Bad debt cannot simply be “socialized”

Once again I am going to discuss debt, and my discussion will be mainly conceptual. I suspect that many of my regular readers might wonder why I keep returning to this subject – and, often enough, keep saying the same things. The reason is because while debt plays a key role in understanding the recent evolution of the Chinese economy and the timing and process of its upcoming adjustment (as it also does for all if not most major economies), there seems to be a remarkable amount of confusion as to why debt matters. In much classical economics debt, or more generally the structure of the liability side of an economic entity, doesn’t even fundamentally matter to the growth of that entity. The liability side of the balance sheet is treated mainly as the way in which the cashflows associated with the management of the asset side of the balance sheet, which we can call operating earnings, are distributed, and it is the growth in operating earnings that ultimately matters.

But even if this is all there were to debt – and in fact in my classes at both Peking University and, previously, at Columbia University I propose to my students that one way to think of the lability side of the balance sheet is precisely as a series of formulae that distribute the operating earnings of a company (or the total production of goods and services of a country) – this would still make it singularly important in understanding the functioning of and prospects for an economy. After all the way you distribute earnings is a major part of an institution’s incentive structure, and changes in the structure of incentives lead almost automatically to changes in the ways economic agents behave.

Investors usually take the topic of debt much more seriously than economists. They have no choice, I guess. Their conceptual failures cost money. This is probably why until very recently brilliant economists like Hyman Minsky, Irving Fisher and even Marriner Eccles were far more likely to be read by thoughtful investors than by academic economists (I myself was introduced to Minsky in the early 1990s by Bob Kowitt, and well-known institutional investor with a great bookshelf in his office).

At any rate for several years I have been arguing that the main reason analysts have managed to get China so wrong is because of their failure to understand the basic distortions driving the economy and one of the major consequences of these distortions is the creation of debt, which itself further impacts the evolution of these distortions. All rapid growth, Albert Hirshman argued in the 1960s and 1970s, is unbalanced growth, and in many if not most cases the kinds of imbalances that result from rapid growth may be acceptable and even necessary in a growing economy.

But as the economy changes, the nature and extent of the imbalances change too, and it is inevitable that eventually the system forces a reversal of the imbalances. This is especially true in countries, like China, with highly centralized decision-making. In these countries the imbalances can be taken to extremes impossible in other countries, thus creating all the more pressure for a reversal of the imbalances.

This means that in China, if you can figure out how the growth model works and how the model generates imbalances and debt, you can pretty much figure out logically, albeit fairly broadly, the various paths that the country must follow in order the reverse the imbalances. I tried to this in my most recent book, Avoiding the Fall, in which I listed the six different ways that China can rebalance, ranging from the catastrophic to the orderly.

These were not predictions. They were simply a list of the various ways in which China could rebalance, and none of these various rebalancing paths included, for example, the possibility that China could maintain average GDP growth rates of 7-8%, or even of 5-6%, during President Xi’s administration except under very specific, and unlikely, conditions. According to the logic of the model, it would require a massive transfer of wealth from the state sector to the household sector, on the order perhaps of 4-5% of GDP annually or more, for China to rebalance at growth rates significantly higher than 4-5%. Without this transfer, however, it simply cannot happen.

Analysts, then, who expected two or three years ago that China might be able to maintain growth rates of 7-8% through the rest of this decade were going to prove wrong, even if they hedged by accepting the possibility that conditions might change and growth rates slow sharply. Their analysis fundamentally confused the sources and consequences of Chinese growth.

I think a similar misunderstanding is taking place in the analysis of Chinese debt. Clearly in the past two or three years there has been a huge shift in market perceptions of Chinese debt. Everyone recognizes that debt has become a serious problem.

But there are two very different ways to recognize this. Some believe that the Chinese financial system, and perhaps the shadow banking system more specifically, took a number of wrong steps, compounded by the lack of discipline among local governments, and created a debt problem. By that logic, Beijing can take administrative steps to address credit creation and to bring debt under control. It is especially important, according to this view, to analyze the source of risky credit creation and to suppress it, which is perhaps why so much attention of late has been placed on the shadow banking system and on ways in which Beijing can “resolve” the existing stock of bad debt.

My view is different. Burgeoning debt was not an unlucky accident. It is fundamental to the way the growth model works, and we have arrived at the stage, probably described most imaginatively by Hyman Minsky in his work on balance sheets, in which the system requires an acceleration in credit growth simply to maintain existing levels of economic activity.

China’s debt problems, in other words, cannot be resolved administratively, by fixing the shadow banking system, by imposing discipline on borrowers, or indeed by eliminating financial repression (much of which, by the way, has already been squeezed out of the system by lower nominal GDP growth). Without a massive transfer of wealth from the state sector to the household sector it will be impossible, I would argue, for GDP growth rates of anything above 3-4% – and perhaps even less – to occur without a further unsustainable increase in debt, whether that increase occurs inside or outside the formal banking system and whether or not discipline has been imposed on borrowers.

There is another important implication, and this has to do with how the existing stock of debt is resolved. Last month I spoke with a very prominent European economist and he assured me that although he now agrees (he used strongly to deny it) that China has debt “problem”, he believes it can easily be resolved by “socializing” the debt, by which he means transferring it onto the government balance sheet.

He is not alone. I keep hearing from analysts, mostly but not always China bulls, that China can manage the debt quite easily by simply transferring it to the government balance sheet. Last week in London, for example, an analyst from a research company with whose views I am usually in strong sympathy and who herself is very bearish on China’s growth prospects, airily dismissed Chinese debt concerns by pointing out that Chinese government debt, even after adding back estimates of losses in the banking system, is lower than that of the Japanese government, and because the government’s debt burden has not been a problem in Japan it won’t be a problem in China.

That proves, she argued, that China’s debt is clearly sustainable. There are so many reasons why this is wrong (to list just the most obvious, poor countries have much lower debt thresholds than rich countries, Japanese debt cannot possibly be dismissed as not being a problem, and because it is almost impossible to find an economist who understands the relationship between nominal interest rates and implicit amortization, Japanese government debt has probably only been manageable to date because GDP growth close to zero has permitted interest rates close to zero) and yet inane comparisons between China’s debt burden and Japan’s debt burden are made all the time.

There also seems to be a real confusion over the difference between a legal definition of insolvency and an economic one. Three years ago Standard Chartered’s Stephen Green, a former China bull, made this mistake when he argued the following:

As a result, the concerns are twofold, with worries over the banking sector as well as government finance. According to Green, however, the debt problems at the local level could probably be mitigated if it is transferred to the central government balance sheet given the country’s strong growth rate and rising tax revenues. The country has successfully implemented bailouts previously, and this strategy will likely be effective again according to Green. 

Why does debt matter?

I disagree completely, and not just because transferring bad debt from local governments to the central government, while undoubtedly reducing the probability of a legal default, does not in the slightest way address the cost of resolving the bad debt. The “successful” previous bailouts were not successful in any way if you place their “success” in the context of the rebalancing process, and this is obvious if you work through the full consequences on the structure of Chinese demand. In spite of Green’s optimism this strategy cannot possibly be effective “again”. To suggest otherwise suggests an inability to understand how balance sheets work.

Because economists for many years have been trained to ignore balance sheets and, more generally, the way debt drives economic activity, the quality of analysis, especially the analysis of economic turning points during which the amount and structure of debt can create significant constraints on the way rebalancing can occur, has devolved, to be replaced mostly by vaguely empirical and very mathematically confused constructions. It is important to understand how debt payments are managed in order to recognize that whether or not China’s debt burden is socialized has very little to do with the resolution of China’s debt burden (aside from the fact that it never was “off” the government balance sheet in any meaningful way), just as analysts must recognize that an unsustainable increase in debt is embedded into China’s current growth model, and is not an accidental bit of bad luck.

In a future blog entry I will try to work out a more nuanced description of the role of liabilities in understanding the “operating” side of an economic entity, but for this entry I mainly want to point out that “resolving” bad debt necessarily involves assigning the costs, and until the impact of that assignation is addressed, no analysis is complete. I have described many times before why excess credit creation is at the heart of much of China’s GDP growth, and why this means that China must choose between a sharp slowdown in GDP growth as credit is constrained, or a continued unsustainable increase in debt.

No other options are available. But even this point is about new credit creation does not address the existing stock of bad debt, which is what I want to discuss in this blog entry. If you assume that for many years China has been misallocating investment (by which I simply mean that the resulting increase in productivity generated by the investment was less than the correctly calculated debt-servicing cost), it should be obvious that because there have been almost no defaults or other forms of debt write-down, the implicit losses have simply been rolled over, most likely in the balance sheets of the Chinese banks. This has several implications:

  1. GDP growth has been implicitly increased by the amount of losses that should have been, but were not, written down. This means that China’s GDP today, compared to countries in which it is more difficult simply to roll over losses indefinitely, is overstated, and I suspect that it may be overstated by as much as 20-30%. Why? Because in an economy in which losses were not simply accumulated and rolled over, the amount of the write-down (which would have occurred, either as a default, or as an equivalent transfer from a more profitable part of operations to subsidize the loss) would have shown up as lower GDP.
  2. In that case all GDP-related data is biased in a predictable way. Productivity numbers, for example, are biased upwards, and real worker’s productivity is lower than the numbers posted officially.
  3. Losses that are rolled over do not disappear. They are implicitly amortized over the period of the loan, which, assuming that loans are rolled over indefinitely, means that every year a declining portion of that loan is effectively written down. Over long periods of time every economy recognizes investment losses, but depending on how these losses are treated, the recognition can take place either in the period in which the losses occur or over the loan amortization period.
  4. There is a lot of confusion over how the implicit amortization of unrecognized losses takes place over time. Let us assume that an investor borrows $100 to invest in a project that creates only $80 of value. The project, in other words, creates a loss of $20. If the loss is not immediately recognized, there is a gap between the true economic value of the debt servicing cost and the increase in productivity associated with the project. This gap must be covered by implicit transfers from some other part of the economy, and these transfers reduce the economic activity that would have otherwise been created.If the gap is covered by financial repression, for example, (i.e. the authorities force down the borrowing cost to less than the increase in productivity generated by the project, so that the borrow shows a profit), the cost of amortizing the loss is passed onto the net lenders (usually, but not always, the household sector, who are net lenders to the banking system) in the form of a lower return on their savings. This lower return reduces their total income and, in so doing, reduces their consumption, which effectively reduces future GDP growth by reducing demand.
  5. GDP growth is only artificially boosted during the period in which the total amount of losses rolled over exceeds the amount of the amortization. After that GDP growth is artificially constrained. When the system is still accumulating and rolling over losses, in other words, GDP growth is systematically biased upwards. When it stops, GDP growth will be systematically biased downwards.
  6. This bias can be considerable. Let us assume, for example, that the real growth in an economy causes it to double its wealth every 10 years. Real GDP would, in that case, increase every year on average by nearly 7.2%. Let us also assume that during the first ten years, GDP growth was overstated by a failure to recognize investment losses, so that reported GDP growth was actually 10%. Finally we will assume that after ten years, this over-reporting stopped, and the excess GDP was amortized during the next ten years so that at the end of twenty years GDP was once more correctly stated. The numbers how that at the end of ten years, reported GDP would be overstated by 22.9% – that is, instead of doubling, reported GDP would be 159% higher. During the next ten years, as real GDP continued to grow by 7.2%, reported GDP would grow on average by just over 4.4% as the earlier losses that had not been recognized were amortized.
  7. My numbers above assume that the overstatement and understatement are symmetrical. In fact the process is not symmetrical because of the possibility of financial distress costs. The total value of overstated GDP during the period when losses are being rolled over is only equal to the total value of the subsequent amortization of those losses if there are no financial distress costs.
  8. But there are in fact likely to be substantial financial distress costs. In corporate finance theory we have a very clear understanding of how high debt levels change incentive structures in such a way so as to reduce overall growth. This means that the longer it takes to amortize the hidden losses, the greater the amount by which the future amortization costs will exceed the current overstatement of GDP. Japan after 1990 might a good example of this process. Its share of global GDP rose from roughly 10% in 1980 to 17% at is peak, only to have declined since then to roughly 9% of global GDP. This is an astonishing relative decline, and it must have been made worse at least in part by the financial distress costs imposed on an economy unwilling to write down debt correctly.
  9. Remember that the only way debt can be resolved is by assigning the losses, either during the period in which the losses occurred or during the subsequent amortization period. There is no other way to “resolve” bad debt – the loss must be assigned, today or tomorrow, to some sector of the economy. “Socializing” the debt, or transferring the debt from one entity to another, does not change this.
  10. There are three sectors to whom the cost can be assigned: households, businesses, or the government. In China we might usefully think of these as households, small and medium enterprises (SMEs), and the state sector (in principle there is a fourth sector, foreigners, to whom the losses can be assigned, but it is very unlikely that they will bear much of the losses). It is pretty clear that after the banking crisis of the late 1990s, the losses were assigned, largely in the form of financial repression, to the household sector.
  11. To the extent that China has significant hidden losses embedded in the balance sheets of the banks and the shadow banks, over the next several years Beijing must decide how to assign the losses. If it assigns them to the household sector, it will put significant downward pressure both on household income growth (which will be less than GDP growth) and, consequently, on consumption growth. Rebalancing means effectively that consumption growth (and household income growth) must exceed GDP growth, which means that even if GDP growth slows to 3-4%, as I expect, household income can continue growing at 5-6%. This explains why, contrary to the consensus, a more slowly growing, rebalancing China will not lead to social unrest.
  12. Of course if the losses are assigned to the household sector, China cannot rebalance and it will be more than ever dependent on investment to drive growth. This is why I reject absolutely the argument that because China resolved the last banking crisis “painlessly”, it can do so again.
  13. Beijing can also assign the losses to SMEs. In effect this is what it started to do in 2010-11 when wages rose sharply (SMEs tend to be labor intensive). It is widely recognized that SMEs are the most efficient part of the Chinese economy, however, and that assigning the losses to them will undermine the engine of China’s future productivity growth.
  14. Finally Beijing can assign the losses to the state sector, by reforming the houkou system, land reform, interest rate and currency reform, financial sector governance reform, privatization, etc. Most of the Third Plenum reforms are simply ways of assigning the cost of rebalancing, which includes the recognition of earlier losses, to the state sector. This is likely however to be politically difficult. China’s elite generally benefits tremendously from control of state sector assets, and they are likely to resist strongly any attempt to assign to them the losses.

This is how I think we need to think about China’s debt problem. Notice that I am making no predictions. I am only trying to outline as schematically as possible the only ways in which the debt problem can be resolved. There are no other possible ways to address the debt, and so any analysis we do or propose must be consistent with the model described above.

The key point is that we cannot simply put the bad debt behind us once the economy is “reformed” and project growth as if nothing happened. Earlier losses are still unrecognized and hidden in the country’s various balance sheets. These losses will either be explicitly recognized or they will be implicitly amortized. The only interesting question, as I see it, is which sector will effectively be assigned the losses. This is a political question above all, and its answer will tell us a great deal about how the newly-constituted, “reformed” China will grow over the next few decades.


 Add your comment
  1. “That proves, she argued, that China’s debt is clearly unsustainable.” Obviously a typo. You meant to say “sustainable”.

  2. Michael, it was great to meet you and hear you speak at the recent Camp Alphaville event in London. I continue to read your work with great interest. Keep it up.

    • Quite unrelated, but that comment seems to be at odds with your user name.

      • @BerkeleyBob

        It sometimes does. I use a common user name across all social networks and occasionally it does seem a bit inappropriate. It is a pun on my original occupation (mining engineer) combined with an ironic (and some would say unforgiving) turn of phrase.

