Hidden debt must still be repaid

Note: When I posted my last entry, somehow or the other I managed to disable the comments section. I think your comments have been the most valuable aspect of my blog, at least for me, and so this disabling was totally unintentional, but I am too technically incompetent to have figured out how to re-open the comments function and so had to wait until my colleague, Charles Saliba, returned form a long trip dedicated in part to working out issues related to my activities in the Beijing new music scene (my money-losing CD label now operates under a Hong-Kong-based entity to which all subscription fees for my newsletter are directed). I think we are back and running, so please, dear readers, comment away. Do not interpret my mistake as in any way implying that I wanted to discourage your comments. One of these days I will catch up to the late 20th Century and will be able to figure out how to mange on my own, but until then, please forgive me.


Five or six years ago, a few skeptics first started pointing out that the credit dynamics underlying Chinese growth was creating an unsustainable increase in debt. This, they warned, would ultimately undermine the banking system and cause growth to collapse if it were not addressed in time.

There were three standard rejoinders to the warnings. First, analysts argued that investment was not being misallocated, and because credit growth poured mostly into investment, it did not therefore follow, as the skeptics argued, that debt was rising faster than debt servicing capacity. Although I think few analysts still support this argument, there remain some analysts who do not think China has an overinvestment problem. For example my Carnegie colleague Yukon Huang, who has argued, for example in one of the FT blogs that China is actually underinvested:

The perception that China has invested too much is also misleading. Actually, China’s capital stock relative to GDP is lower than other comparable east Asian countries. Moreover, much of the surge in investment over the past decade is due to housing construction, where the country is still making up for the shortfalls from the Mao era.

Because I have addressed this issue many times before in my newsletters, especially the common and distressingly ahistorical fallacy that one can determine whether a very poor country like China is over- or under-invested by comparing its capital stock per capita to more advanced countries with much higher levels of social capital and the consequent ability to absorb investment efficiently, I will not do so again. Needless to say, I think that the evidence of investment misallocation has continued to rise, and in the past two years the number of analysts that are not worried about a systematic tendency for debt to rise faster than debt-servicing capacity has dropped significantly. I have no doubt that their refusal to accept the consensus on the subject is useful in that it helps sharpen the debate, but this is a losing battle and, like the capital stock argument, distressingly ahistorical.

The second rejoinder, which has also largely faded away as an argument over the past few years, is that debt in China doesn’t matter. Sometimes, these analysts argue, it doesn’t matter because it is funded domestically. Sometimes it doesn’t matter because the banks are implicitly guaranteed by the central government. Sometimes it doesn’t matter because China was able to resolve its last debt crisis, 10-15 years ago, in an environment of rapid growth and at no cost, and so of course it can do so again.

Again I have addressed all of these arguments as to why debt doesn’t matter in China many times before and it is pretty easy to show that all of these claims are fairly nonsensical, and this is especially obvious from the very wide range of historical precedents. Debt always matters. Either it must be repaid out of the proceeds of the investment that was funded by the debt, or – if the debt funded consumption or was misallocated into insufficiently productive investments – it must be repaid by transfers from some other sector of the economy, and these transfers reduce growth by reducing real demand.

The third rejoinder should have been, in principle, the easiest to refute, and for a while it looked like it had been refuted to everyone’s satisfaction, but in the past year I have seen a revival. China doesn’t have to worry about rising bad debts in its banking sector, according to this argument, because the PBoC’s extensive reserves will make it easy to recapitalize the banks.

Ray Chan, of the South China Morning Post, for example, had an interesting article last Saturday that made this point. He starts off the article by warning that the rapid growth in credit in China has uneasy parallels with rapid credit growth in the US before the 2007 crisis:

Parallels between the United States and China have started to look more ominous after several years of rampant credit growth and the emergence of an increasingly uncontrollable and unsustainable shadow banking system. China’s massive foreign reserves could, however, be the last tool in the bag for its bank-centric financial system if no timely regulations are implemented.

With the memory of the collapse of Lehman Brothers in 2008 still fresh, investors are fretting over the growth of thinly regulated shadow banking activity. Trusts, entrusted loans and bank acceptance bills shot up sharply to a record 294 billion yuan (HK$370 billion) last month. According to Moody’s Analytics, China’s core shadow banking products, which are often opaque and subject to little or no regulation, almost doubled to 20.5 trillion yuan last year from 11.7 trillion yuan in 2010. The US firm excludes entrusted loans and trust loans as they own underlying assets.

Debt and reserves

The article does a good job of listing many of the problems that have emerged in the past few years, but then quotes a number of analysts who argue that China’s problems is very different from that of the US and it is unlikely to suffer the same kind of crisis. The article continues:

China’s credit situation is somewhat different, though, as it has a high saving rate and massive foreign reserves. Mervyn Davies, a former head of Standard Chartered and British government minister, said: “China is very rich in reserves … At the end of the day, the [Chinese] banks do need recapitalising, which is not a huge challenge to them because the government can recapitalise the banks.”

I agree that China is in a very different position than the US, but this isn’t necessarily a good thing. The main relevant difference is that because all the banks are perceived to be guaranteed by the central government, and Chinese households have a limited number of ways to save outside the banking system, it is unlikely that China will experience a system-wide bank run as long as the credibility of the guarantee survives, and runs on individual banks can be resolved by regulatory fiat (banks that receive deposits will be forced to lend to banks that lose deposits). We are not likely to see a Lehman-style crisis.

We are also not likely to see, however, the advantages of a Lehman-style crisis, and these are a relatively quick adjustment in the process of investment misallocation. I have always said that the resolution of the Chinese banking problems is far more likely to resemble that of Japan than the US, and instead of three of four chaotic years as the system adjusts quickly, and at times violently, we are more likely to see a decade or more of a slow grinding-away of the debt excesses. The net economic cost is likely to be higher in a Japanese-style rebalancing, but American-style rebalancing is risky except in countries with very flexible institutions – financial as well as political.

But I do disagree very strongly with Mervyn Davies’ claim that because the PBoC is “very rich in reserves” it will not be much of a challenge to recapitalize the banks. China’s reserves only matter to its credit position if China faced a problem of external debt.

It doesn’t, and so the amount of reserves are almost wholly irrelevant, Because this argument seems to be reviving, it makes sense, I think, to repeat why central bank reserves cannot in any way help China resolve the crisis. I will leave aside the problems of whether the reserves are transferred in the form of foreign currency, in which case it does little to satisfy domestic RMB-denominated funding needs, or in RMB, in which case the PBoC must stop buying dollars in order to hold down the value of the RMB and in fact must sell dollars, which would cause the value of the RMB to soar, thereby wiping out the export sector in China.

A much more important objection is that the idea that reserves can be used to clean up the banks (or anything else, for that matter) is based on a misunderstanding about how the reserves were accumulated in the first place. There seems to be a still-widespread perception that PBoC reserves represent a hoard of unencumbered savings that the PBoC has somehow managed to collect.

But of course they are not. The PBoC has been forced to buy the reserves as a function of its intervention to manage the value of the RMB. And as they were forced to buy the reserves, the PBoC had to fund the purchases, which it did by borrowing RMB in the domestic market.

This means that the foreign currency reserves are simply the asset side of a balance sheet against which there are liabilities. What is more, remember that the RMB has appreciated by more than 30% since July, 2005, so that the value of the assets has dropped in RMB terms even as the value of the liabilities has remained the same, and this has been exacerbated by the lower interest rate the PBoC currently earns on its assets than the interest rate it pays on much of its liabilities.

In fact there have been rumors for years that the PBoC would be insolvent if its assets and liabilities were correctly marked, but whether or not this is true, any transfer of foreign currency reserves to bail out Chinese banks would simply represent a reduction of PBoC assets with no corresponding reduction in liabilities. The net liabilities of the PBoC, in other words, would rise by exactly the amount of the transfer. Because the liabilities of the PBoC are presumed to be the liabilities of the central government, the net effect of using the reserves to recapitalize the banks is identical to having the central government borrow money to recapitalize the banks.

This is the point. Any government that is able to borrow money can borrow money to recapitalize its banks, whether or not it has large amounts of foreign currency reserves. The amount of central bank reserves that China or any other country has is wholly irrelevant, except perhaps to the extent that without those reserves the central government would lack the credibility to borrow domestically, which hardly seems to be a concern in China’s case.

Bailing out the banks, it turns out, is conceptually no different than transferring debt from the banks to the central government. China can handle bad debts in the banking system, in other words, by transferring the net obligations from the banks to the central government, and the large hoard of reserves held by the PBoC does not make it any easier for China can resolve any future debt problems. In fact if anything it should remind us that when we are trying to calculate the total amount of debt the central government owes, the total should include any net liabilities of the PBoC, and that these net liabilities will increase by 1% of GDP every time the RMB strengthens against the dollar by 2%.

