.
When we speak about the Chinese economy, we then run into another problem that seems to beset a great deal of economic analysis. Policies that affect the savings rate of a small country can have more-or-less predictable domestic impacts because the closed system within which it operates, the global economy, is so large that domestic policies are not affected by external constraints. But when you are thinking about a large economy, you have to change your analysis. In a globalized world anything that changes the domestic relationship between savings and investment must automatically change the relationship between savings and investment abroad in the obverse way, and that the changes may be constrained by the relative size of the closed system within which the open system. If the savings rate of Spain (the open system) declined after 2003, as it did, the reason may have as much to do with Spain as it has to do with someone else within Europe (the relevant closed system within which it operated) – Germany, in this case – and so trying to resolve it by “undoing” the Spanish “cause” may be useless, or even reckless, as I think we in fact are seeing.
- I’m dying to know your thoughts on the Keynesian vs. Austrian debate on monetary policy? Do you find yourself lining up with doves like Janet Yellen who believe low interest rates are good for employment or people like Ron Paul and Stanley Druckenmiller who worry about price distortions and asset bubbles?
There is as you know a political divide between economists. One group focuses primarily on managing demand to prevent the underutilization of labor and capital (often called Keynesians). The other insist that it is only by increasing savings, which usually means increasing wealth inequality and allowing the benefits of growth to “trickle down”, that we can generate the increases in investment that drive long-term economic growth (often called supply-siders, or Austrians, although for some reason true Austrians seem to loathe supply-siders).
The point to remember is that rising inequality or, especially in countries like China, a declining household share of GDP, tends to force up the savings rate and to reduce consumption, which sometimes even lowers the investment rate, as we saw in Germany during this century. But because globally savings and investment must always balance (another accounting identity often forgotten in the debate), the tendency to force up the savings rate in any country must automatically be balanced by an increase in investment, an increase in consumption elsewhere, or an increase in unemployment. This is just a matter of logic.
Because of the political divide between supply-siders and demand-siders, most economists either oppose any and every policy that increases the savings rate through greater wealth inequality, or oppose any hint of demand management, especially if it involves fiscal spending. It turns out however – once again using little more that simple accounting identities – that there are conditions under which either supply-side policies or demand-side policies will increase long-term wealth. In fact Keynes, Hayek, and the rest of them understood quite well what those conditions are.
To simplify enormously, when productive investment in the US is constrained by insufficient domestic savings (and an inability to import enough foreign capital to make up the difference), supply-side policies can genuinely create wealth that trickles down to the general population. In the United States during much of the 19th Century, for example, an erratic and unstable financial system combined with the huge infrastructure needs of a rapidly expanding continental economy meant that the US was almost always in short supply of capital. To a large extent the US growth rate, which depended on increases in productive investment, was constrained mainly by British savings, and much of this was the consequence of high British income inequality, as John Hobson pointed out.
It is not a coincidence that just as the Chinese were suffering the consequences of the global silver shortage, in the form of the First Opium War in 1839, the US itself was in the throes of its own crisis. In 1837 a number of states, most shockingly Pennsylvania, defaulted on their debts, beginning a very deep depression that lasted for years (and, perhaps not surprisingly, is generally described in history books with few references to Latin American silver production or Chinese wars over opium). In the 19th century anything that caused the American (or British) savings rate to rise allowed US investment to expand and the country to grow.
When the world is suffering from insufficient demand, however, clearly the problem we face today, income inequality and excess savings are the problem, not the solution. There may be plenty of good investment that are not being funded in the US, but the reason they suffer from lack of funding, unlike in the 19th Century, is not because capital is to scarce or too expensive. Capital is actually too plentiful, and this shows up in the speculative flows that have driven global stock and bond markets to unreasonable levels. It is weak demand or political gridlock that prevents productive investments from being made.