  3. I fully agree

  4. recently Nicholas Lardy commented that in his opinion, China should continue to grow 7-8%. I’ve tried unsuccessfully to compare his arguments against your own. Do you see where your differences lie?

    • Anyone that claims 7-8% GDP growth is sustainable for an extended period of time is spewing BS. Economic growth requires inputs too. What are those inputs? Things like natural resources. Any country that’s growing at 7-8% GDP growth rates for the time period that China has should automatically send red flags through your BS detector. China’s demand for natural resources is absolutely insane. China is the largest importer of natural resources in the world and for China to keep growing at these rates will require an even greater demand for natural resources. Of course, the only way China would realistically be able to get these kinds of natural resources would be to go imperialistic, which means war. China would need to make sure it has 100% control of those supply lanes and trade routes while suppressing more and more conflicts in its buffer regions. This would make the country incredibly politically unstable and could even lead to some kind of a fragmentation where China would end up seceding its borderlands and buffer regions like Inner Mongolia and Tibet.

      • China (and any other country) can grow at any rate it chooses as long as it has debt capacity and is willing to allow credit to grow at whatever rate it takes to achieve the growth target. If you expect China to continue growing at 7-8% for many more years you have to believe one or more of the following:
        1. China’s current economic growth is efficient in its relationship to credit, and involves growth in productive capacity that is at least equal to or greater than the growth in debt. In that case the growth in debt is sustainable and can go on for many more years.
        2. Even if debt is growing faster than debt capacity, China has many more years of credit growth before it reaches debt capacity limits.
        3. China will be able quickly and efficiently to change the legal and financial systems and to eliminate moral hazard distortions so that there will be a smooth transition from the current wasteful investment towards investment in much more productive sectors of the economy (small and medium businesses, for example). The resulting surge in productivity will be great enough to replace the current sources of growth as well as to exceed financial distress costs and the amortization of losses that have been built up in the past.

        Although I do not think any of these conditions is impossible, I find them to be implausible and at odds with both China’s previous experiences and those of other developing countries.
        What worries me is that if China continues to grow at current rate for another one or two years, those of us who believe that China is on an unsustainable growth path will interpret this to mean that the risk of a Chinese crisis will be much higher and the cost of the ultimate adjustment much greater, whereas those who believe that China’s debt growth is sustainable and the economy healthy will see another year or two of high growth rates as justification that they were right. I remember that the fact that by 2005 or 2006 Spanish real estate had not crashed was often used to “prove” that the concerns people had of a real estate bubble as early as 2000-01 were misplaced.

        • But China has been using this massive surge in credit to fund the development of absolutely absurd projects. They’re building massive cities the size of Paris in Western and Northern China. These cities exist in harsh climates where most of the water supply nearby is unusable because of environmental degradation. I find it absurd to think that you’re gonna have poor people live in these massive cities when there’s little arable land nearby. On top of this, how can you expect to have poor people (most of China is poor) live in high rise condos. Nothing that’s going on in China makes any sense. They’re building massive airports, malls, and all sorts of stuff that will never possibly be used. This can’t be a sustainable use of credit. There have to be negative consequences down the line for this kind of behavior.

          • Such projects are symptomatic of a credit bubble manifesting itself in real estate. We saw pretty much the same thing in Japan during their bubble years and to a lesser extent in the US & EU during their housing bubble.

  5. The chief economist of a leading US investment bank goes around with GDP forecasts to which no Debt forecasts are attached because, you see, “debt doesn’t matter”.

    With global non-financial debt over 250% of global nominal GDP, virtually all banks on the planet are most likely in agreement with Standard Chartered that bad debt should be “socialized”, meaning not paid by themselves and their shareholders.

    The argument for “socializing” credit losses is well known since the Great Depression: banking panics hurt economic growth and employment, so it is in fact in the public interest that the public should pick up the bill.

    But, equally important to bad debt being “socialized”, it is also vital that profits should remain private. You see, that’s critical to the proper incentives of the free market (and to the 7-digit compensation package of said chief economist).

    Back in April 2008, David Einhorn made a speech called “Private Profits and Socialized Risks” in which he described the asymetric risk / reward calculation of large speculators that led to financial instability. Six years later, only one thing has changed: it is now worse.

  6. I’m out of my depth here, so forgive me if this question makes no sense. 🙂

    I asked a friend who works in finance in the US about the purpose of QE. He said the purpose was for the Fed to buy bad assets from banks (i.e., nonperforming loans), effectively moving this debt onto the Fed’s balance sheet, and to move US treasury debt onto the balance sheet of banks in exchange. His explanation made sense to me, as a kind of remedy for the financial crisis of 2008. So, assuming he was right, putting that together with what you have written here, those bad loans didn’t “go away”, they are still on the balance sheet of the Fed. My question is this: have the costs been assigned?

    • “I asked a friend who works in finance in the US about the purpose of QE. He said the purpose was for the Fed to buy bad assets from banks (i.e., nonperforming loans), effectively moving this debt onto the Fed’s balance sheet, and to move US treasury debt onto the balance sheet of banks in exchange. His explanation made sense to me, as a kind of remedy for the financial crisis of 2008. So, assuming he was right, putting that together with what you have written here, those bad loans didn’t “go away”, they are still on the balance sheet of the Fed. My question is this: have the costs been assigned?”

      + 1 (millions)

      Yep, private debt can (and has been) purchased massively by the central bank (or via one of its private proxies) at nominal value. This is massively inflationary of course. This implies a strong control of the fiat money provision system.

      You can have the losses of mis-allocated capital born by households, private sector, government… But the monetary system can play a role in and out of itself as well. I appreciate this post by Michael a lot but feel that he should incorporate the potential for a significant destruction of the value of the monetary support. This is not a side issue in anyway.

      This is not a specific case (supported by historical samples…) that IMHO should be addressed specifically. The Chinese government has a large set of choices in this respect as well…

      I understand that Asia has provided a fully deflationary environment – massive deployment of manufacturing was THE driver – for more than over two decades with Inflationary pressures been considered noise for a long time. There was justification for these view. Will this remain so in the coming years? I reckon that this could be challenged by reality. Even in Asia.

    • QE is just a balance sheet operation. The Fed issues dollars on the liabilities side to buy Treasuries or MBSs. This idea that the Fed is increasing bond prices with QE is something I find insane when the evidence shows the opposite. Every single QE program that has taken place has caused yields to rise and bond prices to fall until the programs were discontinued. The same thing has happened since the tapering of QE 3 and 4.

      Prof. Pettis, in his books, talks about how QE is really just a massive expansion of liquidity which creates capital outflows into emerging markets. That’s really all it does. It’s not a remedy for the financial crisis, but it did in 2008 was alleviate a liquidity crisis. QE can even be done with a budget surplus.

    • I think you are referring to what we would call “monetizing” the debt, which means that debt is repaid simply by creating the money to repay it. Of course the wealth of a nation is the total value of goods and services created, so monetizing the debt can only solve a debt problem if it causes the total production of goods and services to rise. If not, it simply represents a transfer of wealth from those who are net long financial assets (households who are net savers in the banking system, for example) to those who are net short (borrowers).
      Monetizing the debt can be good for the economy if by doing so it reduces unemployment or increases productivity, or it can be bad if it encourages investment misallocation.

      • I would argue that currently China has a bunch of excessively-rich “vested interests” who are misallocating investments, and that monetizing the debt, done correctly, could encourage correct allocation.

        Actually I’d argue that the US has the same problem, with the same solution.

  7. Hi Michael,
    I’ve been following your writing work for a while now and felt that you had a slightly defensive tone in this article. The way you try reminding the reader that you’re “not predicting things” gives me the feeling that you have been chastised and rebuked by some as a “China doomer”. Please ignore those comments and not lose yourself to them. Those comments are largely politically agitated and will not back down even if you adopt a slightly more defensive, “I’m not predicting China’s doom” tone as you have written here. Stay strong and voice your mind freely.

    About the article, your argument on the inevitability of debt amortization is clear. However, the way you presented China’s ways of solving the debt problem makes it seem like they have only 3 roads to take. What’s stopping them from simply splitting up the debt pains and distributing them amongst all 3 sectors?

    I believe a big reason why China’s financial markets have been so resilient despite debt fears is that there is this belief, if you will, that China, being “an authoritarian country with abilities that democratic states cannot do”, will somehow make debt disappear by concentrating debts onto a political victim, while letting both the original saver and investors get away scot-free. This may have connection with China’s recent corruption clearing campaign. What ramifications would occur in this scenario?

    Given China’s attitude toward foreign companies already, I wouldn’t say it is unlikely that China would attempt to force the foreign sector to shoulder debts. You mentioned this very briefly in the article. How would this affect China’s standing as a country to invest in compared to if China didn’t touch the foreign sector at all?

    • You can’t really force foreigner creditors to lend, and if they believed that they were likely to take losses, they would stop lending. If China already had an enormous external debt it could in principle default on the debt and renegotiate significant debt forgiveness, which effectively would pass on the costs to foreigners, but China’s external debt, while growing quickly, is still pretty low.

  8. I have two questions.

    (1) What indicators should we watch to track rebalancing? Anything besides nominal GDP growth?

    (2) What would happen to ordinary Chinese households, if the government delayed further rebalancing for another five or ten years? Would household income growth stall quickly, or would it take a long time for ordinary Chinese citizens to feel the pocketbook price of the government’s delay?

    • 1. Probably the most important determinant of rebalancing is the growth in the household income share of GDP.
      2. It is not clear that you can postpone rebalancing for that long. Economies always reverse extreme imbalances, and the question is whether they reverse in an orderly way or in a disorderly way. I would argue that if the government ties to prevent an orderly rebalancing, they simply increase the risk of a disorderly rebalancing, in which investment growth, GDP growth, and household income growth all turn negative, with household income being the least negative and investment the most. This, for example, is what happened in the US from 1930-33.

      • So if consumption grows faster than investment, rebalancing is occurring?

        For example, I read that China’s NBS reports that for the first six months of 2014, consumption growth was 54 percent of China’s total GDP growth. That is, consumption growth was larger than investment growth, but only just barely.

        Suppose that number is accurate. Is it fair to say that number means that China’s economy was “rebalancing, but not enough to make a difference” in the first half of 2014?

  9. I think you’re partly right, but your accounting is off. Non-recognition of bad debt doesn’t inflate GDP, which is simply a measure of final spending. Writing down the value of real assets will depress NDP by adding to depreciation. The key point to understand is that GDP is not a measure of the economic value created by investment. It only counts the amount spent on investment. NDP reflects the value created by investment.

    I think you’d do well to reread Minsky as he does a decnt job of explaining why debt is important. One is as a flow of financing of spending. Think of fiscal stimulus and fiscal drag, which are accelerations and decelerations of public credit expansion. Likewise, acceleration of private credit expansion adds to growth, a stable pace of private credit expansion is growth neutral, and deceleration of private credit expansion subtracts from growth. Recessions are mostly driven by decelerations of private credit expansion. That is the main sense in which sustainf China’s growth pace depends on sustaining the high pace of credit expansion. With growth apparently slowing, China is likely to further accelerate expansion.

    As for bad debt, this is a balance sheet issue. Recognition affects spending flows by increasing the savings rate as people and companies direct income to cover balance sheet holes.

    Whether China can ‘simply’ socialize bad debt depends on how much there is. I’d say the central government could take on another 25% of GDP without any major sovereign bond market rupture. My guess is they’ll put it in some off balance sheet guaranteed SPV. Theoretically the central bank could bail out and monetize any amount of yuan debt.

    Don’t get me wrong – when I see export growth around 7 and investment growth over 15 I know investment is heading for a crash. And when I read of local gov borrowing reviving to counter slowing growth, it sounds to me like keeping the emperor happy today at the cost of a bigger disappointment tomorrow.

    • I am afraid you are mistaken on both counts, Tom. Writing down bad debt causes losses either for the borrower or for the lender, and these show up in the income statements which are then used to calculate the value of economic activity, which is what GDP is supposed to measure. By not recognizing bad debt, you artificially inflate income and, with it, GDP.
      As for whether or not China can socialize the existing level of debt, the point of my article is not that governments cannot socialize debt. Of course they can, and whether the amount is 25% of GDP, as you suggest, or greater, is irrelevant. The point is that when people say debt isn’t a problem because the government can simply “socialize” it, they fail to understand that socializing debt does not resolve it in any way. The debt is only “resolved” when the assets backing the debt are correctly valued and the losses are assigned.

  10. It is remarkable and troubling to see, again, that many if not most economists still do not understand the economy and are so strongly biased to the income/assets while ignoring debt dynamics and particularly the effects that debt restructuring and loss recognition has on the economy. It does not surprise me at all to read about european economists that propose “socializing” debt as the great painless solution since this is precisely what is being painfully done in Europe. My opinion is that this bias in economic thinking is not accidental and that the profession is dominated by “supply-side” thinking amplified in hundreds of Bussiness Schools that see everything through the prism of company managers. It is clearly the case that economists cannot see the forest for the trees.

    • It is definitely remarkable that debt is so poorly understood within academic economics and that many economists will insist that changes in debt do not affect growth because debt is, they say, simply a transfer of spending power, and does not create it.

  11. Luddy … As I was reading this … that is exactly what I was thinking. This could have been written about the US. Politically … we are socializing those losses and those moral hazard has been side stepped. Too bad the legal definition of insolvency has been abridged to allow bad decision makers to avoid taking hits to “their” balance sheets (personally and organizationally).
    And … of course … the US has made no real attempt at reform. Just an acceleration of wealth transfer.

  12. The issue of IOU’s is clearly a form of debt. A sovereign government’s creation of money is the creation of debt or rather IOU’s but the IOU in fact belongs to non-government in that some of it must be returned to the government issuer to be destroyed in the form of taxes and government fees. But the question then remains where does it make sense for a sovereign government to repay the outstanding IOU’s it’s issued to itself? This accordingly leaves the main factor of consideration for a sovereign government to be abnormal inflation or deflation in the amount of money it creates. This is a Functional Finance approach that China has adopted. The hall mark of that approach is to see money not as a commodity but as a set of inter-dependent relationships.

    Here is Adam Smith on the subject over two hundred years ago:-

    “A prince, who should enact that a certain proportion of his taxes should be paid in a paper money of a certain kind, might thereby give a certain value to this paper money; even though the term of its final discharge and redemption should depend altogether upon the will of the prince.”

    ( Adam Smith. “Wealth of Nations” Book II, Chapter II. 1776 )

  13. I’m missing something here. Why can’t China painlessly allocate the costs to the $1 trillion or so of claims it has against the U.S. government; i.e., Treasuries? (Not to mention the additional $3 trillion of forex reserves it holds). The SAFE assigns $1 of Treasuries for every $1 equivalent of bad debt to the internal creditors. Yes, the state sector loses the income on those claims against the U.S. — but it can create money to compensate for the loss. Result, no contraction of internal demand, no GDP amortization of losses, no problem.

    • Yes, selling Treasuries would let the government compensate creditors of bankrupt companies without inflation. But for China, the hard part is probably not bailing out the creditors of bad-debt companies. The hard part is going to be replacing the employment the bad-debt companies currently provide.

      (And shutting down those companies is very politically hard, but that’s a separate issue. Although I get the impression the political issue is actually even more an obstacle than the economic one.)

      China’s bad-debt companies aren’t just politically connected. They employ large numbers of people, do business with large numbers of other companies, and historically have been a large part of how China’s government manages the economy. Shutting those companies down probably means real economic disruption.