Does hidden debt matter?

Before finishing on this topic, I want to address another related fallacy that pops up a surprisingly large number of times when I discuss the net liabilities of the central bank. I am often told that because these liabilities are hidden in the central bank books, and so no one really knows how much debt the PBoC adds to the central government’s debt burden, they really shouldn’t matter in our calculations. The central bank will presumably never default because its obligations are guaranteed by the central government, and the its net liability position is hidden, so why bother even consider the PBoC’s balance sheet when assessing China’s debt position?

Even those who do not understand why this reasoning is incorrect should know that it must obviously be incorrect. If it weren’t, any country could solve all of its debt problems merely by borrowing in a non-transparent way through the central bank. As the Greeks and the Italians most recently showed us, non-transparent borrowing may cause us to recognize a problems later than we otherwise would have, but it cannot solve the problem.

The reason is because in any case debt must either be serviced or the borrower must default. If the assets which were funded by the debt do not create enough wealth with which to service the debt, and if the borrower does not default, then by definition there must have been a transfer from some other entity to cover the difference between the debt servicing cost and the returns on the asset.

Typically this other entity, in China and elsewhere, has been the household sector, and in the case of China the transfer occurred primarily in the hidden form of severely repressed interest rates. Whether the transfer is from the household sector, however, of from other sector, this is where the problem of debt lies for China.

If the central bank (or the commercial banks or any other borrower whose obligations are covered by the central government) is unable to service its debt – and remember that the “economic” debt servicing cost is not the coupon, which is repressed by policymakers, but consists of whatever the “natural” interest rate would have been – the difference will be paid for by someone else, and the economy will suffer slower growth because of the reduction in demand caused by the transfer payment.

So who is likely to cover the cost of NPLs in Chinese banks? This isn’t an easy question to answer. If the household sector continues to pay, either in the hidden form of repressed interest rates, or in the more explicit form of taxes, the existence of bad debt in the Chinese banking system must act to repress future household consumption growth. The transfers from the household sector to pay what may turn out to be a huge NPL bill will significantly lower the household income share of GDP, making it very unlikely that the household consumption share of GDP will rise.

If however the state sector covers the difference (perhaps by privatizing state assets and using the proceeds to pay down debt), we are left with the very difficult political problems, which China currently faces, of assigning the costs to different sectors or groups that control the state sector in China. The potentially very large cost of cleaning up NPLs must be assigned to groups that are likely to be both powerful and reluctant to pay the cost.

Debt always matters because it must always be paid for by someone –even if the borrower defaults, of course, the debt is simply “paid” by the lender. This is why the fact that debt in China seems to be growing much faster than debt-servicing capacity implies slower growth in the future. If the debt cannot be fully serviced by the increase in productivity created by the investment that the debt funded, unless it is funded by liquidating state sector assets it must cause a reduction in demand elsewhere, most probably in household consumption. This reduction in demand implies slower growth in the future and, of course, a more difficult rebalancing process.


This is an abbreviated version of the newsletter that went out three weeks ago.  Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at [email protected], stating your affiliation, please.  Investors who want to buy a subscription should write to me, also at that address.


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  1. This is a test to see if the comments function is no longer disabled.,

  2. Wonderful article. Thanks for the insight.

  3. Excellent article which makes sense in bites. Another argument that is likely to come up is that the PBoC could try to pay of the debt with the foreign currency reserves. However this would be a sell of that currency and make it decrease in value.

    • The point to remember is that if the PBoC uses its reserves to pay down bank debt, its own net indebtedness will be increased by exactly the same amount. In that case it is not paying down debt so much as transferring it to the PBoC balance sheet, which is among the least efficient ways of absorbing it.

  4. Prof. Pettis,

    It’s very common to hear that government debt doesn’t matter if its denominated in by a currency issuer because the central bank can print as much as it wants to pay the bills. Of course, this would seem like a bunch of complete nonsense since debt service costs move exponentially to shifts in interest rates while tax revenues move linearly to inflation when government debt/tax revenue ratio is extremely high.

    Anyways, my question has to do with how high government debt can be dealt with and how often such restructurings happen. I’ve often hear from people how China can simply just transfer the debt from the banking sector to the central government sector without any problems, which just sounds like complete garbage. Anyways, what exactly are the limits for governments to run up massive debts and how are the “thresholds” determined? How have such crises been resolved in the past for developed countries?

    • It is more or less garbage, especially when you consider that the banks are implicitly guaranteed, so the debt is on the government balance sheet anyway. When we think about debt we must always remember both the stock and the flow issues. Whenever there is debt, it must be serviced (default simply means the servicing cost is transferred to the lender), and the cost of the servicing must represent a transfer of resources from one entity to the paying entity.

      • very common to hear that government debt doesn’t matter if its denominated in by a currency issuer because the central bank can print as much as it wants to pay the bills

        It is more or less garbage…

        Prof. Pettis, are refuting Paul Krugman’s recent article where he said as quoted below.

        terror of a debt crisis that keeps not happening, and, in fact, can’t happen to a country like the United States, which has its own currency and borrows in that currency. Yet the scaremongers can’t bring themselves to let go…

        …He and his friends have been wrong about everything so far, and they literally have no idea what they’re talking about.

        Krugman displays a debt-to-GDP chart which is extremely misleading total debt ratio for the UK is over 500%! Additionally we know most of the western government unfunded liabilities are hiding off balance sheet.

        Or here where Krugman misleadingly argues that Spain’s 25% unemployment is due to not enough debt spending, when others of us believe the unemployment is structural for as long as socialism (and the requisite single Euro currency) has stymied Spanish competitiveness.

        The socialist Krugman appears to argue every problem can be smoothed (on the way to resolution) with Keynesian debt spending.

        Krugman even thinks the drop in world trade growth has something to do with container ships and tariffs, and I guess he failed to realize there is trade in services and that lower international trade means lower economic growth (except short-term where the debt is rushing into unsaturated debt markets of the newly emerging countries, such as the Philippines which is growing faster than any other country in the world, if discounting China’s GDP growth as a fabrication).

        P.S. Hope you saw Krugman’s blog post on the Chinese and Middle Easterners parking their (crony ill-gotten) cash in London flats. The G20 socialism cooperation will be going after all this wealth, some of it justifiably so, but unfortunately I postulate the honest upper middle-class small businessmen will get razed too, which will worsen the postulated future implosion.

        • I would never be in a hurry to dismiss what Krugman says about economics as wrong. You may disagree with his politics (as a progressive Democrat I don’t often disagree) but he thoroughly understand trade issues and monetary policy. I think he de-emphasizes balance sheets more than I would, but whether you agree or disagree with him it is always worth understanding him without prejudice.

          • You’re a progressive Democrat?! I’d never have guess it.

          • Michael I recognize his intellect. We live in an imperfect world, so we make different imperfect choices about how we should best manage society. I am minanarchist, which means I would prefer small governments and free markets. However, the fact of history is that government swings from minimal to maximum to minimal in a repeating cycle. So any one can pick where they want their politics to be mainstream along that cycle. Krugman is in his sweet spot, and he admits it. Kudos to him.

          • He doesn’t just de-emphasize balance sheets, he outright dismisses them. He has said on national radio that it would be OK for the US to increase it’s debt to >200% of GDP because because Japan was able to with “no consequences”. He also supports extensive money printing, even though in the US at this point it is very obvious all it has done is inflate more bubbles. With that in mind it’s hard to believe he really does understand monetary policy. These things do have consequences, and assuring us that it doesn’t won’t change that.

          • I don’t know how you can treat liquidity issues if you de-emphasize balance sheets. I admit, i am not very literate on macroeconomics, i come from a money and banking background which puts strong emphasis on the payements and clearing system, cash flows meeting cash commitents, and profit motivated market makers. And it sounds as if macro nets all these things out.

  5. Yeah commenting seems to be working … time to read the article.

  6. Michael,

    I have little formal training in economics, so please forgive me if this question is obvious.

    To paraphrase why China cannot easily use its foreign reserves to recapitalize banks:

    1) If the reserves are in, say, dollars, the PBoC cannot recapitalize banks whose debts are in RMB, without selling dollars and buying RMB. This in turn raises the RMB price and reduces export competitiveness by raising export prices, hampering growth. We assume this reduction in export competitiveness is not trivial but is instead prohibitive.