So, I would argue, today we are very obviously in a “Keynesian” world of structurally weak demand, in which policy must be aimed at increasing either consumption (reducing savings) or increasing productive investment. It would always be preferable to do the latter, but it is politically very difficult to increase investment in US infrastructure through higher fiscal deficits, and of course the private sector is reluctant to increase investment, especially in manufacturing, without a revival in consumption. Washington is absolutely correct, in my opinion, to want to boost American consumption, but the Fed seems to be trying to boost consumption by igniting another asset bubble in the hopes that, like before 2007, Americans will feel “richer” and so will consume more. This isn’t sustainable, however, and will leave us, as Paul and Druckenmiller fear, even more heavily indebted and more dangerously exposed to the underlying weakness in demand.
Unfortunately this analysis leaves us with policy recommendations that are unpalatable to both sides of the aisle. The US government must take the lead in rebuilding US infrastructure, which probably means increasing government debt (although it also means reducing the debt burden by increasing the value of the economy by more than the increase in debt). The US must also increase US consumption, however not by igniting another asset bubble and letting credit cards work their magic.
There are really only two ways to increase household consumption sustainably. One is to force a redistribution of income from the richest Americans to the rest. The other is to impose trade tariffs or, what amounts to the same thing, to tax foreign purchases of US assets, especially US government bonds, in order to drive down the current account deficit and so allow the US to retain a larger share of what has become the most valuable commodity in the world: demand. Needless to say it is hard to imagine either political party, or anyone associated with either the supply-side or the demand-side ideology, signing up to the whole program.
Do you think there is a global currency war going on?
Of course there is. Historically whenever global demand is weak, and unemployment high, countries will try to gain a larger share of that demand by reducing wages or otherwise taxing households to subsidize production (devaluing the currency is just a way to tax the consumption of imports and to subsidize exporters). Unfortunately these policies reduce demand further by reducing real household income and, with it, the amount households can spend. This is why in the 1930s these policies were referred to as beggar-thy-neighbor policies. In effect they forced countries with high unemployment to respond to weak global demand with policies that reduced their own contribution to global demand while grabbing a larger share of the smaller total.
But we must remember that they are not doing this to be pests. In most cases they have little choice. In a world with few constraints on trade or capital flows, if you try to raise domestic consumption by raising household income – for example by raising wages – your contribution to global demand will indeed rise, but your export competitiveness will decline, and so you may retain a smaller share of that greater amount. In a globalized world, without a globally coordinated no-cheating boost in spending, beggar-they-neighbor policies may be systemically crazy but they are individually rational.
And they are always rationalized in exactly the same way. Countries try to force down wages, devalue their currencies, and otherwise increase the short-term, competiveness of their economies only in order to protect themselves from the depredations of others. Spain wants to force down workers’ wages today because German wage growth was cut by more than one-half in the decade after the turn of the century, even though the German economy was growing faster than it had in the decade before, and the creation of the euro was supposed to make everyone richer. If Spain succeeds, global demand will drop but Spain’s share will rise.
- You talked a little bit about the future of currencies in your book. In the book, you seemed to think the Euro might not survive and the dollar would continue to bethe world’s reserve currency. Is that an accurate depiction of your views or not?
The US dollar will remain the world’s dominant reserve currency for a very long time, partly because it is the only currency that exhibits anywhere near the needed level of credibility, mobility, and low transactional costs, and mainly because for all the huffing and puffing about “exorbitant privilege” no other country is willing to pay the considerable cost of allowing its currency to be accumulated by foreign central banks whenever these countries experience weak domestic demand. The only way this will change, I think, is if, and perhaps when, Americans decide that they are no longer willing to enjoy the “exorbitant privilege”, and Washington imposes restrictions on foreign purchases of US dollar assets, as was the case until the 1960s.
Five years ago I would have told you that this would never happen, but two things seem to have changed. First, as Americans become increasingly aware that when foreign central banks amass hoards of dollars and prevent others, including the Fed, from reciprocating, they aren’t doing the US any favors (and if they were, why are they so determined to prevent other central banks, including the Fed, from returning the favor?). Their purchases are aimed at boosting domestic employment, and unless productive investments in the US are unfunded because of a savings shortage (which is all but impossible to believe), their purchases must result either in an increase in US debt or an increase in US unemployment. This may sound surprising to many people, including, shockingly enough, to many economists, but is actually quite easy to prove, either by using balance of payments arithmetic or by looking at the historical precedents.