      Suppose I take $1 trillion from people who are ready to spend it (however inefficiently), and give that $1 trillion to people who were planning on just saving it. Then you’d expect the economy to be disrupted. It’d take those savers a while to find new investors willing to put all that money to work. You’d expect temporary unemployment, maybe even a fall in employed incomes, even though in the long term equilibrium should return.

      Savings may definitionally equal investment, but that doesn’t mean savings magically converts at a fixed rate into hiring. That’s China’s problem.

      It’s actually kind of like the problem in America and Europe today, where zero nominal rates haven’t been enough to produce big growth, because right now so many of the usual would-be borrowers aren’t capable of borrowing at those low rates, thanks to preexisting debt, underwater mortgages, etc.

      If China shut down all its big state-owned enterprises at once, the companies that were left would be far more efficient, but they wouldn’t be able to expand fast enough to instantly make up all that demand.

      Rebalancing too fast might mean temporary mass unemployment. I would guess mass unemployment is something China’s leaders want to do anything to avoid.

      • ” But for China, the hard part is probably not bailing out the creditors of bad-debt companies. The hard part is going to be replacing the employment the bad-debt companies currently provide.”

        Right. Running the credit system at a loss, with the state making up that loss, is a form of fiscal policy (deficit spending by another name). Remove that support and growth drops, until and unless it is replaced by fiscal expansion via another channel (e.g., an expanded Western style transfer payment based welfare state).

      • But for China, the hard part is probably not bailing out the creditors of bad-debt companies. The hard part is going to be replacing the employment the bad-debt companies currently provide.

        Right. Running the credit system at a loss, with the state making up that loss, is a form of fiscal policy (deficit spending by another name). Remove that support and growth drops, until and unless it is replaced by fiscal expansion via another channel (e.g., an expanded Western style transfer payment based welfare state).

    • The problem is you cannot resolve an rmb debt problem with US dollars; “. . .but it can create money etc..” Money supply is now growing at around 15% – twice as fast as the economy. How much faster must it grow to “solve” the problem? and if the rmb begins to lose its value?

    • The PBOC has around USD4 trillion-worth of assets (the treasuries you mention, Bunds, JGBs etc) on one side of the balance sheet and liabilities (RMB-denom commercial bank reserves, bills etc) of the same amount on the other (mismatch aside). If you give away those assets you still have the liabilities and as the central bank is effectively owned by the state, the net-indebtedness of the latter rises with it. These are assets in an accounting sense. They are not equity, i.e. not savings.

      Moreover when a central bank creates money it is a creating a liability for itself not an asset.

    • From a mechanical viewpoint, I just don’t understand this. The notion that China can use those foreign reserves like an off-balance-sheet piggy bank is quite popular, I see it mentioned all the time in the financial press. But, first, if you sell USD to raise RMB to pay back a creditor who lent in RMB, who do you sell the USD to? No one outside China holds RMB in large amounts because the currency isn’t convertible, first, and second, China runs big trade surpluses with everyone except a handful of countries like Australia, so such RMB as is abroad is mostly just working cash for import-export. Or at least I think so. Second, maybe this is being too simplistic, but I like to imagine the accumulation of Chinese reserves from first principles. Suppose on Day 1 China has no paper RMB and no foreign reserves. A Chinese factory makes $1000 of stuff and sells it to WalMart. It takes the $1000 in USD bills to Bank of China and asks to convert it to RMB. In response, the Chinese treasury prints 6000RMB in bills, gives it to the bank which gives it to the factory. The bank gives the Treasury $1000. The Treasury then buys $1000 in US treasuries. At this point the factory could do the reverse exchange of RMB for dollars and everything would work out. Now suppose that a Chinese restaurant borrows 6000 RMB from BOC. The Treasury prints up another 6000 RMB bills and gives it to the bank which gives it to the restaurant, and the bank books a loan for 6000RMB. Later the restaurant goes belly up; the loan has no value. What to do? Well, the Treasury could give the $1000 in Treasury bills to the BOC to make it whole. The bank would then hand them right back to the Treasury in exchange for 6000RMB, which is what it really needs since its customers operate in RMB. Nothing would change except that there are 6000RMB more bills in circulation. I don’t know if this is an accurate picture, but I just don’t see how the foreign reserves helped anything at all; exactly the same state of affairs would be arrived at if in response to the restaurant bankruptcy, the Treasury simply handed the BOC 6000RMB in Chinese currency and left the USD reserves out of it. If the bank were happy with US Treasuries as compensation, then that would be fine except that now if the factory wants to exchange its 6000RMB for USD, there would be no USD to give to them. What am I missing?

  14. And if handing out Treasuries to internal creditors is too destabilizing for party control, there are myriad “bad bank” structures backed by the foreign assets that achieve the same result.

  15. interesting post Michael,

    Isnt there another solution. Just inflate away the debt. Especially in China’s case, if most of the debt is related to over-investment, presumably in long lived assets, then you can just wait for nominal values or cashflows to catch up to fixed debt amount. Seems to me this is the course QE and G4 countries are taking anyways.

    I agree China has a debt problem and that it has overstated ‘real’ (not in the inflationary sense) productivity and growth. I also agree that a slowdown in debt usage will inevitably slow down future growth. However I am not convinced that the ‘bad’ or legacy debt really has to recognized, especially in a fiat currency world.

    • Like direct bailouts, “just inflating the debt away” doesn’t remove in any way the urgent need of recognizing and addressing the root causes of the debt accumulation. Otherwise, the dynamics is self-defeating.

      Let’s look at the numbers:
      – In 2011, the Chinese economy required incremental debt of RMB 12.8 Tr to produce 7.2 Tr of incremental nominal GDP. That’s an incremental Debt / nominal GDP ratio of 179%
      – In 2012, the Chinese economy required incremental debt of RMB 15.8 Tr to produce 4.6 Tr of incremental nominal GDP. That’s an incremental Debt / nominal GDP ratio of 343%
      – In 2013, the Chinese economy required incremental debt of RMB 17.3 Tr to produce 5.0 Tr of incremental nominal GDP. That’s an incremental Debt / nominal GDP ratio of 346%
      – In 2014, the numbers up to June suggest that the Chinese economy will require close to RMB 18 Tr of incremental debt to produce 5.0 Tr of incremental nominal GDP. That would be an incremental Debt / nominal GDP of 360%.

      The order of magnitude suggested by these numbers is that, since 2012, China is fabricating bad debts at an annual rate of 10-15% of GDP. You want to inflate away 10-15% of GDP every year, year after year?

      QE in its various forms in the US, UK, Japan and Eurozone is not inflating debt away. If that were the case, debt to nominal GDP ratios would be declining. Instead they keep rising. Why? Because the root causes of debt growing faster than production and income have not been addressed. So, every year you have to inflate away the new debt, and again the following year, and again and again and again. And each country / region has to do it more than the neighbours so as to export some debt and unemployment abroad rather than have it at home. And so the neighbours do it even more as they want to send back the excess debt and excess unemployment. And so on and so forth. This is self-defeating. It’s a race you can not win.

      Addressing the root causes of the excess debt accumulation is a race we can win. So let’s start running that race instead.

    • If you could simply inflate debt away without anyone having to pay there would never be sovereign debt crises. That is why you can’t “just” inflate it away. Inflating debt means transferring wealth from those who are long monetary assets to those who are short. Inflation is a tax, whose only advantage, which is also one of its biggest disadvantages, is that it is a hidden tax and doesn’t require an explicit tax increase, which is likely to be politically unpopular. But it is a tax nonetheless, and among other things it is a very regressive tax (the poor consume more of their income than the rich, who also find it easier to protect their assets from inflation) and tends to hurt people, like the elderly, whose savings are mainly in the form of bank deposits and bonds.

  16. For banks it is the asset side of the ledger which no longer matters and that to me the better way to see the issue. It is they, and the Shadow Banks and their CDO’s ,the credit issuers, who allow debt, the obverse of credit to expand. Need I mention to make this clearer, that booked loans are a banks assets, deposits are bank liabilities.

    If bank simply do not write down their bad assets, ie defaulted loans and mark them to market the balance sheet loses all meaning. This in a nutshell is where we are and the fact is nobody seems to care if bank balance sheets are a fraud. Economists don’t care nor regulators no central banks care anymore.

    If nobody cares then losses will never have to be recognized, problem solved. There is a whole monetary school now Modern Monetary Theory which does not even recognize the existence of central bank balance sheets. Just print more money and all will be well. This could go on a long time I think, Maybe until the oil runs out.

    • If simply not recognizing losses meant never having to pay for them, every country could grow at any rate it chose and could do so forever. When you take $100 of your resources and spend them in a way that creates $80 worth of value, you are always poorer. Not recognizing the loss simply means pretending that the assets are worth $100. I am not sure why anyone thinks that losing money and pretending not to could ever be a sustainable way to get rich.

      • It’s because they don’t want to understand that money reflects good value. When you think the state can force people to use his money, you think you state can add an arbitrary price on money the price of fear. But when you look at Cuba or Zimbabwe it doesn’t seem to be true.

        • Yup. Money is inherently competitive too. The reason it was monopolized was so that governments could use the revenue collected from seigniorage to fund wars and imperial expansions. Hell, government debts were created explicitly for war. We need to start having serious discussions on changing the monetary system and wiping out national debts of countries, but that won’t happen for at least another decade or so.

  17. Prof. Pettis,
    Thank you for a very interesting article. I have one question. You state that low GDP growth need not be incompatible with social unrest, if the low GDP growth were done in the context of rebalancing, and the higher household income growth that goes with it. This makes some sense, but I imagine that the households with repressed savings are older households, with established jobs and savings, and the people liable to participate in social unrest are younger workers with no family of their own, and no savings.
    In this case, it is not possible to increase household income growth with a higher interest rate paid on household savings, and nevertheless have deep frustration among the younger workers who cannot benefit from this, because they have no savings, and cannot find a job because of the reduced investment growth? If this were the case, then it may still be dangerous for China to entertain re-balancing. Do you agree, or is there a flaw in my scenario?

    • Eliminating financial repression is an important way of rebalancing the economy (by the way financial repression costs have nearly been eliminated in the past three years) but ultimately what matters is that the GDP share retained by ordinary Chinese households must rise, and there are many ways this ca happen. You are right that if only one group of households gains at the expense of another, there is unlikely to be meaningful rebalancing and there could be social unrest. It depends on what policies are implemented, and you will notice that nearly all the Third Plenum reforms involve increasing the household share of wealth.

  18. Good post as usual. “Market Monetarism” economists often say balance sheet recessions don’t exist with the correct monetary policy (NGDP level targeting), so in a sense they are the economists you refer to who says debt doesn’t matter. I think implicit in their argument is that debt is used for consumption only and not for asset speculation (i.e substitutes for money). So that raises two questions: (a) ignoring asset speculation, how do we know that bad consumption debt, which is really an unemployment tax, is unsustainable in China; i.e. growing vs. GDP and exceeding some threshold (e.g. And, (b) how do we know asset speculation is dangerous in China? Could it just not level out now? MM economists argue that Japan would not be where it is if they had used the correct monetary policy.

    • a) i don’t think we need to worry about consumer debt in china. it is pretty low.
      b) asset speculation can be dangerous because 1)it is highly pro-cyclical, 2)it can cause debt levels to rise unsustainably if the rise in debt is generated by an unsustainable rise in asset prices, and this rise in debt can impose significant financial distress costs, and 3)it can change incentives in a way that causes economic agents to engage in wealth-destorying activity (e.g. households over-consume and under-save because they feel richer, businesses over-invest in real estate development on the assumption of ever-rising prices, etc.)

  19. @ R. Lewis,

    Prof. Pettis explained many times in his books and his blog that China took money from its Bank and put in US Treasuries. This money is not extra savings but people’s deposit money. So giving IOU to Chinese people instead real picture ,as shown on a side of this blog, probably will not be easily accepted.

  20. There is a fourth way that in debt discussions seems te be forgotten, commenter Tom got closest. The issue is you are only considering ‘bad debt’ but not ‘good debt’ or ‘excellent debt’. Bad debt is only bad if it cannot be repaid since it was used to create assets that do not provide enough economic value to repay the loan with interest. In the same way there is ‘excellent debt’, that is debt that is covered easily by the assets created. Simply combining a pool of bad debt with a pool of excellent debt, and combining the related asset pools as well, creates a combined debt/asset pool that may again be just ‘good debt’. So the fourth solution is combining debt/asset pools to solve the bad debts with excellent debts. In fact that is what all good portfolio management does, in banks, in companies, in government investment. The Chinese state run system is in fac in a quite unique position to at times be able to pull such debt/asset pooling off, where this would be impossible in more deomcratic systems. In fact all notions of ‘socializing debt’, are also a form of this debt/asset pooling, using the excellent tax assets of the government to socialize the ‘bad’ private debt.

    • At the current level of indebtedness, it is unlikely that the solution you suggest is still viable. The reason is that you need at least 5 of good debt for each 1 of bad debt for this to have a chance to work. Otherwise, the burdens placed on performing debt are too great.

      Consider the following exemple: You have a performing loan portfolio yielding 4% interest that you are funding at 2%, so net interest margin is 2% and it’s all good quality, expected credit losses is 0%. You also have a bad debt portfolio, legally it is also yielding 4% but because the borrowers are in arrears you are only collecting 2%, meaning 0% net interest margin because your funding cost is 2%, credit quality is poor and you expect to recover only 70% of nominal, so 30% expected loss. Say you blend the good and bad portfolios 83.3% / 16.7% (5 of good debt for 1 of bad debt). The blended portfolio will yield 3.7% interest, have a net interest income of 1.7% and have 5% expected credit loss. Because you also have costs other than funding costs, say 0.5%, your pre-tax profit margin is 1.2% (net interest margin of 1.7% – 0.5% operating costs) so that it would take a bit more than 4 years of pre-tax profit to absorb the 5% credit loss. Given that loans are not typically much longer than 5 years, 4 years is quite long.

      So, for your solution to work, it takes about 5 of good debt for each 1 of bad debt.

      In a situation where total debt is ~230% of GDP of which bad debt of ~ 35% of GDP – which is the current situation of ALL the major economies of the world – you have a good debt / bad debt ratio of 5.6x and there is hardly any room left for your solution to work. Certainly not if debt continues to grow relative to GDP.

      Hence, we again go back to the only viable solution left at this stage, which is to identify and address the root causes of the debt accumulation. After all, excess debt originates here and now on this planet as a result of all the economic transactions that are actually taking place. It is not sent to us by some aliens from different corners of the universe. It is therefore possible, though not easy, to track down exactly how and why it happens like that and to pin down the primary source(s) of the cashflow shortfall. That is the mission critical of economists today, and quite fascinating. QE, bailouts, negative deposit rates and everything you hear everywhere everyday from policymakers and “experts” are nothing but short term expedients that are destined to fail if the root causes remain unaddressed.

    • I am not sure there is anyone at all who is not aware that most of the debt is undoubtedly what you call “good” debt, Erikwim. In fact with one exception (the debt of Poyais, for those who are interested) I do not think there has ever been a debt crisis in history in which all or even most of the debt was “bad”.

  21. Extremely timely article.

    The latest China GDP #’s have consumption contributing just 2.3pp in Q2 vs 5.7pp in Q1. This is the lowest level since we have quarterly data (2009).

    Seems like the leadership is back-pedaling a bit here given the increased Total Social Financing numbers recently.