    2) The dollar reserves were purchased by the PBoC by borrowing from (issuing debt to) domestic sources, so if the RMB increases in value relative to the dollar, the ratio of the cost of the domestic debts in RMB to the RMB cost of the dollar reserves increases, along with the debt burden of the PBoC in real value terms.

    Do I have this right so far? The next section is where I am unsure:

    “…any transfer of foreign currency reserves to bail out Chinese banks would simply represent a reduction of PBoC assets with no corresponding reduction in liabilities. The net liabilities of the PBoC, in other words, would rise by exactly the amount of the transfer. Because the liabilities of the PBoC are presumed to be the liabilities of the central government, the net effect of using the reserves to recapitalize the banks is identical to having the central government borrow money to recapitalize the banks.”

    Why is this the same amount? Is it because the rise in RMB price from buying more RMB would exactly cancel out the reduction in RMB debt? i.e. in effect, the real value of the debt stays the same even though the cost of the debt in RMB has been reduced? I am assuming if the PBoC buys RMB, it is effectively removing them from circulation and causing the RMB price to rise.


    • Jason,

      I think the quotes below get at your question. If the foreign currency reserves were accumulated by borrowing RMB, then the reserves would fall on the asset side of the balance sheet, whereas the borrowed money would fall on the liability side. If the PBoC converts the reserves to RMB and essentially gives it away to recapitalize the banks, the value of those reserves (from the asset side) must be moved to the liabilities side. I think the important point is that the reserves are not, as Prof. Pettis stated, “a hoard of unencumbered savings” but rather are assets with corresponding liabilities.

      “There seems to be a still-widespread perception that PBoC reserves represent a hoard of unencumbered savings that the PBoC has somehow managed to collect.

      But of course they are not. The PBoC has been forced to buy the reserves as a function of its intervention to manage the value of the RMB. And as they were forced to buy the reserves, the PBoC had to fund the purchases, which it did by borrowing RMB in the domestic market.”

  7. As always, a well-written and well-reasoned discussion.

    However, though I know Mr. Pettis has written in the past about the fallacy of comparing developing country capital intensity to that of developed economies, I wonder whether there may have been a shift (trend) that allows higher productive investment for a given level of social capital.

    Changes in technology may allow the use of lower value labor for a given value of capital.

    For public infrastructure like roads and bridges, it seems costs have come down over time. So an investment fifty years ago that would have built a segment of 4-lane highway may, say, be able of producing 6-lanes. When we witness low utilization of this highway we are surely seeing over investment, but the same amount of capital investment has been made as the developing country made fifty years ago in a 4-lane highway.

    The big question comes down to how productively the capital is deployed. If today’s technology can utilize low skilled labor to produce what old technology required high skilled labor for, then a country with lower social capital can have a higher level of investment.

    • The required skill level always increases. See the Information Is Alive article on my blog linked from my name. The things that used to be produced with higher-skilled workers and now with lower-skilled (e.g. 3D printing a house instead of skilled masons) cost less and thus do not pay for higher capital stock.

    • You should also remember depreciation. A highway built fifty years ago is likely to be in terrible shape unless there have been steady expenditures to upgrade it. I am no engineer but there is widespread consensus that engineering and construction quality in China are very low so that depreciation is pretty steep. It is unlikely that a highway built today) or an airport, a railway line, or a building, will survive fifty years without significant additional expenditures.

    • I would argue technology of course matters, but even more so are institutions (legal, financial, political, etc.) which determine incentive structures that affect how we use technology. To me social capital is really about institutions.

      • Centralized technology relies more on those social institutions, e.g. there is the banking system technology for wiring funds and investing abroad, but this is not available to many Chinese, because of the FX capital controls.

        Decentralized technology can supercede those social institutions, e.g. any Chinese can buy localbitcoins then wire them abroad employing a VPN to avoid the internet censors and thus increase the social capital of China independently.

        I believe this will be a critical distinction between now and 2033.

  8. US nasdaq bubble burst in 2000, its reflation induced housing bubble burst in 2007.
    If china follows in US’s footsteps, China’s shanghai composite bubble burst in 2007, so it’s reflation induced housing bubble should burst in 2014.

    • Not necessarily. If left to its own devices it might, but the central bank can jump in to keep things going. Of course accommodating speculative excess just makes more bubbles, like what we see in the US right now. All it does is postpone the inevitable and make sure that reckoning is worse than it would have been without the guidance of “wise” government planners.

  9. Hi Michael,

    Thanks for another great article.

    How relevant is the TSF measure now? Interesting to see FT China confidential coming out with figures for ùnderground lending` that are not represented in TSF figures yet growing fast. This would seem to be consistent with a previous prediction of yours in that any measure that the government attempts to control will become irrelevant once other forms of financing are invented.

    I would also be really interested to hear who are the other China commentators (bulls and sceptics) that you respect the most?


  10. Excellent article. I’m a long-time lurker on this blog, but I had to post on this. It’s a rare talent to present these accounting identities in a clear and understandable way.

    I don’t have anything to add to the discussion — but thank you!

  11. Since China’s investment expenditure is comparatively higher than most of the world’s coountries, China’s capital stock relative to GDP is lower than other comparable east Asian countries is a good indication that capital investment in China is not as efficient as other nations. Efficiency in investment should be measured by productivity gain due to capital investment, and value of capital stock is measure by production these capital stock can create. Spending money and not getting comparable productivity gain, hence lower capital stock is a sign of not investing efficiently.

    Many Chinese investment were made by first destroying some productive capital stock, like prime farmland close to large cities, and turn them into non-productive empty malls, apartments, cities, office buildings etc. To have any increase in capital stock in this kind of investment is amazing accomplishment.

    • Bill Rich, you ought to coin a phrase for this: October 22, 2013 at 10:59 pm
      “Many Chinese investment were made by first destroying some productive capital stock…”
      Malinvestment only covers half of the concept here. Perhaps, “mal-destructive investment” or, by adding in the displacement of millions of people in the process, “mal-destructive, dislocative investment”

    • I think the Chinese government holds trump in the capital markets. As the leaders of a fairly ‘command’ economy, they might follow their own historical pattern and sieze the nonperforming assets and redistribute them to the people. By then the government would have already indirectly bought them anyway.

  12. Bought and read your book The Great Rebalancing. A great read and substantially increases my understanding of trade and funds flow between nations.

    Thank you.

    • After reading Michael’s book, ‘The Great Rebalancing’, I was struck at just how simple the the arguments Michael makes are. I was left wondering why such simple logic seem to escape so many professionals, who you assume to know as much. Michael is obviously skilled at making a complex issue deceptively simple to understand. His students are very fortunate to have such a good teacher.

  13. Thank you Prof. Pettis for the article.

    FYI there is a typo: It is in the third paragraph in the “Debt and reserves” section. In “three of four chaotic years”, “of” should be “or”.

    With Kind Regards,
    Gerald Yu

  14. Welcome back. So I have to ask, with China’s closed financial system and taking into consideration the amount of debt proportional to the economy, what if they tried to print their way out?

    • Printing money simply transfers wealth from those who are long fixed nominal monetary assets (savings deposits, for example) to those who are short. More money cannot make you richer. Only more goods and services, although balance sheets and monetary policy can help or hinder the production of goods and services.

  15. Why do the PBOC’S liabilities increase by 1% of GDP when the Renimbie increases in strength by 2%. I kind of get the 1% bit, it has to do with the fact that the assert side of the PBOC’S balance sheet will also strengthen by 2%, I guess, but I don’t get why the measure is GDP. Why isn’t it the amount of the reserves? Unless Chinese just happens to have reserves equivalent to one year of GDP…Thanks in advance, Simon.

  16. I’m wrong in at least one way in my comment above. Starting the again…the PBOC’S reserves are assets and at they one point they equalled its domestic liabilities. The drop in value of the assetts by 2% as the Renimbie strengthens by 2% happens as the liabilities side of the PBOC’S balance sheet moves with the currency revaluation. So the spread between the assets and the liabilities becomes 2%. Accordingly the PBOC’S position becomes 2% worse than it was in terms of its reserves or the asset side of its balance sheet. That’s as far as I can get. I can’t see the 1% or what GDP has to do with it…

  17. Prof Pettis

    As a non-economist I’ve been reading all your columns and I enjoyed all of them (and your book).
    But true insight has not be granted to me. luckily

  18. Prof Pettis

    As a non-economist I’ve been reading all your columns and I enjoyed all of them (and your book).
    But true insight has not be granted to me. Luckily as you describe the lack of insight by some economists, I do not have to feel ashame to post my thoughts.

    Suppose that a lot of bad debt is written off by the private banks. They will see equity drop and will need to raise capital to stay solvent (ongoing already).