Second, it seems to me that the US is becoming increasingly isolationist, largely because it is increasingly uncertain that the benefits to the US of a US-dominated world order still exceed the costs. When the US comprised a much larger share of the “globalized” part of the world, it retained a greater share of the benefits of a stable trading environment and it cost less to maintain that environment. As the US becomes a declining share of the globalized world, the costs of imposing stability (and I have no illusions that this is done for charity) rise, and its share of the benefits decline. It is only a matter of arithmetic that at some point the costs will exceed the benefits.
As a committed internationalist I know of course, and worry, that any withdrawal of US leadership – political, military, or financial – will be painful and chaotic in the short term for the rest of the world, and especially the developing world, which is why it must be such a slow and difficult process. But many Americans believe that the US would be better off if it withdrew from its foreign commitments and maintained its strength, and its virtual invulnerability at home, except from the kinds of terrorist attacks that are anyway more likely, not less likely, to be a consequence of foreign meddling.
Will the US act on its growing isolationist impulses? Eventually it must. But as President Obama knows better than anyone else, Americans want the US to be less entangled abroad, but paradoxically they are also very critical of any of the resulting chaos that is the inevitable consequence of the US turning inwards. There was, on that note, an editorial piece in July in the Wall Street Journal about the Ukrainian crisis that seemed to exemplify that paradox.
Much of the piece made sense to me – although I find very parochial the American tendency always to assume that much of what happens in the world happens only because the US permitted or did not permit it to happen, as if other countries are incapable of generating history on their own – but the argument that a certain disagreeable outcome today was the inevitable consequence of the failure of the US to draw some specific line in the sand during some preceding and seemingly unrelated event three months ago, or three years ago, or whenever, if taken seriously cannot help but lead the country into one hopeless mess after another. There was one paragraph that for me was especially revealing about the difficulty Obama, and any other president wanting to disentangle the US from the world, inevitably faces:
If this doesn’t wise the world up to Mr. Putin, you shudder to think what it might take. Mr. Obama spoiled the moment by, in the next breath, calling for a cease-fire and “a political solution” in eastern Ukraine, reverting to his default mode: a constitutional scholar lost in a world of thugs, to borrow a phrase from the late Fouad Ajami.
I was curious as to what kind of president the author thinks would best serve the US in a world of “thugs”. I suppose Obama himself could have also been a thug, and then he certainly would have been able to handle himself with glamorous equality in the Ukrainian conflict, perhaps by sending troops, but its hard to imagine that the US or the world, over the longer term, would be better off with more of a Putin style in the White House. I can’t even imagine how Russia is better off with Putin in the medium term, and I think it is almost a no-brainer to suggest that the next couple of decades are going to be a very tough decade for Russia, especially if all its neighbors decide that major military expenditures are a good idea.
I suppose instead of a thug or a constitutional scholar we could have been led by the proverbial “man on the white horse” who charges gallantly into the fray and fixes things, but that man usually turns out to be either a thug or an idiot. One of the most famous men on a white horse in history (Napoleon I guess is the exemplar), is General Boulanger, who many Frenchmen, sick and tired of the hopeless mess France – still reeling from the Prussian defeat and on the verge of the Dreyfus Affair – seemed to have become, turned to in the years before 1889 to solve France’s problems. Boulanger of course turned out for all his charisma to be a mediocre leader and a miserable failure, who committed suicide within a couple of years of his defeat, and unfortunately this is all too common a fate for men on white horses.
So what is the alternative? I wonder if a very unglamorous constitutional scholar might not in the long run be exactly what the US and the world needs for the US to extricate itself gradually from some of its global commitments. There is no question that it will be a messy process, and that there are many things that will go wrong, in which case a careful, cautious president who avoids grand gestures and insists on legal niceties might be the leader most likely to pull it off at the minimum long-term cost.