  22. @ David,

    No one in China knows actual debt values or can predict when debt will reach a critical distress level. We know presently increasing investments do not create proportional increases in GDP. So we can say that increasing investments subsidize workers employment. But they also increase debt as time continues because of workers subsidy and also as Prof calls it “Minsky” effect. So your suggestion to delay rebalancing
    will decrease the governments monetary assets to absorb the rebalancing negative aspects such as employment of young people. And if you delay it to the point of critical distress , you totally put the government in an emergency management situation.

  23. I think everything you say about China’s economy and debt applies even more so to the US economy. It is our horrible fate that the US economy is being run by untrained monkeys who randomly twist the knobs and shift the levers of power, with no idea what they are doing, nor why it isn’t working out the way they thought it would.

    • None of what Prof. Pettis is saying applies to the US. The US had a decentralized consumption boom while China has had a centralized production boom. Things in the US are MUCH, MUCH better than they are in China. Do you think the guys in China know what they’re doing better than the guys here? They’re 20 times worse AND even if the guys do know what they’re doing, the political incentives set up there (and in the rest of the world) are much worse. China has all sorts of problems we don’t even have to worry about.

      China has a debt problem that’s worse than the US. China has terrible demographics with more environmental damage than any developed country while China’s physical geography places China with limits the US doesn’t have. China also has less natural resources and a much greater demand for them. Hell, China IS the worldwide demand for commodities.

      Don’t even get me started on the geopolitical problems China has. China is surrounded by countries hostile to it and I think China fragments over the next 2-3 decades. There’s radical Islamist movements in many of the borderlands, which were historically held as buffer regions. All of this military spending you’re seeing in China is also very different than the kind of military spending in the US. The military spending in the US is primarily on technology. Most of Chinese military spending is on internal security as the central government becomes more autocratic while separatist movements in the borderlands and buffer regions become more extreme and other neighbors become more hostile.

      Please DO NOT compare the problems of the developed world to that of the developing world. The problems really are night and day. If you don’t believe me, spend a few days in cities like Chennai or Beijing. Hell, go to the countrysides while you’re at it. You’ll see problems you don’t even think about. Countries like China are incredibly poor.

    • Regarding US economic policy,

      a) It is hard to deny good intentions and good faith when Greenspan first eased monetary policy in 1997 to try to contain the fallout from the Asian crisis followed by LTCM and Russia in 1998.

      b) Having seen the consequences of easy money in the form of speculative excesses in the late 1990’s leading to the equity crash of 2000-2001 and its impact on the economy, it is hard to comprehend why they decided to double down on that same strategy and tried to revive the economy by inflating the housing bubble.

      c) Having seen the consequences of easy money in the form of speculative excesses in 2006-2007 leading to the housing, credit and equity crashes of 2008 and their impact on the economy, it is totally impossible to comprehend why they decided to triple down on that same strategy and tried to revive the economy by inflating the all-financial-asset-classes-together bubble.

      Making a policy mistake is not great but understandable given the complexity of the subject. Making the same mistake twice is annoying. Making the same mistake three times is sheer incompetence.

      • Is it incompetence, or merely complete corruption? Or some amalgam of the two?

        I think it’s denial, first of all, and hubris (we can’t possibly do what FDR did…that’s old-fashioned, and this time it’s different, we are making our own reality, etc. etc. We don’t need the “useless eaters”, so let’s do the earth a favor and get rid of them…)

        And then, it’s Elitism. The game plan is to reduce the global population by starving 99%. I’d like to see the 1% fix anything (plumbing, light switches, dinner, dirty diapers) all by themselves. I’d like to see them killing each other off in an attempt to keep amassing the world’s wealth, once the easy pickings are gone….The 1% ARE the only Useless Eaters on this planet.

        • I don’t find it useful, Demeter, to ascribe bad policies to incompetence and corruption except to the extent that we would argue that all policies throughout history can be explained by these factors. Although we can look back at many periods in US and global history in which there has been impressive leadership accomplishing great things, the consensus always developed much later. Contemporary analysts were always as disgusted with their leaders’ polices as we are with ours, which suggests to me that all contemporary analysis, including our own, tends to be very narrow and partisan, and that we are not especially good at judging whether policies will “work”.

          What’s more, I have met many important policymakers in the US, China and abroad, and I have to say that while there were plenty of venal, greedy and/or self-regarding idiots, in fact most of the people I have met, especially in the US executive branch, are pretty smart and sometimes absolutely brilliant, very hard working, and motivated by a sense of doing right. There are a lot of very impressive people in government (although in democracies the media tends to prefer to highlight idiocy).

          I would suggest that “bad” policy, to the extent we are able to judge, is likely to occur in part because a)the complexity of modern economies makes it very difficult to do anything except incrementally, b)there are very different interests and priorities, often deeply and honestly felt, that need to be balanced, and c) perhaps most importantly, we are all subject to the incentive structures that affect us. We truly “believe” what it is in our best interest to believe. Although we can easily find individual examples, it is very hard to think of many examples of large groups doing the “right” thing when the right thing was clearly not to their benefit, and I don’t think they always do it cynically, or at least I would never accuse them of being cynical until I was absolutely certain that none of my own moral and analytical judgements have ever been affected by the particular incentives that affect me. The goal of a political system should be, I think, to try to structure incentives so that policymakers win by delivering to citizens — in economics we call it the agency problem — and democracies use the threat of removal as their way of aligning incentives. A political system that requires good, honest, and far-seeing leaders who are indifferent to their own interests in order to function will almost certainly be disastrous.

          • Entirely valid and well taken, except that it is out of purpose to ascribe bad policy to incompetence, only the REPETITION of bad policy (that is, one that widely misses its stated objectives).

            At the end of the day, since it was decided in the early 70´s to let trade imbalances go unchecked and to [temporarily] adopt freely floating exchange rates to make them supposedly painless (mainly for the US thanks to the advantage of doing international trade in its own currency) so that not only global debt grew in tandem with accumulated trade imbalances – and even faster due to the elasticity of fractional reserve credit systems – but also that the need arose to hedge all this floating around of currencies and interest rates, and that everything was further compounded by further trade liberalization while the related issue of exchange rates continued to be totally ignored and by further financial liberalization to supposedly hedge all the resulting mushrooming complexity with the consequence that financial instability has been greatly increased, the policy response to every single crisis has always been the same: ease credit conditions.

            So, agree for the complexity, but let´s not forget it is the direct by-product of trade and financial liberalization in the context of floating exchange rates. Agree also for the different priorities and interests that need to be balanced but the growing income inequality you have yourself noticed strongly suggests that the interests of a few are being systematically prioritized over those of the many, which naturally raises some suspicion about the incentive structures of the decision makers.

            Of course, criticism has a duty to be constructive. Different policies must be formulated in good faith based on the observation and explanation of events, and these new policies must themselves, as and when implemented, bear the burden of proof. Only in this way, we can continuously improve the economic conditions of our living together.

  24. @DvD
    Regarding Us economic policy, I think that is very difficult for the US government to make rebalancing effort when substantial population truly believes that for the economy to recover, it only needs to cut taxes, cut school lunches and keep immigrants out. And elites do not help.

    In Europe, Mr. Mario Draghi makes a speech ,calms the markets and even makes the debt seem to disappear. So how can you start rebalancing?

    Prof Pettis provides an explanation other than incompetence. Here is the quote:

    “For now the policy-making elite in peripheral Europe continues to insist that there will be absolutely no flexibility……. . But in the 1920’s the British policy-making elite, who insisted then that there would be absolutely no flexibility on the matter of free trade, was forced to abandon its principles as high unemployment and voter revolt forced it into devaluing sterling and setting up tariffs. There is huge controversy on the sequence and causality..”

    So I guess we will have to wait for a third asset bubble to fall.

    • Probably. The current asset / debt bubble seems too mature and too global now (as China joined in a big way with the credit boom implemented there in 2009) to avoid another crash and recession.

      The window that briefly opened in H2 2009 – H1 2010 after the credit and asset markets had been backstopped to start addressing the root causes of the debt snowball has been closed down by QE2 which signalled that – once again – only the symptoms (a too high interest burden and too low apparent solvency) would be taken care of.

      I believe that the root cause of the global debt snowball is the systematic labor arbitrage allowed within the current world trade and monetary system whereby exchange rates don’t compensate for relative differences in salary and productivity level among countries. The rest follows from that: the trade imbalances settled by debt ; the duplication of credit as debt of deficit countries form the monetary base of surplus countries where it is multiplied through their own domestic fractional reserve credit systems ; the weakening trend of aggregate demand as labor share of production falls globally, further feeding the increase in debt so that demand can keep up with production ; the excess savings feeding speculation and pushing asset markets far from equilibrium. Labor arbitrage is the main source of the leakage. It can be addressed by appropriate reforms of the world trade and exchange rate regime (please see comments to Economic Consequences of Income Inequality).

      But, this time again, the decision makers – the elites – are either blinded by their own ideological biases (remember they are the same guys who pushed trade globalization, financial deregulation, who pushed for the Euro in Europe, on the basis of promises of shared prosperity that have been utterly contradicted by the facts). And / or they are in the pockets of the ~ 3000 large multinational companies who are the main beneficiaries of the system, the “1%” being the ones indexed on the profits of these large companies comprising the world equity marketcap, ie. their managers, shareholders and people working in financial markets. But, as discussed in Economic Consequences of Income inequality, there is a point where a too low labor share becomes detrimental to the wealth of capital owners as wages can no longer buy what is being produced.

      Indeed, achieving a successful and coordinated rebalancing is not easy at all. One more reason to finally drop the false ideologies that are blocking the proper understanding of the situation. We can only start correcting the situation once it has been correctly diagnosed. Otherwise, we condemn ourselves to another round of reactive emergency measures treating the most urgent symptoms when the next crisis hit.

  25. does anyone notice that china is planning to privatize certain SEO’s which are not profitable and absorbing some debt loses. I just hope investor don’t fall for the notion that SEO always profitable because it is backed by govt.

  26. I could not agree more. The reason why debt matters is that in a capitalist society money – in its functions as capital, on one side, and as wages, on the other – acts as a measure of the ability of the people who control social resources to be able to deploy them so as to ensure the reproduction of the wage relation. Growing debt and price instability (inflation or deflation) mean that the role of money as a measure of value – that is to say, as a measure of the effectiveness of capital to control living labour across different sectors of production – is weakening and dissipating to such a degree that it then becomes impossible to use money as a hieroglyph for the respective claims of various social agents to social resources. It is, if you like, as if economic agents suddenly began to communicate in a language that was constantly changing in meaning. It is not that money itself (which is an inanimate thing) loses its efficacy, but rather that the loss of co-ordination among economic agents as to their respective claims to social resources induces the quantitative dysfunction of money – the so-called “balance-sheet adjustment” or, in Minsky’s words, “financial instability”. Money is not a “thing”: it is a social claim to resources. But its loss of efficacy means that the distribution of social resources is becoming impossibly problematic. The same, of course, applies to exchange-rate adjustments. Cheers and keep up the good work!

  27. Asiaassetallocator

    Prof Pettis, Thankyou again for such an informative blog. Why do we have to concern ourselves with investment projects returning the correctly calculated debt servicing cost as opposed to the subsidied WACC? We understand of course that the cost of capital is reduced by financial repression paid for by the houseold sector, but given that the household sector is already paying for the difference surely this means that only returning the subsidied WACC would result in no unsustainable growth rate in debt? Of course I am assuming no rebalancing here, but trying to understand whether you believe that investments to date have generally not returned their subsidised WACC and hence the unsustainable growth rate of debt..

    • From the borrower’s point of view, you are right. Why should I care if my investments are wealth-destroying if I can get subsidies (including interest-rate subsidies) that exceed the amount of wealth destruction? I will still get richer.
      The problem is that for the economy as a whole, it does matter, for at last two reasons. First, the losses borne by the rest of the country are greater than the profits earned by the borrower. Second, the system distorts incentives and tends to concentrate political and economic power among those groups whose interest is to distort incentives even more.

  28. Yes! Finally someone writes about leaky cauldron.

  29. Hi Prof Pettis, I read your post with great interest. I’m a Singaporean currently studying MBA in Fudan University.

    I’m with you in the pessimism about the growth of the Chinese economy. In particular, the transition to a consumption-led model is a necessary move but obviously not an easy one, and the government appears still reliant on investments to boost the numbers during this transition phase. Infrastructure and real estate investments is an industry that fundamentally relies on leverage. This reliance is only going to exacerbate the debt snowball in the economy. It thus appears to me that the Chinese economy is now stuck in a difficult conundrum where the monster that is debt is getting out of hand and deleveraging is badly needed, yet it is dearly reliant on leverage to support investments to boost the GDP numbers. Delaying the deleveraging process is only growing the monster and delaying the end game.

    My fear is that the eventual bust of the debt cycle would lead China into a lost decade, much like Japan. Collapse of the real estate industry not only impedes economic growth, but also massively reduces the wealth of the Chinese people, and thus would greatly reduce the propensity to spend. China could be left in a debacle where its old growth model is destroyed yet its new growth model is no longer supported by economic reality.

    If you may, please, what is your view on the “end game” to the Chinese debt cycle and what are your thoughts on the probability of such depression-like outcome?

    Xin Yao

    • One possible end game scenario is war. The kind of economic growth China has requires inputs–and those inputs are natural resources. If China wants to maintain these growth numbers, China’s demand for natural resources will need to keep increasing. Keep in mind that China already has the largest demand for natural resources out of any country today. The “territorial disputes” with Japan, Vietnam, Philippines, Taiwan, and South Korea are really about the natural resources on the seabed. If China were to take up that policy, I think you could see separatist movements in the borderlands of the North and West in China intensify.

      Keep in mind that over 90% of China’s population isn’t just Han, but that almost all of China’s Han population (>90% of the total population) lives in the Southeastern third of the country where all of the arable land is. I don’t have a doubt that the Han core will stick together, but I’m not so sure about the sparsely populated borderlands with harsh terrain like Tibet, Xinjiang, Inner Mongolia, and possibly even Manchuria. The longer China tries to hang on to these growth rates, the worse the correction will be and the more likely fragmentation will occur.

      Of course, China could also just keep turning up military spending as needed to fund its demands for natural resources/fund its imperialism until the country collapses from within. The longer this goes on, the more likely the breakdown of the central government becomes. China already spends the second most on defense out of any country in the world, which is about $190 billion in 2013, but >$111 billion goes to internal security in its own right. The more I think about it, the more likely fragmentation becomes.

      • Chinese leaders are delaying economic reform, because they want to wait for US economy to recover, thus cushion the Chinese economy from the impact of reform, turning a hard landing into a soft landing. I think they will be disappointed.

        • I agree, Merz. I think the world suffers from excess capacity and insufficient demand, the latter bought on at least in part from rising income inequality. I don’t think the world is going to get a lot better any time soon. Governments never make difficult choices when conditions are optimal because there seems to be no urgency, so they do so when conditions are at their worst.

          • Why just “in part”? The present economic mindset (read ideology) fosters Income inequality. There is too much savings, savings that is concentrated and merely parked in unproductive, non-job creating assets. This mindset and resulting income inequality is the root cause of economic standstill.

            When you pay the working class just enough to survive, you force the working class to borrow to fund the rest of his needs. And, of course, this can’t go on and we’ve been at it since the 1980s when banks transitioned from wholesale banking to consumer banking and securitizations.

            It’s all has to do with one’s vision of society and economic ideology.

    • In my latest book, Xin Yao, I list the different ways (I divided them into six) that rebalancing logically must occur. One of them, as you point out, is a Japanese-style lost decade.

      • Prof Pettis, thank you for your reply and comment. I have not read your book but, with great interest, I intend to.
        Among the 6 ways, what do you consider the most probable, and where does a Jap-style lost decade rank?