    But how can the PBoC contribute?
    I’ll use this graph of the balance sheet of the PBoC
    The liability side shows the loans (deposits and bonds) due to private banks. The central bank just prints money and pays back the private banks which will them provide with sufficient liquidity (it doesn’t change solvability) to lend again.

    Money as a whole will not change (cash plus credit) because cashn increases and credit drops.
    Borrowers can borrow again and banks can lend again and the party can start all over again from scratch.

    With increased capital and abundant liquidity private banks are saved and the central bank got rid of its debt. Nothing more than a huge win-win stituation.

    I know I must be wrong somewhere but I cannot figure out where.

  19. Michael, regarding privatization, would this not also be a a transfer of the costs to the public? Seeing that there would no incentive for the state to continue the indirect subsidies to these entities, the value of these entities would go down to reflect such. The cost would therefore be borne by the public via the reduction in asset value of the newly privatized company or by the individuals who purchase equity at an inflated value and would have a more sober value applied at a later date (akin to an inflated IPO). Either way it appears to me that the public cannot escape paying. The only thing that appears to be at issue is the distribution of the losses. Does that seem right or am I missing something?

    • But don’t the losses already exist? They just haven’t been realized yet. The asset is worth what it is worth, whether or not it’s privatized. You can hide the subsidies, but it doesn’t change the underlying value of the asset.

      • I would think that it is not an issue of hiding the subsidies but more an issue of removing the incentives (influence) for them. To your point though, I do believe that the losses already exist and that the public is on the hook for them. The only issue is how the losses will be distributed. With no privatization, the subsidies continue and the public pays. With privatization, redistributing the equity to public, the shareholders will take the loss, or in effect pay. The only way I can see privatization as being useful is for foreign capital to buy equity at an inflated rate.

        • Glen, assuming the entities are being privatised have a positive value currently then the state will get some cash out of the deal that it can use eg to rescue banks. I agree that there would be a risk for domestic businesses that they may then try to improve profits by squeezing consumers. On the other hand we may be talking about export businesses, or they may raise profits through increases in productivity?

          • That is my question though. My thinking is thus. Privatizing the companies simply monetizes an already held asset. The public, via the state, already owns them. The exercist is in effect a balance sheet transaction. The danger is that once privatized, the incentives that add value to the companies, repressed interest rates, regulatory regimes, access to capital, etc. are no longer in the interest of the State (Public). That reality would surely be reflected in its value.

        • I forsee that eventually the government will eventually sieze the non-performing assets, as a “command” economy as such, and redistribute them to placate the people. Some day in the not too distant future many of the migrants-dispossessed will become the proud owners of millions of as yet (or ever to be) unfinished properties. Nothing like the power of a people’s command economy.

      • Value is a subjective concept. Paper currencies are only as good as the faith placed in them as stores of value. If China vastly over-builds, then the assets can eventually be treated as a form of fiat store of value, especially if declared so. Migrants get an unfinished home if they stay of the streets.

  20. I would like to piggyback on Eric Johnson’s comment and thank Prof. Pettis for his highly logical and reasonable (and quite thorough) writings. I became aware of this blog earlier this year and recently finished reading through all 5 years or so of posts. I have no economic training, which explains why I might be off on the comment above, but feel that I have benefited greatly even if I’ve absorbed only 5% of the material.

    Prof. Pettis, random question, is there a site where one can hear studio recordings by several of the underground/indie/whatever you prefer musicians that you name drop from time to time? I’ve always wondered about such a scene in China. I’ve only seen YouTube clips thus far.

    Thank you!

  21. Dear illumined,

    As an avid reader of Prof Pettis’ books and articles let me try to answer your question.

    Printing monies is similar to the tax on populace which would result in decrease of consumption portion of the GDP. This would also increase import prices on food and other necessities which all would result in populace turmoil. Government would have to increase investment substantially to compensate for loss of consumer wealth. This increase in investment would further increase debt as
    as Prof has explained.

    In summary, you would continue with extending present export driven model but now you would add greater debt and populace turmoil with dubious export increase.

  22. I have to say I’m always taken in by your arguments,and find your reasoning a nice guidance in macroeconomic thought (where I have no training). But I really struggle to get around your thinking on economic growth in general per se, and specifically i terms of the Lehman crisis.

    Maybe you only think in terms of classical economic growth, and perhaps fail to take into account a possibilty of a real restraint on growth in terms of our natural environment? We are after all 7 billion and counting (probably more, given population statistics methodologies). Can we endlessly draw on natural reserves without considering our long term impact?

    I don’t want to drag you too far off-topic, but do you really see the Lehman crisis as having addressed anything in real terms? This is purely anecdotal, but I spoke recently to a friend of mine who was a derivatives trader until 2008, when he found himself out of work during a sick leave… He’s now been through a new round of interviews (and is happily reemployed), and his view is that all potenital employers are still seeking the maximum possible risk exposure for any given scenario. Maybe long term risk has mostly just been shifted to other economic entities?

  23. Thank you Michael.

    A lot of commentators think that ‘central bank reserves’ mean “a pile of cash”; they never stop to think how the central bank acquired these reserves in the first place and how they were funded. Central Bank reserves are not akin to a piggy bank that can be doled out to whomever needs or wants it. I hope the Party leadership understand this too!

  24. Prof. Pettis,

    In your previous works/books, you basically point to QE as the form of a currency war. To my understanding, QE primarily creates bank reserves while creating a relatively smaller amount of bank deposits. How exactly does increased bank reserves result in a currency war?

  25. Professor,

    Have you had the chance to check the book “The Age of Oversupply…” by Dan Alpert? It is not that the perfect explanation behind the trade imbalances: billions of new workers joining the global labor force after the fall of the iron and bamboo curtains.

  26. Glen,

    Your deduction is correct except for the statements that assets will be purchased at inflated values.
    One can not estimate exactly how much say “certain capacity of unknown state subsidy steel plant operating at 50% capacity” is worth? Certain syndicated buyers might overpay and some under pay.
    (Just like one can not tell how much a mortgage debt is worth when it is collateralized with 100 slices.)

    Prof says that debts ” must always be paid”. (I wish we could send on the rocket to the moon.)
    So purchases, in overall , will curtail the duration that the debts will be minimized and the economy will stop slumbering and start growing.

  27. Prof. Pettis,

    “One of these days I will catch up to the late 20th Century and will be able to figure out how to mange on my own..”

    You obviously need the services of a teenager. (It’s generational.)

    I know a perfectly competent, but older, engineer who could not figure out how to use his new DVD player until after 6 months his 14-year-old nephew came to visit. Problem solved in 30 seconds.


    If my son weren’t traveling, I would have never have known how (or why) to use Skype or Facebook.

  28. Hi folks,

    Firstly, thanks for the article Michael, I have seen the argument regarding China’s foreign reserves floating more and more recently, and I kind of understand why it is incorrect, so as usual your piece here is timely.

    I have a couple of questions, that Michael or somebody else here may be able to answer for me. When you talk about the liability side of a central bank’s balance sheet, what does that comprise exactly? Is it simply currency in circulation, or is there more to it? I have been under the impression that the PBoC created new RMB in order to purchase USD when it intervened in the FX market. But here you are saying they borrowed RMB in the domestic market; is this ‘borrowing’ in the sense of, say, the central government issuing bonds in the domestic market? Or is it the issuance of new currency into the system, which is a liability on the central bank’s balance sheet?

    • I believe the PBOC used to mostly credit commercial bank reserves and either issue RMB bonds to sterilise or raise reserve requirements. I’d say reserves comprise about half of PBOC liabilities with currency and central bank bills making up much of the remainder, but I’ve not seen any recent breakdown.

      • Layman comparative question on the liabilities side:

        Why does the PBOC have this problem and not say the fed? Is it because the Fed does not sterilize increases in balance sheet?

        Ie. So when the Fed “prints money” it merely credits the reserve accounts of commercial banks with bills, but does not sterilize this by issuing debt to the banks. But when the PBOC “prints money” it credits the accounts and then sterilizes the increase in the money supply.

        Probably a silly question but Why can’t the PBOC just stop paying interest on those reserves?

        I’ve probably got myself in a muddle but any help amazing.

        • Their aims are slightly different. To maintain the growth boost through the current account, the PBC must buy all the dollars offered if it wants to control the value of the RMB. There’d be little point in doing that if the extra however many yuan in the money supply simply pushed up wages (and therefore costs to the export sector). The Fed’s QE is for a variety of reasons: lowering interest rates; supporting asset prices and therefore bank and household balance sheets; belief this will stimulate lending; devaluing the dollar to counter surplus country accumulations; any other reasons take your pick etc. Whether the effects are the same is debatable.
          Regarding interest on reserves, I suppose the decision needs to be seen against the backdrop of what arsenal the PBC has to control the money supply. So, it’s reserve requirement; levels of excess reserves; how reserve int rates affect other short term rates; how banks anticipate rates (and therefore pre-build reserves; role of non-bank sector etc.