Either way, isolationism will be messy for the US and messier for the world, but the alternative might be worse for both if a US withdrawal eventually occurs, and occurs when the country is economically weaker and forced by circumstances to withdraw. That is when thugs will do especially well. So far, in spite of the greater visibility of sheer spite in the political debate, the US continues to be the kind of country in which a foreign crisis causes people to rally behind the president, whatever else they may think of him. This is a huge advantage that many countries don’t have, and although some Americans are eager to undermine this instinct, I think it is pretty firmly embedded.
In the books, you talk about the European economy and your belief that the EU will likely eventually need to break up. I totally agree. Can you talk about why Spanish and Italian bond yields have fallen so low recently and do you think it can possibly continue? What effect have the ECB’s LTRO programs and Draghi’s hints and pledges of QE had? Are Europe’s leaders correct to be spiking the football and proclaiming that Europe is saved…or do you still think that European leaders will ultimately be unable to make the adjustments that you say in your book that Europe must make?
This is why I am worried about the long-term prospects for the euro. Europe, in a sense, suffers from a contained version of the global weakness in demand and the consequent imbalances. When German wage growth was forced down during the last decade, it caused, or at least accommodated, a rise in the German savings rate (which is the same as a decline in the German consumption rate) and, by the way, had nothing to do with an increase in the fabled thriftiness of Germans, which makes it strange when economists use the rise in German savings to moralize. The same process also accommodated or even caused a decline in German investment.
As German savings were forced up beyond German investment, by definition it had to run a large and growing trade surplus, and for a variety of fairly well-understood reasons this surplus was always likely to be balanced within Europe. Without the ability of smaller European countries to intervene in intra-European trade, or to manage an independent monetary policy, the only possible response, as in the global case, was a rise in the indebtedness of peripheral Europe or a rise in unemployment. We saw the former before 2008 and the latter after.
In 2008 I argued that unless Berlin were willing to lead a European response, centered on a sharp rise in German demand, something Berlin didn’t want to do because it would cause either their debt to grow or their export competitiveness to be undermined, peripheral Europe had only two options: break up the euro, or suffer punishingly high rates of unemployment for a decade or more. So far that analysis seems to have been correct, and Europe seems to have chosen the latter.
But with extreme right-wing parties scooping up votes by baying for the blood of bankers, demanding a withdrawal from the euro, and blaming foreigners – whether immigrants, the US, or China – for their malaise, it isn’t clear to me how long these countries can continue to choose unemployment. That is why I always insist that the most important person in Europe might be not Angela Merkel but Marine le Pen. Merkel wants Europe to continue choosing unemployment, at least until the German banks are sufficiently capitalized to withstand defaults, but le Pen might force Europe to choose to break the euro.
As for why rates are so low, the answer I think is pretty obvious and widely understood. With low or negative economic growth, a serious threat of deflation, and the willingness of the ECB to do “whatever it takes” to prevent a suspension of debt payments, which would bring down both the German and the French banking systems, investors have been given lots of liquidity and assurances that the ECB will step in whenever rates get high enough to threaten the ability of countries like Spain to mange their debt burdens. A lot of investors refer to this quite openly as the “Draghi put”.
The official reason for these policies is that eventually these countries will “grow out” of their debt burdens, but this is what they always say and it almost never happens. Rates will stay low either until the German banks have managed to recapitalize themselves enough to withstand sovereign-debt restructuring (after which the ECB commitment to do “whatever it takes” will almost certainly disappear), or until investor confidence, sapped by the irresistible and unending growth in the debt burdens of these countries, disappears. Because it will take many years for the former to happen, I assume it will be the latter.
Though The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy was published just last year in 2013, in today’s fast changing world (and 24 hour news cycle), that might seem like an eternity ago. You just talked about Europe. How do you feel the rest of the world (the U.S., China, Japan) have done in taking the steps necessary to rebalance global trade and the global economy?