  30. I wonder if you could clarify the possible mechanics of loss assignment in the three (or four) possible scenarios? This post has inspired me to put your book next on my list.

    • It is difficult to be specific because there are literally hundreds of ways losses can be assigned, and the process doesn’t have to be direct. The government could lower interest rates while reforming the hukou system, in which case households as savers lose while households as migrant workers benefit. They could raise taxes on businesses while allocating more and cheaper capital to SMEs, in which case businesses pay, but large ones pay far more than small ones. They could privatize state assets and use the money to pay down debt, in which case the government pays.

  31. Mr. Pettis,

    Great post and very interesting comments too.

    The more I read about China, the more my conviction grows that, at the end of the day, what is at stake is the
    ability of the PCP of China to maintain its control of the country. I struggle to see how could social capital be increased (or inclusive institutions if you prefer) without seriously undermining the Party’s position.

  32. Very interesting, as always. The article on 4 stages of growth in China is fascinating – I will assign it to my students in my class on globalization/development. One quick question. What about the exchange rate? I would love to know your views about that. If the exchange rate appreciates that would definitely help rebalancing. However if there is a disorderly process of adjustment to a slower and less investment driven growth path, that might lead to significant capital outflows because of a broader loss of confidence in China’s economic prospects leading to a fall in the value of the currency? Maybe the government may not even resist that because it will help cushion a hard landing? I mean they might be able to resist it given their foreign exchange reserves, but they may not want to, unless currency movements are large and disruptive. What can we say about the likely direction of exchange rates movements and inflation over the next few years? Thanks a ton for your articles.

  33. Surely debt is debt, and the western world has a debt problem as well as China, and the way the western world is trying to “solve” that problem is by allocating the losses to the savers in favour of the debtors, through low interest rates maintained by QE. The western world is currently making the poor pay for the losses through inflation in food and energy especially.
    Also, even if losses are assigned to the government, that is still in effect assigning them to the households because the assets of the government have been accumulated from households’ taxes.

    • The assets of the government are not created by taxes in China, they were created by the totalitarian socialist system; where they still own the land, everything under each piece of land, vast productive capacity (although subsidiaries have been created and some by Income streams of income stream mechanisms of such on Nasdaq), and while QE is seem as some pundits as such for smart companies and countries the low interest rate environment also enabled them to refinance to lower payments for previous investments, thus was stabilizing, where hubris reigned some created their own problems in the environment. A more insightful theoretical criticism is that inflows might have caused rises in Emerging market currency values, but of course 95% of such are far lower in value against the dollar than they were 20 years ago, as part of their financial repression to build GDP while siphoning external demand for employment while structuring savings model encouraging both FDI and structuring surpluses for money growth (thus high savings rates).

      The companies and economies that emerge unscathed, and lean, will have been the ones who used the low rate environment productively, the ones who hadn’t, and haven’t, wll attempt to create the memes that you list here.

  34. So this may have been asked before. But are their numbers showing in what number all this debt may lie.
    All debts are not equal. For example debts owed to other countries may not be as bad as debts owed to hedge/vulture funds.

    It would be interesting to know this because depending on who the debt is owed to also speaks a little about how it can be moved, amortized, down written etcetera.

    For example I heard, real estate(commercial and residential) investment is nuts in China and a lot of wealthy people “finance” this because they park their money here. The dynamics of that debt would be very different from.
    a debt of a government controlled enterprise.

  35. “The liability side of the balance sheet is treated mainly as the way in which the cashflows associated with the management of the asset side are distributed, and it is the growth in operating earnings that ultimately matters.”

    When this observation is made regarding the business sector, it is almost always forgotten that corporate operating earnings are themselves – even before being split up between corporate debt and corporate equity – subordinated to debt service by the households and public sectors. Indeed, households and public sectors are the end clients of the business sector. As per the legal system, they have to service their own debt before they can purchase any good or service from the business sector. So, business sector operating earnings (final sales – costs) are already economically subordinated to households and governement debt service. Adding another layer of business debt to leverage business earnings further is effectively double leverage.

    While it is understood that business equity is, legally speaking, subordinated to business debt, it is almost never understood that, economically speaking, it is subordinated to all debt in the economy. Because of that, conclusions are being reached – that not only debt doesn’t matter but often enough that debt is good (and cheap debt is very good) – that are dangerous to systemic stability as debt is piled upon debt in a joyful state of unconsciousness.

  36. Of course, once debt has reached a certain multiple of production, it simply can’t realistically be repaid out of operating earnings. For instance, with debt of 300% of GDP and assuming 6yrs amortization period 5% interest rate on average, debt service would absorb about 60% of GDP, putting a huge pressure on discretionary spending.

    If debt can’t be repaid out of cashflows, then the only solution left is to inflate asset values to maintain at all cost the balance sheet appearance of positive net worth. This is exactly the stage where our “bubble” economy is, in which asset values miraculously grow faster than production and income and the ratio “market value of total stock of capital / total production” is ballooning out of proportion. At least until such time as income and wealth finally reconverge, orderly or, most likely, not.

    • “Of course, once debt has reached a certain multiple of production, it simply can’t realistically be repaid out of operating earnings. For instance, with debt of 300% of GDP and assuming 6yrs amortization period 5% interest rate on average, debt service would absorb about 60% of GDP, putting a huge pressure on discretionary spending”

      (1) Debts are almost never repaid either by the government or by corporations or by households as a WHOLE SECTOR. Yes, individual households may payback their debts, mortgages, credit cards and so forth as they get older, but then new, younger households are constantly entering into the sector such that the total debt by the household sector as a WHOLE almost always keeps increasing. Same is true for corporations; some may choose to pay down their debts for a while, but others will keep borrowing such that the total debt of the corporate sector as a whole rarely goes down much. Governments paying back the debt is also very rare, it is usually a ‘borrow from Peter to repay Paul’ sort of thing that Government do.

      Therefore, for a sector as a whole, worrying about paying down the debt is not as important as worrying about whether the total debt is rising FASTER or SLOWER than the GDP as a whole. As long as the debt does not keep growing faster than GDP for extended periods of time as a secular trend, it may still be manageable even at the same interest rate.

      (2) So your calculations should neglect the amortization aspects and focus mainly on the debt SERVICING costs, assuming that sector-wide debts (NOT individual cases) will keep being effectively rolled over. Here are some data for you to consider from the Federal Reserve for Total Debt (Government, Household and Businesses) and Total debt-servicing costs as a percentage of GDP

      Year….Total Debt/GDP…Servicing Cost/GDP

      As you can see, EVEN THOUGH the debt/GDP ratio of the US kept rising for the last 30 years, the COST OF SERVICING the debt as a proportion of GDP has actually been FALLING.

      This astonishing fact follows from the fact that interest rates (nominal and real) have been falling for the last 30 years and they have been falling faster than the debt has been rising as a proportion of GDP.

      What this means is that the total US debt today is easier to service than it was 30 years ago, even though the debt/GDP ratio is almost twice as high today.

      Of course, the REAL DANGER is that this temporarily-happy situation of low servicing-cost/GDP ratios with high debt/GDP ratios is that it is extremely susceptible to rising interest rates.

      If interest rates rise sharply, massive defaults are almost sure to follow.

      So will interest rates rise in the US over the next 10 years? I don’t know. What do you think?

      • 1) The key word is “realistically”. Each individual credit decision is based on the individual borrower ability to repay the credit, not only interest but also principal, out of its own cashflows. That’s what every credit committee in every bank in the world is assessing. It follows from this that in aggregate all debt should be repayable out of aggregate cashflows. Yet, this is not the case anymore. Which strongly suggests that banks are not only lending against future cashflows but that at least some are now lending against future rise in asset values. Which was my point on the current “bubble” economy in which rising debt to GDP triggers a reflexive relationship with rising asset value to GDP. “Realistically” is the key word because when this realistic expectation of repayment no longer exists, the credit system becomes vulnerable to a credit crunch, which tend to be nasty in a fractional reserve system. As a bank, you neglect principal amortization at your own peril, except of course if you rely on “bad debts being socialized”.

        2) Your stats are not showing total US debt / GDP as you say but total non-financial debt / GDP. Total debt (including financial) is more like 345% of GDP. That in itself is interesting because since when banks are borrowers? Normally, they are lenders. Aside from this anomaly, i think the relationship between debt and interest rates is backward. Interest rates have been pinned at lower and lower level as relative debt kept going higher an higher. This is in effect the way the losses associated with bad debts is being allocated over time to lenders and ultimately to savers and depositors. Think about it: given the same inflation and same duration of credit, you charge a higher or lower interest to a borrower who has 140% or 340% leverage? In fact, with your debt servicing costs to GDP of 15% in 2005, you would have seen nothing coming as this ratio looked quite normal. By contrast, with the ratio of principal amortization + interest costs / GDP, you would have very easily detected the problem. So, to answer your question: interest rates won’t go up by any voluntary decision of central banks because they simply can’t normalize interest rates with this kind of debt load. Normally, lower interest rate allow faster principal repayment so it should facilitate deleveraging. But, this is not happening. Instead, relative debt keeps rising as the root causes of the debt accumulation have been left unaddressed post 2008. Meaning, interest rates will likely go up at some stage because of rising credit risks. That won’t be very pretty but “what must happen usually happen”.

        • “Your stats are not showing total US debt / GDP as you say but total non-financial debt / GDP. Total debt (including financial) is more like 345% of GDP. That in itself is interesting because since when banks are borrowers? Normally, they are lenders. ”

          Yes, I have excluded financial debt and so does the Federal Reserve. The Federal Reserve shows financial debt separately in a different column and does not include it in Total Debt. This is because financial debt (i.e. the debt of financial companies like banks etc.) is only a contingent liability on the Government under extreme circumstances. If you think about it, you will see that counting financial debt as a part of the Total Debt statistics implies “double counting” and would be misleading.

          You express surprise that Banks, whom you say are ‘normally lenders’, are now suddenly ‘borrowers’. But Banks are merely intermediaries. In order to lend (beyond equity) they have to be borrowers, whether from ordinary depositors or from bond-holders. That is what Banking has ALWAYS been about– leverage; banks survive on the rate differential between borrowing and lending.

          As you may see, Banks merely borrow from Group A and lend to Group B. So what is called “financial debt” is merely financial intermediation in which money is borrowed from Group A and lent to Group B. This means that a lot of what we call Total Debt (household debt, non-financial business debt, government debt) is merely the asset side of financial companies (e.g. banks), whereas what we call ‘financial debt’ is merely the liability side of the same financial companies (e.g. banks). The difference between the two is the equity of the financial companies.

          Surely, we cannot add the asset side and the liability side and then call it “total debt”. That would be double-counting and hence misleading. Therefore, I hope I don’t sound too muddled when I summarize as follows:
          (1) Financial debt should NOT be counted as part of the Total Debt (Household, Business, Government). This is how the Federal Reserves does it and the Federal Reserve is CORRECT.
          (2) However, we SHOULD keep Financial debt in mind and keep a close eye on it by tracking it in a different column that is separate from Total Debt. This tracking is advisable because Financial debt could become a contingent liability on the Government in the event of a financial crisis.

          Remember that when the Government bailed out the financial companies in 2009, they were really paying for the debts that households and companies defaulted on. Financial companies have ‘debts’ on both sides of their balance sheets; on the right side are the people they borrowed from (their liabilities) and the left side are the households, non-financial companies and governments they lent to (their assets).

          I hope I have made some sense. If not, perhaps Michael could explain this better.

          • I understand your point about “double-counting” financial debt into total debt. However, there is much more to this tricky question than just double counting.

            First, it is worth noting that, while financial debt indeed tracked bank deposits and non-financial debt from 1946 to the late 1970’s, it has been widely diverging from them since then.

            Second, it is not just about the banks:

            – The asset side of the financial sector is all the non-financial debt incurred by the household, non-financial business, government and rest of the world sectors, either in loan or bond form, held either by banks, mutual funds, pension funds, insurance companies or holding companies + all the listed equities held by the same types of financial institutions + some private equity assets held by holding companies and pension funds to a much smaller extent.

            – The liability side is the money supply (currency, deposits), money market funds shares, mutual funds shares, pension liabilities, insurance liabilities, financial debt and equity.

            The key question is to what extent financial debt constitutes double leverage?

            For instance, insurance companies don’t need to issue debt given their cashflow profile: they receive the proceeds from insurance premiums upfront, invest them for their benefit and only pay out claims later, sometimes much latter (see Warren Buffett’s explanation of “insurance float” in his annual letters to shareholders). Yet, many insurance companies do issue debt. Why? To leverage their return on equity.

            Another exemple, holding companies owning the equity of various operating businesses. The debt financing needs of operating companies is done at their level. Operating companies often have debt, sometimes quite a bit. Assuming the residual equity position, the parent holding companies should themselves have a capital base purely made up of equity. Yet, many holding companies issue debt. Why? To leverage their return on equity.

            Even banks or GSEs can assume double (or more) leverage embedded into structured investments. For instance, when a bank securitizes a loan portfolio of say 100 nominal value and only keep a residual position of say 10, the size of its asset side is decreased but not its exposure because the 10% tranche it retains concentrates all the risk. The deposit funding that 10 position on the other side of the balance sheet doesn’t at all carry the same risk than a “normal” bank deposit.

            But the most explicit example is the net margin debt of NYSE member firms. This represents the funding of undated equity positions with on-demand debt and is the exact definition of the most unstable form of double leverage. Net margin debt is currently at record high level. Surprised?

            There are many examples like these and the financial sector is very imaginative to find “yield-enhancing” strategies. The temptation is simply too great. Monetary policy is de facto an encouragement to pursue these strategies.

            At the end of the day, it all depends whether we are in a “non-bubble” economy, in which case financial debt is indeed double counting to a large extent and should be excluded from total debt or whether we are in a “bubble” economy, in which case financial debt is to a large extent double leverage and should be added.

            Financial assets value has been very stable around 250% of nominal GDP from 1946 to 1979. That was a “normal” economy. Financial debt (then typically representing ~ 8% of GDP) could be safely ignored to avoid double counting.

            Then, since the late 1970’s, financial assets have grown relentlessly relative to economic activity. In 2007, they represented 460% of GDP. At the end of 2014 (after the debt write downs from the 2008-2009 crisis), they will be very close to … 500% of GDP! That’s a “bubble” economy. It means that, outside of bubble valuations, the financial sector is bust and financial debt (then typically representing 95% of GDP) either defaults or becomes Government debt (mainly the case for banks, this is your point about contingent liability of the Government).

            Whether you want to immediately recognize the hidden loss of the banking sector in a highly leveraged economy or wait for it to materialize is of course a matter of judgement. But, in any case, the portion of financial debt representing double leverage should be immediately added to non-financial debt.

            In real life, total capital is not an infinite multiple of total production and please remember there are also tangible assets like the net worth portion of residential real estate and of privately-owned businesses which don’t show up on the balance sheet of the financial sector. When you own financial assets worth 500% of nominal GDP and you fund them with financial debt representing close to 100% of GDP, this is clearly double leverage to a very significant extent and should be added to total debt.

            Which means that US total debt / nominal GDP is a lot closer to 350% than 250%. Which means there is not so much equity left in the system. Said differently, it is no longer realistic to expect debt repayment out of operating cashflows. Which in turn explains why it has become a major policy objective in itself to increase the multiple of monetary value of total capital / total production to maintain the appearance of solvency. Indeed, if debt can no longer be realistically repaid out of cashflows, the only thing holding the credit system is asset values greater than debt values. If it is based purely on monetary manipulation without addressing the root causes of the situation, such policy is highly likely to prove illusory. As it has already in 2001 and 2008.