  29. Hello, I’m a long time lurker here. No training in economics so I apologize in advance if my questions are too dumb for you all.

    First I just want to say this blog is my favorite of all those that I’ve come across since 2007. That’s not saying I understand it! Haha! I do find most other blogs overwrought with one form of ideology or another.

    My comment tonight is that every time I read this blog I find myself wishing that the author would say outright whether or not he thinks that the American middle class is doomed within this decade or the next.

    Sometimes I think he is saying that the US is doing pretty darn well in comparison to the rest of the world per the financial crisis and that somehow the US Federal Reserve is going to pull this off and the American middle class will blithely walk away unscathed and debt will be repaid— perhaps because it gets to export the problems to China and other, poorer, export model countries. QE currency war, for example, a war that the Chinese cannot hope to win.

    And, if it is true that a developed country can export inflation, can it export debt problems? Or is this two ways of saying the same thing?

    It seems to me that the same issue that is talked about in this article is current here in the U.S. Some float the idea the U.S. treasury can just hand the Fed a platinum coin and bingo, problem solved.

    It seems to me that toxic debt in the US banking system has only been shuffled about, with plenty of smoke and mirrors by the FED. It hasn’t been written off and therefore will have to be repaid painfully over decades through inflation, increased taxes, cuts to social welfare, loss of interest income, and loss of GDP. A nice way to say there will be high unemployment for a long time, no wage growth for the average working person and an overall lower standard of living for the 90%.

    Or is this scenario now a given, and the author doesn’t say it because it is obvious to himself and the economically educated here on this comment board?

    In other words, it would be great if all you smart people here would offer up some good news for a change and tell me to stop reading the doomsday blogs.

    Also, just want to say that I know there are lots and lots of poor people in China and I don’t mean to imply that it would be great if America could just dump their problems on them.

    On that note, is it too simplistic to say that there are only two ways this is going to go. Either the American middle class will have to take a big step down in lifestyle at some point in the not too distant future or . . . for that NOT to happen the mass of Chinese and the world’s poor will have to keep on being poor so they can keep building things for us for cheap, cheap, cheap.

    Okay, I’ve embarrassed myself enough for tonight with these simplistic questions.

    • In my view its precisely because this blog isn’t “overwrought with one form of ideology or another” that you probably won’t get such an opinion from Michael. Through his various writings and other commentary on economics and finance, he states the ways global imbalances can arithmetically resolve themselves (and that one way or another, they must) but that the exact method chosen will usually be a political decision and therefore outside of his expertise.

      With respect, some of your ideas are a bit muddled, but whether the US is exporting its problems to China depends on your point of view. Could it not equally be said that China is exporting its overcapacity problem to the US? And whilst certainly not poor, Germany doesn’t seem to believe that they are importing rest-of-the-world problems through their own trade surplus (although I think they are wrong.)
      Similarly the debt that the US is exporting (as you say) is really a function of the balance of payments. By running a current account deficit the US must import capital in order to finance it and equally China must export the dollars it accrues from its current and capital account surpluses. This shows up in Chinese central bank reserves with US government bills being the only practical destination. These exchanges are almost unconscious and simultaneous; one cannot exist without the other. This fact has been repeated here ad nauseam. Your mentioning of the platinum coin idea is in my view a domestic and political US issue about the extent of the state in society and politics of Congress and will probably not find answers here!

      On your central theme of the future of the US, one point Michael does make, is that demand is a valuable commodity in the world today and that countries with a shortage of it (those with trade surpluses e.g. China and Germany) historically have borne the brunt of readjustment when imbalances are resolved. Equally, countries with an excess of demand (the US and other deficit nations) do not have the same problem. I’m no expert on banks, but the US appears to be making better progress at writing down bad debt in the banking system than probably those in Europe.

      • Indeed it appears the outcome in the USA will be politically decided. If the government is not successful in convincing the broad populace to backstop the $quadrillion of derivatives of the too big to fail banks, then the writedown will be charged mostly to investors. Whereas, if via the growing socialism movement, the populace can be convinced to accept $trillions in bail-ins and $17 trillion in retirement plan nationalizations, then the broad populace will pay for the writedown.

        I can cite the official G7 government website plans for the bail-ins which stipulate that writing down trading losses (e.g. derivatives) takes precedence over bondholders and depositors; and the discussion of the $17 trillion retirement nationalization has reached official agency level already. Also I cite references on the well documented theory that Obama refused to allow continuing funding proposals during the recent government shutdown in order to enrage the broad populace and insure the democrats win the Congress in 2014, thus giving them the power to carry out these plans and to raise taxes (“tax the rich” which really means the middle class and small business) significantly. Giving traitor Boemer, the Tea Party has split from the Republican party which is now disintegrating.

        Europe is already well along this socialism path as Spain recently added a tax on sunlight and France recently made it illegal to shutdown a company that is unprofitable, thus forcing the company to increase debt perpetually.

        Google “Some Iron Laws of Political Economics” to understand why socialism can’t retreat without a Minsky moment chaos.

        • “the growing socialism movement”


          All I see are fewer and less powerful unions, and infighting between a center-right party and a right wing party. With the health care exchanges, we are also very likely to see US welfare programs be privatized and utilize this same system.

          • Andao, governnment mandated health care exchanges is not privatization. Perhaps less unions, yet the number of Americans receiving government aid is increasing. Your so labeled “center-right party” is far-left and intends to tax above the Laffer limit as soon as they obliterate the Tea Party in the 2014 congressional elections due to the very clever manipulation of blaming the government shutdown on those who wanted to fund everything but Obamacare.

            The central bank ZIRP continues which is the only proof you need that socialism is increasing.

          • Andao, perceptive. Dem moved to right during after Reagon, Rep’s then became disoriented, rather than build a new viable perspective and platform, they are floundering about (see Shelby for one of the camps, although likely he will find himself in no such place, little difference systemo-ideologically, but merely in choice of principles, in the techniques of Marxists or Libertarians).

            Just pushing a set of simplistic belief constructs of lessening relevance in an ever more complex world. Globally, the consuming and investing world, as well the political world, new forms, structures, values and beliefs need emerge due to the interactions and impacts. One man’s saint, another man’s sinner.

            But the Affordable Care Act (known “obfuscatingly” as Obamacare) is useful.
            A 35 year old non-smoking male, can get health insurance for as little as 50 USD a month. It is insurance in the purest sense of the world. Fall down a flight of stairs, break your back, leg, neck, require extensive treatment……you pay the first 10,000, or are liable for such, the rest covered by insurance. Health insurance is just that, insurance. Shelby, I fail to see why you have a problem with this, if I am sick the hospital must care for me, insurance or not, and then bear the cost, raising the cost of care for everyone. If an affordable, true insurance, rather than a warrenty plan, can address these issues, lowering costs, and making more efficient, and rational care, then why do you have a problem. Incidently, 20 years ago, when I used to design programs, the cost of a decent plan was 4,000 a year (11,000 for 2 or more in a “family”) , or (around, considerably more than) 7 times the cost of what can be had currently.

            Such is similar to the cost of Allianz global care (for care outside the US and Canada), on an annual basis, so it would seem there is a global market clearing price at stake here, my friend.

          • I simply don’t believe that any neutral observer of political parties worldwide can characterize the Democratic party as “far left” or “socialist”. A Conservative MP in the UK would get hammered for suggesting the dismantling of the NHS. A Democratic representative from anywhere outside San Francisco would get equally hammered for suggesting single-payer healthcare. That illustration alone puts the Dems to the right of the “center right” Tories.

            The exchanges are a good step towards possible welfare privatization. Economies listed as among the freest in the world like Singapore have mandates.

          • Guys thank you for both pointing out quite eloquently that the world has turned socialist, thus the “far-left” is now the “center-right”. For me as a minanarchist (subset of Libertarian), any redistribution plan is “left” relative to a historical baseline. If the entire population is left, then I have to wait for them to kill themselves as leftists always do, so then the true “center-right” is restored after that.

            They always kill themselves because they don’t understand the basic premise of economics, which is that small things grow faster, thus any form of central planning is waste and bankruptcy, but not until after the socialists do everything they can do to disallow bankruptcy including gestapos, rationing, etc. I want to refer you to some specific comments I already made on this page, which go into more detailed explanation:

            1800s vs. 1900s vs. 2000s coming

            failure of centralized investment

            why smaller things grow faster

            illogic of collective central planning

            The reason insurance is always failure is because it pools investments and the investments are thus centrally planned.