The US was fairly quick to begin the adjustment process, as it always is, perhaps because the American political system can more easily absorb the social consequences (which is a polite way of saying that the US can treat its poor badly and get away with it), but now it might be backtracking. Worsening income inequality all but guarantees, I think, that we will not see sustainable consumption growth for many years, and political gridlock makes the rollout of an infrastructure-improvement program unlikely. I do think that because of its flexibility and creativity the next decade might still be relatively good for the US, however, but any recovery can be postponed or even derailed by events in Europe or elsewhere. At some point, as Americans have always done in their history when income inequality got out of hand and the economy was in the doldrums, there will be a reversal of income inequality driven by politics, although this reversal will probably go, as it always does, too far.
Away from the US, we have also needed to see rebalancing in Europe, China and Japan of course. I have already explained why I think Europe faces many more years of high unemployment, and as for Japan, I really have no idea of how Tokyo will address its debt problem. As long as growth and interest rates are close to zero, we can all pretend the debt burden is sustainable, but any sustained nominal GDP growth will force Tokyo into a tough decision on interest rates. They can keep rates low, in which case the great reversal of the Japanese imbalances of the 1980s will itself reverse, and the Japanese consumption share of GDP will weaken (and investment probably will too in response), which means that Japan will depend even more on foreign demand to keep unemployment from rising.
Or Tokyo can raise interest rates, in which case debt costs will quickly become unsustainable, although I think government liabilities are long enough in duration that Tokyo will have a few years to adjust. Basically if Japan could resolve its debt burden at the expense of anyone but ordinary households, I think it could start to grow sustainably again, but I don’t know enough about the Japanese economy to know if that is even possible. I hate even to discuss the rise of military tensions in the region, but it would be foolish to deny that this could be a way out of a politically difficult adjustment, for more than one country.
Finally, among the major economies, Beijing has eliminated most of the main mechanisms that drove China’s very healthy growth in the 1990s but which resulted in the deep imbalances of the past decade, along with the country’s surging debt burden. But that is just the first of two steps. It now needs to take the next, politically more difficult, step of liberalizing the economy by eliminating many of the constraints which favor politically connected businesses at the expense of China’s small and medium enterprises, increasing the household share of GDP, and paying down the debt, although if it monetizes the debt or otherwise forces households to absorb the losses, which is what happened after its last debt crisis in the late 1990s, consumption will not be able to grow fast enough to bail out the economy.
India is for me sort of a wild card. Among the major economies it is the only country besides the US not to suffer from truly awful demographics (not that US demographics are good, but at least they are not nearly as bad as those of Europe, Japan, Russia and China, thanks mainly to immigration), and like the US it has a great source of sustainable demand in the upgrading of its infrastructure, but when it comes to organizing the political ability to do so it is in worse shape than even the US. I am no India expert, but my Indian friends tell me that their combination of a highly entrenched and brutally constraining bureaucracy and the determination of a growing segment of the Indian population to turn one of India’s greatest strengths, their impressive diversity, into a source of violence and instability, may trump their many advantages.
As for the rest of the developing world, including Africa, high commodity prices always revives enthusiasm and hope, and low commodity prices, which I expect, always dash it. I hope this time is different.
In your books, you seem careful not to directly blame China for the global imbalances, but you do mention how different countries’ domestic policies contribute to the global imbalances. As a professor at Beijing University, what Bill Clinton once called “China’s Harvard”, do you ever feel any pushback from your contacts here in China regarding some of your criticisms of government policy?
I get that question a lot, and I think it is because many foreigners overestimate the degree of control that authorities exercise over public discussion. It is not that there isn’t control. Of course there is, and there is some evidence that things have tightened up in the past year or two, but as long as you do not cross certain lines, the debate within China can be quite vibrant.
I think there may be a misperception about why I don’t “blame” China. As I see it, China imposed a series of necessary and very difficult reforms in the 1980s, followed by an investment-led growth policy that had proven successful for many, many countries in the last 100 years, but like every one of the countries that had a similar “growth miracle”, it also developed deep imbalances and waited too long before it began the rebalancing process (all rapid growth, as Hirschman taught us in the 1960s, is unbalanced, and the imbalances must eventually be reversed). This is why I didn’t think it made sense to excoriate China. China was simply following an historical process that many developed or middle-income countries, including the US, have followed, and now it faces the challenges that some overcame and some didn’t.