        • “1) The key word is “realistically”. Each individual credit decision is based on the individual borrower ability to repay the credit, not only interest but also principal, out of its own cashflows…..”

          Amortization, from the “mort” part, implies DEATH. So when we deal with Government, Household and Business debt we must ask ourselves two questions:
          (a) Will the borrower DIE?
          (b) Will the asset against which the loan is made (or the asset the borrower purchases with the loan) DIE?

          If neither “dies” (i.e. depreciates, gets old & worn, reduces in value or capability and dies) , then amortization is not necessary. If either one “dies”, then amortization is necessary.

          Think about this and let me know if you disagree.

          Let us take (a) from the list above:
          (1) The Government never dies (except occasional violent revolution or foreign invasion etc.)
          (2) Companies rarely die (except occasional bankruptcy, closure etc. but NOT including take-overs and mergers)
          (3) Individual Households, on the other hand, ALWAYS get old and die, even thought the children of those ageing households start their own new households.

          Next, let us take (b):
          (1) Land (and houses) never dies (except for anomalies like the great depression and recent repeat of the same, aggregate house and land prices generally stay constant adjusted for inflation, and in some cases may even increase in real terms in some places)
          (2) Machinery always dies (wear & tear and obsolescence)
          (3) The economy never dies (except for temporary situations like depressions or recessions; even in Japan the economy is more or less the same size despite their long-stagnation)

          Let us compile (a) & (b) as follows:

          A) The government, which never dies, borrows against the revenue (i.e. tax) it gets from the economy (i.e. its asset) which also never dies.

          Therefore, amortization is an unnecessary concept for all government borrowing.

          B) Companies, which never die, borrow against assets like:
          (1) Land and buildings, which never die, and so amortization for such assets is unnecessary
          (2) Machinery, which grows old and dies, and so amortization for such assets is necessary

          C) Households do die. Therefore, all household debt must be amortized.
          (1) Household Mortgages (the word ‘mort’ is a dead giveaway), even though they are against land & houses, which do not die, must be amortized because Households do get old and die.
          (2) Non-collateralized Household loans must also be amortized because either there are no assets backing them or the assets (like household appliances etc.) themselves die.

          Note that in (C)(1), we have a MAJOR break from tradition. Historically, when households died, they left their “paid off” land/house assets to their children as inheritances. Now that is becoming increasingly rarer. What happens now is that any land/house equity that may accrue from amortization of the mortgage is being used as fresh collateral for collateralized consumer loans (HEL, HELOC). In effect, this means that the TRUE amortization of aggregate Mortgages has been considerably REDUCED. Many households now are saying “when we die, we will leave our land/house to the lender and not to our children” and in return they are able to borrow and consume more right now.

          I hope this is somewhat clear, and I have made the case that not all debts need to be amortized. It all depends on whether the borrower or the asset against the loan “morts” (depreciates, gets old, dies) or not.

          Please let me know your thoughts.

          • You are making things un-necessarily complicated. Yes, of course there will always be debt in the overall capital structure of the economy and it will never run-off to 0 in aggregate. That’s not the point. The portion of aggregate debt that is easily serviceable out of aggregate cashflows – whether that’s 100%, 150% or 200% of nominal GDP – is fine. What is under discussion here is excess debt, ie. the portion of debt that is not so easily serviceable out of cashflows and could become bad debt under adverse circumstances.

        • “……Think about it: given the same inflation and same duration of credit, you charge a higher or lower interest to a borrower who has 140% or 340% leverage?….”

          India (Household, Business, Government, Financial) debt = 140% of GDP
          US (Household, Business, Government, Financial) debt = 340% of GDP

          India international USD borrowing rate = 8.5%
          US international USD borrowing rate = 2.5%


          India Credit Rating: BBB-
          US Credit Rating: AA+

          Simply put, the WHOLE WORLD wants to lend money to the US, because they know (or should that be ‘think’?) that it will be SAFE in the US.

          Will that change in the near future? I don’t know. What do you think? Will it change? Should it change? What is your opinion on the matter?

        • “……Think about it: given the same inflation and same duration of credit, you charge a higher or lower interest to a borrower who has 140% or 340% leverage?….”

          Here is something more for all of us to think about….

          YOUR VIEW: Total debt load in the US went from around 140% of GDP in 1980 to around 250% of GDP in 2010, THEREFORE, real interest rates *SHOULD HAVE* also gone up from 1980 to 2010 to account for the higher risk associated with the higher debt load.

          US Nominal Interest Rates 1980-2010 are here:

          US Real Interest Rates from 1980-2010 are here:

          AMERICA’S VIEW 1: Nominal interest rates went down from around 15% in 1980 to around 3% in 2010, THEREFORE, the total debt load in the US *COULD* (and did) go up from 1980 to 2010 on account of lower nominal servicing cost per unit of debt.

          AMERICA’S VIEW 2: Real interest rates went down from around 8% in 1980 to around 2% in 2010, THEREFORE, the total debt load in the US *COULD* (and did) go up from 1980 to 2010 on account of lower real servicing cost per unit of debt.

          Of course, the DANGER of increasing leverage on the justification of constantly-falling interest rates is that such an arrangement is extremely susceptible to the “turning of the tide”. If interest rates turn around make their long journey back up again as a secular upward-trend, then all hell will break loose in America.

          What do you think?

          • So, bond investors who lent to the US in 1980 on a long term basis at real 8% interest rate for a credit risk equivalent to 140% of production value have had both a higher return and a lower risk (hence a much better risk / reward) than bond investors lending today to the US on a long term basis at 1% real interest rate for a credit risk equivalent to 250% of production value. Today’s bond investors are being forced to accept both a higher risk and a lower return. Their risk / reward is very poor. That’s precisely my point. Can it be even poorer? Yes, in Japan investors are effectively paying to lend to a 400% debt / GDP borrower. Does it make sense to invest on these terms? Each one can decide for him / herself. Perhaps the 8.5% Indian Government bond is a better investment, i don’t know as i have not done any work on India credit worthiness. Any return is better than no return … if you ignore risk. Even if you don’t ignore risk, you have to assess it correctly (the speech by David Einhorn referenced earlier is very interesting in that regard). At least part of the answer is provided by the fact that not-for-profit investors (Central Banks) have had to heavily dominate net new money flows into the major Government bond markets of the world (US, UK, Japan, several Eurozone countries) over the past 6 years (so, in terms of the whole world lending to the US Government on these terms, i’m afraid it has rather be essentially only two investors: the Fed and the Bank of China as part of its trade policy). Suvy would say that QE didn’t lower interest rates per say. May be. May be not. But at the minimum, it prevented interest rates to rise in a manner commensurate with rising leverage and allowed profit-seeking investors to chase risk premiums (all established by reference to the “risk-free” government bond yield) in other asset classes. Mind you, many investors are borrowing to invest in risky asset classes (so called carry trade). That’s the internal contradiction of the current monetary policy: on the one hand, it lowers interest cost so as to facilitate deleveraging (principal amortization) – and by the way this actually happened in the 1950’s – but on the other hand, in the current era of financial liberalization and deregulation, the incentive to borrow for profitable speculation are so great that in fact net-net the overall risk in the system doesn’t decrease but rather increase. Remember, it’s not because a risk hasn’t materialized yet that it doesn’t exist. In fact, when it has materialized, it’s too late. So, while everybody feels good enjoying returns meaningfully above the value being generated by economic activity, we should all bear in mind that we are effectively skating on a frozen lake with a very slim layer of ice. Each ice skater should be clear whether he / she will be thrown a life line when we go from ice skating euphoria to drowning in frozen water disaster. In other words, each ice skater should be clear whether his / her losses will be socialized.

  37. European states fare even worse with their uncovered social security obligations (pension schemes and health insurance without any “funds” set aside for the bay-bommers entering old age) than Cina would after socializing debt.
    China’s goverment would be smarter to “write off debts” at relatively good times, blaming it to shadow banks and a few regional goverments. If i waits for bad times, the tides of crises may lead to furter crises, unrest and revolts. An even worse Approach would be attempts to hide economic problems by external actions, e.g. war with Taiwan, just like Hitler had done and Putin is trying just now.

  38. European states fare even worse with their uncovered social security obligations (pension schemes and health insurance without any “funds” set aside for the baby-bommers entering old age) than China would after socializing debt.
    China’s goverment would be smarter to “write off debts” at relatively good times, blaming it to shadow banks and a few regional goverments. If the communist goverment waits for bad times, the tide of crises may lead to furter crises, unrest and revolts. An even worse approach would be attempts to hide economic problems by external actions, e.g. war with Taiwan, just like Hitler had done and Putin is trying just now.

  39. ^^DvD wrote: “…You are making things un-necessarily complicated…..”

    Complicating? I’m sorry, I thought I was simplifying for the sake of clarity. In any case, since Michael and you seem to be debt-worriers, here is something for further thought…..

    Here is the latest Federal Reserve report entitled “Financial Accounts of the US” (PDF file):

    Please take a look at Table D.3 on page 5 entitled “Credit Market Debt Outstanding by Sector”.

    As seen, home mortgage debt went DOWN from 10.611 Trillion$ in 2007 to 9.386 Trillion$ in 2013. Please verify for yourself.

    Now what does this mean? Yes, it is deleveraging, but are households becoming more responsible and paying down their debts? As it turns out, this is not the case. The scale of defaults since 2007 show that MOST of this reduction of about 1.3 Trillion$ in mortgage debt came about because of MASSIVE DEFAULTS (jingle mail etc.).

    For proof, further look at Table D.2 on page 4 entitled “Credit Market Borrowing by Sector”. As seen in that table:
    (a) Mortgage borrowing was positive from 2007-2009 and added a total of 900 billion$ during that period.
    (b) Mortgage borrowing did go negative (more paying back than borrowing) during 2010-2013, and so effectively reduced total debt outstanding, but only by about 260 billion$.

    Therefore, the total charge-offs (defaults) on mortgages so far can be estimated be about 1 Trillion$ or so.

    Also note, that “other consumer debt” (column to the right of the mortgage column) KEPT GOING UP in a secular fashion by a total of 16% during 2007-2013. This is further proof that household as a whole sector are still borrowing and spending (student loans and auto loans for low credit-score borrowers are rising very rapidly).

    Total consumer debt (column to the left of the mortgage column) went down from a peak in 2009 to a trough in 2012, but then started climbing again.

    All this shows are the following:
    (1) Households (net as a sector) have not been paying-back much.
    (2) Most of the reduction in household debt (deleveraging by the sector) came about because of MASSIVE charge-offs (defaults).
    (3) So total household debt did fall a bit, but is now rising again.
    (4) Business debt fell for a bit during the crisis (2007-2009), but has been rising since 2009.
    (5) Government Debt exploded during this period, as we all know.
    (6) Total (HH, Bus, Gov) Debt kept rising in a secular fashion, without interruption, all the while.
    (7) The only real deleveraging has been in the financial-sector debt (separate column to the far right in Table D.3), but this is only because the Federal Reserve bought (“printing money”) a whole lot of debt-securities from financial institutions when it massively expanded its balance sheet, as seen in figure 4 of page 27 here:

    Let me know your thoughts on these trends. Are you worried about the future of the US? What possible “adverse circumstances” do you foresee for the US as a whole in the next 10-years?
    (a) Are you worried that nominal GDP might go DOWN (depression-deflation)?
    (b) Are you worried that interest rates might do UP (nominal and/or real)?
    (c) Are you worried lenders might RAISE standards (i.e. insist on higher principal repayments)?

    • Thanks, i read the very comprehensive Financial Accounts of the US every quarter and find it sad that the Fed saw nothing coming (as least in their public stance) despite having all the data. Clearly, they don’t read their own report or if they do they don’t seem to be very forthcoming with the public.

      The massive defaults seen in from 2008-2009 – or to be more precise their economic impact on the lives of millions of people – is precisely the reason why we should worry about EXCESS debt. Or rather we should have worried before 2008, which would have meant “fighting the Fed” and its misguided policy of inflating the housing bubble to supposedly help the economy recover from the bursting of the TMT bubble in 2001-2002 (itself helped by monetary easing to supposedly cushion the US economy from the Asian crisis of 1997 and LTCM and Russian defaults in 1998. It is important to understand how and why 2008 happened and to draw the lessons from it.

      As you pointed out, there has been no deleveraging, a little bit on a net basis very temporarily and not at all on a gross basis. That’s curious because lower interest cost normally free up cashflow for principal amortization at least on a relative basis vs. nominal GDP. This has not happened. In fact, the US is again releveraging. This suggest that the US economy is simply growing into the new, higher, debt / income limit allowed by lower interest rates and that the underlying causes of debt rising faster than income have not been addressed.

      Total non-financial / nominal GDP was stable around 150% from after WWII to the early 1980’s. The US economy was prosperous during that time, real growth was strong and living standards rose dramatically. Relative debt was stable, meaning that economic growth was self-financed.

      Since the early 1980’s, relative debt is rising significantly and steadily, real economic growth trend is weakening, each cyclical slowdown seems more severe that the previous one, under-employment is rising meaningfully (under-employment = unemployment + part time for economic reasons + falling out of labor force not for demographics reasons) and living standards are no longer rising on average, the average masking a huge opening up of income inequality. All this suggest that economic growth is of a lower quality and in particular is no longer self-financed but debt-financed.

      The key questions i’m concerned with (and the Fed and economists and all interested persons should be concerned with) are:

      – What changed from the early 1980’s and why? Why does economic growth has to be debt-funded for over 30yrs while it was self-financed in the 35yrs before that with much better performance?
      – Is the current path sustainable?
      – Have the conditions that led to 2008-2009 been removed? What are they? What is the source of the cashflow leakage that causes relative debt to rise?
      -If the conditions that led to 2008-2009 have not been removed, what can be done to address the primary causes of the situation and not only its visible symptoms?
      – Why has there been no debate and no desire to understand despite the severity of the crisis? Why this insistence that “debt doesn’t matter” when we all saw so clearly that it does?

      These, in my mind, are the questions. I can see from your comments that you are interested and try to back things up with data. That’s good. Reasonings and ideas always have to be consistent with observable facts, as reported by data. Remember, whenever there is a discrepancy between theories and facts (for instance when Fed Chairman says something and the Fed Financial Accounts of the US says the opposite), it’s always the facts that are correct. You should stay with them. And with that, you will find your own answers. I have tried to put mine in my various comments to “Economic Consequences of Income Inequality”.

      • ^^DvD asked: “What changed from the early 1980s and why?
        ANSWER (to my mind): Increasing Debt load HAD to become the principal engine for generating aggregate demand after 1980s because–
        (a) Internal reason for rising debt load as % of GDP-
        (b) External reason for rising debt load as % of GDP-

        Note that (b) is nothing but the export of debt-generated aggregate demand that became inevitable because the bulk of the global “savings glut” always comes to the US as the “borrower of last resort”.

        DvD asked: “Why does economic growth have to be debt-funded for over 30yrs while it was self-financed in the 35yrs before that with much better performance?”
        ANSWER (to my mind): See answer above.

        DvD asked: Is the current path sustainable? Have the conditions that led to 2008-2009 been removed?
        ANSWER (to my mind): No. To fix the problem, at a very minimum:
        (a) The US must either stop running current account deficits or else at the very least stop financing it with debt.
        (b) Income inequality in US must reduce such that households & governments no longer have to keep increasing borrowing to keep up the aggregate demand. So either wages (unionism?) or taxes (socialism?) or both will have to rise as % of GDP.

        Do you disagree? Let us know if you have any other explanations.