            Sorry to you socialists but I remain a minanarchist because history has always repeated. The socialists get blinded by a recent 50 – 80 years, so then they drive over the cliff as they always do. How many genocides, dark ages, and massive economic implosions from history do you need me to cite and relate to the socialism that caused them. Of course the socialists will invent other causation theories. C’est la vie!

            Since I am the only minanarchist here and since I think Dr. Pettis wants to hear from all sides, I hope you all understand why I have so many comments on this page, because I am the only person speaking from the other side on this page. Yes we are far outnumbered by the socialists, and that is why we need an anonymous weapon to survive the outcome of socialism, such as Bitcoin as I have suggested as a possibility (not certain).

      • Thanks for your reply.

  30. Hi Prof. Pettis. I enjoyed your new book. One debt resolution you don’t discuss in much detail (in the book, on your blog) is monetization (for either public or private debt). For countries built on the Asia model and have accumulated net foreign assets it seems like a no-brainer (future) option, and excuse to increase (present) debt. First, monetization would: (a) devalue and boost their current strength in tradable goods, and (b) increase net balance sheet because of FX adjustment. Second, although this continues the imbalances, there is a subtle strategic political advantage. If a country is in a situation where their debt is perceived as “unpayable” the trade tensions would be less. The situation is similar to how LBOs in the 80’s used large debt to obtain worker and supplier concessions. Third, monetization is a fast and transparent “debt repayment” option (easily valued by and visible to all market participants). What’s your view on this and does the historic record have anything to say for the modern test case — Japan?

    • Jt26

      Isn’t Monetization of Debt part and parcel of the Asian Development Model with their commitment to ever expanding growth in Money Supply added to the financial repression mechanisms that Michael describes here.

      • Monetization in the strict sense: liabilities are on government books; government debt is issued and monetized by the central bank. The Japanese government has certainly not assumed massive hidden liabilities, but China clearly has.

  31. Thank you very much : i have been reading “the great rebalancing” and then became a regular reader of your blog on China’s economy.

    I have found the debt of China to be in the range of 180 % of its GDP, adding up government, household and corporate debts (cf reference below)

    To complete the debt picture, I am trying to figure out what is the level of debt of financial institutions in China : could you enlighten me on this point ?

    reference : http://www.ft.com/intl/cms/s/0/e76db82e-0a4d-11e3-aeab-00144feabdc0.html?siteedition=intl#slide3

  32. The solution to China’s debt spiral is the same as the solution to utilizing the FX reserves most efficiently by increasing imports– liberalize the economy so decentralized fitness[1] of private investment can provide (investment and employment) opportunities for the home sector and thus consumption to rise. The export and housing sectors are heavily subsidized and pushed to overinvestment (and oversubscription of available resources) by centralized policy and crony ownership.

    [1] I’ve explained fitness in terms of simulated annealing and degrees-of-freedom in past blog comments, and a simpler way of visualizing it is that small things grow faster, i.e. selling cold water on a hot day can double or triple capital, yet a billionaire can never do that in a day.

    Correct me if I am wrong, but China’s debt spiral hasn’t peaked yet thus adjustment hasn’t begun in context of a Minsky moment that ALWAYS occurs at the peak (i.e. China’s solution to prior debt crisis was not a peak, rather an extension to enable debt to continue to grow). China can’t make such a drastic shift without chaos (i.e. a transfer from crony sector to write-down the debt), and chaos won’t be accepted willingly. So will China slow grind while increasing debt perpetually as Japan did for 23 years, or will it have a Minsky moment sooner forcing it into chaotic adjustment? I would love to see an article that explored the differences between Japan and China towards understanding the factors. Japan can’t continue to increase debt forever, thus a Minsky moment must eventually occur.

    I again take issue with Michael’s repeated contention that the USA has adjusted. The banks have not been recapitalized because they are sitting on a $quadrillion of derivatives that are going to blow up ostensibly when Europe, China or Japan does. It was the default of Rothschilds’ small bank in Austria that set off the contagion of World War 1, so it may not even require one of the major economies to blow up. Debt continues to increase globally and the USA is no exception.

    Michael, how do 300+% debt-to-GDP levels (with a $quadrillion of credit swap derivatives as the enabler) for the entire world resolve in historically. Every one with a noodle should understand there is going to be massive chaos ahead and there is no solution that can avoid that Minsky moment. What am I missing that causes you to think the USA has adjusted or recapitalized? The socialism and debt is increasing everywhere, no write-downs or peaks have been achieved except perhaps in Iceland.

    P.S. Michael thanks for clarifying that you desire comments. I was contemplating if you had turned them off intentionally.

    • The UK has had similar debt levels several times in its history. The UK has had public debt levels of close to 250% of GDP several times as well. Prof. Pettis talks about how developed countries can sustain much higher levels of both public and private debt because they have sophisticated financial institutions and don’t need external financing.

      • Both prior instances were due to wars that were fought to end socialism, i.e. the 260% level of 1816 was implicitly the victory of the colonists over the Luddites who wanted to maintain the status quo against technology and implicitly the flow of jobs to the new world, and the 225% level of 1945 to defeat the remnants of the fallout of socialism in Europe that culminated in the Great Depression. In both cases, UK was able to leverage the growth from the fall of socialism to pay down the debt.

        We have a very different situation now, because the entire developed world is in 200+% debt, with the developing world following as a child holding the hand of his parent. And that debt was not due to wars to defeat socialism, but feeding and sustaining the socialism.

        So to get future growth and pay down the debt, the socialism must end. But to end socialism, the debt must be paid down. Thus a global Minsky moment is the only way out this time.

        And I believe I know precisely where the growth will come from.

        And I believe the technology of decentralized currency (e.g. Bitcoin) will wage the war.

        • I don’t think I agree with what you represent the history to be. You talk about 1945 to “defeat the remnants of the fallout of socialism”, but Hitler actually criticized the US for the excess amount of wealth/income redistribution. The US, since the beginning of the 19th century, has had the most progressive tax system in the world and everything seems fine.

          I also don’t understand where else is better than the US right now? Europe? Not a chance. Japan? No, due to demographic issues. China? Again, demographic issues will be a major drag. Canada or Australia? Maybe, but they are commodity exporters, which means that a collapse in commodity prices(which I think is inevitable) will hit them really hard. The UK? Doubt it.

          • Yet Hitler printed his money to do Keynesian economics. And how did that universal health care system work out? I had a longer rebuttal, but talking about that period is a sensitive issue and certain things are apparently better left unsaid.

      • Hopefully my prior comment posted. I can’t see it, because this site’s server is so often not responding that my cookie didn’t get set.

        I forgot to respond to second part of your comment:

        Prof. Pettis talks about how developed countries can sustain much higher levels of both public and private debt because they have sophisticated financial institutions and don’t need external financing.

        In my opinion, this is hogwash. Debt always peaks when the socialism that is backstopping it is destroyed so that the productive sector can be freed. Europe has ridden it back up again on the back of the USA’s transition from a producer-lender, to debt-consumer. Sophistication of financial institutions in this case means the ability to write a $quadrillion of derivatives to feed the global sovereign bonds bubble and its synergistic socialism.

        The end this time comes by destroying the western financial system and those so called sophisticated financial institutions.

      • And here comes the contagion as global trades slows for the first time since 1980. Already money velocity is down by 50% in the developed world.

        Socialism and debt are approaching the Minsky moment. Next comes the new frontier of decentralized internet (and other decentralized technologies, e.g. 3D printing for decentralized manufacturing) which enables the productive sector to break free from the socialism tax that is dragging down expansion.

        • The US would be better off relative to all of the other countries in the world if global trade collapses. The US is a deficit country, which means a collapse in global trade would cause the current account balance to increase, thus causing output (and aggregate demand) to rise. It would actually help deleverage because there’s income that wasn’t there before.

          • Agreed the USA will benefit long-term from such a global write-down, but first you have to factor in the political response to such an initial implosion. The postulated implosion has a huge political cost in the USA, because it means everyone who is benefitting from the debt bubble now has to see a reduced quality of life. The socialism simply won’t agree, and instead it will try to increase taxes and nationalize wealth in order to delay the reduction of debt.

            Interestingly the recent Tea Party action to force government shutdown was not a total failure for them. Obama has now decided to move Treasury issuance from short-term to 2 year notes, to avoid weekly funding defaults in a shutdown fight. Thus interest rates will now rise, which will drastically increase the total national debt. This is will reverse the 23 year bond bubble and break the back of the debt bubble.