Given the very touchy nationalism that exists within China, of course I was criticized by some Chinese, although because I don’t really criticize government policy so much as try to describe systematically the Chinese economy and place it as firmly as possible within its historical contexts, ultimately their criticism can only be that I failed to believe that China was gloriously exempt from historical processes. While some Chinese are easily angered at any suggestion that China’s development process faces risks, or at least they used to be, it is hard to credit them with much intelligence.
Most serious Chinese, economists or not, recognize that someone whose work consists of trying to analyze China’s development process by comparing it to that of other countries that have followed the same development path, and describing where things have gone wrong and how these pose risks for China, can hardly be called anti-China. My students at Peking University, for example, are extremely supportive and think very differently about what I do, and I think I have convinced them that as future policymakers, especially in finance and central banking, rather than join the hype that has always accompanied every growth miracle it is their responsibility to be focus on risks and on all the ways things can go wrong.
But I have to say that it was not just aggrieved Chinese nationalists who were angry at me. I have been far more criticized by foreign economists, especially sell-side analysts and “China experts”, not so much for failing to support the overhyped nonsense that was the consensus for many years, but rather because I suggested, perhaps even a little rudely sometimes, that the consensus was such obvious nonsense, and would have been rejected as absurd, as it has, by anyone with some knowledge of economic history, or of the experiences of other developing countries, or even of how balance sheets work. While these analysts were diligently compiling reams of data and processing them with all the resources Wall Street can muster in their competition to see who could come up with the most optimistic possible prediction, I – and, I should add, a number of other economists – rejected their work as being useless and, what was worse, useless in a fairly obvious and predictable way. Most of them loved their mathematical models, but were not sophisticated enough mathematicians to understand how their models worked and under what conditions they were likely to fail.
We have seen a general backlash against the use of math in economics, but we have to be careful. It is not that math is useless. It is that mathematical models imbed lots of assumptions that, if they are not understood, make forecasts useless, especially when we most need them, because when imbalances are being generated, the relationship between variables are likely to be distorted in on direction, and when the economy rebalances, the distortions will flip their signs (i.e. positive biases become negative and vice versa). Our predictions are always right, in other words, as long as nothing happens, but whenever something major happens our predictions are automatically wrong. In any economy where there is more likely to be distortion, or where automatic adjustment mechanisms are weaker, we need to be extra cautious about the assumptions underlying our models. China is clearly such an economy, but like the drunk man searching for his car keys, we prefer to search where the light is better.
But touchy nationalists and sell-side analysts aside, I never felt any pushback from Peking University or from the authorities and no one tried to prevent me from analyzing and writing about the economy. On the contrary, I think many Chinese economists, both among policy makers and among their advisors, have always read what I wrote very sympathetically and many agreed with my views, often coming to them long before me. In fact if you read between the lines it is pretty obvious that as far back as 2007 many policy advisors in Beijing, along with Premier Wen, understood far better than most economists writing about China the kinds of imbalances that China was generating, and how difficult it was going to be, especially politically, for the adjustment process to take place.
There was always a popular myth among foreign China bulls, and it still exists today to some extent, that any skepticism about the Chinese growth miracle marked you out as a misguided foreigner, because every relevant Chinese economist agreed fully with the ecstatic hype that the press and the sell-side were saying about China. But this was never true. You were far more likely to see skepticism and even serious concern among Chinese economists than among foreign economists. How could you not? Many of them were not eagerly selling the bull pitch and were only interested in understanding what was happening in their country.
In another of your books, Avoiding the Fall, you mentioned that you expected that Chinese economic growth would not be steady in the future, but that China would likely avoid a hard landing. There’s a lot that goes on here behind the scenes in China. Sometimes, the government can be quick to take action. Other times, they can be a little slow. Has the new leadership of Xi Jinping and Li Keqiang impressed you with the actions that they have taken to try and rebalance China’s economy for the future?