        • Thanks. Agree. But then the next questions are: What are the drivers of falling domestic labor share of income and rising income inequality since the early 1980’s? And how does the US stop running trade and current account deficits, something it has not done in 50 years? They let the $ float since 1971 precisely not to have to reduce their current account deficit as counterparties were increasingly asking for gold instead of $ as payment. And how does the US could increase domestic wage and decrease trade deficit at the same time? Do you think that’s feasible? And what do you think is the origin of the “global savings glut”? And why do you think US companies don’t increase wage (at least relative to production) despite being financially largely able to do so from their high profit share of production?

          What do you think is the common denominator between all these aspects? What ties all of these together?

          My answers are in my comments to “Economic Consequences of Income Inequality”.

    • Thank you.

      More precisely, the integration of China and many other developing economies into the global economy via the removal of trade tariffs within a global exchange rate framework that didn’t compensate relative differences of labour cost and productivity.

      This opened up tremendous opportunities for labor arbitrage to multinational companies that boosted their profit but were matched by rising debt and rising under-employment in developed economies.

      By its sheer size, China has indeed been the dominant force, especially since joining the WTO in 2001.

      The heart of the matter is that, since the US unilaterally abandoned the Bretton Woods system of global exchange rate coordination from 1971 and since the globalization of free trade from the late 1970’s (Tokyo Round), trade imbalances have been allowed to develop, persist and grow to very large proportions in a non mutually beneficial way.

      Of course, there is no reason whatsoever that developed countries should prevent developing countries the means of their development.

      Symmetrically, there is of course no reason whatsoever that the development of emerging countries should be at the expense of developed countries, with only a tiny fraction of their population benefiting (those indexed on the profits of multinational companies headquartered in developed countries) while everybody else is hurt through wage pressure, job losses, rising debt load and rising taxation from the socialisation of losses (these socialised losses being the counterpart of the extra private profits accruing to multinational companies as a result of labor arbitrage gains).

      In fact, if was an explicit purpose of the GATT when signed in 1947 that trade liberalisation should be done on reciprocal and mutually advantageous terms (see attached document, page 1, which means cross exchange rates set at levels compensating relative differences in labour cost and productivity across countries so as to prevent the appearance and maintenance of large trade imbalances.

      This solemn objective – which had been satisfied from 1947 to the 1970’s – has since been “forgotten”. Financial liberalisation since the 1980’s has thrived on these trade and exchange rate disorders and has compounded them to make things worse. The one way direction of monetary policy towards ever more easing has also been fuel to the fire, exacerbating financial instability and allowing imbalances to grow ever bigger.

      This is extremely rarely – if ever – mentioned by policymakers as the explanation for the great recession of 2008-2009 (only those who have retired and have nothing to lose anymore – like Paul Volcker or more recently Mervyn King – seem to dare to speak up). Instead, we are told that the crisis is due to some exuberance in subprime lending in the US, to too high and too rigid wages in Europe, to weakness in the design of the Eurozone, etc. All of that is locally true but only in relation to the underlying and sine qua non factor of trade and exchange rates imbalances.

      Very few visionary economic thinkers saw it coming from very far and insistently rang the alarm bell. For instance, Maurice Allais spent all the prestige of its 1988 Nobel Prize warning about the dangers of this exact outcome. In vain.

      Now, as Michael Pettis explained, “The Great Rebalancing” is necessary to correct the situation. Unfortunately, the misguided policy response to the crisis – the monetary flight of the West and the gigantic, debt-funded, and partly unproductive investment program of China, both enthusiastically welcomed by financial markets – are significantly reducing the chances of a cooperative and orderly global rebalancing.

      • I agree with everything you said, but I am a bit more optimistic; wages are rising rapidly i n China (now much higher than Mexico); the recent crisis brought the surpluses down dramatically and jobs/wages here are increasing, however slowly; in other words, if you lived on the moon you would conclude that the system worked and continues to work, however slowly.

        • According to the International Labor Organization, total employment in developed economies (North America, Australia, Japan, European Union) went from 448m people in 2000 to 475m in 2013, an annual growth rate of only +0.4% consisting of a drop in agriculture and industry employment and an increase in services employment.

          In developing economies, over the same period, total employment went from 2.16bn to 2.67bn, so 500m people of developing countries have joined the global work force and all of this increase is attributable to employment in industry (+200m) and services (+350m) while the number of people employed in agriculture dropped by -50m. However, there are still 984m people employed in agriculture in developing countries and at least a portion of these jobs will continue to gradually migrate to the industrial sector over a long period of time.

          In other words, even if China successfully rebalance and step down the pressure on developed countries labor markets, there are still many countries that could and will take its place and role in the system.

          So, my point is: it’s better if this trend takes place within an appropriate international trade and exchange rate framework. Otherwise, we will continue to see global debt snowball relative to global production with the related adverse consequences whereby everybody loses in the end.

          • again I agree with everything you say until: “we need an international trading system .. .etc”. Japan’s debt or the European muddle are not functions of an inadequate int. trading system. China’s CAS, in my opinion, is an ongoing Chinese blunder which a cynical American administration is quite happy to allow to run its inevitable course; but again, those decisions are not functions of an inadequate trading system, which is a long way from perfect, but good enough and improving; something we should defend.

      • Import Competition and the Great U.S. Employment Sag of the 2000s

        Daron Acemoglu, David Autor, David Dorn, Gordon H. Hanson, Brendan Price

        NBER Working Paper No. 20395
        Issued in August 2014
        NBER Program(s): ITI LS

        Even before the Great Recession, U.S. employment growth was unimpressive. Between 2000 and 2007, the economy gave back the considerable gains in employment rates it had achieved during the 1990s, with major contractions in manufacturing employment being a prime contributor to the slump. The U.S. employment “sag” of the 2000s is widely recognized but poorly understood. In this paper, we explore the contribution of the swift rise of import competition from China to sluggish U.S. employment growth. We find that the increase in U.S. imports from China, which accelerated after 2000, was a major force behind recent reductions in U.S. manufacturing employment and that, through input-output linkages and other general equilibrium effects, it appears to have significantly suppressed overall U.S. job growth. We apply industry-level and local labor market-level approaches to estimate the size of (a) employment losses in directly exposed manufacturing industries, (b) employment effects in indirectly exposed upstream and downstream industries inside and outside manufacturing, and (c) the net effects of conventional labor reallocation, which should raise employment in non-exposed sectors, and Keynesian multipliers, which should reduce employment in non-exposed sectors. Our central estimates suggest net job losses of 2.0 to 2.4 million stemming from the rise in import competition from China over the period 1999 to 2011. The estimated employment effects are larger in magnitude at the local labor market level, consistent with local general equilibrium effects that amplify the impact of import competition.

  40. ^^DvD’s Question: What are the drivers of falling domestic labor share of income and rising income inequality since the early 1980′s?

    Answer (to my mind):

    (A) In the US, this is caused by globalization. This includes globalization of labor (immigration), globalization of production (offshoring) and globalization of trade in goods, services & capital (surpluses, deficits, debts etcetera).

    (i) Low-skill immigration puts downward pressure on the wages of lower-end blue-collar US workers. (Has happened for all of US history, which is by the Robber-Barons loved the arrival of Huddled Masses during the gilded age”)
    (ii) Offshoring of goods-production puts downward pressure on the wages of higher-end blue-collar US workers. (Started with socks & shoes in the 1950s, but accelerated sharply from 1980s after Deng Xiaoping brought China into the East-Asian export-to-US system)
    (iii) Offshoring of services puts downward pressure on the wages of lower-end white-collar workers. (Took-off during 1990s with rise of information age and global communication revolution)

    (I) Cumulatively, (i), (ii) & (iii) caused the wages of the US “middle-class” to be capped by global competition, whether by physical immigration or by trade-carried import of labor from the Third World. In effect, the wages of such US workers tends to rise slower than their productivity, or, in other words, such US workers get to keep a smaller fraction of what they produce because of their reduced “bargaining power”.

    (II) The only people in the US who are immune to this effect are people whose skills are rare to find in the Third World, and such people tend to be at the higher-end of US wage-income. The wages of such workers rise fast enough that they keep up with their productivity, because they have higher “bargaining power”. Note that I am including the salary-equivalents of people like Buffet & Gates in this category, regardless of whether they receive actual “wages” or not.

    (I) & (II) cause basic wage inequality, which is one component of income inequality.

    After accounting for this basic wage inequality, we note that the workers at the top wage range (see (II)) tend to have a higher marginal propensity to save (401-k etcetera). This leads to higher additional non-wage income for such workers. This non-wage income also rises faster because the other workers (see (I)) are keeping a smaller share of what they produce due to global wage-competition for their type of labor. Adding rising basic wage inequality to rising non-wage income inequality, we get rising overall income inequality in the US.

    (B) In the Third World, rising income inequality is a natural phenomenon associated with incipient capitalism. This happens because the mass migration of unwanted labor from the agricultural economy in the country-side to the urban industrial economy keeps wages from rising relative to production (due to wage competition from the labor surplus). This implies that non-wage incomes rises faster than wage-income and there is upwards pressure on total income-inequality.

    For poor countries where investments are savings constrained (like India), this is not a bad thing, as rising inequality leads to higher savings-rates, which can then be productively-invested to raise production and bring the country out of poverty (“supply side” or “trickle down” approach). On the other hand, for countries like China, where investment is NOT savings constrained (China runs a surplus), rising savings rates generated by the rising inequality would lead to either overinvestment or excessive surpluses– which is exactly as we are seeing in China today.

    Finally, we note that this labor surplus wage-competition in the Third World mentioned in (B) is the same phenomenon that acts as a downward pressure on certain types of US wages due to globalization, as explained in (A) above.

  41. ^^DvD’s Question: “And how does the US stop running trade and current account deficits? And how does the US could increase domestic wage and decrease trade deficit at the same time? Do you think that’s feasible?”

    Answer (to my mind):

    (A) The US has been running a consistent current account deficit. This implies, by definition, that aggregate demand is HIGHER than aggregate supply in the US. Under such circumstances, if the US uses wage increases or tax increases (or for that matter debt increases, as it has been doing for the last 30 years) to FURTHER increase aggregate demand, most of it will just “leak out” as a higher current account deficit (as has been happening for the last 30 years) to match the excess aggregate supply of the rest of the world.

    The mechanism of this “leak”, as you point out, would be that rising wages and rising taxes would make the US even more uncompetitive than it already is in terms of production costs, and so the current account deficit would automatically rise. Therefore, in the US, there is not much point (beyond short-term crisis fighting) trying to increase aggregate demand (whether through wages, tax-redistribution or Krugman’s debt) until the US current account deficit is eliminated or contained FIRST.

    (B) On the other hand, the countries that run current account surpluses (China, Germany et cetera), by definition, have aggregate demand that is LOWER than their aggregate supply. Under these circumstances, it is such countries that must use REAL-wage increases (including allowing currency appreciation, stopping wage-repression etc.) or tax increases to contain, reduce or eliminate their current account deficits FIRST. (Note that the deficits of the US would automatically reduce if this were to happen.)

    So when Michael says that the WHOLE WORLD must increase aggregate demand, he omits to mention the necessary sequence: The current account surplus countries must increase aggregate demand FIRST. This would reduce the deficits of the deficit countries automatically. Once balance has been restored, and demand no longer leaks out from the US, then further increases in aggregate demand in the US may be generated by proportionally-rising REAL wages (including exchange-rate balance) and rising tax-redistribution to keep up aggregate demand.

    (C) As long as it remains a “free market” system and has the de-facto international (or reserve) currency, we observe that the US cannot unilaterally get rid of its current account deficits UNLESS the surplus countries get rid of their surpluses. Whatever global surpluses cannot be absorbed elsewhere will eventually get dumped into the US. So how could the surplus countries get rid of their surpluses? Michael has explained this many times in his writings and lectures on China, Germany et cetera.

    • Agree.

      Looking at the policy response so far, the deficit country (US) that has excess domestic demand vs. supply has supported aggregate demand via the “wealth effect” for far longer than “short term crisis fighting” (money markets froze exactly 7 years ago…) while the surplus country (China) that has excess domestic supply over demand has increased capacity via its large debt-funded investment program. The Eurozone has closed its overall external deficit via lower internal demand, unacceptable level of unemployment and deflation. Doesn’t soundto me like addressing the situation. Quite the opposite, actually.

      So, the final question you have left unanswered to this point is: What can be done to address the primary causes of the situation and not only its visible symptoms?

      I have tried to put my answers in my comments to “Economic Consequences of Income Inequality”, the paragraph about “remedies”.

  42. ^^DvD’s QUESION: And what do you think is the origin of the “global savings glut”?

    ANSWER (to my mind):

    (1) SEVERELY imbalanced economy in China

    (2) Japanese-inspired mercantilist mind-set (Surpluses are “profits” and hence always good, deficits are “losses” are hence always bad)

    (3) Germanic theory of Economics of Social Aging (“run CAS now in order to run CAD later when our society ages”)

    (4) Post-97 fear of BOP crises in South-east Asia (almost over, won’t last much longer)

    (5) High oil-price generated surpluses in Gulf (since 2003, but probably won’t last much longer)


    ^^DvD’s QUESTION: “What do you think is the common denominator between all these aspects?”

    ANSWER (to my mind):

    Here is what should be the IDEAL case for sustainable international balances:
    (A) Developed (“rich”) countries, where productive investment is never constrained by savings, should run a small current account surplus (CAS). Developing (“poor”) countries, where savings are too low to fund the obviously-need investments, should run a small current account deficit (CAD).
    (B) This “natural” capital movement from “rich” to “poor” countries should preferably take the form of equity, and debt should be avoided. If at all debt is used, such debt should be preferably long-term, sparingly-used and judiciously-incurred to ensure that it is not of the unproductive kind (i.e. not for speculative, wasteful investment or consumption).

    But let us look at the global CAD/CAS statistics to see what is ACTUALLY happening today—

    (I) In the linked table, we can see that the LARGE surplus countries are:
    (a) The oil exporters (Gulf countries, Nigeria, Russia etc.), who naturally run surpluses because they cannot possibly consume or invest the kinds of revenue generated by their oil exports during high oil-price periods such as we have today. If oil prices fall, these surpluses will naturally reduce or even vanish.
    (b) The developed Germanic countries (Germany, Netherlands etc.). This is natural, as their domestic productive-investments are not constrained by domestic savings. Whether this is sustainable or not depends on who is absorbing their surpluses and how this absorption is being financed.
    (c) The recently-developed East-Asian countries (Korea, Singapore, Taiwan etc.). This is again natural, as their domestic productive-investments are not constrained by domestic savings. Whether this is sustainable or not depends on who is absorbing their surpluses and how this absorption is being financed.
    (d) The ONLY exception to this is CHINA. This is un-natural. It is very unusual for a relatively-poor, developing country to run such large surpluses for such long periods of time. This is a MAJOR anomaly and suggests a major imbalance. This is UNSUSTAINABLE.

    (II) On the other hand, the LARGE deficit countries listed in the table are:
    (a) The developed Anglo-Saxon countries (US-UK). These Anglo-Saxon countries are not naturally savings-constrained, and so it is unnatural for them to run large CADs for such a long time. As it turns out, they have been using their CAD to actually increase consumption, and they have been financing their CAD with debt. This is UNSUSTAINABLE.
    (b) India, which, as a developing country that is rapidly industrializing, is naturally savings-constrained. Scope for productive investment in India is something that is immediately visible. In addition, given that India’s external debt is about the same level as its forex reserves, it follows that India has been servicing its CAD mainly through equity, whether FDI or portfolio. This is a natural and sustainable CAD.
    (c) The developed Greco-Roman countries (France, Italy, Spain, Greece). These Greco-Roman countries are also not obviously savings-constrained. They have been using their CAD either to increase wasteful-investment (Spain) or consumption (Greece) or both, and they have been financing it with debt. This is also UNSUSTAINABLE.