            Refer to the Financial Times link in my prior post (to which you responded) as it documents world trade falling below global GDP growth in 2012 and 2013, which is the first occurrence since 1980 and considered to possibly be a warning sign given it was a consistent feature of the tumultuous first half of the 20th century and global Great Depression.

            I read in the Nov. 4 issue of the Manila Times, that total ASEAN (excludes China and Japan) exports are roughly $1.5 trillion with imports only $22 billion less. Yet intra-ASEAN trade is only $33 billion. So ASEAN has roughly 1/11 of world population, yet only 3% of global GDP, and while having a respectable 8% of global trade, only 3% of that 8% (i.e. 0.24%) of global trade is intra-ASEAN. And the trade surplus is miniscule.

            Thus ASEAN will plummet if global GDP and trade plummet. Especially the Philippines as it is overly reliant on exported labor (overseas workers) in Middle East, as maids in ASEAN, on ships, etc., which drives the consumption domestically (building malls like crazy here), and everyone is running around as fast as they can to take on more debt to open a retail business. I even read in that issue of the Manila Times a proposal to forgive tax on real estate, so that filipinos could afford to transfer titles from dead parent’s names in order to obtain loans on the collateral. Brilliant idea to give debt to people who are too poor to afford to pay the miniscule real estate and capital gains taxes at the top of a global debt bubble. This sort of misallocation insanity seems to be everywhere in the world now, which is expected near the top of a debt bubble.

          • Oh and add that the likely reason global trade is now growing slower than global GDP, is because the western nations are entering some mild austerity (the postulated horrific austerity will come with the postulated global implosion) while GDP is now being pumped up in emerging nations with debt, which does nothing for global trade, as you can see by the miniscule $33 billion intra-ASEAN trade figure. This was implicitly predicted by Prof. Pettis in his Foreign Policy globalization article.

          • Shelby, do you view the “debt ceiling debates” as a good thing or a bad thing? There is already hatred towards the massive government debt and the Tea Party is recognizing that the deficits are unsustainable. There’s actually a talk to fix it. Our public debt is less than half that of Japan, but there’s already more talk to fix the debt here than there is in Japan. I view this as a good thing.

          • Shelby, do you view the “debt ceiling debates” as a good thing or a bad thing? There is already hatred towards the massive government debt…

            The recent example in France is everybody supports “taxing the rich” so they can keep their cake (social benefits) without paying any more. Yet when Hollande tried to implement taxes, every sector that was affected protested violently, e.g. the farmers blockaded the roads and the millionaire soccer plays refused to play.

            Thus when you say everyone recognizes the problem in the USA, it doesn’t necessarily follow that there is a political solution. Democracy throughout history is paralyzed when it comes to lowering costs, it only can raise costs, because every individual wants benefits and can agree to charge the costs to the collective. The USA Constitution says we are a republic (i.e. the 51% can’t dictate to the 49%), not a democracy, but many of us argue that this document is increasingly no longer applied.

            A recent real world example is a college professor failed his entire class when they insisted that Obama’s social programs were a good outcome. He did this simply by telling them their grades would be the average for the entire class. On the first test, the average grade was a B, by the second test it had fallen to a D because the lazy decided they could free ride on the hard working and the hard working decided they had lost their incentive to work hard. By the third and subsequent tests, the average was F as the students bickered and fought about how the hard working were not doing their part. Sounds very familiar to the rhetoric we hear from politicians such as Bush with “you are either with us or against us” and Obama with “you didn’t earn that without the benefits from the society and government and thus you have a responsibility to share”.

            Rather I think what really matters is where we are in the repeating cycle of minimal to maximum government. In other words, I believe the cycle is on auto-pilot. Right now I assert we are in Public to Private wave shift as government debt and socialism are peaking, and thus the decentralized technologies will be the most effective paradigms as we pass the peak and head down again towards minimal government. I believe the social institutions will all fail and will only be effective again after we reach minimal government and start going back up again.

            I derive this understanding by applying the scientific method on history. Perhaps I am selection biased by my minanarchist politics.

            No one can with certainty predict all the nuances of how that cycle meanders on its way to the what I expect based on history. However, it looks possible that the Democrats will kick out the Tea Party at the mid-term elections because at least 51% hated the government shutdown and receive benefits from the government. From my vantage point, Obama appears to have played his political poker hand astutely.

            Thus what democracy says is much less important than what it does. Government entitlements are increasing, fiscal deficits are grotesque at roughly $1 trillion, debt is increasing, and ZIRP is coming to an end. This means a continued exploding public debt, especially interest rate rises will cause the national debt to explode upwards.

      • ya, the moment Uk’s debt began to decline from 250% was the dissolution of the British empire.

    • ” The socialism and debt is increasing everywhere”

      i am not socialist, nor liberal, nor conservative, nor communist, nor anything else… i just wonder why there is an association made out of the blue between debt and socialism (or any other supposed government style) except as a way for people may feel convenient to use as a scapegoat.
      could you explain if there a specific rationale that i miss here ?

    • Shelby

      Your Quadrillion, isn’t that a reference to global derivatives and (weren’t) aren’t European banks, much more predominate in the practice.

  33. It is clear that even burning the accounting books someone ends paying the debt or holding the bag. Usually those that are the least responsible for the bad loans will end payng the most. The world has become the place where a few privileged gamble with the future of the rest. This is something we are painfully learning in Spain and, sadly, will almost certainly learn in China. It seems that many NPLs were made to SOEs, and those are necessarily backed by the state. Privatization of SOEs assets is an alternative to household income repression. My question is that although privatization could be an opportunity, history teach us that privatizations are often made in ways that render the losses to the households anyway.

  34. Appears that when you re-enabled comments, you forced all comments to be approved by the moderator, whereas prior you had enabled comments with less than two urls (links) to be approved automatically. I don’t know if that is intentional, so I am informing you.

  35. Will the Chinese government and central bank not just step in as a buyer of last resort? At fire sale prices to boot. Since the vast majority of Chinese people actually have very little to lose, this will actually be accepted by the masses as a just desserts for the small percentage who have gotten rich through property speculation and the ability to borrow. When local Chinese governments default, it will only be wealth created by the bubble in the first place that gets destroyed.

    The Chinese central government will be able to do this as they have sufficient reserves to continue to import the goods the country needs until the bubble dynamics are wiped off the books.

    • In what fantasy land does economics mean movement of currency. Money is merely a claim on PRODUCTIVE labor. And only economic production is PRODUCTIVE. Printing a million digits of currency does not make activities PRODUCTIVE. If you don’t understand the relevance of my reply, that is intentional, as it means you don’t have a clue about what economics is.

  36. Thanks Pr Pettis for this excellent post.

    When discussing whether China can or cannot use its FX reserves to recapitalize banks, analysts often claim that China already did it in the past (in 2005 I think), so they should be able to do it again in the future. How can we reconcile this with your argumentation, according to which this should be impossible? What did exactly happen in 2005? Thanks in advance for your insight.

    • Debt continued to expand. Debt is much higher now and can’t expand forever. Recapitalizing the banks again by stealing more from the home sector will just exacerbate all the imbalances China has been exacberating since the prior instance. At some point, the crony sector has to be defeated so that the home sector can take over. Just moving digits around doesn’t change the underlying structural inefficiencies and malinvestment that central planning and cronyism entails. See my comments upthread for elaboration.

    • What you are referring to was when the PBoC bought shares in the banks and paid with dollars, so that assets were unchanged. The banks were fully owned by the government then. Of course any time banks sell equity their ability to absorb losses rises, but this happens no matter who buys the shares and how they pay. Reserves have nothing to do with this. The PBoC could buy as much bank equity as it wanted even if it didn’t have a single dollar in reserves. Of course if the banks lose money, the equity holder must absorb the loss, which is why most central banks do not like to buy bak equity — their ability to bail out the banks is hampered exactly when the banks need to be bailed out.

  37. Nationalizing actual cash value pension funds is a viable idea. Because then the initial Government debt would be interest payments to the pension funds. Otherwise ,the pension funds would seek various investments and even very scary “derivatives”. Of course, the argument can be made that pension funds could earn higher returns besides government bonds. But, then the pensions could suffer worse losses if invested in an insecure world climate. Furthermore, there would be no need for any country to buy US Bonds. But this will be a political decision.

    In the future, government pension funds payout would increase , but by then the economy should improve and governments tax intake would increase to cover substantially the larger payout.