Because I, like all but a group probably no more that 50-100 people, have no idea about what exactly is happening within leadership circles, I can’t really answer except to say that on the surface President Xi and Premier Li are doing pretty much what we would have expected if China were to embark upon a successful rebalancing – one which would, of necessity, be opposed by what in China are referred to as the “vested interests”. Given the opacity of the system of course we must always be prepared to find our assumptions wildly mistaken, but on the surface it looks like the Xi-Li administration is working its way successfully through what will nonetheless be a very difficult process.
How confident are you about the global economy in the short-term, the medium-term, and the long-term (bearing in mind that Keynes famously once said that, “In the long run, we’re all dead.”)
Not to be flip, but when JP Morgan was asked to predict the direction of the stock market, he is supposed to have replied “It will fluctuate”. As good enough an answer as that was, I would add that in the past 200 years whenever we have had a global crisis, we seem to lose confidence in ourselves and begin to lambaste democracies and decentralized economic systems for their inefficiencies and their inability to implement the “right” policies quickly and forcefully. I just read a recent Econintersect piece, for example, that starts right off with “The global brand of dictatorship is making a strong comeback in the democratic world.”
But it did in the 1930s too. Let’s not undervalue the inability of decentralized political and economic systems also to implement the wrong policies quickly and forcefully. Decentralized systems tend to correct mistakes relatively early, and do a pretty good job (or maybe a terrible job, but better than the alternatives) at economic adjustment. Growth always creates imbalances, and the important part always turns out not to be how quickly we grew during the good times but rather how successfully we adjusted from the imbalances, especially because the adjustment usually takes place during the bad times.
This is why the political, legal, social and financial institutions that constrain the adjustment process for each country are so important. Not all growth miracles, for example, are followed by successful adjustments and more long-term growth. In fact they rarely are. In the 1960s it was widely “known” that the USSR, then completing nearly two decades of phenomenal growth, whose exploits included the first manned satellite and the first space walk, would almost certainly overtake the US both technologically and economically by the end of the century.
Today those expectations seem almost comical. The country had wracked up so much debt during the late stages of its growth miracle, and for all its spectacular growth was unable to deliver more than a minimum amount of consumer products to it citizenry (it is considered shocking to say this in polite company, but consumption-driven economies seem to be far more innovative and productive that investment–driven economies, perhaps because of the decentralization of demand). By the late 1980s, when I started my career as a trader of defaulted and restructured sovereign debt, Russian debt was widely considered to be part of our market and had only not been formally restructured because foreign banks agreed to roll over principal and interest payments in order to maintain the fiction that it could repay at will.
Brazil was another miracle – indeed the first country to be called a “miracle”, I believe – whose astonishing growth ended in the early 1980s, after which its relative position in the world retreated until soaring iron ore prices a decade ago reignited the boom. Beginning in the late 1950s Brazil had followed a consumption-repressing, investment-driven growth model different from that of China’s mainly because consumption was repressed not with hidden transfers but rather with high explicit income taxes. It was able to achieve growth rates that exceeded 10% annually for well over a decade, but when the inevitable investment misallocation and fraudulent spending began to exhaust domestic debt capacity, the oil shocks of the early 1970s, which created the urgent need to recycle burgeoning petrodollar reserves, gave Brazil a second lease on growth. Brazil – and the rest of Latin America, I should add – then grew rapidly through the rest of the 1970s on borrowed dollars, even though the US economy, and the European to a much lesser extent, was in a severe recession (prompting, for the first time, I think, confident assertions that the developing world, had decoupled from US demand).
Many other countries have had investment-driven growth miracles in the past sixty years. A few of them, like Japan, were already developed countries with advanced institutions, which is perhaps why the belief in the late 1980s that it would inevitably overtake the US before the end of the century as the world’s largest economy seemed so credible.