    Note: Given that II(c) is linked to I(b), it follows from the unsustainability of II(c) that I(b) is NOT sustainable in its current form. Further given that II(a) is linked to I(c) & I(d), it follows from the unsustainability of II(a) & I(d) that I(c) is also NOT sustainable in its current form.

    Therefore, instead of the ideal, sustainable situation described above, what we are seeing today are the following un-natural and unsustainable arrangements:
    (A) Some developed rich-countries are running sustained surpluses against other developed rich-countries. This is a repeat of what happened in the run-up to the Great Depression.
    (B) Developing poor-countries are running sustained surpluses against developed rich-countries. This is a new phenomenon inspired either by BOP-crisis fears, or by the Japanese-inspired mercantilist mindset, or by uncontrolled imbalances developing inside such developing countries due to excessive state-control.

  43. Import Competition and the Great U.S. Employment Sag of the 2000s

    Daron Acemoglu, David Autor, David Dorn, Gordon H. Hanson, Brendan Price

    NBER Working Paper No. 20395
    Issued in August 2014
    NBER Program(s): ITI LS

    Even before the Great Recession, U.S. employment growth was unimpressive. Between 2000 and 2007, the economy gave back the considerable gains in employment rates it had achieved during the 1990s, with major contractions in manufacturing employment being a prime contributor to the slump. The U.S. employment “sag” of the 2000s is widely recognized but poorly understood. In this paper, we explore the contribution of the swift rise of import competition from China to sluggish U.S. employment growth. We find that the increase in U.S. imports from China, which accelerated after 2000, was a major force behind recent reductions in U.S. manufacturing employment and that, through input-output linkages and other general equilibrium effects, it appears to have significantly suppressed overall U.S. job growth. We apply industry-level and local labor market-level approaches to estimate the size of (a) employment losses in directly exposed manufacturing industries, (b) employment effects in indirectly exposed upstream and downstream industries inside and outside manufacturing, and (c) the net effects of conventional labor reallocation, which should raise employment in non-exposed sectors, and Keynesian multipliers, which should reduce employment in non-exposed sectors. Our central estimates suggest net job losses of 2.0 to 2.4 million stemming from the rise in import competition from China over the period 1999 to 2011. The estimated employment effects are larger in magnitude at the local labor market level, consistent with local general equilibrium effects that amplify the impact of import competition.

  44. ^^Dvd wrote: “I understand your point about “double-counting” financial debt into total debt. However, there is much more to this tricky question than just double counting….”

    Yes, you are correct. You wrote:

    A) FS_Liability = currency + deposits + financial debt + FS_equity + money market funds shares + mutual funds shares + pension liabilities + insurance liabilities

    B) FS_assets = NFS_debt + listed equities + private equity

    Where, FS= Financial Sector & NFS-debt = Debt of Non-Financial Sector HELD as assets BY the financial sector

    We note that:
    1) currency + deposits + financial debt = All_FS_debt
    2) pension liabilities + insurance liabilities = Either payouts from asset earnings or non-balance-sheet contingent liabilities
    3) money market funds shares + mutual funds shares + FS_equity= All_FS_equity
    4) listed equities + private equity = External Held_equity = EH-equity

    Therefore, we can rewrite (A) & (B) as follows:
    A) FS_Liability (RHS of balance sheet) = All_FS_debt + All_FS_equity
    B) FS_assets (LHS of balance sheet)= NFS_debt + EH_equity

    Using LHS = RHS of balance sheet, we get,
    All_FS_debt + All_FS_equity = NFS_debt + EH_equity, or,
    All_FS_debt – NFS_debt = All_FS_equity – EH_equity

    Therefore, we can conclude:
    (I) If All_FS_equity > EH_equity, then All_FS_debt > NFS_debt, and,
    (II) If All_FS_equity <= EH_equity, then All_FS_debt <= NFS_debt

    If (I) is true then SOME of Financial Sector debt should be added to the Total Debt statistics. The amount that should be added can be estimated as (All_FS_debt minus NFS_debt) or (All_FS_equity minus EH_equity).
    Alternatively, if (II) is true then the Total Debt statistics should NOT include financial sector debt, even though the concentration of risk (as you mention) implies that we should track the debt of the Financial Sector separately.

    Do you disagree?

    • ERRATA: There are a few SIGN (direction) errors in my comment above. To preclude any misunderstanding, I would like to rectify them to as follows—

      All_FS_debt – NFS_debt = EH_equity – All_FS_equity

      Therefore, we can conclude:
      (I) If All_FS_equity NFS_debt, and,
      (II) If All_FS_equity => EH_equity, then All_FS_debt <= NFS_debt

      If (I) is true then SOME of Financial Sector debt should be added to the Total Debt statistics. The amount that should be added can be estimated as (All_FS_debt minus NFS_debt) or (EH_equity minus All_FS_equity).

      • The Fed itself provides the answers buried within the pages of the Financial Accounts of the United States: for many years already, all financial debt needs to be added to US non-financial debt. Said differently, adjusted for double leverage, the US financial sector has negative net worth. This is the real reason why QE has been in place for most of the past 5 years: to keep asset values above the level necessary to make the financial sector appear solvent. Unfortunately, while it has worked in the 1950’s post WWII, in the current regime of unregulated finance and freely moving international capital flows, QE is self-defeating. The rising asset values and the moral hazard thus created make it irrestible for financial players to leverage up for profitable speculation. Deleveraging is simply not possible in that system and the financial sector remains in an underlying state of permanent insolvency.

        Obviously, this is not specific to the US, even though the better disclosure makes the analysis easier there.

  45. Dan Berg said above that “Japan’s debt or the European muddle are not functions of an inadequate international trade system … which is good enough and improving ; something we should defend.”

    Japan’s debt is largely the result of the inadequate international trade and monetary system (the trade and monetary sides are impossible to separate, they are the two sides of the same coin).

    In the 1980’s, Japan was assuming China current place in the system as the main trade surplus country recycling its accumulated monetary reserves mostly in the US (US total debt to GDP took off from 1982 after 35 years of stability). In 1985, the Plaza Accord decided to appreciate the Yen vs. the US$ to rebalance the trade side. The Yen indeed appreciated sharply. But that’s when the duplication of credit inherent to the system went into play and the monetary side went off-balance to counteract the attempted rebalancing of the trade side: after having been used once already to finance US deficits, Japan monetary reserves forming the base of its own fractional reserve banking system began to be used a second time. Easing by the Bank of Japan, doing “whatever it takes” to cushion the economy from the appreciating Yen, triggered a spectacular credit boom in Japan from the mid1980’s. Thus began a massive speculative bubble in Japan concentrated in real estate and equities. The Nikkei tripled in 4.5 years. Real estate prices went through the roof. The bubble peaked in 1989 and burst in 1990, asset values dropped sharply, leaving the debt behind. The resulting “balance sheet recession” has been on-going since then despite quasi permanent stimulative Government budget, 20 years and counting of 0% interest rates and several attempts at quantitative easing. The supposed aggregate demand benefits of all these measures never materialised, leaving even more debt behind. In the early 1980’s, Japan had a pristine balance sheet (the real kind of AAA rating, now extinct). In 1990, after 5 years of dramatic credit expansion, Japan’s non-financial debt reached 227% of nominal GDP. At the end of 2013, it was 390%.

    It is in fact a highly predictable outcome of the system that after two economic cycles, both the debtor country and the creditor country will find themselves over-indebted. The debtor country will first go into excess debt during the first cycle as it accumulates deficits financed by the trade surplus country. As debt grows, growing debt service will tend to put pressure on discretionary spending, provoking the first economic slowdown. As a result of this slowdown, the imports of the trade deficit country will grow more slowly during the second economic cycle. This naturally tends to rebalance net trade. To avoid the slowdown in growth from the forced trade rebalancing, the creditor country will then find it impossible to resist the temptation of using its accumulated monetary reserves to unleash a domestic credit boom. The over-investment and speculative excesses will fade after a while as returns fall and debt rise, thereby provoking the second cyclical slowdown, after which the creditor country will also find itself in too much debt. This is precisely what China is now finding out.

    The rise and fall of Japan as the first major creditor country in the post Bretton Woods / Tokyo Round system ; the rise and fall of China now as the second major creditor country of the system (hopefully, China will be “Avoiding the Fall) ; the continued leveraging up of the US as the main debtor country at the center of the system ; it all goes to show just how inadequate (is “dysfunctional” too strong a word?) the current international trade and monetary system is. It is a lose-lose system whereby everybody ends up in excess debt.

    As for the Euro Area, it is doubly complicated: an inadequate regional system within an inadequate international system.

    There is no more urgent task than to profoundly reform this system if we are to avoid a “balance sheet recession” engulfing the entire world. Indeed, this would be the logical outcome of the system after just a few more iterations. The system, as such, is un-defendable. Which is not at all saying that we should all go back to protectionism. It is simply saying that we collectively have to make sure to have a balanced, self-financed and cooperative international trade and monetary system. A win-win system.

    • This is how Shakespeare put it:

      “Neither a borrower nor a lender be;
      For loan oft loses both itself and friend,
      And borrowing dulls the edge of husbandry.”

      A) “For loan oft loses both itself and friend”
      Germany has lost the money it loaned Spain/Greece it is unlikely to get paid back. In addition, the pain there now has caused tremendous ill-will towards Germany, and so it looks like Germany has lost its friends as well.

      B) “And borrowing dulls the edge of husbandry”
      The borrowing in Spain encouraged bad behavior like waste & conspicuous consumption, and in Greece it caused excessive gluttony & sloth, thereby weakening the social fabric of both countries.

      It look like Shakespeare, writing way-back in the 16th century, was right after all.

      • Ha ha maybe, but most people don’t know that Shakespeare owed money to the tax authorities, was known to be an avid and pretty greedy moneylender, and in 1598 was prosecuted for hoarding grain during a time of shortage. “Do as I say, not as I do” is, I guess, one of the few well-known quotes that doesn’t come from the Bible, Mark Twain or Shakespeare himself (I believe it comes from a near-contemporary, John Selden), but it might as well have come from the Bard.

        • So Shakespeare was a two-faced piece of shit with little character. That’s good to know.

        • Speaking of the Bible, Jesus said, “love your enemy”; and yet he smashed the tables** of the money-lenders in the temple.

          Was this violence on the part of Jesus an example of “do as I say, and not as I do”?

          Superficially, yes; but upon reflection, there is more to this. For example, there are plenty of doctors who counsel their patient to live healthier lifestyles, and yet they smoke themselves. Should their patients then mock them for this “double-standard” and say ‘physician heal thyself’ or ‘practice what you preach’ ? Or should they take the advice in the spirit in which it was meant?

          Demonstrated wisdom in preaching should not preclude being fallibly-human or even having weakness in personal practice. In the example above, Jesus was human; he had weaknesses, and he made his mistakes. But his violent smashing of the tables in the temple does in no way devalue his message that we should love our enemies. Surely, it is the message that is importance, and not the man and his foibles.

          Something for a world drowning in debt to think about.

          **Note: As you know, the word “bank” comes from the Latin word for “table/bench/counter”, and is related structurally to terms like “river bank”. So Jesus was actually attacking the banking system and probably created a MASSIVE financial crisis there in Jerusalem of 70 AD.

          • We are straying a little from the topic, Vinezi, but I don’t think Jesus had much do with a crisis if it occurred in 70 AD because he is supposed to have died around 33 AD. There is, however, an interesting connection here that maybe some other readers can help flesh out. Several times on this blog, when I discuss how similar financial crises have been throughout history, I have mentioned the first, really well-recorded financial crisis in history (there were many earlier ones, but not nearly as well documented).

            This occurred under Emperor Tiberius in 33 AD, and it was only when Tiberius, acting on good Walter Bagehot advice 1800 years before Bagehot’s book, took on the role of the central bank by lending out (if I remember right) 100 million silver sesterces of his money against good collateral, that he was able to stop the panic. Like all such crises it was preceded by a substantial asset and real estate bubble which drew in money from all over the empire. I don’t know enough to say, but I wouldn’t be surprised if hatred of moneylenders in 33 AD Jerusalem was due in part to the Roman bubble.

          • ^Michael Pettis WROTE: “…..Jesus…is supposed to have died around 33 AD……..the first, really well-recorded financial crisis in history …..occurred under Emperor Tiberius in 33 AD…..”

            I am not a historian, and so I will defer to you as to what happened where and when. As the risk of deviating even further from the topic, however, here is something for all of us to think about :

            STEP 1) A huge debt-bubble begins to develop in that area around that time.
            STEP 2) Jesus goes around warning people about the fact that the Laws of Moses frown on debt/usury.
            STEP 3) The debt-bubble bursts; a massive financial crisis follows; multitudes lose their savings.
            STEP 4) The people are hurting from the crisis and are looking for someone to blame.
            STEP 5) Somebody says that it was the negative-preaching of Jesus against debt that CAUSED the crisis.
            STEP 6) The mob needs a scapegoat and begins baying for his blood. Jesus get crucified.
            STEP 7) Christianity is launched and, surprisingly, goes on to become the pan-European common-religion.
            STEP 8) Over the centuries, this common-religion slowly leads to a sense of common pan-Europeaness
            STEP 9) The EU is formed as an expression of this pan-Europeaness and the EURO is launched in 1999.
            STEP 10) Go to STEP 1)

            Does this sound like a plausible 2000-year ‘cycle of history’ to the other readers on the forum? If so, who does the mob in Europe want to crucify this time? Merkel? Trichet? Any views?

  46. Japan is a good example of what happens when bad debt is socialized by the government, put simplistically, the LDP spent a lot of time and trouble bailing out its zombies, to the end result that while Japanese corporate debt has fallen by around 50%, the Japanese government debt level has doubled.

    I am more sanguine, however, about the Chinese economy. While the decision to unleash stimulus, or at least stimulus to this degree, can be considered questionable, China was actually in a state of underinvestment when you consider capital goods at 4% depreciation and 12% GDP growth with a 3:1 ratio before the global economic crisis kicked in. It’s only been since the crisis that investment has been outpacing GDP growth + asset depreciation.

    Regarding debt in general, while the level of debt to GDP has risen and can be expected to continue to rise for the next couple of years, the rate of debt accumulation is actually decreasing as a percent and looks as though it will zero by 2018 with a total debt level of about 310% to 320%.

    The key way of getting through this, however, seems to lie in SOE reform rather than drastic economic restructuring. One of the multiple problems with the Chinese GFC response was that stimulus and restructuring benefited SOEs disproportionately at the expense of the private sector, which was also rather in tow to exports. The SOEs comprise a massive drain on the economy through inefficient use of capital and lower, if not negative, TFP growth relative to private sector entities.

    Dr. Pettis in the original post mentions the possibility of 5% growth in the case of transfers from the state sector to households, is this what we’re seeing in the present situation with attempts to increase private ownership of SOEs? And what happens if China opts for double reforms, i.e, a decision to both drastically cut money supply growth and force SOE privatization at the same time? What about a more moderate version of double reforms?

  47. Surely the bad debt could be socialized by *writing it off* — paying it off with newly printed money (inflating it away), or a jubillee cancelling the debt, or generous bankruptcies defaulting on the debt…

    The only way to socialize the debt is to default on it, but it’s really easy to do that. Is this what you mean?

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