  38. China does not sell its foreign reserves but buys a lot of things abroad with them . China becomes an important shareholder abroad in Southern America, Africa, and European major businesses. China buys European huge areas of land with former European military airports with the purpose of establishing there European companies using Chinese imports and components.

    Thus, even if China uses a part of its foreign reserves to recapitalize its banks, the rest is not sold and it is unlikely to see the yuan rise because of the huge Chinese foreign reserves .

    • Instead of ‘foreign reserves’ I should have written ‘FOREIGN CURRENCY RESERVES” or DOLLAR RESERVES. It is what I meant .
      Thus, even if China uses a part of its DOLLAR reserves to recapitalize its banks, the rest of its US dollar bonds is used to buy businesses abroad and it is unlikely to see the dollar fall and the Chinese yuan rise because of China’s huge dollar reserves. Thus, they are not a problem for China but an advantageas they are used to buy foreign land or shares of major foreign businesses abroad with the purpose of implanting Chinese businesses everywhere in the world . It is a mistake to rely on the huge foreign currency reserves detained by China to boost foreign (American) exports and refrain Chinese exports.

      • @ Canto… the strategy you mention is not a new idea. It has been executed to great failure many times before. Billions of dollars have been lost letting government bureaucrats purchase assets in foreign lands. I believe substantial losses have already been incurred from Chinese investments in raw materials abroad. Most of which are paper losses at this point, but losses none the less. I wonder about the present value of projects where infrastructure was completed by a Chinese state firm in a foreign land in return for a stream of primary materials.

      • Reserves are really a consequence of suppressing the Renminbi, not the cause, and this action boosts Chinese exports, not American (or any foreign).

        China’s purchase of foreign assets would likely show up in the capital account, not really as a use of reserves, although the effect on them (a reduction) would be the same. It is not the function of central banks to act as sovereign wealth funds and is usually undesirable. Any losses would of course be borne by the state anyway. Moreover, given that China already exports its tremendous excess production, I’m not sure adding to it with foreign purchases is helpful.

        • Buying huge areas in Europe, some including existing AIRPORTS ( for example the firm Beijing Capital Land has bought former OTAN military airports in France) is a way for China to neutralize in Europe the new European protectionistic measures meant to stop cheap imports from China. It is a way to avoid the very high taxes on some imported goods from China and the total prohibition of others such as the cheap solar photovoltaic tiles made in China . This way, Chinese businesses in Europe, all with European sounding names, can import cheap Chinese components and spare parts, assemble the products in Europe and thus legally stick would-be European labels on them .
          Purchasing firms, land and airports abroad is, for the Chinese, a very clever way of getting rid of reserves of worthless American dollars for the sake of Chinese prosperous businesses. ..

  39. Interesting times in Beijing. Peking University economics professor, Xia Yeliang, was recently fired over his dissent against The Party, and Uighur separatist are suspected of causing a fatal vehicle crash in Tiananmen. Be safe, Michael.

  40. Hello Dr pettis. I read your book: the great rebalancing. And i was thinking since we have the ability to control the expansion and contraction of credit in a local economy using central banking and interest rate targeting. Isn’t there a possibility to do the same for global current account imbalances?

    I do not believe that imbalances being periodically rationalized by a crisis is a necessity of global capitalism, this analysis ignores the monetary system wich could impose some discipline on agents and force them to settle payements before they get overextended,or provide elasticity if things get to slow down;what you called a “rationalisation of contradiction” could be understood as the fact that there was a period of too much elasticity of credit followed by a Minsky moment, central banks can solve this in a national economy. So why not have a world central bank? with a world currency? this central bank would force surplus countries to share the adjustement burden with deficit countries by cutting their ability to maintain a prolonged current account surplus by rising the funding cost of rolling over the deficit. I confess this is a bit scketchy but a better international monetary policy could solve these problems in principle.

    • Remember that before central banking came. The 19th century was sequence of crisis after crisis, not just booms and busts. Panics were common, and understanding of the role of liquidity, volatility risk and the nature of money was primitive at the time. So many thinkers of the victorian era, Marxists, and non-Marxists believed that crisies and panics were a necessity of Capitalism; yet after we got better at monetary policy, we still had booms and busts but not a sequence of panics, at least at the national level. So isn’t there a way to extend this to the international framework?

      • Panics in the 1800s were due to the private banks writing fractional receipts for gold on deposit, thus expanding debt and monetary velocity, until individual bank runs would reveal the insolvency of fractional receipts thus causing frequent corrections to the overexpansion of debt.

        In the 1900s, we replaced this with centrally controlled fractional reserves, which has enabled the global system to run to extremely insane levels of debt without frequent correction. And this is going to end in a scorched earth.

        There is no solution as documented in my upthread comment with link to Mancur Olsen’s analysis. Decentralized currencies such as Bitcoin have the potential to bring us back to the 1800s with more frequent corrections, by restoring the balance-of-power between socialists and private enterprise. As a minanarchist, I would prefer that, but today the world is dominated by socialists and they will not like it. So there is fight coming. Sorry to say. I wish it wasn’t so.

        • I don’t see how bitcoins can change anything, people can still issue promises to pay bitcoins in the future as a means to expand the money supply. For large multinational corporations with an army of lawyers and lobbiests it is easy to devise arrangements in order to build a credit structure on the discipline imposing currency. Governements on the other hand can always force you to use their issued liability as money, since you are obliged to make payments to them in the form of taxes. In fact you end up with two monetary systems, one with private money and the other with state money. The only ones who will see any discipline imposed on them are ordinary people like you and me.

          • Well I was going to tell you, but Michael deleted my comment.

            Michael, Bitcoin is sanctioned by the elite, as they created it. Don’t be so worried when I talk about central banks w.r.t. to Bitcoin.

    • Keynes wanted the IMF to play this role, but unfortunately he was overruled by HD White.

      • I guess that such an overruling shows that money is not just a neutral means of payement, but also a creature of the nation state. Central banks are not just bankers’s banks but governements banks too. They intervene not only to keep borrowing costs low but also to keep some exchange rate down, this duality evolved in progressive steps with the civil war, WWI and WWII as central banks started to hold even more treasury bills for war funding.

        This duality of money makes things even more complicated in an international crisis, where the political side starts to manifest and many people start to worry about currency wars and complain about effects of foreign central banks policies on their national economy .

        The US dollar is freely floating and tradable but the fed also buys treasury bills and MBS to keep borrowing costs low. The Renmenbi on the other hand is an agent of the state; China will probably never allow it to be an international reserve currency; it means losing a lot of its grip on capital controls and credit rationing. The other side of the extreme is the Euro, which displays an unflinching hard money bias. Since its creation, the ECB’s actions have preserved German surpluses, and forced deflation on peripheral Europe. Although Draghi’s announcement about peripheral bond buying did something to change that.

        The logical conclusion i suppose is that any currency coordination and rebalancing must necessarily come by political means. Fair enough, i just hope political leaders would stop delaying action on this issue, as it is really endangering global stability.

        • I don’t know how effectively central banks can keep borrowing costs low. They can control short term interest rates, but I don’t think they control longer end yields. Every single time QE took place, longer term yields went up and stayed elevated until after the programs were discontinued. Traders are clearly discounting the inflation/growth/inflationary/increased growth expectations of QE. I don’t think central banks have very much control over the long end of the yield curve.

  41. Michael, regarding China’s rebalancing, the leadership seem quite aware of how badly this could turn out (Japan). Do you see the post-Soviet model of privatisation (at a large discount) being a viable alternative? I get the feeling both Premier Li and President Xi are taking a deliberate hardline stance of late, the former on finance (market credibility), the latter on politics. As many vested interests would potentially lose out does Xi Jinping as a princeling have a better chance of persuading insiders to change without either losing face? Vastly complex situation.

  42. Shelby:
    “Yet Hitler printed his money to do Keynesian economics. And how did that universal health care system work out? I had a longer rebuttal, but talking about that period is a sensitive issue and certain things are apparently better left unsaid.”

    Germany had a universal healthcare system since the 1880’s. Until 1914 they did it while on the classical gold standard. Before the Nazi take over of the country it worked rather well.


    • Some things are better left unsaid. Healthcare (and other spending from printing money) was expanded by Hilter. I am not going to argue against socialism on a blog dominated by socialists. I have another understanding of events of that period.

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  44. Hi Professor Pettis,
    Thanks for the great article and understandable prose. I was a little confused by your point on the irrelevance of the currency reserves though. I think you imply that the reserves were primarily generated by currency controls that were in place — not reflective of a trade surplus? Is that an assumption? Apologies if I’ve just muddled that up.

    Also, you mention interest rates are too high. I didn’t think 5/6% was too bad… Why do you think they are too high? Thanks.

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