Other countries, like South Korea, were among the poorest and least developed in the world. All of the growth-miracle countries that I can identify, however, ended their miracle periods either with painful debt crises or with “lost decades” of stagnant growth, and all went through difficult transitions, some cases of which were followed by further growth miracles and most were not. But very few countries have gone from backwards economies to advanced economies. It is worth noting that excluding city-state trading entrepots like Hong Kong and Singapore, and a few oil sheikdoms, both of whose growth models cannot be replicated by most countries, the only two unquestionable success stories I can think of are South Korea and the province of Taiwan, both of whom grew most rapidly during the Cold War, when their economic success was considered to be vitally important for the US. Chile may be the third country that joins that limited group.
Rather than make wild predictions we need to understand who so few countries have actually made the transition from poor to rich. My explanation has to do with the kinds of institutions that permit adjustment, and perhaps you can find similar explanations by people like Daron Acemoglu and James Robinson, to whose work I often refer, but whether I am right or wrong, the fact is that any prediction of success that doesn’t first explain why there has been so much failure is a waste of time.
And contrary to the popular press, China is probably not the fastest growing country in history. That prize probably belongs to Argentina in the four decades before 1914, but the subsequent decades nonetheless turned out pretty badly. There is a furious debate on where Argentina went wrong. Some argue that Argentina’s relative decline began with the Uriburu coup in 1930, after which it seemed that the main role of government was to disrupt economic liberalization and income redistribution and unassailably to protect the existing elite. Others blame Juan Peron, whose presidency in the 1940s and 1950s entrenched a near-autarchic state-corporatism, which some would call fascist. Finally others argue that Argentina’s decline only really occurred in the decade that began with Peron’s death in 1974, followed by the 1976 coup that established the right-wing administration of Jorge Rafael Videla. Nearly all the explanations stress the breakdown of civil society, the entrenchment of the elite and the resistance to income redistribution. This might be a lesson worth learning for China and other developing countries.
For all the many cases of growth miracles, or of debt-fueled consumption-driven advances, like that enjoyed by Spain in the years before the 2007-08 crisis, economists seem incapable of placing whichever is the latest example within a proper historical context. We are always surprised when an economic miracle stalls, and even when that happens, in spite of the many precedents, we are always shocked by how painful adjustment turns out to be (I cannot find a single case in history in which even the most pessimistic of skeptics did not understate significantly the amount by which growth would slow), and it takes years for us to consider that the adjustment period might not just be a temporary setback, during and after which the miracle country will sill grow relatively faster than the rest of the world.
I am sorry to say that none of this tells us much about future growth in China, the US, Europe, or the rest of the world. What it tells us is that rapid growth is always unbalanced growth, and many years of rapid growth are nearly always derailed by debt. It also tells us that relative performance in the past doesn’t help us predict relative performance during the adjustment period or even after the adjustment period. Either way we’ll just have to wait and see how the US and different countries in Europe and Asia adjust from the great imbalances of the past two decades. Global economic growth, to steal JP Morgan’s prediction, will fluctuate.
Can you talk about deflation? Some say that deflation causes consumers to persistently put off purchases while they wait for prices to fall. I feel this violates everything we know about what happens to demand when prices fall. But if prices do fall in a prolonged deflationary period, it would make debt repayment much harder and make defaults more likely. What are your thoughts and what effect would wholesale debt restructuring have on both wealth and economic growth? What is better for average people: trying to slowly inflate away debt or global debt restructuring?
It really depends on the circumstances. I am not an economist so much as a balance sheet guy, and I can tell you that inflating debt, or monetizing it in any other way (e.g. financial repression) simply transfers wealth from those who are long monetary assets (usually households) to those who are short. Deflation does the opposite.
Generally speaking I would argue that in most countries we need to boost the wealth of median households at the expense either of the state or of the economic elite, but in the case of the latter I also recognize that we have to do so carefully. Income inequality may itself be the outcome of a highly desirable incentive structure that rewards innovation and entrepreneurialism. I know this answer is sort of a copout, but the specific circumstances of each country matter, and I don’t want my having gotten a few things right in China to tempt me into trying to punch too far above my weight.
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